U.S. taxpayers are generally taxed on their worldwide income. But what happens when that income is also taxed by another country? The Internal Revenue Code’s primary mechanism to alleviate this double taxation of income is the foreign tax credit. The foreign tax credit provides U.S. taxpayers who owe taxes to a foreign country with a credit against their U.S. tax equal to the amount of qualifying foreign taxes paid or accrued.
Generally, U.S. taxpayers are entitled to a credit for income, war profits, and excess profits taxes paid or accrued during a tax year to any foreign country or U.S. possession, or any political subdivision of the country or possession. U.S. taxpayers living in certain treaty countries may be able to take an additional foreign tax credit for the foreign tax imposed on certain items of income. In addition, note that taxpayers making an election under section 962—to be taxed at corporate rates on certain income from a controlled foreign corporation (CFC)—are required to include that income in gross income under sections 951(a) and 951A(a) and may be entitled to claim the credit based on their share of foreign taxes paid or accrued by the CFC.
Foreign Tax Credit Basics
The foreign tax credit was first introduced in 1918. Its purpose is and was to alleviate the double taxation that occurs when a U.S. person’s income is subject to taxation by the United States and a foreign country. The United States cedes its own taxing rights, however, only where the foreign country has the primary right to tax income. See Bowring v. Comm’r, 27 B.T.A. 449, 459 (1932) (“In the case of the citizen and resident alien, the United States recognizes the primary right of the foreign government to tax income from sources therein . . . and accordingly, grants a credit.”).
Not all foreign taxes qualify for foreign tax credit treatment. Section 901 allows a credit only for income, war profits, and excess profits taxes. In other words, not all foreign taxes that may be imposed by a foreign jurisdiction—such as value-added taxes or sales taxes, or for other levies such as tariffs—will qualify for the foreign tax credit. Other taxes, such as foreign real and personal property taxes, do not qualify, although a taxpayer may be entitled to deduct these taxes.
The foreign tax credit applies only to foreign-source income. That is, the foreign tax credit can only reduce U.S. taxes on foreign source income; it cannot reduce U.S. taxes paid on U.S. source income.
U.S. taxpayers can generally elect whether to utilize the amount of any qualified foreign taxes paid or accrued during the year as a foreign tax credit or as a deduction. With some exceptions, the treatment elected applies to all qualified foreign taxes.
What Taxes Qualify for the Foreign Tax Credit?
Foreign taxes must satisfy the following criteria to qualify for the foreign tax credit:
- The taxpayer must have paid or accrued the tax.
- The tax must be an income tax or in lieu of an income tax.
- The tax must be the legal amount owed in foreign tax liability.
- The tax must be imposed on the taxpayer, and the taxpayer must be legally obligated to pay it.
The following taxes generally do not qualify for a foreign tax credit:
- Taxes on excluded income (such as the foreign earned income exclusion),
- Taxes that can only be taken as an itemized deduction,
- Taxes on foreign mineral income,
- Taxes from international boycott operations,
- Taxes paid to certain foreign countries,[1]
- A portion of taxes on combined foreign oil and gas income,[2]
- Taxes of U.S. persons controlling foreign corporations and partnerships who fail to file required information returns,
- Taxes related to a foreign tax splitting event,
- The disqualified portion of any foreign tax paid or accrued in connection with a covered asset acquisition,[3] and
- Social security taxes paid or accrued to a foreign country with which the United States has a social security agreement.
Taxes Paid or Accrued
Section 901 allows a credit for foreign income taxes in either the year the taxes are paid or the year the taxes accrue, in accordance with the taxpayer’s method of accounting for such taxes.
Taxpayers who use an accrual method of accounting can, therefore, claim the credit only in the year in which they accrue the tax. Generally, foreign taxes accrue when all the events have taken place that fix the amount of the tax and your liability to pay it.[4]
Thus, if a taxpayer is contesting the foreign tax liability, the taxpayer generally cannot accrue the liability and take a credit until the amount of foreign tax due is finally determined. However, if a taxpayer chooses to pay the tax liability being contested, if other criteria are satisfied, they may take a credit for the amount paid before a final determination of foreign tax liability is made.
Taxpayers reporting under the cash method of accounting can take the credit either in the year paid or accrued.
Note that the amount of tax withheld by a foreign country is often not entirely creditable.
The Tax Must be an Income Tax (or a Tax in Lieu of Income Tax)
In general, only income, war profits, and excess profits taxes (income taxes) qualify for the foreign tax credit. Foreign taxes on wages, dividends, interest, and royalties qualify for the credit in most cases. Furthermore, foreign taxes on income can qualify even though they are not imposed under an income tax law if the tax is in lieu of an income, war profits, or excess profits tax.
In order to constitute an income tax for U.S. tax purposes, the base of a foreign tax must conform in essential respects to the determination of taxable income for Federal income tax purposes. See, for example, Keasbey & Mattison Co. v. Rothensies, 133 F.2d 894, 895 (3d Cir. 1943) (holding that the criteria prescribed by U.S. revenue laws are determinative of the meaning of the term “income taxes” in applying the former version of section 901); and Comm’r v. American Metal Co., 221 F.2d 134, 137 (2d Cir. 1955) (providing that “the determinative question is ‘whether the foreign tax is the substantial equivalent of an ‘income tax’ as that term is understood in the United States’”).
