How to compute foreign tax credit?
1 – Compute creditable foreign income taxes.
2 – Compute the foreign tax limitations.
3 – Determine the lesser of creditable foreign income taxes or the foreign tax credit limitation.
Example:
USAco’s taxable income = 100,000
Included in it = 30,000 foreign source income
Foreign income tax paid = 15,000
Assume U.S. tax rate = 35%
- Foreign income taxes = 15,000
- Foreign tax credit limit =
- Worldwide taxable income = 100,000
- Pre-credit U.S. tax = (35% x 100,000) = 35,000
- Foreign source taxable income = 30,000
Limitation = B x (C / A) = 35,000 x (30,000 / 100,000) = 10,500
Credit = lesser of creditable taxes (10,500) or the limitation (10,500)
USAco can carry its excess credit (15,000 – 10,500) = 4,500 back one year or forward 10 years.
Taxpayer can deduct foreign income tax instead of taking a credit.
Taxpayer cannot take a double tax benefit.
Taxpayer cannot claim a credit and deduct at the same time for same foreign income taxes.
In general a credit is more advantageous that a deduction because it reduces a person’s tax dollar for dollar as opposed to a reduction in taxable income.
The choice between a deduction and credit applies to all foreign income taxes paid or accrued during the year.
A taxpayer cannot claim a credit for a portion of the foreign income taxes incurred in a taxable year and claim a deduction for the remaining foreign income taxes.
Taxpayers are allowed to change their election from year to year.
Taxpayers can also change their election any time before the expiration of the stature of limitation, which is 10 years in the case of a refund claim based on the foreign tax credit.
Annual election is made on form 1118 for domestic corporations or form 1116 for individuals.
A partnership of S corporation can make an election to claim a credit in lieu of a deduction for the foreign income taxes paid or accrued by the partnership or S corporation and it is made at the partner or shareholder level.
References:
Practical Guide to US Taxation of International transactions 9th Edition
Robert J. Misey Jr.
Michael S. Schadewald
Publishers: Wolter Kluwer, CCH Incorporated.