TAX CREDIT FOR FOREIGN TAXES:  

EASY CONCEPT, COMPLICATED RULES

U.S. individuals and U.S. corporations pay income tax on currently earned world-wide income, including, with certain exceptions, foreign income earned by subsidiaries of U.S. Corporations.  Many Countries tax business and corporate income on the "Territorial" system, which essentially taxes only income sourced in that Country.  Congress continues to debate whether this system should replace the current corporate tax regime, but for now, the tax credit (or deduction if elected) for foreign taxes paid may allow U.S. taxpayers to avoid paying tax in two or more Countries on the same income.

 

The U.S. has an extensive network of income tax treaties which include protection against double taxation. However, some Treaties allow for tax credits which might not otherwise qualify under the Code and some Treaties modify source rules as well.  Just for example, the U.S. / Canada Treaty defines certain income earned in the U.S. by U.S. Citizens resident in Canada as "Canadian source income", to allow such person the U.S. tax credit against Canadian taxes. A Country by Country analysis is critical.

 

IRC Section 901(b) allows a tax credit for "any income, war profits, and excess profits taxes paid or accrued...to any foreign country (or U.S. Possession)".  "Income tax" includes levies on income by a local government below the national level, by a Canadian Province for example. Foreign withholding taxes are also usually creditable.

 

Of course, the IRS complicates the rules for every benefit, and many payments to foreign governments will not qualify as "income tax" for the tax credit. Regulations and case law provide guidance as to what is a creditable tax, which does not include, for example, property taxes, excise taxes, value added taxes (VAT), penalties, charges for the right to do business and essentially  any governmental charge not assessed directly against income. Such "non-income tax" charges may of course reduce taxable income as business expenses.

 

Tax credits are not allowed against taxes paid to a Country which is "deemed to support terrorists", Countries with governments not recognized by the U.S, and Countries with which the U.S. does not maintain relationships, and, of course, any Country subject to a U.S. imposed Embargo.

 

Furthermore. a foreign income tax is not deemed "paid" and is therefore not allowed as a credit, if it is not absolutely compulsory, and/or if a refund is expected or a refund claim is made. or if the tax does is not directly based on earnings.

 

In addition to direct taxes, the tax credit generally can be taken on dividends paid to U.S. corporate shareholders of foreign corporations, (with a minimum 10% ownership interest). However, shareholders of a U.S. "C" corporation do not generally get a foreign tax credit as that is taken at the corporate level.  Partnerships have their own special rules and advance planning is essential.

 

Just to illustrate only some the of the tax credit rules:

 

1. A U.S. corporate parent must own at least 10% of the foreign subsidiary.  
2. Foreign source income must be in the same category or "basket"; the primary "baskets" are passive income (dividends, royalties, interest. Etc), shipping income, and general active business income. The credit generally cannot be separated from its "basket", to be used against tax on other forms of income.  
3. The foreign tax credit is limited to avoid artificially reducing U.S. tax, by, for example, the use of hybrid entities.  
4. Regulations generally provide that the foreign tax credit is available only to the person or entity which has the legal liability to pay the tax. This requirement is often relevant in both partnership and corporate situations.  
5. If the creditable foreign tax is greater than the applicable U.S. tax, such excess credits may be carried back one and forward up to ten years.

THERE ARE LIMITATIONS AND COMPLEX REGULATIONS ON ALL LEVELS RELATING TO FOREIGN TAX CREDITS.