Foreign Tax Credit and Foreign Oil Stocks

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Foreign Tax Credit and Foreign Oil Stocks

Postby imelina » Sun Apr 15, 2012 12:38 pm

I need help with Form 1116. I hope someone here has dealt with these issues and can offer some insight based on experience.

I am a US resident, filing singly, working with the form 1040 and schedule D. I am very confused by IRS rules for the foreign tax credit (FTC). I have had my taxes done in recent years by a couple of professional preparers, one an EA and the other a CPA, but I am not sure that they understood all of the rules. (I am trying to work out the carryovers based on what they filed, but it is very confusing.)

I have received dividends from foreign energy companies such as BP.
How should these dividends be handled for purposes of obtaining the FTC?

The instructions for Form 1116 (FTC for Individual, Estate, or Trust ) and the information in Publication 514 (FTC for Individuals) refer to oil and gas in several places.

To begin with, Pub 514 states that
Taxes in Connection With the Purchase or Sale of Oil or Gas

You cannot claim a foreign tax credit for taxes paid or accrued to a foreign country in connection with the purchase or sale of oil or gas extracted in that country if you do not have an economic interest in the oil or gas, and the purchase price or sales price is different from the fair market value of the oil or gas at the time of purchase or sale.


Am I correct that this would not be relevant to receiving dividends from a company like RDS or BP?
It seems instead to apply to someone who is directly trading commodities - purchasing or selling oil or gas - rather than to someone who holds shares in a company that produces oil. Is this right?


Moving along, the instructions for Form 1116 line 12 state
Taxes on combined foreign oil and gas income.
Reduce taxes paid or accrued by a portion of taxes imposed on combined foreign oil and gas income. The amount of the reduction is the amount by which your foreign oil and gas taxes exceed the amount of your combined foreign oil and gas income for the year multiplied by a fraction equal to your pre-credit U.S. tax liability (for example, Form 1040, line 44) divided by your worldwide taxable income. You may be entitled to carry over to other years taxes reduced under this rule. See section 907(f).
Combined foreign oil and gas income is the sum of foreign oil related income and foreign oil and gas extraction income. Foreign oil and gas taxes are the sum of foreign oil and gas extraction taxes and foreign oil related taxes.


Now, this is the really confusing part.

First, would this reduction rule apply to dividends received from a company like Royal Dutch Shell or BP?
I would think that it would, yet neither of the tax preparers who worked on my taxes in past years made any kind of reduction.

Second, if the rule does apply, what exactly is the formula for the reduction? The way it is worded is confusing to me and the IRS instructions do not include any examples.


Can you tell me specifically what the formula would be if, as an example (not the actual numbers - but using large whole numbers for easy calculations), say that

a = taxes withheld at the time dividends were paid by the energy companies totaled $2,000
b = total dividends received from the energy companies is $10,000
c = pre-credit US tax liability (form 1040, line 44) is $15,000
d = worldwide taxable income is $100,000?
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Re: Foreign Tax Credit and Foreign Oil Stocks

Postby imelina » Mon Apr 16, 2012 1:18 pm

Looking at some other discussions on the web, it seems that 1116 is pretty universally considered a pain-in-the-rear and rather mysterious, even among professional tax preparers.

But I would think that the questions I am asking would be something that even average investors and tax returns agents deal with routinely. These are not tiny start-up companies that nobody ever heard of! They are some of the largest and most profitable corporations in the world, so wouldn't it be reasonable to assume that many US taxpayers would have some shares of these companies in their portfolios, apart from whatever additional interests they might have through ETFs or mutual funds?

Maybe many investors are being hit by the alternative minimum tax, so whatever foreign tax credit to which they might otherwise have been entitled doesn't apply?
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Re: Foreign Tax Credit and Foreign Oil Stocks

Postby Buysider » Mon Apr 16, 2012 1:25 pm

Am I correct that this would not be relevant to receiving dividends from a company like RDS or BP?


Yes - you did not buy purchase or sell gas or oil. No different if you own Unilever or BP ...
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Re: Foreign Tax Credit and Foreign Oil Stocks

Postby Grt2bOutdoors » Mon Apr 16, 2012 1:32 pm

Buysider has it right - claiming dividends from entities such as BP is not the same as actually receiving Gas/Oil income and deductions.


The ADR's for BP to my knowledge do not have foreign taxes withheld, the dividend paid is the dividend received.
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Re: Foreign Tax Credit and Foreign Oil Stocks

Postby earlyout » Mon Apr 16, 2012 2:13 pm

As GRT2B points out, dividends from BP ADRs do not include any foreign tax and there is no FTC. I've been receiving BP dividends for several years and IIRC about 5 years ago the reporting of foreign tax for dividends from BP ADRs was eliminated. The 1099s should show how much foreign tax you paid.

