Taxpayers who have paid or accrued qualified income taxes to a foreign country or U.S. possession may generally credit those taxes against their U.S. income tax liability on foreign-source income. Specifically, the foreign tax credit is a dollar-for-dollar credit equal to the amount of foreign taxes (or taxes imposed by U.S. possessions) paid or deemed paid by the taxpayer.
The foreign tax credit is designed to relieve taxpayers from double taxation when income is subject to both U.S. and foreign tax. By permitting a credit against U.S. tax for tax paid on foreign-source income, the U.S. is ceding taxing jurisdiction to the source country and thereby reducing the total tax burden to the lower of the U.S. tax on the foreign-source income or the source country’s tax on the income. Subject to various limitations, the amount of tax paid to foreign countries and U.S. possessions on foreign income offsets any U.S. tax that would be paid on the same income.
The 2017 Tax Cuts and Jobs Act (TCJA) made significant changes to the foreign tax credit and related rules for allocating and apportioning expenses for purposes of determining the FTC limitation under §904, which spurred a flurry of regulatory guidance.
How is foreign income tax defined?
A “foreign income tax” means a foreign income tax as described in Reg. §1.960-1(b)(5), that is, each separate levy that is an income, war profits, and excess profits tax, and a tax in lieu of such taxes within the meaning of §903 and the regulations thereunder, imposed by a foreign country or U.S. possession, including any such tax deemed paid by a CFC. The fact that a foreign government calls a payment a tax is not determinative. Treasury and the IRS published proposed regulations in November 2020 that would revise the definition of a foreign income tax by providing that a foreign income tax means a foreign tax that is a net income tax.
Subscriber-Only Resource: OnPoint: Foreign Tax Credit 2020 Final & Proposed Regulations
This presentation highlights key takeaways from the 2020 final regulations, which address topics including the allocation and apportionment of certain expenses and foreign tax redeterminations under §905(c).
What is the difference between a direct and an indirect foreign tax credit?
Direct FTCs are credits for foreign income taxes paid by a foreign branch of a U.S. taxpayer, as well as foreign withholding taxes. Indirect FTCs are based on foreign income taxes paid by foreign subsidiaries and deemed paid by a U.S. domestic corporation that meets the 10% ownership threshold.
This roadmap covers the 2019 and 2020 proposed and final regulations relating to the foreign tax credit, as introduced by the 2017 Tax Cuts and Jobs Act.
If a U.S. corporation receives a dividend from a foreign subsidiary, is it entitled to a foreign tax credit for foreign income taxes paid or accrued by the foreign subsidiary?
For taxable years of foreign corporations beginning after 2017, the answer is no. However, if a U.S. corporation owns at least 10% (by vote or value) of a foreign corporation from which it receives a dividend, the U.S. corporation is allowed to deduct an amount equal to the foreign-source portion of that dividend, in effect providing a U.S. tax exemption for that portion of the dividend and eliminating the need for a foreign tax credit to prevent double taxation.
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Is there a limitation on the amount of foreign income taxes that can be credited in a particular taxable year?
Foreign tax credits are limited annually to the amount of U.S. tax on foreign-source taxable income as computed under U.S. tax principles. Thus, if the U.S. person pays more tax to the source country on the foreign-source income than is due to the U.S. on the same foreign-source income, the U.S. will limit the amount of taxes paid to the source country that can be used as credits against U.S. tax liability. The foreign tax credit limitation is computed as a taxpayer’s pre-credit U.S. tax liability multiplied by a ratio (not to exceed one), the numerator of which is the taxpayer’s foreign-source taxable income and the denominator of which is the taxpayer’s worldwide taxable income for the year.
Foreign income taxes not credited because of the limitation can generally be carried back or forward to other taxable years, subject to the limitations for those years. However, foreign income taxes paid or accrued with respect to amounts includible in gross income under the GILTI regime may not be carried back or carried forward.
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 make up the foreign tax credit, generally referred to as the “direct” credit, and the “indirect” or “deemed-paid” credit.
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