Introduction to U.S. Foreign Tax Credit II
According to our last article, the Foreign Tax Credit serves as a key strategy for alleviating the issue of double taxation within a global tax framework. Its purpose is to minimize the potential burden of being taxed twice on income sourced from foreign entities, by either the United States or the foreign jurisdiction where the income originates. Then, this article will discuss how to calculate the U.S. Foreign Tax Credit and its limitations.
- How to Calculate the Foreign Tax Credit?
There are three steps to calculate the FTC. According to our last article “Introduction to U.S. Foreign Tax Credit I? the initial stage in this process involves the computation of creditable foreign income taxes. The remaining two steps are computing the foreign income tax credit limitation and determining the lesser of creditable foreign income taxes and the foreign tax credit limitation.
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Computing the Foreign Tax Credit Limitation
The foreign tax credit limitation sets a maximum threshold on the extent to which foreign taxes can be used to reduce U.S. tax liabilities.
The limitation prohibits individuals in the United States conducting business in countries with high tax rates from using those higher foreign taxes to reduce the U.S. tax liability on income sourced in the U.S. If the foreign taxes are lower than the limitation, they are entirely offset by the tax credit.
The calculation of the foreign tax credit limitation is U.S. Tax Liability * Foreign-Source Income/Worldwide Income.
U.S. Tax Liability = taxpayer’s Worldwide Income * applicable U.S. income tax rate
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Determining the Lesser of Creditable Foreign Income Taxes or the Foreign Tax Credit Limitation
Assuming a U.S. tax rate of 35% and a German tax rate of 50%, and a U.S. source income of $100,000 and a German source income of $100,000, several calculations are made as follows:
Worldwide income is $200,000=German source income + U.S. source income
U.S. tax liability is $70,000=Worldwide income * U.S. tax rate
Without limitation, Foreign Tax Credit is $50,000=German source income * German tax rate
Foreign Tax Credit Limitation is $35,000=U.S. liability * (Foreign Source Income/Worldwide Income)
Due to the foreign tax credit limitation is lower than the foreign income taxes, the final calculation of the foreign tax credit is the lesser $35,000. What’s more, the taxpayer should pay $35,000 U.S. taxes instead of $20,000 U.S. taxes.
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- Foreign Tax Credit Limitation (Section 904 Limitation)
The overall limitation protects the crediting of foreign taxes against the U.S. tax on income from U.S. sources. There are also separate categories of income limitations—general basket income (i.e., active business income) and passive basket income. Credits are restricted to the specific basket in which they were generated, necessitating separate computations for each basket to minimize cross-crediting.
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Example
Assuming a Country X tax rate of 30% and a Country Y tax rate of 15%, and a Country X active income of $1 million and a Country Y passive income of $1 million, several results are made as follows:
Foreign Income Taxes Country X = $300,000
U.S. Foreign Tax Credit Limit for X = $210,000
Excess Credits from Country X = $90,000
Foreign Income Taxes Country Y = $150,000
U.S. Foreign Tax Credit Limit for Y = $210,000
Excess Limitation from Country Y = $60,000
Residual U.S. Taxes to be Paid = $60,000
Cross-crediting can help reduce the excess credits from Country X and eliminate the residual U.S. taxes tied to Country Y, that is:
Total Foreign Source Income = $2 million
Total Foreign Taxes Paid = $450,000
Total Foreign Tax Credit Limit = $420,000
Excess Credits from Country X = $30,000
Excess Limitation from Country Y = $0
Residual U.S. Taxes to be Paid = $0
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Further Considerations
Excess credits in the separate baskets can be carried back one year and carried forward 10 years (except income in Global Intangible Low-Taxed Income basket).
What’s more, a de minimis exception applies for passive investment income, that is, $300 of single individual income and $600 of married couple income.
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Reference:
https://www.irs.gov/individuals/international-taxpayers/foreign-taxes-that-qualify-for-the-foreign-tax-credit
https://www.irs.gov/individuals/international-taxpayers/foreign-tax-credit-how-to-figure-the-credit
https://www.irs.gov/individuals/international-taxpayers/foreign-tax-credit
https://www.irs.gov/taxtopics/tc856
https://www.irs.gov/individuals/international-taxpayers/foreign-earned-income-exclusion-what-is-foreign-earned-income
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