A foreign levy is an income tax only if it meets both of the following requirements:
- It is a tax; that is, the taxpayer is required to pay it and receives no specific economic benefit from paying it.
- The predominant character of the tax is that of an income tax in the U.S. sense.
A foreign levy is a tax in lieu of an income tax only if it meets both of the following requirements.
- It is not payment for a specific economic benefit.
- The tax is imposed in place of, and not in addition to, an income tax otherwise generally imposed.
The Tax Must Be the Legal and Actual Foreign Tax Liability
The amount of foreign tax that qualifies is not necessarily the amount of tax withheld by the foreign country. Only the legal and actual foreign tax liability that is paid or accrued during the year qualifies for the credit. Thus, a taxpayer cannot take a foreign tax credit for income taxes paid to a foreign country if it is reasonably certain the amount will be refunded, credited, rebated, abated, or forgiven if a claim is made. Likewise, if a tax payment to a foreign country gives rise to a subsidy, the tax does not qualify for the foreign tax credit.
Taxpayers Eligible for the Foreign Tax Credit
US persons and tax residents are generally eligible for the foreign tax credit. Nonresident aliens and foreign corporations are only eligible for the foreign tax credit if they conduct business or trade within the U.S. and owe tax on effectively connected income (“ECI”).
Limitations on the Foreign Tax Credit
The tax laws impose limitations on the amount of foreign tax credit allowed. The foreign tax credit is, for example, limited to the amount of tax liability owed.
In addition, a foreign tax credit cannot be used to reduce U.S. taxes on income that is unrelated to the foreign income. Thus, separate income limitations are calculated for each of the following categories:
- Passive Income[5]
- General Income
- Foreign Branch Income[6]
- Global Intangible Low Taxed Income[7]
- Foreign Sourced Income from Sanctioned Countries
- Income resourced by tax treaties[8]
- Lump-sum distributions
Under IRC 904(a), taxes that are paid or deemed paid in a given year, but that are not utilized because they exceed the limitation of §904(a), can be carried back one year and carried forward 10 years. Taxes that are carried back or forward to another taxable year must be credited and cannot be deducted in the carryback or carryover year. Other limitations may also apply. The carry forward treatment is performed on a category-by-category basis to the extent that there is foreign tax credit limitation equal to or greater than the foreign tax credits paid or accrued in the carryover or carryback year or carried over from earlier taxable years.
How to Claim the Foreign Tax Credit
Individuals, estates, and trusts can claim a credit by filing Form 1116 if they paid or accrued foreign taxes. Corporations must file a separate Form 1118 to claim their foreign tax credit.
Alternatively, individual taxpayers may elect to deduct the foreign taxes.
The IRS allows for an extended period to amend previous tax returns and file a claim for a refund of taxes paid if the taxpayer did not initially claim a foreign tax credit.
International and Offshore Tax Compliance Attorneys
Need help with tax issues? Contact us as soon as possible to discuss your rights and the ways we can assist in your defense. We handle all types of cases, including complex international & offshore tax compliance. Schedule a consultation or call (214) 984-3000 to discuss your international tax concerns or questions.
[1] These countries are those designated by the Secretary of State as countries that repeatedly provide support for acts of international terrorism, countries with which the United States doesn’t have or doesn’t conduct diplomatic relations, or countries whose governments aren’t recognized by the United States and aren’t otherwise eligible to purchase defense articles or services under the Arms Export Control Act.
[2] This includes taxes paid or accrued to a foreign country in connection with the purchase or sale of oil or gas extracted in that country if the taxpayer doesn’t have an economic interest in the oil or gas, and the purchase price or sales price is different from the fair market value of the oil or gas at the time of the purchase or sale.
[3] Covered asset acquisitions include certain acquisitions that result in a stepped-up basis for U.S. tax purposes.
[4] Regardless of the year in which the credit is allowed, the taxpayer must both owe and actually remit the foreign income tax to be entitled to a foreign tax credit for such tax. The taxpayer’s liability for the tax may become fixed and determinable in a different taxable year than that in which the tax is remitted, so that the taxpayer’s entitlement to the credit may be perfected in a taxable year after the taxable year in which the credit is allowed.
[5] Passive income generally includes dividends, interest, royalties, rents, annuities, excess of gains over losses from the sale of property that produces such income or of non-income-producing investment property, and excess of gains over losses from foreign currency or commodities transactions. Capital gains not related to the active conduct of a trade or business are also generally passive income.
Passive income doesn’t include export financing interest, active business rents and royalties, or high-taxed income. High-taxed income is income if the foreign taxes you paid on the income (after allocation of expenses) exceed the highest U.S. tax that can be imposed on the income.
Specified passive category income. Dividends from a domestic international sales corporation (DISC) or former DISC to the extent they are treated as foreign source income, and certain distributions from a former foreign sales corporation (FSC) are specified passive category income.
[6] Foreign branch category income consists of the business profits of U.S. persons that are attributable to one or more qualified business units (QBUs) in one or more foreign countries. Foreign branch category income doesn’t include any passive category income.
[7] Section 951A category income includes any amount included in gross income under section 951A (other than passive category income). Section 951A category income is otherwise referred to as global intangible low-taxed income (GILTI) and is included by U.S. shareholders of certain CFCs.
[8] See sections 865(h), 904(d)(6), and 904(h)(10) and the regulations under those sections (including 1.904-4(k)) for any grouping rules and other exceptions.
