Limitation on foreign tax credits
In the U.S. a corporation’s foreign tax credit is limited to the U.S. tax on income from foreign sources and apply to sourcing rules.
If you assume a U.S. corporation has earned $100 of U.S. source income, earned $100 of foreign source income, and paid (or is deemed to have paid) $50 of foreign taxes. If the applicable U.S. tax rate is 35%, the U.S. corporation’s FTC is limited to $35 ($100 of foreign source income x 35%).
- Limitation is computed separately for certain categories of income and taxes attributed to those categories
- Carry-back and carry-forward rules apply
Most systems limit FTC in one way or another. A common limitation is based on the domestic income tax considered generated by the foreign source income that is subject to tax. This limitation may be applied overall or at one or more of the following subsets:
- country or region
- type of income
- member of a group
- sub-type of domestic tax
Amounts in exceed this limitation may be allowed to reduce prior period taxes and could also be subject to refund or future taxes. This carryover period may be limited to a number of years or could also be limitless. In 2009 the U.S. system for example permitted taxpayers to apply excess FTC's to reduce U.S. Federal income tax for the first prior year (carry back) and then successively for each of the next succeeding 10 years (carry forward).
At one time or another various countries have limited FTC based on type of income. UK individual income tax limits FTC by the types of income taxed separately in the UK system. Therefore foreign taxes that are incurred with respect to trading income are limited separately from foreign taxes that are incurred with respect to investment income. From 1987 through 2006 the U.S. limited FTC according to different categories or "baskets" of income, commonly described as nine baskets but in reality occasionally it could be many more. The definitions of these baskets were combined into two baskets beginning 2007 with some exceptions. The U.S. baskets are currently passive and consist of foreign personal holding company income like interest, dividends, rents, royalties, and certain gains, with significant exceptions. All others are general limitation with some exceptions generally not applicable.
Countries that have alternative tax regimes that impose certain minimum income taxes may alter the rules for computing FTC for those minimum taxes.
Tax Planning Implications of Foreign Tax Credit Limitations
The foreign tax credit limitation determines whether foreign taxes have an incremental effect on a U.S. person’s total tax costs. When a taxpayer is in an excess limitation position, foreign taxes do not represent an out-of-pocket tax costs since the cost of paying those taxes is entirely offset by the U.S. tax savings associated with the credit. Therefore, tax planning focuses on reducing the residual U.S> tax due on foreign –source income. In contrast, when a taxpayer is in an excess credit position, no U.S. tax is collected on foreign source income because the credit fully offsets the pre-credit U.S. tax on that income. In addition, the non-creditable foreign income taxes increase the total tax burden on foreign source income beyond what it would have been if only the United States had taxed that income. Therefore, planning focuses on reducing those excess credits.
When a taxpayer is in excess limitation position, any decrease in foreign tax costs is accomplished by an offsetting increase in the residual U.S. tax on foreign income. As a result, foreign tax reduction planning has no effect on the taxpayer’s total tax cost. The circumstances are quite different, however, for U.S. persons in excess credit positions. Foreign taxes increase the total tax costs of such taxpayers by the amount of excess credits. As q consequence, every dollar of foreign income tax saved reduces the taxpayer’s total costs by a dollar, up to the amount of excess credits.
As a first basic strategy, the technique that a U.S. person can use to reduce foreign income taxes are often the same as those used to reduce income taxes in a purely domestic context. Examples include taking advantage of any special exemptions, deductions, or credits provided by local law, realizing income in a form that is taxed at a lower rate, deferring the recognition of gross income, and the acceleration in the recognition of deductions.
A second strategy for reducing excess credits is to increase the foreign tax credit limitation by increasing the proportion of worldwide income that is classified as foreign source income for U.S. tax purposes. As a consequence, the U.S. rules for sourcing gross income and deductions can play a decisive role in eliminating excess credits. For example, by arranging for the passage of title in the foreign country at issue rather than the United States will generate foreign source income.