Revenue Code 906: Foreign Tax Credit for Corporations

Internal Revenue Code Section 906 provides a tax credit to foreign corporations operating a business in the United States. This provision allows such a corporation to reduce its U.S. income tax liability by the amount of foreign taxes it has paid or accrued. The credit is specifically targeted at foreign taxes imposed on income that is “effectively connected” with the corporation’s U.S. business operations. This mechanism prevents double taxation, where the same income would otherwise be taxed by both the foreign country and the United States.

Eligibility for the Credit

To qualify for the foreign tax credit under Section 906, a corporation must be classified as a “foreign corporation.” For U.S. tax purposes, this is any corporation that was not created or organized within the United States or under U.S. law.

The second requirement is that the foreign corporation must be “engaged in a U.S. trade or business.” This involves more than passive investment; it implies a considerable, continuous, and regular level of activity within the United States. Income generated from these activities is known as Effectively Connected Income (ECI). ECI is defined as income that has a direct factual and economic link to the corporation’s U.S. business.

Determining Creditable Foreign Taxes

The primary category of creditable taxes includes income, war profits, and excess profits taxes. These are levies imposed by a foreign government on a corporation’s net income or profits, similar in nature to the U.S. corporate income tax. The tax must be a compulsory payment and not a payment made in exchange for a specific economic benefit from the foreign government.

A second category of creditable foreign taxes are those paid “in lieu of” a generally imposed income tax. This applies when a foreign country has a general income tax but imposes a different tax, such as one on gross receipts or gross income, on specific industries or activities as a substitute. For instance, a country might levy a tax on the gross revenue of a mining operation instead of its net profits. If this gross revenue tax acts as a direct substitute for the country’s standard corporate income tax, it may be creditable under U.S. law.

Calculating the Credit Limitation

A corporation cannot automatically claim a dollar-for-dollar credit for all eligible foreign taxes paid. The amount of the credit is restricted by a limitation to ensure it only offsets the U.S. tax liability on the corporation’s foreign-source ECI. This prevents the credit from reducing U.S. tax on income earned from U.S. sources. The calculation is governed by a specific formula that determines the maximum allowable credit for the tax year.

The formula is: (Foreign-Source ECI / Total ECI) x U.S. Income Tax on Total ECI. The first component, Foreign-Source ECI, is the portion of the corporation’s effectively connected income derived from activities outside the United States. Total ECI represents the corporation’s entire effectively connected income from all sources. The final part of the formula is the U.S. income tax calculated on the total ECI before the application of any credits. Any eligible foreign taxes paid in excess of this limitation cannot be credited in the current year, though they may be subject to carryback or carryforward provisions.

Claiming the Credit

A corporation must complete and attach Form 1118, Foreign Tax Credit—Corporations, to its annual U.S. income tax return, which for foreign corporations is Form 1120-F, U.S. Income Tax Return of a Foreign Corporation. Completing Form 1118 involves providing detailed information that substantiates the credit claim. The corporation must report the total amount of creditable foreign taxes it paid or accrued during the tax year. It must also perform and show the credit limitation calculation, demonstrating how it arrived at the maximum credit amount.

Corporations should maintain and be prepared to provide supporting documentation that verifies the foreign taxes claimed. This can include tax receipts or other official notices from the foreign taxing authority.