Foreign Tax Credit Limitations and Rules for U.S. Corporations

May 14, 2024
Foreign Tax Credit Limitations and Rules for U.S. Corporations

Taxpayers who have paid or accrued foreign 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. The foreign tax credit is designed to relieve taxpayers from double taxation when income is subject to both U.S. and foreign tax.

In this article, we break down the new foreign tax credit limitations, requirements, and related international tax planning considerations for U.S. corporations to help you determine how to leverage foreign tax credits as part of your corporate tax planning strategy.

What is the foreign tax credit?

The foreign tax credit is a dollar-for-dollar credit equal to the amount of foreign income taxes paid or deemed paid by the taxpayer.

Subject to various limitations, the amount of tax paid to foreign countries and U.S. possessions on foreign-source income is designed to offset U.S. tax that would be paid on the same income.

How is foreign income tax defined?

A “foreign income tax” is described in Reg. §1.901-2(a) as each separate levy that is an income, war profits, or excess profits tax, or a tax in lieu of such taxes within the meaning of §903, paid or accrued to a foreign country or U.S. possession, as well as income taxes deemed paid by a controlled foreign corporation under §960.

The U.S. Treasury and IRS published final regulations in 2022 that revised the definition of a foreign income tax to mean a foreign levy that is a foreign tax and that is either a net income tax or an in-lieu-of tax. To qualify, foreign net income taxes need to generally match the way U.S. net income taxes are calculated, including incorporating receipts and gains and allowing for deductions.

[Find out if you can claim foreign tax credit under Section 901. Our Guide to Foreign Tax Credit §901 breaks down the requirements.]

Direct vs. indirect foreign tax credits

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

Indirect foreign tax credits (also referred to as deemed paid foreign tax credits) are based on foreign income taxes paid by foreign subsidiaries and deemed paid by a U.S. corporation that meets the 10% ownership threshold for U.S. shareholder status.

Foreign tax paid on dividends

For taxable years beginning after 2017, U.S. corporations aren’t entitled to a foreign tax credit on income received through dividends received from a foreign subsidiary.

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.

Foreign tax credit limitation

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

Foreign tax credit rules limit the amount of credit available to offset U.S. tax on foreign-source taxable income. If the U.S. corporation 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 how much of the foreign income taxes paid to the source country can be used as credits.

Temporary relief from new foreign tax credit rules

On July 21, 2023, the IRS issued Notice 2023-55, which offers taxpayers temporary relief from new foreign tax credit rules, barring a few exceptions.

When the IRS tightened foreign tax credit regulations in 2022, many corporate taxpayers complained that the new rules limited their ability to credit some of their foreign tax expenditures toward their U.S. tax bills. To qualify as a creditable tax, the 2022 standards required taxpayers to have a nexus of activity in a foreign country and recover significant costs attributable to their gross receipts there.

After significant pushback, the IRS, per Notice 2023-55, allowed taxpayers to follow pre-2021 rules when determining their foreign tax credit eligibility for tax years 2022 and 2023. Notice 2023-80 subsequently extended this relief to future years. Digital service taxes, however, are not eligible for credit.

Foreign tax credit calculation

The foreign tax credit limitation is calculated as a taxpayer’s precredit U.S. tax liability multiplied by a ratio (not to exceed one), where the numerator is the taxpayer’s foreign-source taxable income, and the denominator is the taxpayer’s worldwide taxable income for the year.

Foreign tax credit carryover

Foreign income taxes not credited because of the limitation can generally be carried back one year or forward to the 10 succeeding 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.

Simplify your foreign tax credit calculations with Bloomberg Tax Workpapers

With new foreign tax credit regulations and guidance from the IRS, international tax planning for U.S. corporations must include a thorough understanding of how to determine whether a foreign tax is creditable under the new rules. Find out if you can claim a foreign tax credit under §901 with our complimentary Guide to Foreign Tax Credit §901.

Translating tax regulations into usable calculation templates is cumbersome, and relying on manual updates to keep up with tax law changes and compliance requirements can be dangerous. Bloomberg Tax Workpapers can help you save time during compliance and provision with repeatable templates created by experts that automatically update your calculations with the latest tax laws and regulations. With automatic data transformation and timesaving tax-specific functions, our all-in-one solution lets tax practitioners focus on high-level analysis and corporate tax planning strategies that optimize their tax position.

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