In an International Practice Unit (IPU), the IRS explains how it determines that a taxpayer has exhausted administrative remedies for a foreign tax for purposes of the tax being considered creditable.

Both the U.S. and foreign countries may tax the foreign source income of U.S. taxpayers. To ease this double taxation burden, most U.S. taxpayers who pay income taxes to a foreign country can either deduct the taxes from gross income for U.S. purposes or credit them dollar for dollar against their U.S. income tax liability on foreign source income.

To be eligible for the credit, foreign income taxes must be compulsory — required under the competent authority of a foreign government. Penalties, fines, interest, customs, duties, etc., aren’t taxes and aren’t creditable. In addition, paid foreign taxes that exceed what is legally required under foreign law also aren’t creditable.

What Compulsory Means

According to the IPU, in general, the amount of foreign taxes paid is compulsory if:

  • The amount was determined using a reasonable interpretation and application of the foreign tax law, and
  • The taxpayer has exhausted all effective and practical remedies to reduce his or her foreign tax liability over time.

When determining whether taxpayers have exhausted all remedies, IRS examiners are instructed to consider whether:

  • It’s reasonably certain the payment will be returned (in a refund, credit, etc.),
  • The taxpayer pursued all available means to obtain the refund or credit,
  • There was a foreign income tax audit which could be contested on several levels, and
  • The taxpayer’s efforts to contest an issue with the foreign tax authority through available channels were adequate and comprehensive.

Proving Exhaustion

Taxpayers have the burden of proof to show that they’ve exhausted all remedies to contest their foreign tax liability. Examiners are instructed, however, to keep in mind that taxpayers may ordinarily take a “reasonable business approach” and aren’t required to pursue ineffective remedies. In determining that remedies wouldn’t be practical or effective, taxpayers should be prepared to demonstrate the basis for the decision.

A taxpayer must exhaust all practical local law remedies (within the foreign statute of limitations) to reduce their foreign tax. Taxpayers also should ascertain whether they may be eligible for any tax amnesty the foreign country may offer. But they should also keep in mind that accepting a foreign tax amnesty may deprive the competent authority of the chance to negotiate a better settlement, which could render such taxes noncompulsory. A similar effect could happen if taxpayers settle a dispute on their own accord.

Effect of Tax Treaties

If a reduced treaty rate applies, the taxpayer must claim the reduced rate. Taxpayers that operate in treaty countries are also generally required to request competent authority assistance. Any act or omission that precludes help from a competent authority may constitute failure to exhaust all remedies, which could render the taxes noncompulsory.

If a taxpayer seeks assistance but obtains no relief, the taxpayer must still demonstrate exhaustion of other administrative and judicial remedies in the foreign country for the tax to be compulsory. In this case, and in other situations where the taxpayer claimed to have settled the case themselves, examiners are instructed to request copies of all documentation and consult the competent authority.

If a taxpayer in a treaty country doesn’t invoke the right to competent authority assistance, this failure will, in most cases, preclude exhaustion of remedies.

Possible Deduction for Noncreditable Taxes

The IPU clarifies that, even if foreign taxes aren’t treated as tax payments under exhaustion of remedies principles, a taxpayer may still be able to take a deduction (rather than a credit). However, because the payment isn’t an amount of tax paid, a taxpayer would need to establish it was an “ordinary and necessary” expense.

For a no-obligation discussion on the possible impact and steps you should take now, contact Lien Le, the head of our International Tax practice.

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