What Does HTKO Mean?
HTKO stands for High Tax Kick Out. It is a provision of the tax code that applies when the effective tax rate for foreign source income allocated to the passive category exceeds the greatest United States tax rate. When this happens, the high-taxed income is moved from the passive category and into general income.
Why is the HTKO Rule Important?
The HTKO rule is important because it can have a big impact on your taxes. If you have foreign income that is classified as passive, you may be subject to higher taxes if the HTKO rule applies. This is why it’s important to understand the HTKO rule and how it works.
Who Must File IRS Form 1116?
The HTKO rule, and IRS form 1116 applies to taxpayers who have foreign income that is classified as passive. If you have this type of income, you need to be aware of the HTKO rule, IRS Form 1116, and how it could impact your taxes. Before you fill out Form 1116, you will need to classify your foreign income by category. Currently, there are a few different categories for calculating foreign tax credits. They are Passive Income, General Income, Foreign Branch Income, and GILTI Income.
The High Tax Kickout rule will apply when the effective tax rate for foreign source income allocated to the passive category exceeds the greatest United States tax rate. Based on this rule, the high-taxed income is moved from the passive category and into general income. An attorney who specializes in reporting offshore assets is your only real sources of good advice regarding High Tax Kick-Out; this is simply the panoramic view.
How Does High Tax Kick Out Work?
The high-tax kickout rule applies when the tax rate on income from foreign sources that is put in the “passive basket” is higher than the tax rate on income from all other sources. This rule kicks out the high-taxed income and moves it to a different category. The main impact of this rule is that it stops money from being counted twice within the “passive basket.”
This means that if a company earns income in a country with a higher tax rate than in the United States, that income will no longer be able to reduce the taxes that the company pays on other income sources that are taxed at a lower rate. Second, the high-tax kickout prevents companies from manipulating how they allocate their expenses so they can pay less tax on their profits. This helps ensure that companies do not use cross-crediting to avoid paying taxes on their profits.
What Is High Taxed Passive Income?
High taxed income is not necessarily millions of dollars invested abroad–it’s simply passive income taxed by a foreign government at a higher rate than the highest US income tax rate. This foreign source of income is classified as “general category income” and is eligible for the Foreign Tax Credit on IRS Form 1116.
The Secretary of State has deemed some foreign taxes ineligible to be claimed as foreign tax credits on your US 1040. If you’re doing business with countries that support international terrorism–North Korea, Iran, Cuba–there’s no tax break from Uncle Sam. On the other hand, if you’ve been an expat living in France, the Foreign Tax Credit limitation was removed last year, and any American whose FTC in Form 1116 didn’t completely offset their US taxes at any point in the last ten years can amend their returns and file for a refund. Talk to your tax advisor about Form 1116 and the carryover of foreign income from prior years.
How Foreign Passive Income Is Treated
Passive income does go in the passive category. But countries have different tax rates, so chances are you would pay a higher rate in Country A than in Country B. Averaging those taxes allows the taxed income from Country A to offset the income from Country B, if it were as simple as that. Since the IRS is involved, it’s not that simple.
The IRS wants as much from you in taxes (paid or accrued) as they can get, so they limit the foreign tax credits you earn from high-taxed foreign passive income. If the passive foreign income is taxed at a higher rate than the maximum applicable US rate, the income “kicks out” from the passive category. The foreign source of income then goes into a separate category and is taxed accordingly.
HTKO Groupings
Because this is the IRS and they are fond of chapters and subchapters and sub-subchapters, there are three primary groups the high taxed income can kick into, and further exclusions after that.
- The first general grouping is the default, and is categorized by withholding tax rates.
- The second group is focused on dividends and inclusions from Controlled Foreign Corporations (CFCs), dividends from noncontrolled Section 902 corporations, and income from foreign Qualified Business Units (QBUs). A QBU is a taxpayer who independently compute their individual income and loss, usually in a non-USD currency.
