The Internal Revenue Service (IRS) has taken special interest in the tax treatment of foreign income earned by US residents and companies.

In fact, over the past few years there have been numerous voluntary disclosure initiatives aimed at bringing taxpayers into compliance with international tax rules. While overall enforcement of international taxation is on the rise there are still steps that can be taken to reduce overall tax burden. The Foreign Tax Credit(FTC), is a federal tax credit designed to eliminate the double taxation effect that occurs when both the US and a foreign government taxes income. To help clients, prospects and others learn about the credit, qualification criteria and other essential details. Hanson & Co has provided a summary below.

What is the Foreign Tax Credit?

It is a federal income tax credit designed to offset the double taxation that occurs when income is earned in a foreign country and is taxed by both the US and foreign government. The purpose is to provide relief from the double taxation effect. In general, only income and excess profits taxes qualify for the credit (e.g. foreign taxes on wages, dividends, interest and royalties). Although foreign taxes can be claimed as a deduction, it is usually more advantageous to claim the credit. Taken as a credit, the FTC reduces U.S. tax liability dollar for dollar.

The following four tests must be met for any foreign tax to qualify for the credit:

  • The tax must be imposed on you

  • You must have paid or accrued the tax

  • The tax must be the legal and actual foreign tax liability

  • The tax must be an income tax (or a tax in lieu of an income tax)

Who is Eligible?

The foreign tax credit is available to anyone who either worked in a foreign country or has investment income from a foreign source and can be claimed both by individuals and U.S. corporations. Taxpayers who can claim the FTC include; American citizens, resident and nonresident aliens, residents of Puerto Rico for the entire tax year and domestic and foreign corporations.

US companies can claim the FTC for taxes paid on earned income and other profits to a foreign country or U.S. possession. Foreign corporations can take the U.S. foreign tax credit for taxes they paid on income earned while conducting their trade or business domestically. If a foreign company has an office in the United States, but doesn’t earn domestic income then they are not eligible to claim the credit.

Important Limitations

Key issues to consider with the FTC, including:

  • Interest expense must be apportioned between U.S. and foreign source income

  • The amount of foreign tax that qualifies as a foreign tax credit is not necessarily the amount of tax withheld by the foreign country (i.e., a company can’t take a foreign tax credit more than its U.S. corporate tax rate, regardless of the amount of foreign tax paid)

  • U.S. corporations must separate their income into passive and active categories as the FTC is calculated on each category separately (gain realized from a stock sale, dividends and interest income is considered passive income, while business activities such as banking, insurance and financing corporations is considered active income).

  • Foreign sourced qualified dividends and/or capital gains (including long-term capital gains, collectible gains, un-recaptured section 1250 gains and section 1231 gains) that are taxed in the U.S. at a reduced tax rate must be adjusted in determining foreign source income.

  • Contributions to charities organized in Mexico, Canada and Israel must be apportioned against foreign source income, although other charitable contributions are usually not.

  • If a foreign tax redetermination occurs, a redetermination of U.S. tax liability is required in most situations, and failure to notify the IRS can result in a failure to notify penalty.

Contact Us

Foreign tax rules and regulations can be complex and often require the assistance of a qualified tax provider. If you have questions about the foreign tax credit, or other issues related to international income tax, Hanson & Co can help. For additional information please call us at (303) 388-1010, or click here to contact us. We look forward to speaking with you soon.