IRS thaws tax treatment of Cuba, allows ‘credit’ on Cuban taxes paid, but embargo limits benefits

Author: Karen J. Lapekas
Date: March 11, 2016

The thawing of relations between the United States and Cuba is also having consequences on the taxes and tax credits of United States taxpayers. Earlier this month, the US Internal Revenue Service ruled that United States taxpayers are no longer prohibited from taking a “foreign tax credit” for income taxes paid or accrued to the Republic of Cuba.

IRS Revenue Ruling 2016-8, issued on March 1, 2016, is consistent with the loosening of U.S. restrictions on travel to Cuba and its efforts to build deeper diplomatic and other relations with the island nation. The IRS Revenue Ruling will come as welcome news to United States companies and investors who are looking to gain or expand a foothold in Cuba.

Ruling has minor impact because of continuing embargo

However, if you expect to hear anything but crickets, the only response that is likely to be heard from most actual and potential investors is a dispassionate, “So what?” The reality is that the relative lack of bilateral business with Cuba makes the IRS foreign tax credit change of little consequence. Business as usual with Cuba, for the moment at least, is little business at all.

The Internal Revenue Code (IRC) generally allows as a tax credit the amount of taxes that are paid to another country, subject to certain limitations. The United States income tax applies to the worldwide income of U.S. persons. Therefore, income earned abroad is taxed to the same extent as if it was earned in the United States.

However, the U.S. recognizes that the “foreign-source income” may also be taxed by the country where it was earned or derived. Thus, in general, the IRC provides that U.S. persons may claim a foreign tax credit in the same amount as the foreign income tax that was paid. Therefore, U.S. taxes are reduced dollar-for-dollar by the amount of foreign taxes paid.

“Blacklisted countries” are not eligible for foreign tax credits

Under Internal Revenue Code Section 901(j), U.S. persons may claim only a deduction—not a foreign-tax credit— against income tax attributable to “blacklisted countries.” These are countries whose government the U.S. does not recognize, or with whom the U.S. has severed diplomatic relations or has determined support acts of international terrorism. In addition, U.S. persons who reside in blacklisted countries are not entitled to the foreign-earned income exclusion or foreign housing expense.

Congress presumably enacted the provision in order to increase the cost of foreign investment and commerce in countries deemed to sponsor terrorism, or to create economic incentives for certain countries to address human rights abuses. The list of blacklisted countries has included Afghanistan, Vietnam and Yemen and others. However, as of December 21, 2015, under IRS Revenue Ruling 2016-8, Cuba is no longer included. The only remaining blacklisted countries are Iran, North Korea, Sudan and Syria.

IRS ruling does little to make commerce with Cuba more appealing

While the removal of Cuba from the U.S. tax code’s blacklist seems to be a big step toward putting investments in Cuba on equal-footing with those in other countries, it does little to make investment in or commerce with Cuba more attractive. These are some of the reasons:

(1) Under Cuba’s “Foreign Investment Act” (Law No. 118 of 2014), despite Cuba’s tax incentives to joint ventures and parties to international economic association contracts, investors have no autonomy to choose their labor force. The Cuban government, through currency exchange operations, charges the investors more for the labor force than it pays the employees, among other disincentives and limitations that stifle commerce;

(2) U.S. persons residing in Cuba still may not claim the foreign-earned income exclusion or housing expense;

(3) Cuba may still expropriate the investor’s assets for “public utility” or “social interest,” although they are promised indemnification;

(4) Cuban courts have jurisdiction over certain disputes. Though Cuba has three branches of government, including a “separate” judiciary, Cuba’s constitution provides that the Communist Party is “the highest leading force of society and the State.” This relegates the judiciary to a subordinate position to the executive branch, making it “independent” more in theory than in practice; and

(5) Although restrictions on travel to Cuba have been relaxed, travel remains limited and the Cuba embargo is still very much an obstacle in many respects.

As recently as January 26, 2016, the U.S. Treasury Department said the Cuba embargo remains in place and “[m]ost transactions between the United States, or persons subject to U.S. jurisdiction, and Cuba continue to be prohibited.” It added, “OFAC continues to enforce the prohibitions of the [Cuban Assets Control Regulations (CACR)].” OFAC is the Treasury agency that enforces US sanctions.)

US Cuba regulations still pose big obstacles

The CACR contain a long list of prohibited acts and continue a comprehensive embargo on trade with Cuba. For example, although there is a growing list of exceptions, a license is required for the export and reexport to Cuba of all “U.S. origin items wherever located.” Requests to OFAC for licenses are subject to a “general policy of denial for exports and reexports to Cuba,” except for specified items, including such things as medical devices and “telecommunications items that would improve communications to, from, and among the Cuban people”.

With such uncertainty and multiple restrictions on commerce, investors who are unwilling or unable to conduct extensive compliance reviews and licensing applications, are probably well advised to avoid jumping on the Cuban commerce bandwagon. Those unprepared to traverse the regulatory labyrinth who are anxious to proceed should probably dampen their enthusiasm for the moment.

—Karen J. Lapekas is a lawyer in Miami who practices at Lapekas Law, which focuses on tax defense, representation of businesses and individuals before the IRS and the U.S. Tax Court. She previously served as Senior Attorney with the IRS Office of Chief Counsel, in Miami, representing the IRS in more than 170 cases at the U.S. Tax Court. She also provided counsel to IRS agents. She was honored with the IRS “Litigation Excellence” award. A frequent speaker and author on tax issues, she earned a Master’s Degree in tax at the University of Florida.

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