- Finally, certain rents and royalties, income from partnerships, and income or loss from currencies comprises the third group.
Subsections of General Grouping
Since the general grouping only has the withholding tax rates as its guide, the IRS decided to separate that into four more groups. Keep in mind these rates are only for passive income, and the rate test is applied separately.
- Subject to tax of 15% or more
- Subject to tax more than 0% and less than 15%
- Not subject to any withholding or other foreign tax
- Not subject to withholding tax, but subject to other foreign taxes
A Simple Dividend Example
Mary B is an expat living in Ireland and is invested in a foreign mutual fund that earned $500 in dividends. Her deductions were $300. Her residency status requires that she pays $100 in taxes in that country where the mutual fund originated.
After the deductions are calculated, there is a potential for $200 in double taxation. The tax of $200 exceeds the maximum US rate, so her income, deductions, and taxes are “kicked out” to the “general group”.
How to Qualify for a Foreign Tax Credit
Before we get into the details of rules, we first need to explain how a taxpayer can qualify for a foreign tax credit. In general, a taxpayer must do the following:
- Receive income from a foreign country
- Pay taxes on that foreign income to the same foreign country
- Not claim the foreign earned income exclusion on the same income
Additionally, the foreign tax must:
- Be paid to a country on income that was derived from that foreign country
- Be similar to the United States income tax
- Provide no economic benefit to the taxpayer paying the tax
Typically, foreign taxes that qualify for a credit include taxes on wages, interests, dividends, royalties, and annuities.
The High Tax Kick-Out (HTKO) Rules
In the United States, an individual who pays taxes on foreign passive income can claim a foreign tax credit. Some countries have higher tax rates than in the U.S., though. This means that if these tax credits are applied in full, it can cause an artificial tax reduction of U.S. taxes — which the Internal Revenue Service does not support. This is where the high tax kick-out regulations come into play. In these situations, the foreign tax credit will be “kicked out” of the passive category and moved to the general category on Form 1116 There are two primary purposes of the HTKO rules:
- Preventing cross-crediting within the passive income category
- Preventing the manipulation of expenses allocation rules of shifting taxes from categories with excess credits to categories with excess limitations
So, how do these rules work? In the U.S., individuals in the highest tax bracket will generally pay 20% long-term capital gains. Consequently, the highest rate for long-term capital gain is 20%. As a result, if an individual paid 50% for foreign long-term capital gain income they earned abroad, the rules indicate that the credit cannot be applied as “passive income credit.” Instead, it will shift to the “general category income.”
HTKO Rules & How to Know if You Need to Fill Out Form 1116
As a taxpayer, you need to pay specific attention to how your foreign income is taxed and the considerable expenses, deductions, and losses associated with it. Even though the concept as a whole may sound simple, it is rather complicated, and you must know how to adhere to these HTKO rules.
The following steps will help you understand how to address HTKO:
- You will start by determining your foreign income.
- Next, you will need to allocate your foreign income into separate categories based on the income type.
- Make sure you gather all of your associated expenses, losses, and other deductions.
- Take the foreign passive income category and break it into sub-categories of passive income under the new grouping rules.
- You will now need to consider each foreign passive income sub-category with associated losses, expenses, and other deductions against the associated foreign tax. This will require you to compare the foreign tax rate calculated against the maximum United States tax rate applicable.
- Once you finish calculating the foreign rate, you will need to determine if it exceeds the U.S. tax rate. If it does, this sub-category is highly taxed and must be considered related to other separate categories other than passive income.
One important thing to note is this guide only provides the general actions you will need to take when addressing High Tax Kick-Out (HTKO) rules. If your corporation intends to claim foreign tax credits, it would be best to consult with an experienced tax attorney who can walk you through these tax planning procedures and compliance issues.
Who Can Elect Not To File Form 1116?
You don’t have to file Form 1116 if you meet certain requirements, as laid out below, and can instead claim the foreign tax credit on Form 1040, Schedule 3.