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Re: Foreign Tax Credit and Foreign Oil Stocks

Postby G12 » Mon Apr 16, 2012 2:18 pm

The ADR's for BP to my knowledge do not have foreign taxes withheld, the dividend paid is the dividend received.


As an example, when TOT and STO pay dividends and the cash is received in the brokerage account, 15% is withheld for foreign tax whether I want it to be or not. The OP should be able to receive a credit if held in a taxable account.
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Re: Foreign Tax Credit and Foreign Oil Stocks

Postby Grt2bOutdoors » Mon Apr 16, 2012 2:34 pm

G12 wrote:
The ADR's for BP to my knowledge do not have foreign taxes withheld, the dividend paid is the dividend received.


As an example, when TOT and STO pay dividends and the cash is received in the brokerage account, 15% is withheld for foreign tax whether I want it to be or not. The OP should be able to receive a credit if held in a taxable account.


In the case of BP, there is no credit given since dividends are not subject to foreign tax witholding. I happen to own this equity, there is no FTC on it.
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Re: Foreign Tax Credit and Foreign Oil Stocks

Postby G12 » Mon Apr 16, 2012 2:38 pm

In the case of BP, there is no credit given since dividends are not subject to foreign tax witholding. I happen to own this equity, there is no FTC on it.


I'll keep that in mind for IRA purposes.
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Re: Foreign Tax Credit and Foreign Oil Stocks

Postby imelina » Mon Apr 16, 2012 3:42 pm

Thanks, everyone, for the input.

Let me clarify that the companies involved are not actually BP or RDS, but they are foreign companies that are involved in similar oil exploration and production activities. The numbers I posted in the original post are also not the actual numbers I am working with. I used these names and numbers for the sake of discussion.
(In the even that I am headed for an audit, I would rather not have anything I posted in this or any other forum affect my dealings with the IRS.)

The specific companies I am dealing with do in fact distribute dividends that are reported on brokerage 1099 statements.
Last edited by imelina on Tue Apr 17, 2012 1:45 am, edited 1 time in total.
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Re: Foreign Tax Credit and Foreign Oil Stocks

Postby grabiner » Mon Apr 16, 2012 9:04 pm

imelina wrote:Maybe many investors are being hit by the alternative minimum tax, so whatever foreign tax credit to which they might otherwise have been entitled doesn't apply?


The foreign tax credit is still allowed under the AMT; you just have to recompute it with the AMT as your tax and your foreign income recalculated if necessary.
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Re: Foreign Tax Credit and Foreign Oil Stocks

Postby livesoft » Mon Apr 16, 2012 9:40 pm

Are you using tax software to help with Form 1116? This year I used TurboTax and it seemed pretty straightforward. Almost all our taxable dividends arise from foreign equity ETFs: VEU, VSS, SCZ. All I want to see is that I get 100% of the foreign taxes paid (and shown on the Form 1099DIVs) as a foreign tax credit. That seems to have happened.
It's all about short-term opportunistic rebalancing due to a short-term change in one's asset allocation, uh, I mean opportunistic rebalancing, uh I mean rebalancing, uh I mean market timing.
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Re: Foreign Tax Credit and Foreign Oil Stocks

Postby imelina » Tue Apr 17, 2012 1:37 am

Yes, I am using tax return software. I am trying to use H&R Block Deluxe this year, which is what I have used for a number of years in the past. The software uses a combination of an interview along with having the user directly enter figures on a 1116 form to try to get this credit. The interview doesn't ask any questions pertaining to reductions to be used for line 12. If you are carefully trying to make sure every blank is filled in on the software screen's version of the form, though, you will see that there is a space for line 12, with the instruction on the form (same as in the paper version of the form from IRS) saying "Reduction in foreign taxes (see IRS instrucs)."

