Foreign tax credit

What Is Foreign tax credit?

The foreign tax credit (FTC) is a provision in U.S. tax law that allows individuals and corporations to reduce their tax liability by the amount of income tax paid or accrued to a foreign country or U.S. possession. This mechanism falls under the broader field of International Taxation and is primarily designed to prevent double taxation on the same foreign source income. When income earned abroad is subject to taxation in both the foreign country and the United States, the foreign tax credit provides a dollar-for-dollar tax credit, which is generally more advantageous than taking it as an itemized deduction⁵⁹, ⁶⁰.

History and Origin

Before 1918, foreign taxes were generally treated as ordinary business deductions in the United States⁵⁸. The concept of the foreign tax credit was first introduced in the U.S. with the Revenue Act of 1918. This landmark legislation, enacted fundamentally to address the unfairness of double taxation on foreign-source income, made the U.S. the first country in the world to offer such a credit against U.S. income for taxes paid to foreign governments by U.S. citizens or residents⁵⁶, ⁵⁷.

A significant development followed in 1921 when the Revenue Act of 1921 introduced a limitation on the foreign tax credit, ensuring that the total foreign tax credits claimed by a taxpayer could not exceed the amount of U.S. tax liability on their foreign-source income⁵⁴, ⁵⁵. This limitation was intended to prevent foreign taxes from reducing U.S. tax liability on U.S.-source income, especially from countries with higher tax rates than the United States⁵², ⁵³. The basic framework established during this period, particularly the credit and its limitation, remains a cornerstone of U.S. international tax law today⁵¹.

Key Takeaways

• The foreign tax credit is a significant tool in U.S. tax law to alleviate double taxation on income earned abroad.⁴⁹, ⁵⁰
• It allows taxpayers to offset foreign income taxes paid or accrued against their U.S. tax liability on that same income.⁴⁷, ⁴⁸
• To claim the foreign tax credit, individuals typically use IRS Form 1116 as part of their U.S. tax return.⁴⁵, ⁴⁶
• The credit is generally limited to the amount of U.S. tax attributable to foreign source income, preventing it from reducing U.S. tax on domestic income.⁴³, ⁴⁴
• Unused foreign tax credits can often be carried back one tax year and carried forward for up to 10 succeeding tax years.⁴¹, ⁴²

Formula and Calculation

The foreign tax credit is subject to a limitation to ensure that the credit does not offset U.S. tax on U.S.-source income. The general formula for calculating the foreign tax credit limitation is:

$\text{Foreign Tax Credit Limit} = \text{U.S. Tax Liability (before FTC)} \times \frac{\text{Foreign Source Taxable Income}}{\text{Total Worldwide Taxable Income}}$

Where:

• U.S. Tax Liability (before FTC): The total U.S. federal income tax calculated before applying any foreign tax credits.
• Foreign Source Taxable income: The income earned from foreign sources, reduced by any related deductions and exclusions.
• Total Worldwide income Taxable Income: All income from both U.S. and foreign sources, after all allowable deductions.

Taxpayers must generally calculate this limitation separately for different categories of income, such as passive income or general limitation income³⁹, ⁴⁰. If the foreign taxes paid exceed this calculated limit, the excess amount may be carried back one year or carried forward for 10 years to offset foreign tax liability in those periods, subject to their respective limitations³⁷, ³⁸.

Interpreting the Foreign tax credit

The foreign tax credit serves as a critical mechanism in International Taxation to prevent double taxation for U.S. taxpayers with foreign-source income. When interpreting the foreign tax credit, it is essential to understand that its primary purpose is to allow taxpayers to offset taxes already paid to a foreign government against their U.S. tax liability on the same income. This means that if the foreign tax rate is lower than the U.S. tax rate on that income, the taxpayer will still owe some U.S. tax. Conversely, if the foreign tax rate is higher, the foreign tax credit may eliminate the U.S. tax on that specific foreign income, but generally, no refund is provided for the excess foreign taxes paid³⁶. This excess may, however, be carried over to future tax years.