• All of the money from foreign sources was generated through interest and dividends, and all of that income as well as any foreign tax paid on it were recorded on Form 1099-INT, Form 1099-DIV (or substitute statement), or Schedule K-1.
• For shares of stock to qualify for dividend income, you must have held those shares for a minimum of 16 days.
• You are not filing Form 4563, Exclusion of Income for Bona Fide Residents of American Samoa, or excluding income from sources within Puerto Rico.
• The total of your foreign taxes was not more than $300 (not more than $600 if married filing jointly).
• All of your foreign taxes were: – Legally owed and not eligible for a refund, and – Paid to countries that are recognized by the United States and do not support terrorism.
Taxpayers who must complete Form 1116 because they cannot qualify to claim the foreign tax credit without filing Form 1116 should speak to a professional tax preparer.
Passive and General Category Incomes in Relation to Foreign Income
Before you fill out Form 1116, you will need to classify your foreign income by category. Currently, there are a few different categories for calculating foreign tax credits. They are Passive Income, General Income, Foreign Branch Income, and GILTI Income.
The HTKO rule will apply when the effective tax rate for foreign source income allocated to the passive category exceeds the greatest United States tax rate. Based on this rule, the high-taxed income is moved from the passive category and into general income.
Passive Income
This category includes passive income and specific passive category income. Typically this includes interest, dividends, royalties, annuities, rents, and net gains from the sale of property or non-income producing investment properties.
General Category Income
This category consists of income earned in a foreign country that an individual did not exclude or excluded only part of under the foreign earned income exclusion. In addition, any foreign income that did not come under any of the other categories on Form 1116 can be included as General Category Income.
Taxpayers who paid taxes to a foreign nation may be able to take a nonrefundable foreign tax credit, but it is important to realize that there are many regulations and specific steps a taxpayer needs to follow in order to claim this credit. Consider speaking with a qualified and experienced tax professional to ensure you get everything right.
Example of How Capital Gains Can Trigger High Tax Kick-Out
Paul is a high-net-worth individual whose father gifted him a rental property in Tuscany. Since it was a gift and not an inheritance, there is no “step-up” basis, rather a Transfer Basis plus Gift Tax paid.
Paul’s father bought the apartment building for $100,000 USD; when he gave it to his son it was worth $900,000 USD. When Paul sold the property, pre-recession, for $1.7 million, he paid foreign Capital Gains taxes on the difference between the $100,000 basis (plus any gift tax) and the $1.7 million sales price.
Paul is paying income taxes in Italy and the US. On his US return, he reports the tax credit on Form 1116, the sale on Schedule D, and any rental income on Schedule E. Instead of hitting the tax credit trifecta, Paul’s a victim of High Tax Kick-Out. He paid too high a rate on his foreign taxes in Italy, and the IRS wants to avoid artificial reduction of tax liabilities, which is pretty common when there are multiple credits taken, at different rates. So Paul is kicked into the non-passive income category, and paid more in taxes.
Had Paul’s father left the property as in inheritance, the stepped-up basis would apply so his basis would be $900,000 with a difference at sale of only $800,000 USD. That lower gain would result in less tax liability and probably kept Paul out of High Tax Kick-Out purgatory.
Why did Paul get so hammered? In the US, the individuals–like Paul–in the highest tax bracket pay 20% on Long-Term Capital Gains (LTCG). If Paul paid a 50% tax rate on his Italian capital gains, that credit cannot be considered passive income credit, and thus is subject to the High Tax Kick-Out rule.
Get Help with High Tax Kick-Out, Form 1116 and Offshore Asset Compliance
This whole process of calculating foreign tax credits or figuring out HTKO rules is extraordinarily complex, leaving even the most knowledgeable taxpayers confused with what they need to do next. You do not have to figure out these complicated laws and forms on your own. Contact Silver Tax Group today to speak with an expert about any high tax kick-out questions you might have.