I used TurboTax Deluxe last year. The TurboTax software interview is a bit more helpful at the carryback-carryforward part for form 1116 (although it doesn't mention anything about limitations on carryback-carryforward for oil and gas related income/taxes).
However, it isn't really any more helpful for 1116 line 12. In fact, TurboTax (2010) is arguably more misleading. The interview/fill-in-form combination for 1116 is more detailed in TurboTax than in H&R Block, and it asks a number of questions pertaining to a reduction for line 12 (most of those questions dealing with the foreign earned income - a different subject than applies in my case), but it completely leaves out any mention of oil and gas related income/taxes, leaving you with what may be a false sense that you have thoroughly addressed all the issues. In fact, if I hadn't switched back from TurboTax to H&R Block software for this year, and as a result had to more carefully read all of publication 514 and IRS instructions for 1116, I might not have realized there could be any issues here at all! The TurboTax website has a section that lists calculations that are not supported by TurboTax and that may require manual calculations and entry into the forms. No mention there of reductions related to oil & gas income/taxes, either.
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Re: Foreign Tax Credit and Foreign Oil Stocks

Postby imelina » Tue Apr 17, 2012 1:42 am

I've actually called IRS twice to ask about this, and spoken with two IRS representatives.
(Granted, I called right before the filing deadline, so I am sure they are swamped with questions, and the specialists who would know best were doubtless not the people that I spoke with.) Both of the agents read from a script (it was obvious because they asked the same exact questions, and it sounded like they were reading from a script). The first one eventually told me that I did not need to fill in line 12 - ie, that the reduction would only apply if I had foreign earned income (I do not). That agent then referred me to someone else at IRS, but after being on hold (almost 45 minutes) and being transferred multiple times up to that point, I had to call back and start over.

The second agent eventually said that she just wasn't sure how to answer my questions and also said I would need to speak with someone at IRS more familiar with the subjects.
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Re: Foreign Tax Credit and Foreign Oil Stocks

Postby Buysider » Tue Apr 17, 2012 8:42 am

I still am confused - you didn't buy or sell oil/gas. Line 12 is irrelvant to you if you own common stocks. The foreign tax credit applies to the taxes you paid for the foreign company. Line 12 applies to royalty calculations, (among other things) - this has nothing to do with common stock dividends and the foreign taxes paid you receive from your broker. Keep it simple, this is related to folks who have direct ownership of oil/mineral rights, not common stocks.
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Re: Foreign Tax Credit and Foreign Oil Stocks

Postby grabiner » Tue Apr 17, 2012 6:36 pm

livesoft wrote:Are you using tax software to help with Form 1116? This year I used TurboTax and it seemed pretty straightforward. Almost all our taxable dividends arise from foreign equity ETFs: VEU, VSS, SCZ. All I want to see is that I get 100% of the foreign taxes paid (and shown on the Form 1099DIVs) as a foreign tax credit. That seems to have happened.


Did you check your Form 1116 against the IRS instructions? When I used TurboTax in the past, it made an error that was potentially in the IRS's favor, but which didn't actually affect my taxes. (Certain deductions are considered to offset your US and foreign income on a pro rata basis; TurboTax incorrectly applied that to my charitable contributions, which the IRS instructions say can be deducted entirely from your US income.)
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Re: Foreign Tax Credit and Foreign Oil Stocks

Postby livesoft » Tue Apr 17, 2012 7:03 pm

For 2010 taxes, I read the Form 1116 instructions. I read the associated Publication. I had my spouse read both of those as well. I read many of the threads on the forum.

For 2011 taxes, I sent in a request for extension after a quick prelim. I will not itemize for 2011, so I'm not deducting charitable contributions in 2011.

By the time I file in October, I expect to be better informed --- not by reading the 1116 instructions, but by reading several more yet-to-come threads on all this. :)
It's all about short-term opportunistic rebalancing due to a short-term change in one's asset allocation, uh, I mean opportunistic rebalancing, uh I mean rebalancing, uh I mean market timing.
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Re: Foreign Tax Credit and Foreign Oil Stocks

Postby Karamatsu » Tue Apr 17, 2012 11:44 pm

Form 1116 is a house of mirrors in many cases, often the single most complex part of a return, at least for those of us living abroad. I'm impressed that the IRS would even try to answer your questions. Whenever I write to them with anything but the simplest of questions they always respond that the rules are too complicated for them to explain, so I should pay a professional preparer. This is, of course, a total abdication of their Congressional mandate to help taxpayers comply with the law, but they're the IRS: if you make a mistake, they win. What I always end up doing, and it always disturbs my sleep for a few days, is make a good-faith effort to follow the rules, document what I have done, and staple that to my copy of the return. That way if/when the time comes at least I'll have some idea of what I did and why. I admit there have been times when I thought I would just forget about the FTC. Taking the loss seemed less traumatic than going out on a limb with the IRS. But I hate giving up...

