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The U.S. foreign tax credit is intended to grant a U.S. taxpayer an offset for foreign income tax paid or accrued against its U.S. federal income tax liability under appropriate circumstances. For this purpose, to be a foreign "tax," a payment must be compulsory and pursuant to the authority of a foreign country to levy taxes.1 The voluntary tax rule is that an amount paid is not compulsory, and thus is not an amount of tax paid, to the extent that it exceeds the liability for tax under foreign law (Reg. 1.901-2(e)(5)(i)). * Many laypersons would say that 'Voluntary tax" is an oxymoron. Used as a verb, "levy" has been defined as "an imposing or collecting, as of a tax, by authority or force."2 However, U.S. foreign tax credit provisions have their own special logic. 1RS policy is that a foreign tax credit should be denied unless the taxpayer has taken reasonable measures to mitigate its foreign tax liability. The foreign tax credit is designed to reduce the possibility of double taxation when a taxpayer is subject to income tax in the U.S. and a foreign country, not to permit a taxpayer to be indifferent to its potential foreign income tax liability so long as the foreign tax can be offset against its U.S. tax liability.
A voluntary tax rule is not necessary to protect the fisc when foreign taxes are deducted because a deduction (as opposed to a credit) does not allow the taxpayer to recoup fully the cost of the foreign tax against its U.S. tax liability. Since the taxpayer necessarily bears some of the burden of the foreign tax paid when a deduction is claimed, it has an incentive to ensure that its foreign tax liability is as low as possible. The situation is different when foreign taxes are credited and, as is becoming increasingly common, the foreign tax rate is lower than the U.S. tax rate.
The appropriate foreign tax credit rules for requiring taxpayer diligence in reducing foreign tax are not intuitively obvious. The current Regulations defining a voluntary tax have remained unchanged since 1983.3 Reductions in foreign tax rates, ambiguities in the current Regulations, the advent of checkthe-box planning, and, perhaps most importantly, the Service's continuing search for...