Taxpayers who pay foreign taxes are entitled to a foreign
tax credit. The credit is limited to the
portion of current year Federal income tax caused by foreign source income. Available credits in excess of this limit may
be carried over to other years.Corporate
shareholders of foreign corporations paying dividends may claim a deemed paid
foreign tax credit for taxes on earnings underlying the dividend.
The limit on foreign tax credits is based on foreign source
taxable income, after allocating and apportioning all deductions. Computing the
amount of the limit can be quite complex. IRS regulations specify how deductions must be
allocated and apportioned. Special
mechanical rules apply to interest, R&D, and state income tax deductions.
Interest is apportioned based on the basis of assets. R&D is apportioned
based on sales for the worldwide group of companies or gross income of the U.S.
consolidated return group. Elections of
which method to use for R&D expense apportionment apply for five years, and
are irrevocable.
The calculations are further complicated by "check the
box" rules that allow taxpayers to treat some types of foreign entities as
flow-through. Where such entities are
wholly owned by a U.S. taxpayer (including consolidated return members collectively),
the income, deductions, assets, and liabilities are combined with the U.S.
taxpayer's itmes in computing the limitation. Thus, interest, etc., deductions of the
foreign checked entities must be apportioned, and the assets of those entities
combined in apportioning interest.
Further complication, and potential benefit, arises from
foreign title passage sales under the rules of section 863(b). Revenues from sales of U.S. made goods sold
with title passing outside the U.S. are considered 50% foreign source, and CoGS
and deductions related thereto must be apportioned. Often such sales income is not subject to any
foreign tax, improving the foreign tax credit limit.See the Journal of Taxation article on this
site.
