Avoiding Double Taxation: When is a Foreign Tax Credit Allowed?
The United States is one of the few countries in the world that taxes its citizens and residents on their worldwide income. This contrasts with the majority of countries which only tax only income that is earned in the country. As a result, U.S. taxpayers have the potential for being taxed twice on the same income. For example, if a U.S. citizen is working in London, the income earned by that individual will be subject to tax in the United Kingdom, which will tax the person’s income since services were performed there, and in the United States, which will tax the individual’s worldwide income. Fortunately, to avoid double taxation, the United States permits taxpayers to credit certain taxes paid to a foreign government against their U.S. income tax liability. This article discusses the rules for determining which taxes levied by foreign governments are creditable for U.S. income tax purposes.1
Amounts Eligible for the Foreign Tax Credit
Overview. To determine whether an amount paid is creditable as a foreign tax credit, a taxpayer must identify each levy. Each levy will then be tested separately. 2 It is important to understand that the same income may be subject to multiple taxes in the foreign jurisdiction. For example, assume Country A imposes a national income tax on income earned in Country A, and City B, located within Country A, also imposes a tax on the income earned in City B. These are two separate levies. To be considered a single levy, the levy must be imposed by a single taxing authority.3
A levy is treated as separate if the base of the levy differs in kind. 4 However, it is possible for the base of a single levy to vary in degree. For example, the United Kingdom may tax active income on a net basis and passive income on a gross basis. Incidentally, these would be two separate levies, one on active income and one on passive income.
Compulsory Payment. A levy is creditable in the United States if it is a “tax” and either has the “predominant character” of an income tax in the U.S. sense or is “in-lieu of” an income tax.5 Subject to exceptions for “soak-up” taxes and “dual capacity” taxpayers, once a levy is found to be creditable, the full amount of the tax is creditable for all taxpayers subject to that foreign levy.6
To qualify as a tax, the levy must (i) require compulsory payment and (ii) be made pursuant to a country’s taxing authority.7 These requirements are fairly straightforward. A tax is compulsory to the extent the taxpayer cannot eliminate it through the application of foreign law or interpretation.8 Only the compulsory levy is creditable. As such, a taxpayer must take reasonable steps to pay no more tax than is legally required. For example, if a person can reduce the rate of tax imposed by the foreign government by electing to apply a treaty, the amount that is considered a tax is limited to the amount that would be imposed if the taxpayer elected to apply the treaty.
If the individual makes a payment to a taxing authority and receives an economic benefit that is not generally available to taxpayers or the population at large, the levy is not considered to have been made pursuant to a country’s taxing authority.9 This can occur when an individual is subject to a country’s generally applicable tax but pays an increased amount to the government in exchange for a specific economic benefit. The amount paid for the specific economic benefit is considered a separate levy on a “dual capacity” taxpayer.10 However, part of the payment to the foreign government may still qualify as a creditable tax.
Predominant Character of an Income Tax. A levy is only creditable if it has the “predominant character” of an income tax in the U.S. sense or is “in-lieu of” an income tax. A tax has the predominant character of an income tax if it is calculated to reach net gain in the ordinary circumstances in which the tax applies.11 The applicable Treasury Regulations set forth the following three principles:
- the tax must have as its base an amount that includes only transactions that involve realization;
- the tax base must begin with gross receipts; and
- the tax must allow for the recovery of costs and expenses, so it taxes net income.12
These principles do not require strict adherence. Rather, a foreign tax must satisfy the principles only in its predominant character. The realization requirement is met if income is recognized no earlier than permitted under U.S. tax law.13 Certain exceptions are allowed. For example, the realization requirement is satisfied if a foreign jurisdiction imposes tax upon recapture of previous deductions or credits allowed, changes in fair market value under a mark-to-market regime that adjusts basis for the gains and losses taxed, deemed distributions if a subsequent actual distribution does not cause the income to be taxed twice, or transfers or exports of readily marketable property under a system that does not overlap with an income tax.14 A tax satisfies the gross receipts requirement if it is based on the U.S. concept of gross receipts or uses a method that is not likely to produce an amount greater than fair market value of property received.15 Additionally, a tax meets the deduction requirement if gross receipts are reduced by significant costs and expenses or a method is used that estimates costs and expenses and the estimate is likely to approximate or exceed the actual amount.16
In-Lieu of an Income Tax. Even if a levy does not have the predominant character of an income tax, it may still qualify as a tax levied “in-lieu of” an income tax.17 Unlike an income tax, an in lieu of tax does need to be imposed on net income. For example, gross-basis withholding taxes, which do not allow for deductions of expenses, can often qualify as an in-lieu of tax.18 A tax qualifies as an in lieu of tax, only if it is imposed in substitution for a generally imposed income tax.19 In other words, there must be a creditable income tax in place in the foreign jurisdiction for a tax to be considered an in-lieu of tax. In addition, an in lieu of tax can only be imposed in substitution of an income tax; it cannot be an addition to the income tax imposed on the same taxpayer.20
Restrictions of the Foreign Tax Credit
The foreign tax credit is limited to the amount paid or accrued to a foreign government.21 An amount is not considered paid to a foreign government to the extent that it is reasonably certain the amount will be refunded, credited, rebated, abated, or forgiven.22 In addition, an amount is not paid or accrued by a taxpayer to a foreign government to the extent (i) it is used by the foreign country to provide a subsidy to the taxpayer, a party related to the taxpayer, or a person that is party to a related transaction and (ii) the subsidy is determined by reference to the amount paid by the taxpayer or the tax base.23 For example, if a foreign government taxes interest received by lenders on amounts loaned to residents of the country and the foreign government remits the amount collected to borrowers resident in the country, the amount remitted is considered a subsidy because it subsidizes the cost of borrowing for residents of the country.
