Foreign Tax Credit

Key Takeaways

• The foreign tax credit can reduce U.S. income tax when a taxpayer has already paid qualifying income taxes to a foreign country or U.S. possession.
• The credit is generally limited to the U.S. tax attributable to foreign-source income, preventing foreign taxes from offsetting tax on U.S.-source income.
• Different types of foreign income are placed into separate categories, or “baskets,” and the limitation is calculated separately for each.
• Excess qualifying credits may generally be carried back one year and forward up to 10 years, subject to specific rules.
• Proper documentation and tracking are important when foreign tax liabilities later change.

What Is the Foreign Tax Credit?

The foreign tax credit is designed to reduce double taxation when U.S. taxpayers earn income abroad and pay income tax to another country. Rather than paying full income tax twice on the same income, an eligible taxpayer may claim a credit against U.S. income tax for qualifying foreign taxes paid or accrued.

Individuals generally claim the credit using Form 1116, while corporations generally use Form 1118. The credit is nonrefundable, meaning it can reduce U.S. tax liability to zero but cannot create a refund beyond the amount of tax otherwise owed.

Which Foreign Taxes Qualify for the Credit and Which Do Not?

Generally, the foreign tax must be imposed on the taxpayer, actually paid or accrued, represent the taxpayer’s legal and actual foreign tax liability, and qualify as an income tax or a tax imposed in place of an income tax. Income taxes on wages, dividends, interest and royalties may qualify.

Foreign taxes generally do not qualify for the credit if they are refundable or relate to income excluded from U.S. taxation. Taxes such as VAT, sales taxes, property taxes, and penalties generally do not qualify because they are not income taxes or taxes imposed in place of income taxes. Certain foreign social security taxes and taxes associated with restricted activities may also be ineligible under specific IRS rules.

How the Section 904 Limitation Prevents the Credit From Offsetting US-Source Income

The foreign tax credit limitation generally prevents taxpayers from using foreign taxes to reduce U.S. tax attributable to U.S.-source income. Under Section 904, the maximum credit is based on the portion of total U.S. tax associated with foreign-source taxable income.

In simplified terms, the calculation compares foreign-source taxable income with total taxable income and applies that ratio to U.S. tax before foreign tax credits. The limitation is calculated separately for applicable income categories, so excess foreign tax credits generally cannot offset U.S. tax attributable to income in another category. Eligible unused credits may be carried back or forward, subject to applicable rules.

How Foreign Tax Credit Carryovers Work When the Limitation Is Exceeded

When qualifying foreign taxes exceed the amount allowed under the Section 904 limitation, the unused amount may become a foreign tax credit carryover. In general, excess foreign taxes are carried back one year first and may then be carried forward for as many as 10 years.

Carryovers must remain within their original income category. For example, an unused passive-category credit cannot normally be used against the limitation for general-category income. Credits that remain unused after the permitted carryforward period expire. Special rules apply to certain categories, including Section 951A income, where excess credits generally do not carry forward or back.

How to Plan Around the Foreign Tax Credit Limitation

Planning begins with correctly identifying the source and category of foreign income, allocating deductions and tracking foreign taxes by year and basket. Taxpayers should also determine whether using the foreign earned income exclusion affects the amount of credit they can claim, because taxes associated with excluded income generally cannot also generate a credit.

Businesses may also need to consider how Transfer Pricing affects where income is reported and taxed across jurisdictions.

Careful recordkeeping becomes especially important when foreign taxes are later refunded, reassessed or otherwise changed, because those events may require a prior-year U.S. tax calculation to be revisited.

FAQ

How does the foreign tax credit differ from the income exclusion?

The foreign tax credit reduces U.S. taxes for qualifying foreign taxes paid, while the foreign earned income exclusion removes eligible foreign earnings from taxable income. Taxes on excluded income generally cannot be credited.

Can individuals claim the foreign tax credit on a Form 1040?

Yes. Individuals may claim qualifying foreign tax credits with their Form 1040. Depending on the amount and type of foreign income and taxes involved, they may need to attach Form 1116 and calculate the applicable limitation by income category.

Does the foreign tax credit apply to foreign withholding taxes?

It can. Foreign withholding taxes on items such as dividends, interest and royalties may qualify when the tax otherwise meets the U.S. requirements for a creditable foreign income tax. The amount creditable can also depend on applicable treaty rates.

Which foreign tax credit basket applies to most individual investors?

Foreign dividends, interest, rents, royalties and many foreign investment gains generally fall within the passive category. Earned income such as wages, salaries and active business income generally belongs in the general category, with each basket receiving its own limitation calculation.

Companies with international operations may also face related considerations during Transfer Pricing Examinations, particularly when income allocations across jurisdictions affect the taxes ultimately reported and paid.

How BT Can Help

For more than four decades, Bennett Thrasher has provided businesses and individuals with strategic business guidance and solutions through professional tax, audit, advisory, and business process outsourcing services. Contact Bennett Thrasher’s International Tax practice, or call us at 770.396.2200.