Foreign Tax Credit Limitation

Taxpayers who pay foreign taxes are entitled to a foreign tax credit. The credit is limited to the portion of current year Federal income tax caused by foreign source income. Available credits in excess of this limit may be carried over to other years. Corporate shareholders of foreign corporations paying dividends may claim a deemed paid foreign tax credit for taxes on earnings underlying the dividend.

The limit on foreign tax credits is based on foreign source taxable income, after allocating and apportioning all deductions. Computing the amount of the limit can be quite complex. IRS regulations specify how deductions must be allocated and apportioned. Special mechanical rules apply to interest, R&D, and state income tax deductions. Interest is apportioned based on the basis of assets. R&D is apportioned based on sales for the worldwide group of companies or gross income of the U.S. consolidated return group. Elections of which method to use for R&D expense apportionment apply for five years, and are irrevocable.

The calculations are further complicated by "check the box" rules that allow taxpayers to treat some types of foreign entities as flow-through. Where such entities are wholly owned by a U.S. taxpayer (including consolidated return members collectively), the income, deductions, assets, and liabilities are combined with the U.S. taxpayer's itmes in computing the limitation. Thus, interest, etc., deductions of the foreign checked entities must be apportioned, and the assets of those entities combined in apportioning interest.

Further complication, and potential benefit, arises from foreign title passage sales under the rules of section 863(b). Revenues from sales of U.S. made goods sold with title passing outside the U.S. are considered 50% foreign source, and CoGS and deductions related thereto must be apportioned. Often such sales income is not subject to any foreign tax, improving the foreign tax credit limit. See the Journal of Taxation article on this site.

Watch videos on the foreign tax credit:

Foreign Tax Credit, Part 1

Foreign Tax Credit, Part 2: Deemed Paid Credits (for corporations)

Foreign Tax Credit, Part 3: Limitation on Credit

Call Steve Fox for international tax advice to improve your or your clients' foreign tax credit limitation.