All that said, I think you'd be on reasonable ground not to apply any of the weird oil and gas income rules to your dividends from companies listed on a US stock exchange. The foreign taxes you paid will be listed on your 1099, and if they're attributed to dividends then it's dividend income, not income from the sale of oil and gas. But of course, that's as I understand the situation, and given incorrect symbols and amounts it's hard to say that I understand the situation at all! One note is that sometimes a foreign oil/gas company (especially those in Canada) may itself provide some guidance to US investors. Of course it's couched in "consult your tax professional" language, but it might give you some hints or confidence that you're doing the right thing (or not!). Good luck!
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Re: Foreign Tax Credit and Foreign Oil Stocks

Postby Wagnerjb » Wed Apr 18, 2012 10:39 am

imelina wrote:However, it isn't really any more helpful for 1116 line 12. In fact, TurboTax (2010) is arguably more misleading. The interview/fill-in-form combination for 1116 is more detailed in TurboTax than in H&R Block, and it asks a number of questions pertaining to a reduction for line 12 (most of those questions dealing with the foreign earned income - a different subject than applies in my case), but it completely leaves out any mention of oil and gas related income/taxes, leaving you with what may be a false sense that you have thoroughly addressed all the issues. In fact, if I hadn't switched back from TurboTax to H&R Block software for this year, and as a result had to more carefully read all of publication 514 and IRS instructions for 1116, I might not have realized there could be any issues here at all! The TurboTax website has a section that lists calculations that are not supported by TurboTax and that may require manual calculations and entry into the forms. No mention there of reductions related to oil & gas income/taxes, either.


I agree that this form is exceedingly complex. I was on an international assignment for several years, and as a result after my repatriation my employer pays to have my tax return professionally prepared (by a Big Four company). Like you, I also owned shares in a few international companies. One of those was RD Shell. The accounting firm prepares two form 1116's - one for passive income and another one for general income. The passive income form 1116 is strictly for the dividends, so I believe this is analogous to your situation (the general income is for income I earned while living overseas). I can assure you that line 12 is blank, and also that there are no oil & gas taxes to deal with. Just the foreign income tax credit.

On your form 1116, you should expect to have entries on lines 1, 3a, 3c ,3d, 3e, 3f, 3g. You will also have subtotals on line 6 and 7. In Part II, you will have an entry for your foreign tax withholdings on line A. In part 3, you should have entries on lines 9, 14, 16, 17, 18, 19, 20, 21 and 22. Part IV is straight forward.

If you are in AMT, you will fill out a separate form 1116 for the AMT calculation. In my tax return, the difference was that line 3a and 3c were blank. All other entries were identical....and of course the resulting percentages and subtotals were different.

Hope this helps. In general, I would expect your foreign tax credit (generated on the form 1116) to equal the amount withheld by the foreign governments, unless you have an unusual situation. One such situation would be where your average tax rate (for all income) was quite low while your foreign tax withholdings were at a higher rate. This might cause your FTC to be limited to an amount lower than the actual withholding....but I believe you can claim the unused FTC in later years if your tax rate situation turns around.

Best wishes.
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Re: Foreign Tax Credit and Foreign Oil Stocks

Postby imelina » Thu Apr 19, 2012 12:38 am

Buysider wrote:I still am confused - you didn't buy or sell oil/gas. Line 12 is irrelvant to you if you own common stocks. The foreign tax credit applies to the taxes you paid for the foreign company. Line 12 applies to royalty calculations, (among other things) - this has nothing to do with common stock dividends and the foreign taxes paid you receive from your broker. Keep it simple, this is related to folks who have direct ownership of oil/mineral rights, not common stocks.

You sound very certain, and I do appreciate your input. However, I'm new to the site, so I don't know what kind of background you have.
Is your opinion based just on reading the IRS instructions that I posted in the thread? Or are you basing your interpretation on experience, or training, specifically related to this topic?

(Disclaimer: Of course, I am not asking for professional advice from anyone here related to my personal situation. I am trying to get a general sense of how most people who are familiar with this topic would approach a hypothetical case.)
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Re: Foreign Tax Credit and Foreign Oil Stocks

Postby imelina » Thu Apr 19, 2012 1:30 am

Thanks, karamatsu and wagnerjb for your thoughtful comments.


I think I may have found a clear justification for what everyone seems to be saying, that the kind of dividends I am talking about are not subject to the reduction discussed in line 12.

Line 12 is based on section 907 of the Internal Revenue Code, which reads, in part (I have added emphasis in bold):
(b) Combined foreign oil and gas income; foreign oil and gas taxes
For purposes of this section—

(1) Combined foreign oil and gas income
The term “combined foreign oil and gas income” means, with respect to any taxable year, the sum of—
(A) foreign oil and gas extraction income, and
(B) foreign oil related income.

