Definition
The Foreign Tax Credit (FTC) is a provision in the U.S. tax code that allows taxpayers to offset their U.S. federal income tax liability with the foreign taxes they paid or accrued on income earned outside the United States. The primary goal of the FTC is to eliminate the double taxation of income that is subject to tax in both the U.S. and another country.
Computation
The Foreign Tax Credit limitation is calculated by multiplying the U.S. tax liability before the credit by the ratio of foreign taxable income to total taxable income (both U.S. and foreign). The formula is as follows:
\[ \text{FTC Limit} = \text{U.S. Tax Liability} \times \left( \frac{\text{Foreign Taxable Income}}{\text{Total Taxable Income}} \right) \]
Examples
Example 1:
John, a U.S. taxpayer, earned $50,000 of taxable income in a foreign country and $150,000 in the U.S., with a total taxable income of $200,000. He paid $10,000 in foreign taxes on his foreign income. His U.S. tax liability before the FTC is $40,000.
First, compute the FTC limit: \[ \text{FTC Limit} = 40,000 \times \left( \frac{50,000}{200,000} \right) = 40,000 \times 0.25 = $10,000 \]
Since John’s foreign taxes paid ($10,000) do not exceed his FTC limit ($10,000), he can claim an FTC of $10,000, offsetting his U.S. tax liability dollar-for-dollar by the foreign taxes paid.
Example 2:
Anna, a U.S. taxpayer, earned $70,000 in a foreign country and $130,000 in the U.S., with total taxable income of $200,000. She paid $15,000 in foreign taxes on her foreign income. Her U.S. tax liability before the FTC is $30,000.
Compute the FTC limit: \[ \text{FTC Limit} = 30,000 \times \left( \frac{70,000}{200,000} \right) = 30,000 \times 0.35 = $10,500 \]
Since Anna’s foreign taxes paid ($15,000) exceed her FTC limit ($10,500), she can only claim an FTC of $10,500. The excess foreign tax paid ($4,500) may be carried back or forward to other tax years.
Frequently Asked Questions
Q1: What is the purpose of the Foreign Tax Credit? A1: The FTC aims to eliminate the double taxation of income that is subject to tax in both the U.S. and a foreign country.
Q2: Who is eligible to claim the FTC? A2: U.S. taxpayers who have paid or accrued foreign taxes on income earned outside the United States can claim the credit.
Q3: Can all foreign taxes paid be claimed under the FTC? A3: No, only income taxes or taxes imposed in lieu of an income tax by a foreign country qualify for the FTC.
Q4: Is there a limitation on the amount of FTC that can be claimed? A4: Yes, the FTC is limited to the lesser of the foreign taxes paid or the FTC limitation calculated based on the proportion of foreign taxable income to total taxable income.
Q5: Can excess foreign taxes paid be used in other tax years? A5: Yes, excess foreign taxes paid can be carried back one year or forward up to ten years to offset future U.S. tax liabilities.
Related Terms
Double Taxation: The imposition of taxes by two or more jurisdictions on the same income, asset, or transaction.
Foreign Earned Income Exclusion (FEIE): A provision that allows U.S. citizens earning income abroad to exclude a certain amount from their taxable income.
Tax Treaty: Agreements between two or more countries to resolve issues related to double taxation and to promote reciprocal trading relationships.
Online References
- Internal Revenue Service (IRS) – Foreign Tax Credit
- Tax Foundation – Foreign Tax Credit
- Investopedia – Foreign Tax Credit Definition
Suggested Books
- “Federal Income Tax: Code and Regulations–Selected Sections” by Martin B. Dickinson
- “International Taxation in a Nutshell” by Richard L. Doernberg
- “The International Taxation System” by Andrew Lymer and John Hasseldine
Fundamentals of Foreign Tax Credit: Taxation Basics Quiz
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