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Posted by Jim McClaflin, EA, NTPI Fellow, CTRC

Understanding Foreign Tax Credits

Understanding Foreign Tax Credits

Taxpayers who have accrued or paid foreign income taxes in a U.S. possession or foreign country can generally deduct those taxes from their U.S. tax on foreign source income. The foreign tax credit (FTC) is intended to relieve taxpayers of double taxation, where income is subject to both U.S. and foreign taxes.

What is the foreign tax credit?

An FTC is a dollar-for-dollar credit that equals the amount of foreign income tax paid or withheld by the taxpayer. Subject to various limitations, the amount of foreign taxes paid and U.S. holdings of foreign source income offset any U.S. taxes that would have been paid on the same income.

The Tax Cuts and Jobs Act (TCJA) of 2017 made significant changes to the foreign tax credit (FTC) rules for allocating and apportioning expenses to determine an FTC limitation under Section 904, which spurred a flurry of regulatory guidance.

How is foreign income tax defined?

"Foreign Income Tax" is a foreign income tax, as described in the Tax Regulations §1.901-2(a), that is, each different levy that is an income, excess profits tax, war profits, or a tax, in lieu of such taxes under Section 903 and applicable regulations, paid or accrued to or in a foreign country or United States possessions, including any tax deemed payable by a CFC (controlled foreign company).

The Treasury and IRS issued a final rule in January 2022 revising the definition of foreign income tax, stating that foreign income tax means a levy that is a foreign tax and that is a foreign income tax or an in-lieu of tax.

What is the difference between a direct foreign tax credit and an indirect foreign tax credit?

Direct foreign tax credits are credits for foreign income taxes that are paid by a U.S. taxpayer or a foreign branch of a United States taxpayer, as well as foreign withholding taxes. 

Indirect foreign tax credits (also known as deemed paid foreign tax credits) are foreign income taxes paid by foreign subsidiaries and withholding taxes paid by a U.S. business that meets the required 10% ownership threshold for U.S. shareholder status.

Is a U.S. corporation qualified for a foreign tax credit for dividends received from a foreign subsidiary on which the subsidiary has already accrued or paid foreign income tax?

For foreign corporation tax years beginning in 2017, the answer is no. However, suppose a U.S. corporation owns 10% or more (by value or vote) of a foreign corporation from which it receives a dividend. In that case, the U.S. corporation may deduct an amount equal to the foreign source portion of that dividend, thereby providing a tax exemption for that part of the dividend and eliminating the need for a foreign tax credit to avoid double taxation.

Is there a limit to the foreign tax credit companies can claim on foreign income tax paid in a given year? How is it calculated?

The foreign tax credit laws limit the amount of annual U.S. tax on taxable foreign source income calculated per U.S. tax principles. Thus, if the United States enterprise pays more tax to the original country on the foreign-source income than what is due to the United States on the same foreign-source income, the United States will limit how much of the income taxes that are paid to the source country can be utilized as credits against U.S. tax liability. The FTC limitation is calculated as a taxpayer's pre-credit United States tax liability multiplied by a ratio (it must not exceed one). The numerator is the taxpayer's foreign source taxable income, whose denominator is the taxpayer's global taxable income for the year.

Foreign income taxes not credited due to the limit can generally be carried forward to one or the following ten taxation years, subject to the limits in those years. However, foreign income taxes paid or payable on amounts included in gross income under the GILTI regime cannot be carried forwards or backward.



Jim McClaflin, EA, NTPI Fellow, CTRC
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