The U.S. taxes U.S. persons on all of their income, regardless of its source. This creates a double taxation problem with respect to a U.S. person’s foreign-source income, since foreign countries usually tax all the income earned within their borders, including that derived by U.S. persons.
If the U.S. did nothing to mitigate international double taxation, U.S. companies would be at a competitive disadvantage in overseas markets, since their total tax rate would exceed that of their foreign competitors by the amount of the U.S. tax burden on foreign-source income.
The U.S. mitigates international double taxation by allowing U.S. persons a credit for any foreign income taxes paid on their foreign source income,
The computation of the foreign tax credit is a three-step process called the framework of analysis:
1. Step 1: Compute creditable foreign income taxes (FITs). To be creditable, a foreign levy must be a tax, the predominant character of which is an income tax in the U.S. sense,
2. Step 2: Compute the foreign tax credit limitation.
a. A key feature of the U.S. credit system is the foreign tax credit limitation, which restricts the credit to the portion of the pre-credit U.S. tax that is attributable to foreign source income.
b. Foreign tax credit limitation: (pre-credit U.S. tax on WWI) x FSI/WWI
c. Purpose of limitation: To confine the effects of the credit to mitigating double taxation of foreign-source income. The limitation accomplishes this by preventing U.S. persons operating in high tax foreign countries from offsetting those higher foreign taxes against U.S. taxes on U.S. source income.
3. Step 3: Determine the lesser of creditable foreign income taxes (step 1) or the foreign tax credit limitation (step 2).
a. Foreign tax credit is the lesser of:
i. FITs, or
b. If the FITs is the lesser, you are in an excess limitation position. If the limitation is the lesser, you are in an excess credit position,
c. Creditable foreign taxes in excess of the limitation cannot be claimed as a credit in the current year. However, these excess credits can be carried back one year or carried forward up to ten years, and taken as a credit in a year that the limitation exceeds creditable foreign taxes.
Facts: USAco is a domestic corporation. It has $ 30 million of worldwide income, including $ 6 million of foreign source taxable income, on which USAco paid $ 3 million in foreign income taxes. Assume that the U.S. tax rate is 35%.
1. Step 1: Compute creditable foreign income taxes
$ 3 million
2. Step 2: Compute the foreign tax credit limitation
a. Worldwide taxable income: $ 30 million
b. Pre-credit U.S. tax [35% x $ 30 million]: $ 10,500,000
c. Foreign-source taxable income: $ 6 million
d. Limitation = [line b x (line c/line a)]
e. Limitation = $ 10,500,000 x ($ 6 million/$ 30 million) = $ 10,500,000 x 1/5 = $ 2,100,000
3. Step 3: Credit equals the lesser of (1) creditable taxes ($ 3 million) or (2) the limitation ($ 2,100,000)
Credit = $ 2,100,000
Note: USAco has excess credits of $ 900,000 [$ 3 million (-) $ 2.1 million]. USAco can carry those excess credits back one year or forward ten years.