Proper interpretation also requires considering the four categories of income (passive, general, high withholding tax interest, and certain others) for which the foreign tax credit must be computed separately³⁵. This "basket" approach ensures that taxes paid on one type of foreign income cannot be used to reduce U.S. tax on a different category of foreign income.

Hypothetical Example

Consider an individual, Sarah, who is a U.S. citizen and earns a salary in a foreign country. Her annual salary is $100,000, which constitutes her entire worldwide income. She pays $25,000 in income tax to the foreign country on this salary. Her U.S. tax liability on this $100,000, before considering any foreign tax credit, is $28,000.

To determine her foreign tax credit, Sarah applies the limitation formula:

• U.S. Tax Liability (before FTC) = $28,000
• Foreign Source Taxable Income = $100,000
• Total Worldwide Taxable Income = $100,000

$\text{Foreign Tax Credit Limit} = \$28,000 \times \frac{\$100,000}{\$100,000} = \$28,000$

Sarah's foreign tax credit limit is $28,000. Since she paid $25,000 in foreign taxes, which is less than her limit, she can claim the full $25,000 as a foreign tax credit.

Her final U.S. tax liability will be:
U.S. Tax Liability ($28,000) - Foreign Tax Credit ($25,000) = $3,000.

In this scenario, Sarah would pay $25,000 to the foreign country and $3,000 to the U.S., totaling $28,000 in taxes, effectively preventing double taxation up to her U.S. tax rate.

Practical Applications

The foreign tax credit has several practical applications across various financial contexts:

• Individual Income Tax Planning: For U.S. citizens and resident aliens who work or invest abroad, the foreign tax credit is a fundamental tool for managing their overall tax liability. It allows them to reduce or eliminate U.S. taxes on their foreign source income, preventing the same income from being taxed twice³⁴. Taxpayers can find detailed guidance on claiming this credit in IRS Publication 514, "Foreign Tax Credit for Individuals".³³
• International Business Operations: U.S. corporations with foreign subsidiaries or branches frequently use the foreign tax credit to offset foreign income taxes paid on their international earnings. This is crucial for maintaining competitive tax rates for global businesses and facilitating international investment³². The credit applies to both direct foreign taxes (paid by the U.S. company) and "deemed paid" indirect foreign taxes (paid by a foreign subsidiary on its earnings before distributing dividends to the U.S. parent)³¹.
• Portfolio Diversification: Investors holding foreign stocks, mutual funds, or exchange-traded funds (ETFs) that generate foreign dividends or interest may be subject to foreign withholding taxes. The foreign tax credit can often be claimed for these taxes, thereby reducing the U.S. tax due on that investment income and supporting a globally diversified portfolio.
• Global Tax Treaties: Many countries, including the U.S., enter into bilateral tax treaties to further reduce or eliminate double taxation. These treaties often incorporate provisions consistent with the OECD Model Tax Convention, which outlines methods for relief from double taxation, including the credit method²⁹, ³⁰. Such treaties can modify the application of the foreign tax credit, for example, by adjusting the source of income or limiting withholding taxes in the source country²⁷, ²⁸.

Limitations and Criticisms

While the foreign tax credit is an essential mechanism for mitigating double taxation, it comes with several limitations and has faced various criticisms:

