Foreign tax credits

What Is Foreign Tax Credits?

Foreign tax credits (FTCs) are a provision in many countries' tax codes that allows taxpayers to reduce their domestic tax liability by the amount of income taxes paid to a foreign country. This mechanism falls under the broader category of International Taxation and is primarily designed to prevent double taxation, where the same income is taxed by two different jurisdictions. By providing a direct dollar-for-dollar reduction of U.S. income tax rather than merely a tax deduction, foreign tax credits are generally more beneficial to taxpayers earning foreign income.

History and Origin

The concept of foreign tax credits emerged as a response to the increasing globalization of commerce and the potential for income earned abroad to be taxed by both the source country and the taxpayer's home country. In the United States, the foreign tax credit was first enacted with the Revenue Act of 1918. Before this, foreign taxes were generally treated as a deductible expense, similar to other business costs. However, with the rising tax rates during World War I, allowing only a deduction proved insufficient to alleviate the burden of double taxation, prompting Congress to introduce the credit system.¹⁷,¹⁶

This unilateral measure by the U.S. in 1918 aimed to prioritize the mitigation of double taxation for its citizens and corporations.¹⁵ Subsequently, the Revenue Act of 1921 introduced a limitation to the foreign tax credit, ensuring that the credit could not exceed the U.S. tax liability on foreign-source income, preventing taxpayers from using foreign taxes to offset U.S. tax on domestic income.¹⁴,¹³ The development of international tax treaties and model conventions, such as the Organisation for Economic Co-operation and Development (OECD) Model Tax Convention, further solidified global efforts to combat double taxation and streamline international tax rules.¹²,¹¹

Key Takeaways

• Foreign tax credits directly reduce a taxpayer's domestic tax liability, offering greater relief than a tax deduction.
• Their primary purpose is to prevent double taxation of income earned in foreign countries.
• The credit is generally limited to the amount of U.S. tax on the foreign-source income.
• Taxpayers typically report and calculate foreign tax credits using Form 1116 for individuals or Form 1118 for corporations.
• Only qualified foreign income taxes are eligible for the credit, generally excluding property or sales taxes.

Formula and Calculation

The calculation of 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 limitation formula aims to restrict the credit to the amount of U.S. tax that is attributable to foreign source income.

The foreign tax credit limitation is calculated as:

Where:

• U.S. Tax Liability (before FTC) represents the taxpayer's U.S. federal income tax before applying any foreign tax credits. This amount is derived from their overall tax return.
• Foreign Source Taxable Income is the taxpayer's gross income from foreign sources, reduced by any expenses directly related to that income and a ratable share of expenses not directly related.
• Worldwide Taxable Income is the taxpayer's total taxable income from both U.S. and foreign sources.

If the foreign taxes paid or accrued exceed this limit, the excess amount can often be carried back one year and carried forward for up to ten years to offset foreign income tax liabilities in those periods.¹⁰

Interpreting the Foreign Tax Credits

Understanding foreign tax credits involves recognizing their role in mitigating the burden on individuals and corporations with international earnings. When a taxpayer has paid taxes to a foreign government on income also subject to U.S. tax, the foreign tax credit allows for a direct offset, effectively treating the foreign tax as if it were paid to the U.S. Treasury. This prevents the taxpayer from being penalized for engaging in international economic activity or investment.

Interpreting the credit also means understanding its "use it or lose it" nature within the limitations. If the amount of foreign taxes paid exceeds the calculated limit for a given year, the excess credit cannot be used in that year to reduce U.S. tax on domestic income. Instead, these excess foreign tax credits may be carried forward or backward, allowing for potential future tax savings or a refund in prior years. This carryover/carryback provision highlights the credit's intent: to relieve double taxation on foreign income, not to reduce U.S. tax on U.S. income.

Hypothetical Example

Consider Sarah, a U.S. citizen living abroad, who earned $100,000 in taxable income from a foreign country in 2024. She paid $25,000 in income taxes to that foreign country. Her total worldwide taxable income, including her foreign earnings, is $100,000. Sarah's hypothetical U.S. tax liability before any credits on this $100,000 income would be $30,000.

To calculate her foreign tax credit, she would use the limitation formula:

In this scenario, Sarah can claim a foreign tax credit of $25,000 (the lower of the foreign taxes paid, $25,000, or the FTC Limit, $30,000). Her final U.S. tax liability would be $30,000 - $25,000 = $5,000. If the foreign tax paid had been, say, $35,000, she would still only be able to claim a credit of $30,000, and the excess $5,000 could be carried forward or back. Individuals typically report this on Form 1116.

