F1116 allocation of foreign taxes paid using formula from IRS, confused by IRS call with rep

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rne
Posts: 6
Joined: Thu Oct 07, 2021 8:00 am

F1116 allocation of foreign taxes paid using formula from IRS, confused by IRS call with rep

Post by rne »

I recently spoke with an IRS representative who seemed pretty well versed in the intricacies of the foreign tax credit (f1116). They described deriving the foreign tax paid in Part II on a category of income that seems to run counter to what I've read in the instructions for the form and Pub. 514 and hoping someone can help clarify if there is a definitely right or wrong way of deriving this breakdown.

The rep said that in order to calculate correct tax that was paid to a foreign country an algebraic formula would be needed to properly allocate the tax based on the foreign tax code (e.g. CRA taxes capital gains income at half the rate of wages). Using a simplified example with the following amounts:

75k wages
25k interest/foreign dividends
100k capital gains
50k tax owing to CRA

75000x + 25000x + (100000/2)x = 50000
x = 0.3333 = 33.33%
25000*0.3333 = 8333.33 <- tax paid on passive income

This seems to run counter to Pub 514 instructions on "Allocation of Foreign Taxes" which seems to take a more straight forward proration: "multiplying the foreign income tax related to more than one category by a fraction. The numerator of the fraction is the net income taxed by the foreign country in a separate category. The denominator is the total net income." They also include an example (although their example deals with income taxed at the same rate), but for the simplified values used above it would be:

75000x + 25000x + 100000x = 500000
x = 0.25 = 25%
25000*0.25 = 6250.00 <- tax paid on passive income

The IRS rep's interpretation seems to be more advantageous and they admitted as much, but do you think it is safe to use? I did notice this as well in the same Pub 514 section:

"Because the foreign tax is not specifically for either item of income, you must allocate the tax between the wages and the interest under the tax laws of Country A. For purposes of this example, assume that the laws of Country A do this in a manner similar to the U.S. Internal Revenue Code."

Country A here being Canada, of course. Given this above statement it seems to lend weight to the idea that you would calculate tax allocation based upon the CRA's tax policies instead of a simple proration, but I was hoping someone had more direct experience with this. It is easy with a simplified example, but with something like eligible dividends and federal dividend tax credits mixed with the BPA tax credit it could get complicated.

thanks
nelsona
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Re: F1116 allocation of foreign taxes paid using formula from IRS, confused by IRS call with rep

Post by nelsona »

When there is published guidance, never trust what a telephlunkie says.
nelsona non grata. Non pro. Please Search previous posts, no situation is unique as you might think. Happy Browsing :D
rne
Posts: 6
Joined: Thu Oct 07, 2021 8:00 am

Re: F1116 allocation of foreign taxes paid using formula from IRS, confused by IRS call with rep

Post by rne »

haha that's true, though i've always had better success with the intl/overseas reps. I guess the issue here is that the guidance doesn't go enough in detail, their example uses two forms of income that are suggested to be taxed at the same rate.

if there was actual withholding on wages, interest, dividends, capital gains/loss, etc the amounts would not be contested and would reflect the effective tax rates being applied. therefore it seems safe to assume that if you can accurately derive the actual tax rate being applied to the income you would extract the correct amount of taxes paid and should use this amount or default to the simplified formula if in doubt.

I think the key part of Pub 514 is this line: "you must allocate the tax between the wages and the interest under the tax laws of Country A." I would think that treatment should be extended to all forms of income even if not included in the specific simplified example and so it makes sense that the effective tax rate would be different for incomes taxed differently by the CRA. As long as the total tax paid per category of income adds up to total tax paid to the foreign country then it seems like it should be passable. But who knows, I'd be interested if there was a specific case where this came up and the specifics ironed out.
nelsona
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Joined: Wed Oct 27, 2004 2:33 pm
Location: Nowhere, man

Re: F1116 allocation of foreign taxes paid using formula from IRS, confused by IRS call with rep

Post by nelsona »

Never heard of ANYONE being questioned on allocation. Especailly Cdn, who almost always have tax that they have leftover to carryforward.
Still wondering why you would have even bothered calling IRS on this.

You are using CDn rules to determine "gross" income. There are three types of allocation:
1. Ordinary income, wages, interest, whatever. Every dollar taxed.
2. Cap gains. Half of every dollar taxed.
3. Dividends. Apply the dividend tax credit.

Using your example,

your gross income was
75K + 25K + (half of 100k) = 150k

Your tax was 50K,
so wages get 25K Cdn tax
Interest and dividends get 8k
Cap gains get 17k

Plug that in your tax softwars and your 1116s (one genreal, one passive) will be fine.
nelsona non grata. Non pro. Please Search previous posts, no situation is unique as you might think. Happy Browsing :D
rne
Posts: 6
Joined: Thu Oct 07, 2021 8:00 am

Re: F1116 allocation of foreign taxes paid using formula from IRS, confused by IRS call with rep

Post by rne »

Great! Those are the same amounts returned on the first IRS recommended formula, so I think that makes a lot of sense and then the dividends would have the dividend tax credit applied and everything should add up to the same tax paid just apportioned/allocated the way the CRA would tax it. I don't think it would make a difference to allocate the BPA.

You are right to wonder why it would be worth making the call to figure this out and it is based on an unusual tax situation. the tldr version would be that i have a much greater share of capital gains income that is taxed by the CRA, but not by the IRS. With the simple allocation the effective tax rate on the IRS taxable income is low, but using the recommended IRS allocation I can claim double the credit for that smaller amount of income that is taxed by the IRS.
rne
Posts: 6
Joined: Thu Oct 07, 2021 8:00 am

Re: F1116 allocation of foreign taxes paid using formula from IRS, confused by IRS call with rep

Post by rne »

also, thanks a lot for your help! it feels like Serbinski should be compensating you for making these forums so helpful!
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