What Is a Foreign Tax Credit and How Does It Work?

Paying taxes on the same income in multiple countries can be a financial burden for individuals and businesses with international earnings. To mitigate this, many governments offer a foreign tax credit (FTC), allowing taxpayers to offset some or all of their foreign tax liability against their domestic tax obligations. This prevents double taxation on income earned abroad.

Understanding the FTC is essential for those earning income outside their home country. Claiming it requires meeting eligibility criteria, identifying qualifying taxes, and calculating the correct amount. Proper documentation and strategies for managing excess credits help maximize its benefits.

Who Can Claim the Credit

Eligibility depends on residency status, income sources, and the type of foreign taxes paid. U.S. citizens, resident aliens, and certain nonresident aliens who report foreign income on their U.S. tax return may qualify. Businesses structured as corporations, partnerships, or sole proprietorships with taxable foreign earnings can also claim the credit if they meet specific requirements.

The IRS requires that the foreign tax be legally imposed by a foreign country and either paid or accrued by the taxpayer. It must be an income tax or a tax in lieu of an income tax—sales, value-added, and property taxes do not qualify. The taxpayer also cannot expect a refund or reimbursement from the foreign government.

Individuals typically claim the credit on Form 1116, while corporations use Form 1118. Taxpayers with foreign taxes of $300 or less for single filers and $600 or less for joint filers may bypass Form 1116 and claim the credit directly on their tax return.

Types of Eligible Taxes

Foreign tax credits apply only to income taxes or taxes levied in place of an income tax. General business taxes, excise duties, and consumption-based levies such as value-added tax (VAT) or sales tax do not qualify. The IRS evaluates a foreign tax based on its function rather than its name, ensuring that only taxes on net income or profits are eligible.

Some countries impose taxes that function like an income tax but are labeled differently. For example, a corporate profits tax may qualify if it is based on gross receipts minus allowable deductions. Tax treaties between the U.S. and foreign countries often clarify which taxes qualify.

The tax must also be mandatory. Voluntary payments, such as optional social security contributions or payments under government incentive programs, do not qualify. However, withholding taxes on dividends, interest, or royalties paid to U.S. taxpayers by foreign entities can be eligible if they are not subject to refund or reduction under a tax treaty.

Calculating the Credit

The foreign tax credit is limited to the amount of U.S. tax that would have been owed on the foreign income. This prevents taxpayers from using high foreign tax rates to offset domestic tax liabilities beyond what they would have paid in the U.S. The calculation differs depending on whether the credit is claimed directly or indirectly and the type of income involved.

Direct Credits

A direct foreign tax credit applies when an individual or business pays foreign taxes directly to a foreign government. This is common for self-employed individuals, employees working abroad, and companies with foreign operations. The credit is calculated using the foreign tax credit limitation formula:

Foreign Tax Credit Limit = (Foreign Source Taxable Income / Total Taxable Income) × U.S. Tax Liability

For example, if a taxpayer earns $50,000 in foreign income and $100,000 in total taxable income, with a total U.S. tax liability of $20,000, the maximum credit they can claim is:

(50,000 / 100,000) × 20,000 = 10,000

If the taxpayer paid $12,000 in foreign taxes, they can only claim $10,000 as a credit. The remaining $2,000 may be carried forward or back under IRS rules.

Indirect Credits

Indirect, or “deemed paid,” foreign tax credits apply primarily to U.S. corporations that own at least 10% of a foreign subsidiary. Under Section 960 of the Internal Revenue Code, these corporations can claim a credit for foreign taxes paid by the subsidiary on income repatriated to the U.S.

If a foreign subsidiary earns $1 million and pays $250,000 in foreign taxes, and the U.S. parent company receives a $200,000 dividend, the deemed paid credit is calculated as:

(200,000 / 1,000,000) × 250,000 = 50,000

This means the U.S. corporation can claim a $50,000 credit against its U.S. tax liability. However, changes under the Tax Cuts and Jobs Act (TCJA) of 2017, including the Global Intangible Low-Taxed Income (GILTI) provisions, have altered how these credits apply, limiting their use in certain cases.

Different Income Categories

Foreign income is categorized into different “baskets” for tax credit purposes under Section 904 of the Internal Revenue Code. The main categories include:

– General income: Wages, salaries, and business profits.
– Passive income: Dividends, interest, rents, and royalties.
– Foreign branch income: Earnings from foreign branches of U.S. businesses.
– GILTI income: Certain low-taxed foreign earnings subject to U.S. tax under TCJA rules.

Each category is calculated separately, meaning excess credits in one category cannot offset taxes in another. For example, if a taxpayer has excess credits from passive income but owes U.S. tax on general income, they cannot use the passive income credits to reduce their general income tax liability.

Managing Excess Credits

When foreign tax credits exceed the allowable limit in a given year, taxpayers can carry them back one year or forward for up to ten years under Section 904(c) of the Internal Revenue Code. This helps smooth out fluctuations in foreign tax liabilities, particularly for businesses and individuals with variable international income.

Strategic planning is important when applying carryforwards. If a taxpayer expects higher foreign-source income in future years, deferring excess credits may be more beneficial than carrying them back. However, credits that remain unused after ten years expire. Timing income recognition and foreign tax payments can help optimize credit utilization.

Documentation Requirements

Claiming the foreign tax credit requires maintaining thorough records to substantiate the taxes paid. The IRS mandates that taxpayers retain proof of foreign taxes paid, including official tax receipts, withholding statements, and foreign tax returns. These documents must clearly indicate the amount of tax paid, the tax period, and the foreign jurisdiction imposing the tax.

Employers often provide Form 1042-S or similar foreign equivalents detailing taxes withheld on wages. Self-employed individuals and businesses must keep copies of foreign tax assessments, bank statements showing tax payments, and any correspondence with foreign tax authorities. Corporations claiming indirect credits must maintain records of subsidiary earnings, foreign tax payments, and dividend distributions. If a taxpayer is subject to a tax treaty, additional documentation proving eligibility for treaty benefits may be required. In cases where foreign tax disputes arise, maintaining records of appeals or adjustments is necessary to support any future claims.