Practical Applications

Foreign tax credits are a crucial component of tax planning for individuals and businesses engaged in international trade and investment. For expatriates, the credit helps prevent their foreign-earned income from being taxed twice, once by the host country and again by the U.S. For multinational corporations, foreign tax credits are vital in managing their global tax liability and ensuring competitive operations across different tax jurisdictions.

The credit is particularly relevant in the context of global investment portfolios, where dividends, interest, and capital gains from foreign sources may be subject to withholding tax in the country of origin. Taxpayers can often claim a foreign tax credit for these amounts. Furthermore, the U.S. has established income tax treaties with many countries to further clarify taxing rights and reduce or eliminate double taxation, often complementing the foreign tax credit provisions. A comprehensive list of these treaties is available through the U.S. Department of the Treasury.⁹,⁸

Limitations and Criticisms

While designed to prevent double taxation, foreign tax credits are subject to specific limitations and have faced some criticisms. The primary limitation is that the credit cannot exceed the U.S. tax attributable to the foreign income. This rule, known as the foreign tax credit limitation, means that if a foreign country's tax rate is higher than the U.S. rate, the taxpayer may not be able to credit all the foreign taxes paid. The excess foreign taxes are then either carried over to other years or lost, creating what is sometimes referred to as "excess foreign tax credits."

Another area of criticism and complexity arises from the definition of what constitutes a "creditable" foreign tax. Generally, only foreign income taxes qualify, meaning that other taxes, such as value-added taxes (VATs), sales taxes, or property taxes, are not eligible for the credit.⁷ Recent changes to U.S. Treasury regulations regarding creditable foreign taxes have also drawn scrutiny, with some arguing that these amendments deviate from the historical policy goal of mitigating double taxation without explicit Congressional authorization.⁶ These complexities necessitate careful consideration and detailed recordkeeping to ensure compliance and maximize the benefit of the foreign tax credit.

Foreign Tax Credits vs. Tax Deduction

The distinction between foreign tax credits and a tax deduction for foreign taxes paid is significant for taxpayers. A foreign tax credit directly reduces the amount of U.S. tax liability on a dollar-for-dollar basis. For example, if you owe $10,000 in U.S. tax and have a $1,000 foreign tax credit, your U.S. tax liability is reduced to $9,000.

In contrast, taking a tax deduction for foreign taxes reduces your taxable income. If you have $100,000 of taxable income and deduct $1,000 in foreign taxes, your taxable income becomes $99,000. Your tax liability is then calculated on this lower amount. Since credits provide a direct offset to the tax owed, they are almost always more advantageous than deductions, particularly for income taxes. The Internal Revenue Service (IRS) generally advises taxpayers that taking the credit is more beneficial.⁵ Taxpayers must choose each year whether to take a credit or a deduction for all qualified foreign taxes paid.⁴

FAQs

Q1: Who is eligible to claim foreign tax credits?

U.S. citizens and resident aliens who pay or accrue income taxes to a foreign country on foreign-source income that is also subject to U.S. tax are generally eligible to claim foreign tax credits.

Q2: Can I claim a foreign tax credit for all types of foreign taxes?

No, generally only foreign income taxes qualify for the credit. Taxes such as sales taxes, property taxes, or value-added taxes (VAT) typically do not qualify. However, some non-creditable foreign taxes might be deductible as itemized deductions or business expenses.³

Q3: What is Form 1116?

Form 1116 is the Internal Revenue Service (IRS) form used by individuals, estates, and trusts to calculate and claim the foreign tax credit. It helps determine the amount of creditable foreign taxes and applies the foreign tax credit limitation.

Q4: What happens if my foreign taxes paid are more than the foreign tax credit limit?

If your qualified foreign taxes exceed the foreign tax credit limit for a given year, you may be able to carry back the unused credit one year or carry it forward for up to ten years to offset future U.S. tax liabilities on foreign income.²

Q5: Do tax treaties affect foreign tax credits?

Yes, tax treaties between the U.S. and foreign countries can influence how foreign income is taxed and how foreign tax credits are applied. These treaties often clarify which country has the primary taxing right and can reduce withholding tax rates, further reducing the potential for double taxation.¹