Introduction to Foreign Tax Credit Computations

The foreign tax credit is a non-refundable tax credit implemented by the United States to ease the burden of double taxation for taxpayers with tax liabilities in other countries. It’s an important item to consider when developing a firm’s international strategy.

The foreign tax credit was initially introduced in the Revenue Act of 1918 after U.S. taxpayers became subject to taxation on their worldwide income. Since then, it has gone through numerous changes to match the U.S. international policy, such as excluding taxes paid to boycotted countries in the Tax Reform Act of 1976, the introduction and application of the Foreign Tax Credit (FTC) regarding Global Intangible Low Tax Income (GILTI), or increased limitation when it comes to definition of foreign sources.

For a foreign tax to be met for FTC, it generally must meet a four-part test:

1. Was it imposed?
2. Has it been accrued or paid?
3. Is it the legal and actual tax liability?
4. Is it an income tax or an in lieu of tax?

Additionally, it must not meet certain exclusions, such as taxes that can only be deducted, which are a portion of taxes on combined foreign oil and gas income. These excluded taxes aren’t eligible for the Foreign Tax Credit but can still typically be used as a deduction.

The maximum amount of FTC that can be used is determined by the FTC limitation. The limitation is calculated by the ratio of eligible foreign income divided by worldwide income, multiplied by total U.S. taxes, or ((Foreign Income/ Worldwide Income) X U.S. Income Tax).

Taxpayers who elect to take FTC must submit an 1116 if they are an individual or an 1118 if they are a corporation. An additional 1116 or 1118 must be attached for each individual category of income. These forms are complicated, arduous, and prone to error without the proper skillset. 

If you have any questions about the Foreign Tax Credit, its computation, the related compliance, or any other international matters, please contact our Global Business Services team.