• Qualified Taxes: Only certain types of foreign taxes qualify for the credit, primarily income tax, war profits tax, or excess profits tax, or taxes paid "in lieu" of such taxes²⁶. Taxes like foreign value-added taxes (VAT), sales taxes, or property taxes generally do not qualify²⁴, ²⁵. This restriction can limit the overall tax relief for taxpayers operating in jurisdictions with different tax structures.
• Limitation Calculation: As discussed, the foreign tax credit is subject to a complex limitation to prevent it from offsetting U.S. tax on U.S.-source income. This limitation, often calculated separately for different categories of foreign source income, can significantly reduce the amount of credit a taxpayer can claim²², ²³. The rules for allocating deductions to foreign-source income can further complicate this calculation and reduce the creditable amount²¹.
• Nonrefundable Nature: The foreign tax credit is a nonrefundable tax credit²⁰. This means it can reduce a taxpayer's U.S. tax liability to zero but cannot result in a tax refund beyond the amount of U.S. tax owed. Any excess foreign taxes beyond the limit can typically be carried back or forward, but they are not immediately refundable¹⁹.
• Complexity and Compliance Burden: The rules surrounding the foreign tax credit, particularly for individuals and corporations with diverse international income streams, are notably complex. Completing IRS Form 1116 (for individuals) or Form 1118 (for corporations) requires meticulous record-keeping and a detailed understanding of income sourcing rules, expense allocation, and separate limitation categories¹⁶, ¹⁷, ¹⁸. This complexity can lead to errors and impose a significant compliance burden on taxpayers.
• Interaction with Global Tax Reforms: Recent international tax initiatives, such as the OECD's Pillar Two GloBE Rules, aim to establish a global minimum corporate tax rate of 15%¹⁴, ¹⁵. The interaction between these new rules and existing foreign tax credit mechanisms is complex. For instance, top-up taxes imposed under the GloBE Rules may not benefit from a foreign tax credit in domestic tax regimes, raising new challenges for multinational corporations¹³. Critics argue that some of these new international proposals could disfavor U.S.-style non-refundable tax credits¹².

Foreign tax credit vs. Foreign Earned Income Exclusion

The foreign tax credit (FTC) and the Foreign Earned Income Exclusion (FEIE) are both U.S. tax provisions designed to provide relief from double taxation for Americans living and working abroad. However, they operate differently and often serve different taxpayer situations.

The foreign tax credit allows a dollar-for-dollar reduction in U.S. tax liability for income tax paid to a foreign government on foreign source income. It is a credit against taxes, meaning it directly reduces the amount of U.S. tax owed. This can be particularly beneficial for individuals in countries with higher income tax rates than the U.S., as the credit may entirely eliminate their U.S. tax obligation on that foreign income¹¹.

In contrast, the Foreign Earned Income Exclusion allows eligible taxpayers to exclude a certain amount of their foreign earned income (from wages or self-employment) from their U.S. taxable income¹⁰. This means the excluded income is not subject to U.S. federal income tax at all. The FEIE is generally advantageous for those in countries with lower or no income tax, as it reduces the amount of income on which U.S. tax is calculated, rather than directly offsetting taxes paid. Taxpayers must typically choose between claiming the foreign tax credit or the Foreign Earned Income Exclusion, as they cannot usually apply both to the same income⁹.

FAQs

1. Who is eligible to claim the foreign tax credit?

Generally, U.S. citizens and resident aliens who pay or accrue income taxes to a foreign country or U.S. possession on income that is also subject to U.S. federal income tax may be eligible to claim the foreign tax credit.⁸

2. What types of foreign taxes qualify for the credit?

Typically, only foreign income taxes, or taxes paid in lieu of income taxes, qualify for the foreign tax credit. Taxes based on net income are usually creditable. Other taxes, such as foreign sales taxes, property taxes, or value-added taxes (VAT), generally do not qualify.⁶, ⁷

3. How do I claim the foreign tax credit?

Individuals usually claim the foreign tax credit by filing IRS Form 1116, "Foreign Tax Credit (Individual, Estate, or Trust)," with their U.S. tax return. There are certain exceptions for those with small amounts of foreign passive income that may allow them to claim the credit directly on Form 1040 without filing Form 1116.⁵

4. What happens if my foreign taxes paid are more than the foreign tax credit limit?

If the qualified foreign taxes you paid exceed your foreign tax credit limitation for a tax year, the excess amount cannot be used to reduce your U.S. tax on U.S.-source income. However, you may be able to carry back the unused credit to the immediately preceding tax year or carry it forward for up to 10 succeeding tax years, subject to the limitations in those years.³, ⁴

5. Can I deduct foreign taxes instead of taking a credit?

Yes, U.S. taxpayers generally have the choice each tax year to either take foreign income taxes as a tax credit or claim them as an itemized deduction on Schedule A (Form 1040). In most cases, taking the credit is more beneficial because it reduces your U.S. tax liability dollar-for-dollar, while a deduction only reduces your taxable income.¹, ²