(2) Foreign oil and gas taxes
The term “foreign oil and gas taxes” means, with respect to any taxable year, the sum of—
(A) oil and gas extraction taxes, and
(B) any income, war profits, and excess profits taxes paid or accrued (or deemed to have been paid or accrued under section 902 or 960) during the taxable year with respect to foreign oil related income (determined without regard to subsection (c)(4)) or loss which would be taken into account for purposes of section 901 without regard to this section.
and

(c) Foreign income definitions and special rules

For purposes of this section—
(1) Foreign oil and gas extraction income
The term “foreign oil and gas extraction income” means the taxable income derived from sources without the United States and its possessions from—
(A) the extraction (by the taxpayer or any other person) of minerals from oil or gas wells, or
(B) the sale or exchange of assets used by the taxpayer in the trade or business described in subparagraph (A).
Such term does not include any dividend or interest income which is passive income (as defined in section 904 (d)(2)(A)).

(2) Foreign oil related income
The term “foreign oil related income” means the taxable income derived from sources outside the United States and its possessions from—
(A) the processing of minerals extracted (by the taxpayer or by any other person) from oil or gas wells into their primary products,
(B) the transportation of such minerals or primary products,
(C) the distribution or sale of such minerals or primary products,
(D) the disposition of assets used by the taxpayer in the trade or business described in subparagraph (A), (B), or (C), or
(E) the performance of any other related service.
Such term does not include any dividend or interest income which is passive income (as defined in section 904 (d)(2)(A)).


(3) Dividends, interest, partnership distribution, etc.
The term “foreign oil and gas extraction income” and the term “foreign oil related income” include—
(A) dividends
and interest from a foreign corporation in respect of which taxes are deemed paid by the taxpayer under section 902,
(B) amounts with respect to which taxes are deemed paid under section 960 (a), and
(C) the taxpayer’s distributive share of the income of partnerships. [1]
to the extent such dividends, interest, amounts, or distributive share is attributable to foreign oil and gas extraction income, or to foreign oil related income, as the case may be; except that interest described in subparagraph (A) shall not be taken into account in computing foreign oil and gas extraction income but shall be taken into account in computing foreign oil-related income.

http://cpaclass.com/tax-accounting/tax-law/internal-revenue-code/26-usc-section/907.htm

(section 902: http://cpaclass.com/tax-accounting/tax-law/internal-revenue-code/26-usc-section/902.htm)

So it seems that according to these definitions, assuming I am interpreting this all correctly of course, "combined foreign oil and gas" income and taxes do not include dividends that are passive income, except (section 902) in certain cases in which the foreign corporation paying dividends is partly owned (10% or more voting stock) by a domestic corporation to which the dividends are paid (which would not apply in the situation I outlined above).

For those who are interested, this December 2008 IRS article(LMSB-4-1208-056) offers a bit of background that helps explain the rationale behind some of the oil and gas questions and calculations on form 1116 (scroll down to the section on "FOGEI/FORI Allocations"). It doesn't directly address the specific questions I posed in this thread, but I think it does help the layperson understand the oil and gas parts of publication 514 and form 1116 better:
http://www.irs.gov/businesses/article/0,,id=201386,00.html
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Re: Foreign Tax Credit and Foreign Oil Stocks

Postby imelina » Thu Apr 19, 2012 1:40 am

(Note that the links to the internal revenue code I posted in my last post include a line which says, "USC Title 26 enacted through 2008." However, from checking the Cornell law website, it appears that the text of these sections of the code are still current [I posted the other links though because the font colors and other formatting make the text in them a little easier to read than the text on the Cornell site]).
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Re: Foreign Tax Credit and Foreign Oil Stocks

Postby Karamatsu » Thu Apr 19, 2012 9:57 pm

Good research! Thanks!
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Re: Foreign Tax Credit and Foreign Oil Stocks

Postby imelina » Thu May 03, 2012 9:14 am

Update:

It turns out my last professional tax preparer did make an error in the 1116 form, although the error did not involve the specific questions concerning this thread. (I should be getting a refund back from the IRS from the tax that I overpaid as a result of that error. I'd have never known had I not been going back through several years of returns in order to take advantage of any past carryovers that the foreign tax credit might allow.)

Also - I mentioned upthread that when I called IRS 3 weeks ago, one of the agents said she really didn't know the answer and would have to have a specialist get back to me.
Well, someone did just call back. He seemed to be trying to help, but he didn't seem to be familiar with that particular section of the code/form, so I wasn't left with a sense that what he was saying was incontrovertible.
He ultimately said he couldn't say whether dividends on common stock would be affected, and that it would be necessary to ask the individual corporations that paid the dividends. :oops:
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