U.S. Taxpayers and Foreign Tax Credits

Allison Dougherty for Aronson Blogs writes: The U.S. federal tax system provides for the direct foreign tax credit and the indirect foreign tax credit.  U.S. taxpayers may claim the direct foreign tax credit as a dollar-for-dollar offset against their U.S. federal income tax liability.  The credit is claimed for foreign taxes paid directly by the U.S. taxpayer on foreign source income earned outside the United States.  The direct foreign tax credit can be claimed by a U.S. individual or corporation that pays foreign tax on foreign source income from activities engaged in directly in a foreign country.  The direct foreign tax credit is also available forforeign taxes paid by a foreign branch or a foreign partnership owned by a U.S. taxpayer.  For U.S. partnerships or S corporations, the foreign taxes paid will pass through to the partners or shareholders who will claim the foreign tax credit on their respective federal tax return.

The indirect foreign tax credit is referred to as the deemed paid credit.  Only a U.S. Subchapter C corporation that owns 10% of a foreign corporation may claim the indirect foreign tax credit for foreign taxes paid on earnings that are actually distributed as a dividend.  However, there is a special rule which allows a U.S. parent corporation to claim the indirect foreign tax credit for foreign tax paid on undistributed earnings of a foreign corporation that are subject to U.S. federal taxation as a deemed dividend.

The foreign tax credit is subject to a limitation, which is calculated as the amount of the foreign tax paid or accrued multiplied times the amount of foreign source taxable income divided by worldwide taxable income.  Foreign taxes that are greater than the limitation for the tax year can be carried back one year and forward 10 years. The limitation applies to separate baskets of income, including passive income and general limitation income.  In determining foreign source taxable income for purposes of the limitation, it is necessary to allocate and apportion expenses to each class of income.

It is important to be aware of overall foreign loss rules which recharacterize foreign source income as U.S. source income for purposes of the foreign tax credit limitation in years after the U.S. taxpayer has utilized a foreign loss as a deduction to offset U.S. taxable income. An example of this is where a U.S. individual owns an interest in a hybrid foreign partnership and utilizes losses from the foreign partnership as a deduction to offset U.S. taxable income.  In a subsequent year, when the hybrid foreign partnership pays foreign tax on positive net income, the U.S. partner is required to recapture the prior year foreign loss and recharacterize the foreign source income as U.S. source income in calculating the foreign tax credit limitation.  A similar rule exists for an overall domestic loss that is utilized as a deduction to offset the U.S. taxpayer’s foreign source income.  The overall domestic loss is recaptured when U.S. source income is earned in a subsequent year and it is recharacterized as foreign source income.