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Information provided on this site is for general guidance
only and is often simplified. Actual IRS procedures
are complex, and taxpayers should obtain professional
assistance or use IRS sources for complete information.
Foreign
Tax Credits
Foreign taxes paid by a US taxpayer can often be credited
against US tax liability or deducted in figuring taxable
income on a US income tax return. It is often better
to claim a credit for foreign taxes rather than to
deduct them. Whereas a credit reduces US tax liability,
with any excess able to be carried back and carried
forward to other years, a deduction reduces taxable
income and may be taken only in the current year.
All foreign income taxes must be given the same treatment;
it isn't permitted to deduct some foreign income taxes
and take a credit for others.
In
order to take a foreign tax credit, Form 1116 should
be filed with Form 1040. Form 1116 is used to figure
the amount of foreign tax paid or accrued that can
be claimed as a foreign tax credit. The foreign income
tax on which a credit can be claimed is the amount
of legal and actual tax liability paid or accrued
during the year.
A
foreign tax credit cannot be claimed in respect of
tax that would be refunded by the foreign country
if applied for, or if the foreign country returns
tax payments in the form of a subsidy. Credits cannot
be claimed in respect of foreign taxes paid on income
that is excluded from a US tax return.
Foreign
tax credits are limited to a proportion of total US
tax liability equal to the proportion formed by taxable
income from sources outside the United States of total
taxable income.
Foreign
tax credits are figured separately in relation to
different types of income, including: passive (investment)
income; financial services income; shipping income;
dividends from a domestic international sales corporation
(DISC); lump-sum distributions from employer benefit
plans; and section 901(j) income.
Expenses
(such as itemized deductions or the standard deduction)
not definitely related to specific items of income
must be apportioned to the foreign income in each
category in the proportions that the various types
of income form of total income.
The foreign tax credit and deduction, their limits,
and the carryback and carryover provisions are discussed
in detail in IRS Publication 514, Foreign Tax Credit
for Individuals.
In
March 2007, the IRS and Treasury announced the release
of proposed regulations that would disallow foreign
tax credits for foreign taxes purportedly paid in
connection with certain artificially engineered, highly
structured transactions.
The
IRS explained that foreign tax credits are designed
to relieve taxpayers from double taxation of their
foreign source income. Transactions addressed by the
regulations, in contrast, are structured so that the
taxpayer voluntarily subjects itself to foreign tax
where an ordinary business transaction generally would
result in little or no foreign tax paid by the taxpayer.
“The
proposed regulations complement the vigorous enforcement
efforts of the IRS to identify and, in appropriate
cases, to challenge the tax benefits claimed in these
foreign tax credit generator transactions under principles
of existing law,” explained IRS Chief Counsel
Donald L. Korb.
The
significant impact of these transactions on the US
tax base was brought to the attention of the IRS by
members of the Joint International Tax Shelter Information
Centre (JITSIC). JITSIC is an information exchange
arrangement under which the US, the UK, Canada and
Australia exchange information bilaterally on tax
avoidance schemes.
Also
in 2007, several income categories were eliminated
for the purposes of computing the foreign tax credit
limit. Income that previously fell in these categories
is either passive category income or general category
income:
-
High withholding tax interest.
-
Financial services income.
-
Shipping income.
-
Dividends from a domestic international sales corporation
(DISC) or former DISC.
-
Certain distributions from a foreign sales corporation
(FSC) or former FSC.
In
August, 2010, The Education Jobs and Medicaid Assistance
Act was sent to the President's desk on August 10
after the House of Representatives, returning specially
from its summer recess, approved the legislation by
a vote of 247 to 161. Included
in the bill are rules to prevent splitting foreign
tax credits from the income to which they relate.
This provision would implement a matching rule that
suspends the recognition of foreign tax credits until
the related foreign income is taken into account for
taxing purposes in the US. This provision would apply
to all split foreign taxes claimed by taxpayers after
the date of introduction, and, according to the Joint
Committee on Taxation (JCT), would increase company
taxes by USD4.25bn over 10 years.
An
additional provision would prohibit taxpayers from
claiming the foreign tax credit with regard to foreign
income that is never subject to US taxation because
of a covered asset acquisition. The legislation would
apply to related party transactions occurring after
the date of introduction. The JCT estimates that this
measure would raise USD3.64bn in tax over ten years.
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