No foreign tax credit is permitted to the extent a foreign tax constitutes a “soak-up” tax.24 A tax is a soak-up tax to the extent that liability for the tax is dependent on the availability of a credit for the tax against income tax liability to another country.25 For example, if a foreign country requires a person to a pay a tax only if the tax is creditable under U.S. tax law, the tax is a soak-up tax and the foreign tax credit will be denied.
The party claiming the credit must be the person on whom foreign law imposes liability for the tax.26 This is known as the “technical taxpayer” rule. The person that remits the tax or agrees to assume the liability is irrelevant.27 For example, if a withholding agent is required to withhold tax from a payment to a payee, the payee and not the withholding agent is the party that may claim the credit. If foreign tax is imposed on the combined income of two or more persons, such as a married couple, the tax is allocated to each person based on the person’s share of the tax base.28 Similarly, if foreign tax is imposed on an entity that is a pass through entity for U.S. federal income tax purposes, such as a partnership, the tax passes through to the partners.29 Shareholders of a mutual fund may also receive a foreign tax credit for foreign taxes paid by the fund if the fund elects to pass such taxes through to the shareholders.30
Only Foreign Source Income is Eligible
Not all income on which a taxpayer pays a foreign tax is eligible for the foreign tax credit. Rather, the credit is only available for income that is considered foreign source income.31 The source rules are designed to determine whether the United States or a foreign country has a closer connection or “nexus” to the income. If income is foreign source income, a foreign country has the primary right to tax the income. Therefore, the United States will allow the taxpayer to take a credit for foreign income taxes paid. In general, income from interest and dividends is sourced according to the residence of the payer, income from royalties is sourced where the property is used, income from services is sourced where the services are performed, income from the sale of goods is sourced where title passes, and capital gains are sourced according to the residence of the seller.32 The source rules can be very complicated and are subject to numerous exceptions.
The United States allows a credit for certain taxes paid to foreign governments. Before starting operations in a foreign jurisdiction, taxpayers should carefully examine the local tax regime to ensure it will qualify for the foreign tax credit.
1 This article only discusses the direct foreign tax credit available under IRC § 901. It does not discuss the deemed paid foreign tax credit available under IRC § 902 to U.S. corporations that own at least 10 percent of the stock of a foreign corporation.
2 Reg. § 1.901-2(a)(1).
3 Reg. § 1.901-2(d)(1 .
5 Reg. §§ 1.901-2(a); 1.903-1(a).
6 Reg. § 1.901-2(a)(1).
7 Reg. § 1.901-2(a)(2)(i).
8 Reg. § 1.901-2(e)(5)(i).
9 Reg. § 1.901-2(a)(2)(i).
10 Reg. § 1.901-2A(a)(1).
11 Reg. § 1.901-2(a)(3)(i).
12 Reg. § 1.901-2(b)(1).
13 Reg. § 1.901-2(b)(2)(i)(A).
14 Reg. §§ 1.901-2(b)(2)(i)(B), (C); 1.901-2(b)(2)(ii).
15 Reg. § 1.901-2(b)(3)(i).
16 Reg. § 1.901-2(b)(4)(i).
17 IRC § 903.
18 Reg. § 1.903-1(a).
20 Reg. § 1.903-1(b)(1).
21 Reg. § 1.901-2(e)(1).
22 Reg. § 1.901-2(e)(2).
23Reg. § 1.901-2(e)(3)(i).
24 Reg. §§ 1.901-2(a)(3)(ii); 1.903-1(b)(2).
26 Reg. § 1.901-2(f)(1).
27 Reg. § 1.901-2(f)(2)(i).
28 Reg. § 1.901-2(f)(3).
29Reg. § 1.901-2(f)(4)(i).
30 IRC § 853.
31IRC § 904(a). The mechanics are much more complicated than suggested. The foreign tax credit under IRC § 901 is subject to the limitation set forth in IRC § 904. IRC § 904 limits the credit to the taxpayer’s tentative U.S. income tax liability multiplied by the ratio of the taxpayer’s foreign source income to the taxpayer’s worldwide income. The limitation is subject to numerous adjustments for carrybacks and carryforwards, prior year losses, and lower tax rates on capital gains.
32 IRC §§ 861, 862, 865(a).