Foreign Tax Credit: What is it?

An Overview of the Foreign Tax Credit

The foreign tax credit is exactly what it states in the title. It is a credit for the foreign taxes paid in another country. However, a taxpayer must qualify for the credit. Under 26 U.S.C. 901, a taxpayer may choose to be credited with the amounts provided (paid) by US Citizen and the amount of income taxes paid or accrued to any foreign country. 

Generally, four tests must be met to qualify for a foreign tax credit: 

  1. The foreign tax must be imposed on the taxpayer.
  2. The taxpayer must have paid or accrued the tax in a foreign jurisdiction.
  3. The tax must be the legal and actual foreign tax liability.
  4. The tax must be an income tax.

Tax Must Be Imposed on the Taxpayer

Essentially, the foreign tax must be imposed on the taxpayer by a foreign country or U.S. possession. U.S. possessions include Puerto Rico, The U.S. Virgin Islands, Guam, the Northern Mariana Islands and American Samoa. 

The Taxpayer Must Have Paid or Accrued the Tax

The foreign tax credit can be claimed only if the foreign tax was paid or accrued during the tax year.

The Tax Must be the Legal and Actual Foreign Tax Liability 

The foreign tax liability that was paid or accrued in the year is not necessarily the amount of tax withheld by the foreign country. The foreign tax that qualifies for the credit varies. For instance, some deciding factors are: if the foreign country provided a refund for the foreign tax paid or is there a United States income tax treaty with the foreign country that states a specific treatment or definition?

The Tax Must be an Income Tax (or a Tax in Lieu of an Income Tax)

The foreign tax paid must be an income tax. Generally, the types of foreign tax on wages, dividends, income, interest, war profits, excess profits and royalties qualify for the credit. 

A tax in lieu of an income tax is foreign taxes on income even if the tax is not imposed under an income tax law. The tax is a foreign levy that is not a payment for an economic benefit and the tax is imposed in place of an income tax. This tax could qualify for the credit. 

The IRS gives the examples of such taxes in lieu of foreign income taxes may include:

  1. The gross income tax imposed on nonresidents on income not attributable to a trade or business in the country, where residents with a trade or business are generally taxed on realized net income.
  2. A tax imposed on gross income, gross receipts or sales, or the number of units produced or exported.

If a foreign country imposes a tax in lieu of an income tax that is a soak-up tax imposed in lieu of an income tax, the amount that does not qualify for the foreign tax credit is the lesser of:

  1. the amount of the tax that would not be imposed unless a foreign tax credit would be available; or
  2. the foreign tax you paid that is more than the amount you would have paid if you had been subject to the generally imposed income tax.

Although on its face, the test above seems fairly straightforward, foreign tax credits are far from simple. As with most of tax law, there are exceptions to these tests and specifically carved out scenarios where the foreign taxes paid DO NOT qualify for the foreign tax credit. You should seek the advice from a tax professional.   

If you have any questions or concerns about the foreign tax credit, contact Moskowitz LLP at (415) 394-7200 or schedule a meeting with us today!

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