What taxes are creditable?
The United States restricts the credit to foreign income taxes that duplicate the U.S income tax against which the credit is taken.
Under code section 901, a foreign levy must satisfy that:
- The levy is a tax paid to foreign country.
- The predominant character of the tax is an income tax in the United States sense.
Tax Requirements
A foreign levy is a tax if it requires a compulsory payment pursuant to the authority of a foreign country to levy taxes. Penalties, fines, interest and custom duties do not qualify.
A foreign levy does not qualify as a tax if the payer receives a specific economic benefit in exchange for the levy.
Governments sometimes impose hybrid taxes that are difficult to classify, such as a tax on the value of minerals extracted from mining or a tax on the receipts from banking. If these taxes are of the same character as an income tax in the United States taxpayer may be able to get a credit.
Three aspects of U.S income taxation are considered fundamental:
- The tax must be imposed on income resulting from an exchange transaction or other event that would trigger a realization of income under U.S principles.
- The tax must be imposed wither upon actual gross receipts or according to a formulary method that is not likely to produce an amount that is greater than fair market value.
- The tax base must permit the recovery of significant costs and expense attributable to the taxpayer’s gross income.
Foreign withholding Taxes
Creditable taxes also include any foreign taxes imposed “in lieu of” an income tax. The most common type of in lieu of taxes are the flat rate withholding taxes that most countries impose on the gross amount of interest, dividends, rents and royalties derived by passive offshore investors. Withholding is required because it is the only sure way to collect taxes from passive offshore investors. In order to withhold the withholding agent must be able to readily ascertain both the tax base and the applicable rate.
Taxpayers cannot claim a credit for foreign withholding taxes imposed on dividends unless the taxpayer holds the stock of the foreign corporation for at least 16 days during the 31 day period beginning 15 days before the ex-dividend date. In the case of dividends on preferred stock, the requisite holding period increases to 46 days during a 91 day period.
Denial of Credit
A credit is denied to any foreign income taxes paid to a country whose government the United States does not recognize, does not conduct diplomatic relations with or has designated as a government that repeatedly supports act of international terrorism.
Presently this provision applies to Cuba, Iran, North Korea, Sudan and Syria.
Method of Accounting
Accrual basis taxpayers compute the foreign tax credit on an accrual basis. A foreign tax liability cannot be accrued unless all the events have occurred that determine the fact of the liability and the amount of the liability can be determined with reasonable accuracy.
Cash basis taxpayers generally compute the credit on cash basis under the cash method, creditable foreign taxes equal the amount of foreign income taxes paid during the year, regardless of whether the payment relates to the current year or some other year.
Cash basis taxpayers can elect to compute the credit on an accrual basis. Once made, this election appliers for all subsequent years.
Income taxes are paid in the currency of the country imposing the tax. In order to compute foreign tax credit, a U.S taxpayer must translate its foreign income taxes into U.S dollars.
References:
Practical Guide to US Taxation of International transactions 9th Edition
Robert J. Misey Jr.
Michael S. Schadewald
Publishers: Wolter Kluwer, CCH Incorporated.