The IRS has updated its tax tax practice unit (a resource on substantive topics for IRS agents) on limitations and computation of the foreign tax credit. The overview is as follows:
United States (U.S.) citizens and resident aliens are subject to tax on worldwide taxable income (WWTI), which includes both U.S. source taxable income (USTI) and foreign source taxable income (FSTI). When a foreign jurisdiction also taxes FSTI, the U.S. provides a foreign tax credit (FTC) to relieve this double taxation. This credit is limited to the amount of U.S. income tax imposed on FSTI. This is called the FTC limitation. This Practice Unit explains in general terms the computation of an individual taxpayer’s FTC limitation.
The purpose of the FTC limitation is to prevent foreign taxes from offsetting the U.S. tax on USTI. In other words, U.S. national tax policy is not to subsidize the levies of foreign countries but to provide relief where double taxation exists. The FTC should only reduce U.S. tax on FSTI.
The FTC limitation is also designed to prevent the blending of high foreign tax rates in excess of the U.S. tax rate with low foreign tax rates to get to an overall foreign tax rate below the U.S. tax rate. To this end, a separate FTC limitation is determined with respect to various specific categories of income. A separate Form 1116 – Foreign Tax Credit (Individual, Estate, or Trust), must be completed to determine the FTC amount allowed for each separate category.
The amount of a taxpayer’s FTC is the lesser of the creditable foreign income taxes actually paid or accrued, or the FTC limitation. In other words, if the creditable foreign taxes paid or accrued by a taxpayer in a given tax year exceeds the taxpayer’s FTC limitation, the taxpayer cannot take a credit for the excess amount of foreign taxes. However, the taxpayer may carry back and/or carry over the unused foreign taxes to another tax year in which the taxpayer’s FTC limitation exceeds the amount of creditable taxes paid or accrued (taxpayer is in an excess limitation position).
Note: FTC issues related to creditability, categorization, sourcing, alternative minimum tax FTC, carryback and/or carryover and residency are beyond the scope of this Practice Unit. The Index of Related Practice Units slide provides a listing that may address some of these issues.
As described on the previous slide, the FTC limitation is equal to the U.S. income tax imposed on FSTI. This amount is determined by multiplying the taxpayer’s entire U.S. income tax liability (determined without regard to the credit) by a fraction, the numerator of which is FSTI and the denominator of which is WWTI.
Posted by Lewis J. Saret, Co-General Editor, Wealth Strategies Journal.