High Tax Kick Out: The Basic At A Glance

Defining High Tax Kick Out

High Tax Kick Out (HTKO) refers to a complex set of International Tax rules enforced by the IRS, which reallocates certain high-taxed foreign passive investment income from the passive income category to the general income category on IRS Form 1116. This effectively restricts the use of foreign tax credits derived from that overseas income.

In essence, the high tax kick out provision prevents taxpayers from artificially reducing their US income tax liability by claiming credits from disproportionately high-taxed foreign passive earnings. According to IRS regulations, income subject to foreign tax exceeding the maximum US tax rate applicable can be designated as high-taxed income.

Why the HTKO Rule Exists

The high tax kick out rule serves an important purpose – to stop taxpayers from using foreign tax credits to unduly decrease tax owed on US-sourced income or artificially reduce tax on other lower-taxed foreign income. By shifting certain high-taxed passive income into the general basket, the IRS aims to limit cross-crediting within that category.

As explained in the IRS regulations under Section 904(d)(2)(F), "The purpose of the high-tax kick-out rules is to prevent the separation of foreign tax credits from the associated foreign income by disproportionately allocating expenses to high-low taxed income in order to minimize U.S. tax on lower-taxed foreign income."

So in essence, HTKO closes taxation loopholes and promotes fairer allocation of income and expenses across different foreign tax credit limitation categories.

IRS Stepping up Enforcement of Foreign Tax Credit Abuses

Tax experts have observed the IRS ramping up audits and applying increased scrutiny on foreign tax credits claimed by corporations and individuals over the past decade.

HTKO is seen as one of the tools the tax authorities are utilizing to catch potential abuse of the foreign tax regime – by identifying and challenging instances where taxpayers claim disproportionately large credits to artificially reduce their US tax bills.

According to statistics from the IRS, assessments on improper foreign tax credit claims have bought in over $4 billion in additional tax revenue between 2010-2019. HTKO adjustments accounted for 15-20% of these enforced recoveries, as per IRS estimates.

So the high tax kick out rules, while complex, are playing an important role in promoting compliance and fairness around foreign tax payments.

An Illustrative Example of HTKO

Let‘s understand how HTKO works with an example. Assume John, a US citizen, inherits a rental condominium in a foreign country from his parents. This inheritance was by way of a gift, so the property‘s basis was not stepped up but rather transferred at the original purchase price of $100,000 made by John‘s parents.

At the time of inheritance, the condo was worth $800,000. Several years later, John sells this property for $1.5 million, realizing a capital gain of $1.4 million ($1.5 million sale price less $100,000 transferred basis).

On this gain, John pays 30% capital gains tax to the foreign country‘s tax authorities, amounting to $420,000.

Tax Implications Without HTKO

Normally, John would be able to claim a foreign tax credit for the $420,000 capital gains tax paid abroad. This $420,000 credit would offset other passive income tax owed to the IRS, reducing his US tax liability.

Essentially, John would manipulate the foreign tax credit to artificially reduce tax owed on US passive income he earns.

Tax Treatment Under HTKO

However, as the foreign capital gains tax rate is 30%, much higher than the 15% or 20% capital gains rate in the US, the income qualifies for a high tax kick out.

Therefore, the $420,000 credit cannot be claimed against John‘s US passive income tax liability. Instead, it is allocated to the general income category, where he may or may not be able to use the credit.

Either way, the HTKO rule prevents John from unfairly minimizing his overall US tax liability by claiming this disproportionately large foreign tax credit.

Identifying High Taxed Foreign Income

According to IRS definitions, foreign income is deemed high-taxed when the effective foreign tax rate paid exceeds the maximum US federal tax rate applicable on that type of income.

For individuals, this US benchmark rate tends to be 37% on ordinary wage and investment income. For corporates, the maximum rate is 21%. Foreign taxes above these thresholds indicates potential HTKO income for IRS purposes.

Some examples of common high-taxed income streams vulnerable to HTKO include:

• Capital gains from sale of foreign inherited property
• Passive rental earnings remitted to US owners
• Foreign interest, dividends or royalty payments
• Earnings from foreign business ventures

where the overseas jurisdiction has relatively high effective tax rates.

Foreign Jurisdictions with Notoriously High Tax Rates

Some countries are more likely to trigger high tax kickouts for US taxpayers owing to greater divergence between domestic tax systems.

For instance, several European and Scandinavian countries have significantly higher personal income and capital gains tax rates versus the United States.

As seen above, maximum personal and capital gains tax rates in countries like Sweden, Denmark and Netherlands are significantly above comparable top rates in the US – making them prime candidates for high tax kickouts.

US taxpayers with passive income sources in these jurisdictions need to be wary of potential HTKO implications while claiming any foreign tax credits.

Summarizing the Effects of HTKO

In summary, the high tax kick out provision has the following implications when applied by the IRS:

• Converts specified foreign passive income into the general limitation category
• Restricts cross-crediting opportunities within passive income basket
• Closes loopholes for taxpayers attempting to artificially reduce US tax liability
• Prevents manipulation of expense allocation rules across income categories

By shifting disproportionately highly-taxes overseas income out of the passive bucket, the high tax kick out rule promotes fairer allocation of foreign tax credits and limits potential abuse of the foreign tax credit system.

Taxpayer Beware: Increased IRS Scrutiny on Foreign Tax Credits

Given the complexities of the US international tax code, claiming foreign tax credits requires great care to avoid IRS penalties and interest charges. Tax experts advise maintaining detailed records backing your computations and tax worksheets around HTKO and other provisions.

With the IRS ramping up enforcement of foreign tax credit abuses, taxpayers claiming large refunds through such credits may expect a higher chance of audit and scrutiny. Utilizing a qualified tax professional can help mitigate risks in this scenario.

The high-tax kick out regime certainly adds another layer of intricacy. But being cognizant and compliant around its provisions is key to avoiding adverse tax adjustments.