Foreign Tax Credit
Many national tax systems the world over offer a version of the foreign tax credit (also known as a rebate or offset in some countries), but its availability and the mechanics for claiming it can vary considerably. Regions where a foreign tax credit is generally not available include much of Central America – excluding Mexico – and the Middle East, aside from Turkey and Israel. And, of course, for jurisdictions that operate on a territorial basis or as tax-free zones, the need for foreign tax credit falls away.
What is the foreign tax credit?
A foreign tax credit is one of three main methods, alongside deduction and exemption, by which to prevent, or at least mitigate, the double taxation of foreign-source income. Whereas the credit is usually tied to the amount of the domestic tax liability on the same income, the deduction treats the foreign tax paid as an above-the-line expense, reducing net taxable income by that amount.
Under a pure exemption method, the foreign income concerned avoids tax in the residence country. If progressive rates are involved, however, the method adds the exempt income back to the non-exempt income in calculating the domestic tax liability. Although not a general rule, it is common among jurisdictions to find a combination of these options available.
Barring the availability of an exemption, if a taxpayer has the option to choose between taking a credit or deduction and is not in a loss position, the credit will generally be the preferred choice, given that it reduces the taxpayer’s overall domestic tax liability on a 1:1 basis (or approximately so), perhaps subject to limitations.
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What is the scope of covered foreign taxes eligible for credit relief?
The classic foreign tax credit system may apply to any foreign-source taxable income, be it active (business profits/wages), passive (rents/royalties), and/or portfolio-based (dividends/interest/capital gains) and will be available to companies and individuals and trusts and estates, albeit according to different rules.
Domestic laws on this point span the gamut from being general to extensive. In terms of treaty relief, the basic principle is that the credit applies to foreign tax on all kinds of income, including profits and gains, and elements thereof. This coverage may extend to taxes at the subnational levels. It is also common for treaties to identify other taxes associated with a special industry that concern a treaty partner.
Ineligible taxes under current models of income/capital tax treaties include gross receipts-type taxes (e.g., VAT and GST) and refundable taxes, as well as penalties/fines and any other levy not expressly covered. Some of these items may be dealt with by other agreements (e.g., on pensions and inheritance). However, digital services remain outside the scope of standard tax treaties, because typically such services occur without physical presence in a jurisdiction.
Once the Two Pillar solution (BEPS 2.0) being negotiated under the auspices of the OECD/G20 is implemented, a new aspect to the foreign tax credit, in this case affecting cross-border digital services, will come into existence, but as it stands it will affect only the largest technology companies in the world.
Learn how the OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting (BEPS) addresses tax challenges arising from the growth of the digital economy.
How do foreign tax credit calculations vary?
There can be substantial differences among countries in terms of the mechanics for applying foreign tax credit. Although some jurisdictions may provide a full credit for eligible foreign taxes, the most common approach is based on the ordinary method, which limits the maximum credit to the corresponding amount of domestic tax assessed on the foreign income at issue.
However, some jurisdictions will require involved calculations to arrive at that sum. It may be that the foreign income concerned must first be separated by source country and then categorized according to type, each grouping with respective limitations.
There are also jurisdictions that take a mixed approach, for example, offering the option to choose to calculate the credit on a per country or overall limitation, with the possibility of allocating losses among countries, based on a ratio of income in the first country to worldwide income. Complex rules on timing, ordering, and imputing passive income may also factor into the calculation. Moreover, even after the credit amount has been determined, some jurisdictions will place a cap on the total amount of credit allowed.
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What is the difference between a direct and indirect foreign tax credit?
A direct foreign tax credit ameliorates foreign taxes paid or accrued directly by the taxpayer, including the case in which a local office or disregarded entity of a foreign corporation is engaged in business activities in the source country. Foreign taxes in this sense are levied either by way of assessment on net income or by withholding on a gross basis on the income derived locally from business operations, the provision of employment or other services, or investments.
Indirect foreign tax credit (also known as deemed-paid or underlying credit) addresses the two-level taxation inherent in taxing the business profits of foreign subsidiaries or investment companies in the source jurisdiction that are distributed up the ownership chain as dividends to shareholders. Ownership thresholds must be met and typically range from 10–20%. Restrictions are also placed on the kind and number of subsidiary tiers in the ownership structure that are allowed to be utilized for this purpose.
Subscriber-Only Resource: Tax Practice Series: U.S. Persons — Worldwide Taxation
This section of the Tax Practice Series covers the two kinds of credits that comprise the foreign tax credit, generally referred to as the “direct” credit, and the “indirect” or “deemed-paid” credit.
What are excess foreign tax credits?
A common situation confronting taxpayers occurs when, after determining the final credit amount in a given year, taking into account all applicable limitations and restrictions, one ends up in a position of excess credits. This outcome can also occur, for instance, in situations involving adjustments to a tax year based on the inclusion of net operating losses from another year, where such flexibility is permitted.
To address this outcome, many jurisdictions will allow taxpayers to carry forward excess credits to future years, and a lesser number permit them to be carried back to prior years. At the other end of the spectrum, there are jurisdictions, such as Germany, that do not offer these rules. If there is no such provision in the domestic law or an applicable treaty, excess credits will be forfeited.
On January 4, 2022, the Treasury and the IRS published T.D. 9959, finalizing portions of the third set of proposed foreign tax credit regulations published in the Federal Register in November 2020.
What are tax sparing credits?
Many countries have incorporated a policy into their tax treaty networks by agreeing to forego resident state taxation of the foreign source income of constituent taxpayers who benefit from incentives (be it trade, investment or tax) in the partner source country (often a developing country). This special relief may be in the form of a credit or deduction or an exemption for the amount of foreign tax deemed paid in the source country, up to the value of the incentive concerned.
For decades, tax sparing arrangements have remained a fundamental part of the global map of available foreign tax relief. In particular, Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Italy, Norway, Sweden and the United Kingdom stand out for the high number of tax treaties with these arrangements. The United States, on the other hand, has never negotiated such an agreement.
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