Yes, limitations on the foreign tax credit strive to protect the claim of the United State to tax the domestic source income of its taxpayers. The overall method operates so the foreign tax credit cannot exceed the proportion of foreign source income to worldwide taxable income. For example, assume a U.S. taxpayer earns $30 U.S. source income subject to a 30 percent tax rate and $80 of foreign source income subject to a 50 percent tax rate (yielding a foreign tax liability of $40). Without an appropriate limitation, the $40 would be creditable foreign tax and wipe out domestic tax ($33, i.e. 30 percent of worldwide income of $110). If such were the case, the United States would have completely surrendered its claim to tax. Rather, the limitation caps the credit at $24 ($80/$110*$33). The tax attributable to the higher foreign tax rate is considered as the non-creditable cost of investing or conducting business in a foreign country.
This overall method of limiting the foreign tax credit has been adjusted by Congress to apply differently to distinct types of income. Broadly speaking, income either falls into the passive income basket or the general income basket. The purpose of the separate baskets is to ensure the taxpayer’s foreign tax credit is limited to the U.S. imposed tax on foreign source income by restricting the ability to average high tax and low tax income in an effort to utilize excess foreign tax credits. Without this basket system, taxpayer’s could potentially reduce U.S. source income liability via excess foreign tax credits.
