Foreign Tax Credit: Identifying Opportunities for Clients

Identifying Foreign Tax Credit Opportunities

Don’t Let Your Clients Pay Taxes Twice on Foreign Income

For businesses and individuals with foreign income, paying taxes in another country can be an unavoidable part of international business. But that doesn’t necessarily mean those foreign taxes have no benefit as it relates to the taxpayer’s U.S. tax burden.

The Foreign Tax Credit may allow eligible taxpayers to reduce their U.S. tax liability for qualifying foreign taxes paid or accrued on foreign-source income. For CPAs, identifying whether a client has an opportunity — and whether the credit has been properly calculated — can be an important part of maximizing the client’s tax position.

The challenge is that Foreign Tax Credit rules can become highly technical, and opportunities are easy to overlook.

What Is the Foreign Tax Credit?

The U.S. tax system generally taxes worldwide income. As a result, a taxpayer who earns income in a foreign jurisdiction may pay tax on that income to the foreign government and then include the income on their U.S. tax return and pay tax again.

The Foreign Tax Credit is designed to help alleviate this potential double taxation by allowing eligible taxpayers to claim a credit for certain foreign income taxes paid or accrued.

The concept sounds straightforward. The calculation often isn’t.

As McGuire Sponsel’s International Tax team discussed in a recent conversation, the fundamentals of the Foreign Tax Credit are relatively simple, but applying the Internal Revenue Code and Treasury regulations can become significantly more complicated — particularly when expense allocations and other technical considerations come into play.

Why Are Foreign Tax Credit Opportunities Often Missed?

There are several reasons a potential credit may not be identified.

The opportunity is overlooked.

A client may report foreign income and foreign taxes paid without realizing those taxes could generate a U.S. tax credit. In other cases, the client or tax preparer may not recognize the presence of foreign-source income in a more complex return.

The rules and calculations are complex.

Forms 1116 and 1118 can make the process seem intimidating. Individuals, estates, and trusts generally use Form 1116, whereas corporations claiming a foreign tax credit use Form 1118.But completing the appropriate form is only part of the process. The underlying calculations and technical analysis can be much more complicated.

The focus may be limited to the current year.

Another potential missed opportunity is failing to look at prior-year returns. A review of previous filings can sometimes reveal information that affects the client’s ability to maximize the Foreign Tax Credit in subsequent years.

Which Clients Should CPAs Review?

A Foreign Tax Credit review doesn’t need to begin with every client in the firm. Start by looking for indicators of international activity. Potential clients to review include those with:

Foreign business operations
Foreign investments
Foreign-source capital gains
Foreign dividends
Foreign trust income
Other foreign-source income
Foreign taxes paid or accrued

Certain forms can also provide useful indicators.

Form 5471

A corporate return that includes Form 5471 generally indicates foreign ownership or controlled foreign corporation activity and warrants a closer look at the client’s international tax position.

Form 1116

If an individual, estate, or trust has filed Form 1116, the client is already reporting foreign tax credit activity. That may be an opportunity to evaluate whether the calculation is complete and properly optimized.

Form 1118

For corporate clients, Form 1118 similarly indicates that foreign taxes and foreign-source income are already part of the client’s tax picture.

The key question isn’t simply: “Did the client claim a Foreign Tax Credit?”

It should also be: “Was the opportunity fully evaluated and the credit maximized?”

Don’t Just Look at This Year’s Return

One of the most important considerations when evaluating Foreign Tax Credit opportunities is the client’s history. McGuire Sponsel’s International Tax team often reviews two or three years of prior filings when evaluating a client’s situation.

Why?

Because an issue identified in a prior year may affect the credit available in subsequent years. For example, the team discussed a situation involving an overall domestic loss that had not been quantified previously. Properly identifying that loss could allow the taxpayer to claim a larger Foreign Tax Credit in subsequent years. This illustrates why a current-year-only review may not tell the whole story.

The opportunity may be in the return you are preparing — or in returns already filed.

Foreign Tax Credits Aren’t Just a Corporate Issue

It can be tempting to think of Foreign Tax Credit opportunities as primarily a corporate tax issue. The experience of McGuire Sponsel’s International Tax team suggests otherwise. The team has worked on Foreign Tax Credit matters involving both individual and corporate taxpayers, including technically challenging situations involving individual returns.

For individual clients, consider reviewing:

Foreign investments
Foreign real estate
Foreign-source capital gains
Foreign dividends
Foreign business interests
Other foreign-source income

For corporate clients, consider:

Foreign branches
Controlled foreign corporations
Foreign operations
Foreign investments
Foreign-source income
Foreign taxes paid or accrued

The amount of foreign income and the nature of the client’s foreign investments and activities will ultimately determine whether a meaningful opportunity exists.

When Should a CPA Bring in an International Tax Specialist?

Not every foreign tax issue requires outside assistance.

But when the facts become complex, specialized international tax expertise can help a CPA firm determine whether an opportunity exists and how to address it.

Consider bringing in a specialist when:

The client has significant foreign operations or investments
Foreign taxes are substantial
The return includes Forms 5471, 1116, or 1118
The client has never evaluated the Foreign Tax Credit
The credit calculation is unusually complex
Prior-year returns may contain missed opportunities
You’re unsure whether the current calculation fully captures the client’s potential credit

The goal isn’t to replace the CPA’s relationship with the client. It’s to provide specialized expertise when the international tax issues become more complex.

Don’t Let Foreign Taxes Become an Unnecessary Tax Burden

For clients with international activity, foreign taxes are often viewed simply as another cost of doing business, but they may represent something more.

A properly performed Foreign Tax Credit analysis can help determine whether qualifying foreign taxes may reduce the client’s U.S. tax liability — and whether opportunities have been missed in the current or prior years.

The first step is simply knowing where to look. Don’t let your clients pay taxes twice on foreign income.

If you have a client with foreign income, investments, or operations and aren’t sure whether their Foreign Tax Credit position has been fully evaluated, McGuire Sponsel’s International Tax team can help assess the opportunity.

You know your clients. We know international tax. Let’s uncover the opportunity together.

Request a Foreign Tax Credit Opportunity Review

Watch the Discussion

In this short discussion, Jerry Hammel, CPA, Greg Lambrecht, CPA, and Ashu Mahal, CPA, J.D., explain how the Foreign Tax Credit may help prevent double taxation, why opportunities are often missed, and what CPAs should look for across current- and prior-year individual and corporate returns.