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Monday, 22nd April 2024
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Foreign Tax Credits Back  
Exposure to taxation in more than one country is a routine risk for an international financial services firm. The foreign tax credit regime is one of the principal means of redressing double taxation. The Finance Act 2004 has improved our foreign tax credit regime in respect of double taxation of dividend income.
Double taxation
Double taxation can occur where a financial service operator in Ireland does business or transacts with somebody established in an overseas country. That other country may levy tax in relation to the transaction eg on an interest payment, a dividend, an insurance premium or even on a lease payment. The same items will be taken into account in computing the trading profit of the Irish recipient and can thus be exposed to taxation in two countries.

This problem is partly avoided in so far as double tax agreements allocate taxing rights between the contracting states. The usual pattern is to provide that only the country in which the recipient is resident should tax interest, but to allow both countries (that of source and of the recipient) to tax a dividend within certain limits. Other types of income can similarly be allocated to one of the contracting states, or be taxed by both within certain limits. There is no uniform treatment as treaties differ from each other in detail.
Where both countries are permitted to levy taxation, then a double taxation situation arises.

The remedies
Once double taxation does arise, a remedy may be available from two sources ie by means of a tax credit and/or a tax deduction. Usually, where a double tax agreement is applicable, it will provide that the country in which the recipient is resident must grant credit against its taxes for any foreign tax. The EU Parent Subsidiary Directive, in the specific area of intra EU dividends from substantial holdings, may also require that Ireland grants a credit for foreign tax.

Irish domestic law fully implements the Parent Subsidiary Directive and the provisions of treaties as regards the giving of tax credits. In fact, in the area of dividends from shareholdings of 5p.c. or more, it goes much further than this, and also gives relief even where there is no double tax treaty.

The EU Interest and Royalties Directive, when fully operational in all EU member states, may permit payment of interest and royalties free of withholding tax between associated EU companies.

Irish domestic law also gives a tax deduction (ie a deduction as an expense of earning the income) for any part of foreign tax for which a credit cannot be given eg because the foreign tax exceeded the effective Irish tax on the same income. Where no foreign tax credit is available eg in respect of royalty income taxed in a country with which we do not have a double tax agreement, the foreign withholding tax is treated as a deduction in computing Irish taxable income.

Dividends different
The foreign tax credit system, particularly after the Finance Act 2004, deals more generously with dividends than with any other type of foreign source income. Generally all dividends attract foreign tax credit relief, even in the absence of a double tax agreement provided only that they are derived from a 5p.c. or greater holding.

The only foreign tax for which a credit is granted in respect of interest or similar payments received in Ireland is a direct foreign tax charge on that interest. This is usually imposed by a withholding tax. In contrast, in the case of a dividend, a credit is granted not only for any withholding tax, but also (subject to the dividend being from a 5p.c. or greater holding except in a number of cases where a treaty eliminates the minimum holding) the credit may be in respect of underlying tax paid by the foreign company on the profits out of which it paid its dividend.

Finance Act 2004 (subject to EU approval which is pending) has ensured that the foreign tax on the underlying profits out of which the dividend is paid will take into account not only federal taxes, but also state taxes, provincial taxes and municipal taxes, where they are levied on profits.

If the withholding tax suffered on an interest or similar payment exceeds the Irish corporation tax attributable to that income, the excess cannot be relieved as a credit against Irish tax on other interest receipts which may have borne lesser or no foreign tax. In contrast, if the credit available in relation to a foreign dividend exceeds the Irish tax on that dividend, the surplus may be offset against Irish tax on other foreign dividends to the extent not covered by credits on those dividends. The surplus credit can be carried forward to future years for offset against Irish tax on foreign dividends in those future years.

Therefore, the foreign tax credit relief granted in respect of a dividend is significantly more generous and valuable than in respect of any other form of income including interest.

Difficult areas
The legislation in relation to foreign tax credits is mainly in Schedule 24 of the Taxes Consolidation Act 1997. It is widely regarded as a complex piece of taxation legislation which leaves a number of grey areas such as the determination of the Irish tax attributable to any particular foreign income item eg interest or dividends.

One step in that calculation is to calculate the amount of the taxable income in question and that involves decisions on the allocation of expenses amongst the items of revenue. The legislation does not provide clear guidance in this area. In certain circumstances the Revenue Commissioners will agree that major expenses which relate directly to specific transactions will not be apportioned pro rata over all transactions but can be directly attributed to that income.

The legislation itself permits charges (principally certain interest payments on borrowings to finance strategic investments) and other reliefs to be apportioned amongst income items entirely at the taxpayer’s discretion, even if they might commercially be related to the foreign item of income. Generally the taxpayer will be seeking the maximum portion of his Irish tax to be attributed to the foreign item of income, so as to maximise the amount of foreign taxes which he may credit against this Irish tax. Therefore in general it is in the taxpayer’s interest to have charges allocated for these purposes against income which did not attract foreign tax credits.

There can also be difficulties in the calculation of the amount of foreign tax for which credit can be claimed. There is no ambiguity where the tax in question is a direct tax on the dividend or interest. It is more difficult however to determine the amount of underlying tax on the profits out of which a dividend is paid. That requires one to relate the dividend to the profits of a particular period, and to then determine the foreign tax appropriate to that particular period. The ability to relate the dividend to the profits of a particular period, and in particular of a period with a high tax charge, may be dependent on whether or not the dividend was declared by the company to be in respect of a period. Not all foreign dividends are declared in this fashion. If the dividend is coming from a company over which the shareholder has substantial control, it may be possible to ensure that the dividend is declared in this fashion.

Planning
Foreign tax credits can make the difference between paying Irish tax, and not paying Irish tax, on a particular item of income. Even at the 12.5p.c. corporation tax rate applicable where an item of income is a receipt of a trade, the Irish tax can make a substantial difference. This is even more obviously the case when the tax rate is the 25p.c. applicable to non-trading income including most foreign dividends.

Although generally taxpayers seek to minimise tax, paradoxically in the case of foreign tax credit planning the objective is to identify the maximum possible amount of both foreign tax and Irish tax! This is not the same as saying that the taxpayer is setting out to pay more tax, but rather that of the tax which is paid, both abroad and at home, the maximum amount is attributed to the item of foreign income which can attract foreign tax credit relief, as opposed to being attributed to other income items that do not attract foreign tax credit.
It may be possible to ensure that the dividend is paid from profits to which, as far as possible, foreign underlying tax is attributable. One area of ambiguity relates to whether deferred tax should be taken into account as a foreign tax in respect of profits from which a dividend is paid. The matter is not beyond doubt but generally the credit tends to be restricted to the actual foreign tax payments in a period without regard to deferred tax.

The significantly more generous foreign tax credit regime applicable to the dividends compared to interest may suggest that where there is a choice between receiving a dividend or receiving interest, that the receipt of a dividend may be a preferable solution, provided the conditions for a foreign tax credit (generally a minimum holding of 5p.c.) are met and subject to any additional withholding tax cost. One certainty however is that for financial service operators in particular, foreign tax credits deserve close attention and planning.

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