Unit
- Definition: The Foreign Tax Credit (FTC) is a provision in U.S. tax law that allows taxpayers to reduce their U.S. tax liability by the amount of foreign income taxes paid on the same income. It is found in Internal Revenue Code Section 901. The purpose is to prevent double taxation of income earned abroad.
- Legal basis: The FTC is not a deduction; it is a direct credit against U.S. tax. Taxpayers may elect either a credit or a deduction each year, but the credit is usually more valuable because it reduces tax dollar-for-dollar, subject to limitations.
- Who qualifies: U.S. citizens, resident aliens, domestic corporations, and in some cases foreign entities with U.S. tax nexus can claim the FTC. It applies to income taxes paid to a foreign country or U.S. possession.
- Income tax requirement: Only foreign income taxes qualify. These are taxes that are the predominant character of an income tax in the foreign country. Taxes on gross revenue, property, or transactions generally do not qualify unless they are in lieu of income tax.
- Creditable taxes: The foreign tax must be an income tax or a tax in lieu of an income tax. The IRS uses the realization, gross receipts, and net income tests to determine if a foreign levy is creditable.
- Direct vs. indirect credit: Direct credits apply to taxes paid directly by the taxpayer. Indirect credits (deemed paid) apply to taxes paid by a foreign subsidiary, available to domestic corporations owning 10% or more of the voting stock.
- Limitation overview: The credit cannot exceed the portion of U.S. tax attributable to foreign-source income. This prevents taxpayers from using the FTC to offset tax on domestic income, maintaining the principle of source-based taxation.
- Interaction with other provisions: The FTC interacts with foreign earned income exclusion (FEIE) for individuals, and with GILTI and Subpart F rules for corporations. Double benefits are generally not allowed.
- Carryover of unused credit: If the foreign tax credit limitation prevents using the full amount of foreign taxes paid, the unused credit may be carried back one year and forward up to ten years. This carryover mechanism helps taxpayers absorb fluctuations in foreign tax amounts or income levels across tax years.
- Separate limitation categories: The FTC is computed separately for different categories of foreign income, known as baskets. Passive income, general category income, and certain other types are segregated to prevent cross-crediting of high-taxed and low-taxed income. This rule ensures credits match the specific income streams.
- Alternative minimum tax impact: For individuals subject to the alternative minimum tax (AMT), the FTC is computed separately under AMT rules. Only 90 percent of the AMT liability can generally be offset by the FTC, and any carryover must be tracked both for regular tax and AMT purposes to avoid lost benefits.
Financial Formula
Foreign Tax Credit Limitation
FTC Limitation = (Foreign Source Taxable Income / Worldwide Taxable Income) × U.S. Tax Liability
FTC Limitation = (Foreign Source Taxable Income / Worldwide Taxable Income) × U.S. Tax Liability
Where:
- Foreign Source Taxable Income: Net income from sources outside the U.S., allocated and apportioned as per regulations.
- Worldwide Taxable Income: Total taxable income from all sources, both domestic and foreign.
- U.S. Tax Liability: The total U.S. federal income tax before credits.
- Result: The maximum credit allowable for the tax year.
Quick Revision
- The FTC prevents double taxation of foreign income by crediting foreign taxes against U.S. tax.
- Only income taxes or taxes in lieu of income taxes are creditable.
- The credit is limited to the U.S. tax attributable to foreign-source income.
- Taxpayers choose annually between credit and deduction for foreign taxes.