Foreign Tax Credit Rules Under Revenue Code 905

U.S. taxpayers who earn income from foreign sources may be taxed in both the United States and the foreign country. To prevent double taxation, the U.S. tax code provides a foreign tax credit. This credit reduces a taxpayer’s U.S. income tax liability for taxes paid or owed to a foreign country. The rules within the Internal Revenue Code establish specific requirements for when and how this credit can be claimed.

Choosing When to Claim the Credit

A taxpayer must decide on the timing for claiming the foreign tax credit, a choice that is independent of their overall method of accounting. The first option is the cash basis method. Under this approach, the credit is claimed in the U.S. tax year that the foreign tax is actually paid. For example, if a taxpayer earns foreign income in one year but pays the associated foreign tax in the following year, the credit is taken in that second year.

The alternative is the accrual basis method. With this method, the credit is claimed in the U.S. tax year that the foreign income is earned and the tax liability is established, regardless of when the tax is physically paid. If a taxpayer earns income and incurs a foreign tax liability in one year but pays it in the next, the credit is claimed in the first year. A taxpayer can elect the accrual method, but Internal Revenue Code Section 905 specifies that this choice is binding for all subsequent tax years.

Required Documentation for the Credit

To claim the foreign tax credit, specific documentation must be filed with the IRS. Individuals, estates, and trusts use Form 1116, Foreign Tax Credit, while corporations file Form 1118, Foreign Tax Credit—Corporations. These forms are the primary documents for computing the credit limitation and reporting the creditable taxes.

Completing the appropriate form requires gathering detailed financial information. The taxpayer must establish the total amount of income from sources outside the United States and the amount of income derived from each specific country. It is also necessary to document the foreign taxes that were either paid or accrued. All foreign currency amounts must be translated into U.S. dollars using the appropriate exchange rate.

Beyond the main form, taxpayers must maintain thorough records to substantiate their claim. This supporting documentation includes receipts for foreign taxes paid, official notices of assessment, or copies of the foreign tax returns filed. The IRS can request this information to verify the credit computation.

Handling Foreign Tax Adjustments

A “foreign tax redetermination” occurs when the actual foreign tax liability differs from the amount that was initially claimed as a credit on a U.S. tax return. These adjustments are not uncommon due to the different timelines of foreign tax systems. The tax code outlines the circumstances that trigger this event to ensure the U.S. tax liability is ultimately corrected to reflect the true amount of foreign tax paid.

Several events can lead to a foreign tax redetermination, including:

• Receiving a refund of foreign taxes previously paid and claimed as a credit.
• A foreign tax authority conducting an audit and determining that additional tax is owed for a prior year.
• An accrued tax not being paid within two years after the close of the taxable year to which it relates.
• Changes in the exchange rate between the time a tax is accrued and when it is paid, if the dollar value of the payment differs from the accrued amount.

The Redetermination Process

When a foreign tax redetermination occurs, the taxpayer is required to notify the IRS. This is done by filing an amended tax return for the year the credit was originally claimed, attaching a revised Form 1116 or Form 1118 that reflects the adjusted foreign tax amount.

An amended return is not required if the foreign tax redetermination does not change the taxpayer’s U.S. tax liability for the year. In such cases, the adjustment is accounted for on the tax return for the year in which the redetermination occurred. The IRS has also established alternative notification procedures for certain corporate taxpayers under its Large Business and International (LB&I) division.

If the redetermination results in a lower foreign tax credit, the taxpayer will owe additional U.S. tax, which is due upon notice and demand from the IRS. If the redetermination leads to a higher foreign tax credit, it will result in an overpayment of U.S. tax, which will be refunded to the taxpayer. The IRS has an extended period to assess additional tax resulting from a foreign tax redetermination, so timely notification is important to avoid potential penalties and interest.