Foreign Tax Credit
The U.S. tax system includes a foreign tax credit to mitigate the possibility of double taxation. This credit, which is at the heart of U.S. outbound taxation, reduces the U.S. taxes on income earned outside the country that has been subjected to a tax in the foreign jurisdiction. In effect, the foreign tax credit allows for a full offset for any foreign taxes paid, up to the level of tax that would be assessed on that same income in the United States.
Limitations and Applicability
The foreign tax credit [IRC Section 901(a)] allows U.S. taxpayers to reduce U.S. tax paid on foreign income by the amount of foreign taxes paid on that income. Generally, taxpayers are prevented from using foreign tax credits to reduce U.S. tax liability on income from sources within the United States. A primary area of concern with respect to the foreign tax credit relates to the classification of income. Determining whether the income is classified as foreign or U.S.-sourced will impact the foreign tax credit limitation and the available credit.
The amount of the foreign tax credit that can be applied against U.S. tax liability is subject to limitation under the foreign tax credit limitation [IRC Section 904]. The credit against U.S. income tax is allowed for any income, war profits and excess profits taxes paid or accrued by the taxpayer to a foreign country or United States possession during the tax year. This includes taxes paid in lieu of income, war profits and excess profits taxes [IRC Section 903]. The credit may not be claimed against any U.S. tax, such as the accumulated income tax, that is not treated as a regular income tax. The credit is nonrefundable.
A foreign tax credit may be claimed for taxes paid directly, as well as indirectly. A domestic corporation that owns at least 10% of the voting stock of a foreign corporation from which it receives dividends is deemed to have paid a percentage of the foreign corporation’s foreign taxes. Additionally, domestic corporations (or individuals electing to be taxed at corporate rates) that are 10% shareholders in foreign corporations are entitled to claim the foreign tax credit with respect to amounts attributable to the foreign corporation’s earnings and profits that are included in gross income.
Note, that as an alternative to claiming the credit, a taxpayer may choose to deduct the foreign taxes paid or accrued.
Deduction vs. Credit
The taxpayer can choose whether to take a deduction or claim a credit. Generally, it is more advantageous to credit qualified foreign taxes than to deduct them because the credit, which is taken against a taxpayer’s U.S. tax liability, reduces U.S. income taxes on a dollar-for-dollar basis. In contrast, a deduction merely reduces the taxpayer’s income subject to tax.
Further, the foreign tax credit can be claimed by an individual taxpayer regardless of whether the taxpayer itemizes deductions. Individual taxpayers who deduct foreign taxes must claim the taxes as an itemized deduction on Schedule A, Form 1040. Also, a taxpayer may not deduct foreign taxes paid on income exempt from U.S. tax; whereas, within certain limitations, this restriction does not apply to taxes credited.
In certain circumstances, particularly with lower-level adjusted gross income, there will be cases where a deduction yields a more advantageous tax position. No portion of the taxes subject to the credit is allowable as a deduction from gross income for the tax year or any succeeding tax year.
Taxpayers entitled to claim the foreign tax credit, with respect to taxes paid or accrued to foreign countries and U.S. possessions, generally include:
- U.S. citizens, whether residents or nonresidents;
- Domestic corporations;
- Alien residents of the United States; and
- Alien individuals who are bona fide residents of Puerto Rico for the entire tax year.
Note, that any of these potential claimants may claim the foreign tax credit for that taxpayer’s share of taxes of a partnership in which the taxpayer is a partner, or of an estate or trust, in which the claimant is a beneficiary. For purposes of the foreign tax credit, an S corporation is treated as a partnership, with its shareholders treated as partners. Accordingly, the foreign taxes paid by an S corporation will pass through to its shareholders who may claim the foreign tax credit. An S corporation is ineligible for the foreign tax credit with respect to foreign taxes paid by a foreign corporation in which the S corporation is a shareholder.
When determining the possible benefits of utilizing the foreign tax credit, it is important to fully understand which taxes assessed by the foreign country are considered (creditable) in calculating the foreign tax credit. Foreign taxes that are creditable are generally those that are based on net gain. The term “foreign tax” is mainly defined by Treasury regulations. However, even with this detailed information, it can be exceedingly difficult to immediately ascertain which foreign taxes fall within this definition.
The IRS has issued a number of specific rulings to address which foreign taxes qualify, and other limitations may apply. Tax treaties with other countries should also be considered. It is best to consult your GYF Tax Executive for assistance with determining which taxes are creditable.
Year of the Credit
The foreign tax credit may ordinarily be taken either in the year when the taxes are accrued or in the year in which they were paid, depending upon whether the taxpayer is on the accrual or the cash basis. However, a cash-basis taxpayer may elect to claim the credit on an accrual basis. Unused credits, which cannot be claimed for a tax year because of the limitations on claiming the foreign tax credit, may be carried back to the two preceding years and forward to the five succeeding years. Further, a taxpayer may elect the foreign tax credit at any time during the 10-year period of limitations.
One great resource for learning more about the foreign tax credit and the many nuances associated with its proper determination is IRS Publication 514