Understanding Foreign Tax Credits
With so many U.S. businesses operating abroad and an increasing number of U.S. citizens residing abroad or receiving income from foreign sources—especially through partnership investments—there are often questions on the taxation of this income. While many countries have a territorial tax system in which a person is only taxed on income earned in that country, the United States taxes U.S. persons on their worldwide income. If foreign income is earned by a U.S. person, this can lead to double taxation since income earned abroad is often taxed abroad, and is then also taxed in the United States. In order to alleviate this double taxation, the U.S. allows a foreign tax credit which permits U.S. persons to take a credit, subject to certain limitations, on their U.S. Income Tax return for taxes that they have paid to foreign jurisdictions.
In order for taxes paid to a foreign jurisdiction to be creditable, the tax must either be paid or accrued, and it must be either an income tax or a tax in lieu of income tax (such as withholding on dividends). Sales tax or value added tax paid to a foreign jurisdiction would be an example of a foreign tax for which a U.S. person cannot take a credit. Similarly, fines and penalties are not creditable. The foreign income tax must be compulsory and must not exceed the amount of tax liability under foreign law. In addition, if it is reasonably certain that the tax will be refunded in the foreign jurisdiction, a credit cannot be taken in the United States.
Once the amount of foreign tax that is eligible to be credited has been determined, the amount of the credit allowed to be taken against U.S. tax for a certain year must be determined. This is a detailed process which involves:
- Sourcing gross income as either U.S. source or foreign source based upon the sourcing rules for that type of income
- Classifying foreign source income as either Passive Income (certain investment type income), or General Limitation income (any income that is not passive income)
- Properly allocating direct expenses, indirect expenses, and interest expense against foreign source income
- Determining the amount of credit that may be taken in the current year based upon a ratio of foreign source taxable income to total taxable income, which is then applied to the U.S. income tax shown on the tax return
Other factors that can further complicate this computation include:
- Foreign source income from partnership investments
- Deemed dividends from controlled foreign corporations
- Income tax treaties between the U.S. and foreign governments
- The foreign earned income exclusion for U.S. citizens residing abroad
- Payment versus accrual of taxes
- Overall domestic or foreign losses
From this brief overview, it is clear that the computation of foreign tax credits can often be quite complex to understand. Nevertheless, foreign tax credits are very helpful in reducing the impact of double taxation on the foreign income of U.S. persons. For more information on foreign tax credits or our services, please contact us at firstname.lastname@example.org or (212) 245-5900.
Eric Swerdlow, CPA, MST is a Tax Manager who has been with FF&F for 10 years. He specializes in corporate and partnership taxation, with a strong background in consolidated corporations, business planning, provisions for income tax, international operations, foreign tax credits, partnership basis step-up and special allocations, fixed assets, and capitalization. Eric’s focus industries include shipping, transportation, oil and gas services, energy, and manufacturing and wholesale.