Definition
The Foreign Tax Credit is a non-refundable tax credit offered by U.S tax law for income taxes paid to a foreign country as a result of foreign income tax withholdings. It is intended to prevent double taxation of income earned in foreign countries. The credit is applicable to taxpayers who pay taxes to both the U.S. IRS and a foreign entity.
Key Takeaways
- The Foreign Tax Credit is a non-refundable tax credit for income taxes paid to a foreign government as a result of foreign income tax withholdings. This means it can reduce a taxpayer’s overall tax obligation to their home country.
- It is designed to help taxpayers avoid being double taxed on their income: once by their home country and another by the foreign country in which they are making earnings. This primarily benefits corporations and individuals who conduct business internationally.
- Claiming the Foreign Tax Credit requires specific forms dependent on the taxpayers home country; for example, in the US, this is IRS Form 1116. Not all taxes paid to a foreign country qualify. The taxpayer must refer to the IRS guidelines or consult a tax professional to ensure they qualify.
Importance
The Foreign Tax Credit is a crucial financial term because it directly relates to international business and investment activities. Essentially, this credit prevents taxpayers from being doubly taxed on income earned overseas.
If a taxpayer, whether an individual or a corporation, earns income from foreign sources and pays tax on that income to a foreign government, they can use the Foreign Tax Credit to offset their U.S. tax liabilities.
This system is designed to promote fair treatment of taxpayers, encourage global trade and investment, and prevent the complication of double taxation. Without it, taxpayers could be unfairly penalized for engaging in international affairs, which would be counterproductive to economic globalization.
Explanation
The Foreign Tax Credit serves an essential role in preventing the double taxation of foreign income, thereby promoting fairness in the taxation system. This is especially pertinent for U.S. citizens and resident aliens who have income from foreign sources. The U.S.
is one of the few countries that tax their residents on worldwide income, meaning individuals and corporations can potentially be taxed by two jurisdictions – by the U.S. and also by the country where the income was earned. The Foreign Tax Credit mitigates this issue by providing a tax credit for the taxes paid to foreign governments, thereby reducing one’s overall U.S. tax liability.
The purpose of the Foreign Tax Credit is extremely beneficial in fostering international business and encouraging individual investment in diverse markets. U.S. corporations with operations overseas can reinvest their foreign earnings without incurring double taxation, creating an environment that supports global expansion and diversification. Similarly, for individual investors who hold international assets or receive foreign sourced income, the Foreign Tax Credit can help maintain more of their income without a heavy tax burden.
This allows for a more globally interconnected economy, fostering economic growth and development.
Examples of Foreign Tax Credit
An American earning income in Germany: Suppose an American employee named Tom travels to Germany to work for a year and earns $60,The German government taxes that income at a rate of 25%, so Tom owes $15,000 in German income tax. When Tom returns to the U.S., the IRS also taxes his foreign income, say 30%, which would be $18,
However, Tom can apply the $15,000 he paid to the German government as a foreign tax credit, meaning he only owes the IRS $3,An U.S. Corporation doing business in China: An U.S. based company named XYZ Corp. has a subsidiary in China that earned $1 million in profits. The Chinese government subjects those profits to a 25% tax, amounting to $250,
When the $1 million is repatriated back to the U.S., it is also subject to U.S. corporate income tax. However, XYZ Corp. can apply for a foreign tax credit for the $250,000 they paid in China, offsetting their U.S. tax liability.A Canadian investor with stocks in India: Let’s say an investor, Rachel, from Canada, invests in Indian stocks and receives dividends of $20,
India imposes a dividend withholding tax of 10%, so Rachel has to pay $2,000 in taxes in India. When she reports this income on her Canadian tax return, she can claim a foreign tax credit for the $2,000 she already paid to India, reducing her tax bill in Canada.
FAQ Section: Foreign Tax Credit
What is the Foreign Tax Credit?
The Foreign Tax Credit is a non-refundable tax credit for income taxes paid to a foreign government as a result of foreign income tax withholdings. This credit is available for anyone who works in a foreign country or has investment income from a foreign source.
Who qualifies for the Foreign Tax Credit?
U.S. citizens and resident aliens who paid or accrued foreign taxes to a foreign country or U.S. possession on foreign sourced income are eligible for the Foreign Tax Credit.
How do you claim the Foreign Tax Credit?
To claim the Foreign Tax Credit, you must complete and file IRS Form 1116 along with your Federal income tax return, unless you meet certain requirements that allow you to bypass Form 1116.
Can the Foreign Tax Credit exceed my tax liability?
No, the Foreign Tax Credit cannot exceed your total U.S. tax liability. However, if it does, you may carryback for one year and carryforward for up to 10 years the unused foreign tax credit.
What types of foreign taxes qualify for the credit?
Generally, only income, war profits, and excess profits taxes qualify for the credit. Other taxes, such as wealth, estate and gift, sales, and value-added taxes do not qualify. However, in certain cases, a tax that is not generally creditable may become creditable under a specific provision in a U.S. income tax treaty.
Related Entrepreneurship Terms
- International Taxation
- Double Taxation Agreement
- Income Tax Act
- Non-Resident Alien
- Tax Treaty
Sources for More Information
- Internal Revenue Service (IRS): The IRS offers extensive information on foreign tax credit rules, eligibility, and how to claim it.
- Investopedia: This platform explains complex finance and investment terms in easy-to-understand language, including the foreign tax credit.
- Tax Policy Center: A joint venture of the Urban Institute and Brookings Institution, the center provides in-depth analysis on tax policy, including foreign tax credit.
- KPMG: As a professional services company and one of the Big Four auditors, KPMG offers a wealth of resources and expert analysis on various tax issues, including foreign tax credit.
