California Foreign Tax Credit: What It Is and How to Claim It

California’s foreign tax credit allows taxpayers to reduce their state tax liability by accounting for taxes paid to foreign countries. This credit is particularly useful for individuals and businesses with international income, as it helps address the issue of double taxation.

Who Can Claim This Credit

Eligibility for California’s foreign tax credit depends on residency status and the nature of income. California residents, taxed on worldwide income, are the primary beneficiaries, including individuals, estates, and trusts that pay or accrue foreign taxes on income also subject to California tax. Nonresidents and part-year residents may qualify but only for California-sourced income taxed by a foreign jurisdiction.

The credit applies to both individuals and businesses meeting the criteria. Businesses often qualify if they have foreign operations or investments generating taxable income. The credit is non-refundable, meaning it can only reduce tax liability to zero. Eligible foreign taxes must be similar to California’s income tax, applying to income, profits, or gains, while taxes like property or sales taxes are excluded. The foreign tax must be compulsory under the foreign jurisdiction’s laws.

Federal vs. California Calculation Differences

Federal and California calculations for the foreign tax credit differ significantly. Federally, the credit under Internal Revenue Code Section 901 allows taxpayers to claim a credit for foreign taxes paid on income sourced outside the U.S. The calculation involves a limitation based on the proportion of foreign income to total income, capping the credit to the U.S. tax liability attributable to foreign income.

California’s calculation focuses on the ratio of foreign income taxed by California to total foreign income. This ensures the credit only applies to the portion of foreign taxes corresponding to California-taxed income. The state limits carryovers to seven years with no carryback option, requiring careful planning to maximize benefits.

Sources of Eligible Foreign Taxes

Eligible foreign taxes must align with California’s taxation principles and apply to income, profits, or gains imposed by a foreign country or U.S. possession. For example, income taxes levied by countries like Canada or the United Kingdom on dividends, interest, or royalties typically qualify. Withholding taxes on payments to non-residents, such as interest or royalties, are often creditable as they directly tax income. Foreign taxes must be legally owed and paid during the tax year for which the credit is claimed. Taxpayers should maintain records of all foreign tax payments, including receipts and documentation from foreign tax authorities.

Reporting on State Returns

Claiming California’s foreign tax credit requires precision. Taxpayers must use Form 540, specifically Schedule S, to report the credit. This form details foreign income, corresponding foreign tax paid, and the credit calculation. Foreign taxes must be converted into U.S. dollars using the appropriate exchange rate for the tax year, consistent with the rate recognized by the IRS or another documented rate.

Documentation

Proper documentation is critical for claiming California’s foreign tax credit. The Franchise Tax Board (FTB) requires taxpayers to substantiate their claims with detailed records of foreign taxes paid and their connection to California-taxed income. Receipts or certificates from foreign tax authorities should clearly indicate the amount of tax paid, the type of income taxed, and the tax period. Businesses may need additional documentation, such as financial statements, transfer pricing records, or agreements with foreign tax authorities like advance pricing agreements (APAs). Foreign tax payments must align with applicable tax treaties, as these agreements can affect credit eligibility and calculation. Keeping records organized ensures compliance and efficient reporting.