The foreign tax credit is one method of avoiding the deleterious effects of double taxation. Individuals and corporations in the international context are subject to potential taxation in two places: the source country of the income and the taxpayer’s country of residence. If taxed in this manner individuals and corporations would be penalized for operating in the global market. Therefore, the foreign tax credit preserves neutrality by operating as a dollar-for-dollar credit against U.S. tax liability for foreign taxes already paid.
To be eligible for the tax credit U.S. citizens/residents and domestic corporations must have paid income taxes to a foreign country that the United States recognizes or has diplomatic relations with. However, the President may disallow the foreign tax credit to residents who are citizens of a foreign country that does not allow U.S. citizens resident there a similar credit for taxes paid to the United States or other countries.
Not all payments to a foreign government are creditable taxes. To qualify, the foreign levy must be a tax, not a voluntary payment or payment for a specific right or service. Next, it may be necessary to determine whether the payment is a separate tax or part of a unified tax in order to evaluate creditability. A levy once identified as separate, will never be apportioned into creditable and non-creditable amounts. Third, it is necessary to determine if the tax is an income tax in the “United States sense.” Finally, if the tax is not an income tax, it may still be creditable as an “in-lieu-of” tax. In other words, the tax is imposed as a substitute for, and not in addition to, an income tax or series of income taxes otherwise imposed.
If a foreign levy is a creditable income tax, then it is necessary to determine who can claim the credit and what is the amount of the creditable tax that is paid. As referenced above, U.S. citizens, residents, and domestic corporations can claim a foreign tax credit. This includes a U.S. partner in a partnership for the proportionate share of foreign tax paid by the entity. As a further benefit, nonresidents subject to U.S. tax on income associated with a U.S. trade or business may be able to credit foreign taxes paid. As for the amount of the credit, even where all the requirements are satisfied, an amount paid to a foreign government is not creditable to the extent that it is reasonably certain that the amount will be refunded, credited, rebated, or forgiven.
The calculation of the direct foreign tax credit is straightforward. After having determined what is the creditable amount of tax paid, the credit reduces the U.S. tax liability dollar-for-dollar. To illustrate, if taxpayer pays $10,000 in foreign income tax, and the taxpayer’s U.S. income tax liability before the foreign tax credit is $20,000, the taxpayer only pays $10,000 to the U.S. government.