Foreign Tax Credit
Updated on September 14, 2022
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.
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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 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 rules for allocating and apportioning expenses for purposes of determining an FTC limitation under §904, which spurred a flurry of regulatory guidance.
This roadmap covers the final regulations relating to the foreign tax credit, as introduced by the 2017 Tax Cuts and Jobs Act.
How is foreign income tax defined?
A “foreign income tax” means a foreign income tax as described in Reg. §1.901-2(a), that is, 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 and the regulations thereunder, paid or accrued to a foreign country or U.S. possession, including any such tax deemed paid by a CFC.
Treasury and the IRS published final regulations in January 2022 that revise the definition of a foreign income tax by providing that a foreign income tax means a foreign levy that is a foreign tax and that is either a net income tax or an in-lieu-of tax.
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What is the difference between a direct and an indirect foreign tax credit?
Direct foreign tax credits (FTCs) 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 FTCs (also referred to as deemed paid FTCs) 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.
Indirect FTCs (also referred to as deemed paid FTCs) 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.
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Is a U.S. corporation entitled to a foreign tax credit on dividends received from a foreign subsidiary that the subsidiary has already paid or accrued foreign income taxes on?
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.
New regulations dramatically modify the analysis for determining whether a foreign levy is a creditable foreign tax, and taxpayers will be shocked to learn that many common previously foreign taxes are no longer creditable.
Is there a limit on the foreign tax credit corporations can claim on foreign income taxes paid in a particular taxable year? How is it calculated?
Foreign tax credit rules limit the amount of annual U.S. tax on foreign-source taxable income as calculated under U.S. tax principles. Thus, 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 against U.S. tax liability. The foreign tax credit limitation is calculated 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 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.
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