FOREIGN TAX CREDIT ON CORPORATION

The Unites States (U.S.) retains the right to tax its citizens and residents on their worldwide taxable income. This approach can result in double taxation, presenting a potential problem to U.S. corporations with foreign income and individuals who invest abroad. Double taxation occurs when foreign income is taxed by both the United States, as well as by the country where the income was generated. To reduce the possibility of double taxation, Congress enacted the foreign tax credit (FTC) (Willis, 2011). The corporate foreign tax credit is a set of provisions designed by Congress to eliminate potential double taxation on the foreign source income of U.S. corporations. The current provisions allow U.S. businesses to credit their foreign taxes paid, accrued, or deemed paid against their U.S. income tax liability, subject to limitations that prevent taxpayers from using taxes paid in a country with a higher tax rate than the U.S. to offset their tax liability on U.S. income. The credit is a dollar-for-dollar reduction of U.S. income tax liability (taxpolicycenter.org, 2010). 
Corporations are required to calculate this credit separately for different income categories to prevent taxpayers from combining income that is traditionally taxed at low rates, such as dividend or interest income, with income that is typically taxed at higher rates, such as active business income. Internal Revenue Code Section 901 specifies the provisions for the foreign tax credit. Corporations report the foreign income and taxes related to the credit on Form 1118, Computation of Foreign Tax Credit-Corporations and attach it to their corporate tax return (irs.gov, 2011). The foreign tax credit is elective for any particular year. If the taxpayer does not choose to take the foreign tax credit Section 164 allows a deduction for foreign taxes paid or incurred. A taxpayer cannot take a credit and a deduction for the same foreign income taxes. Foreign tax credit is a type of nonrefundable credit that is subject to carryover provisions if they exceed the amount allowable as a credit in a given year. Unused credits may be carried back 1 year and forward 10 years.  The taxes can be credited in years when the formula limitation for that year exceeds the foreign taxes attribution to the same tax year. The carry back and carry forward provisions are available only within a specific basket. Excess foreign taxes in one basket cannot be carried over unless there is an excess limitation in the same basket for the carryover year (irs.gov, 2011).

The foreign tax credit is available to individuals with foreign source income, including wages earned abroad, but the great bulk of foreign tax credits go to U.S. corporations with operations abroad. U.S. corporations earn foreign source income by operating branches abroad and by operating or investing in affiliates incorporated abroad. If the foreign source income is earned through a foreign branch, it is subject to U.S. tax in the same tax year in which it is earned. The tentative U.S. tax is simply the U.S. tax rate times the income of the branch. A credit is given for foreign income taxes and for any foreign withholding taxes that are levied when the branch remits the income to the U.S. parent. Losses incurred by a foreign branch can be deducted from the corporation’s domestic source income to reduce the corporation’s U.S. income tax. In succeeding years, however, if the branch becomes profitable, its income is treated as U.S. source income and no foreign tax credit can be claimed on it until the U.S. Treasury recovers the reduction in tax revenue caused by the branch’s initial losses (Rousslang, 2005). If the foreign source income is earned through a foreign affiliate that is a separate company incorporated abroad, the income generally is subject to U.S. tax only when it is remitted as dividends to the U.S. parent corporation. The U.S. tax on unremitted earnings is thus deferred until the earnings are repatriated. This is advantageous to the corporation because of the benefits associated with deferral of tax (Rousslang, 2005).
To be eligible for a credit for foreign taxes on the affiliate’s income, the U.S. parent must own at least 10 percent of the affiliate. A foreign affiliate that is separately incorporated abroad and that is at least 10 percent owned by the U.S. parent is called a foreign subsidiary. A subsidiary distributes dividends to the U.S. parent from earnings and profits after foreign income taxes. To determine the tentative U.S. tax and the foreign tax credit for the dividends, it is necessary to construct the underlying foreign source income from which the dividends were derived. The formula for the tentative U.S. tax (TA) on the underlying foreign source income is TA = tUS D/ (1 − tF), where D is dividends, tUS is the U.S. tax, and tF is the foreign income tax rate used for purposes of calculating the foreign tax credit (foreign income taxes paid divided by the subsidiary’s earnings and profits as measured using the U.S. definition of taxable income). From the tentative U.S. tax, the U.S. Corporation subtracts the sum of the foreign income taxes paid on the income underlying the dividends plus the foreign withholding taxes on the dividends. If the difference is positive, the U.S. Corporation owes a residual U.S. tax. If the difference is negative, the U.S. Corporation is said to have excess foreign tax credits (Rousslang, 2005).
In general, the U.S. parent corporation is allowed to sum the foreign source income and foreign taxes from all of its foreign operations, both branches and subsidiaries, when calculating the foreign tax credit and the residual U.S. tax. To be lumped together, however, the foreign source income must be within the same category of income (or income “basket”), as defined by the Internal Revenue Code. The main income baskets are for passive income (primarily interest, dividends, royalties, rents, or annuities received by the subsidiary), financial services income (income earned in banking, insurance, or finance), shipping income (income earned in international shipping), and general limitation income (primarily income earned abroad in the active conduct of a trade or business other than financial services, shipping, or income in the passive basket). Income in each of these baskets is subject to a separate foreign tax credit limitation. The maximum foreign tax credit that can be claimed in any basket (the foreign tax credit limitation) is the tentative U.S. tax. Any excess credits can be applied to offset the residual U.S. tax on foreign source income earned during the previous two years or the following five years, but if the credits cannot be used within that period, they are lost (Rousslang, 2005).
The separate income baskets help discourage U.S. corporations from moving offshore some types of highly mobile investments (such as international shipping, financial services, and portfolio loans) that can easily be located in low-tax countries. Subpart F of the Internal Revenue Code denies deferral for income from such investments, but U.S. corporations might still have a tax incentive to locate these activities abroad if they were allowed to combine the income and foreign taxes from these investments with those from other, less mobile, business activities that often generate excess foreign tax credits. The separate income baskets remove this incentive (Rousslang, 2005).
The FTC is progressing yearly. In 2005 (the latest year for which tax data are available), US taxpayers claimed over $90 billion of foreign tax credits. The foreign tax credit offsets most of the U.S. tentative tax on foreign source income. Compare to 2004, total taxable foreign source income of U.S. corporations was about $150 billion. Foreign taxes on this income (income taxes and withholding taxes) amounted to about $87 billion, of which about $50 billion was creditable against the tentative U.S. tax. The residual U.S. tax on the income was about $15 billion (irs.gov, 2011).
To prevent taxpayers from crediting foreign taxes against U.S. taxes levied on U.S. sources taxable income, the foreign tax credit is subject to a limitation. The foreign tax credit for any taxable year cannot exceed the lesser of two amounts. First the actual foreign taxes paid or accrued. Second the U.S. taxes (before the FTC) on foreign source taxable income. The foreign limitation is derived in the following manner FTC limitation is equal to Foreign-source taxable income/Worldwide taxable income multiply by U.S. tax before FTC (irs.gov, 2011).