What is the High-Tax Kick Out?
High-Tax Kick Out (HTKO): The High-Tax Kick Out impacts the way the Foreign Tax Credit is applied. Generally, U.S. persons who pay tax on foreign passive income can claim a foreign tax credit. In some countries, their tax rate on the type of income is significantly higher than the tax rate in the U.S. If applied in full, it may lead to an artificial tax reduction of U.S. Taxes — which the IRS does not support. In these types of situations, the Foreign Tax Credit in the passive category is “kicked out,” and move over to the general category on your Form 1116.
HTKO is a very complicated topic. The key takeaway from this post is to simply understand how to recognize the issue.
High Tax Kick-Out & Form 1116
As with most unnecessarily complex tax issues, it may help to better understand this concept through example.
High Tax Kick Out Example
David is a high-income U.S. person who owns a rental property overseas. He received the home many years ago as a gift. When a person receives a gift (vs. an inheritance) there is no “step-up basis.” In other words, they take it at a Transfer Basis plus Gift Tax Paid.
In this example, David’s father purchased the home for $100,000. When he gifted it to David, it was worth $800,000.
When David receives the land and sells it at a later date, he will have to pay foreign Capital Gain on the difference between the basis he received it at $100,000 (plus any gift-tax paid) and sold it at (let’s assume he sold it for $1.5 Million)
**Alternatively, if David had received it as an inheritance in a year it was worth $800,000, David, would have received a stepped-up basis value, so that his basis would be $800,000 and the resulting gain & tax liability would be significantly less.
Reporting the Tax Credit
Since David is a U.S. person, he must report the sale on his U.S. Tax Return as well. David reports the tax credit in the U.S. for his foreign property sale the same way he would ordinarily do, on Form 1116. He reports the sale on Schedule D, along with any rental income in the same year that was earned prior to the sale, on Schedule E.
David claims the Foreign Tax Credit on Form 1116. Unfortunately, in this scenario, the amount of the Foreign Tax Credit is limited.
Understanding the High-Tax Kick-Out (HTKO)
HTKO is the result of paying too high of a tax rate on the Foreign Taxes.
In other words, the IRS wants to prevent any artificial reduction of the tax liability in the U.S. (especially when there are multiple foreign tax credits being applied from different countries, that each have different tax rates). It achieves this by disallowing the tax credit (or rather, re-categorizes the tax credit).
What is Considered a High Tax?
In some cases, passive income and taxes must be treated as general category income and taxes. Generally, passive income and taxes must be treated as general category income if the foreign taxes you paid on the income (after allocation of expenses) exceed the highest U.S. tax that can be imposed on the income.
However, passive income that is financial services income is treated as general category income regardless of whether it is high-taxed income. See Pub. 514 and Regulations section 1.904-4(c) for more information.
High Tax Kick Out As Applied
Long-Term Capital Gain (LTCG): In the United States, when a person is in the highest Tax Bracket, they will pay 20% LTCG. Thus, the highest tax rate for Long-Term Capital Gain is 20%. If David paid 50% for Foreign Long-Term Capital Gain Income he earned abroad, the general rules is that the credit cannot be applied as a Passive Income credit.
Rather, it is shifted to the “General Category Income.”
*There are two schools of though on this issue, as to whether the “highest U.S. tax that can be imposed on the income” refers to the highest Tax Rate of any type of income 39.6% (General Income) or highest tax rate of the category of income (aka 20% for Long-Term Capital Gain).
A Further Explanation, Sort Of…
This type of information is dense, even to the most seasoned of tax professionals. We will try to provide a breakdown of the IRS analysis to “maybe” try to make it more palpable.
Here is a breakdown the IRS Regulation. The analysis moves from from General-to-Specific.
First, the term passive category income means passive income and specified passive category Income. Passive income does not include…high-taxed Income
What is High-taxed income?
“The term “high-taxed income” means any income which (but for this subparagraph) would be passive income if the sum of—
(i) the foreign income taxes paid or accrued by the taxpayer with respect to such income, and
(ii) the foreign income taxes deemed paid by the taxpayer with respect to such income under section 902 or 960, exceeds the highest rate of tax specified in section 1 or 11 (whichever applies) multiplied by the amount of such income (determined with regard to section 78).
(1)In general. Income received or accrued by a United States person that would otherwise be passive income shall not be treated as passive income if the income is determined to be high-taxed income.
Income shall be considered to be high-taxed income if, after allocating expenses, losses and other deductions of the United States person to that income under paragraph (c)(2)(ii) of this section, the sum of the foreign income taxes paid or accrued by the United States person with respect to such income and the foreign taxes deemed paid or accrued by the United States person with respect to such income under section 902 or section 960 exceeds the highest rate of tax specified in section 1 or 11, whichever applies (and with reference to section 15 if applicable), multiplied by the amount of such income (including the amount treated as a dividend under section 78).
If, after application of this paragraph (c), income that would otherwise be passive income is determined to be high-taxed income, such income shall be treated as general category income, and any taxes imposed on that income shall be considered related to general category income under § 1.904-6.
If, after application of this paragraph (c), passive income is zero or less than zero, any taxes imposed on the passive income shall be considered related to general category income.
*As with any tax situation, there are exceptions and exclusion; in addition, grouping rules apply.
If you are in a position where you are considering using a Foreign Tax Credit for Foreign Income which is at a high tax rate, you should consider speaking with an experienced tax professional.
If you are considering an IRS Offshore Voluntary Disclosure application and have high-taxed income abroad, it is very important to speak with experienced Offshore Disclosure counsel to review this issue, along with the countless of other issues you may come across.
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