The foreign tax credit is a credit that is available to individuals and corporations through the IRS which helps alleviate taxation by the United States for certain income taxes of foreign countries. This credit basically helps individuals and corporation avoid double taxation to a certain degree when they derive income from two taxing jurisdictions.
How Double Taxation Works
A United States citizen is subject to tax on their worldwide income simply because they are a citizen of the United States. In the event that the citizen was employed by another country, that government would have an equal right to tax the income of the individual or corporation.
To avoid the detrimental effects of double taxation by two taxing jurisdictions, the United States has implemented the foreign tax credit to help individuals and corporation lower their overall tax burden when dealing with two or more countries.
Credit vs. Deduction
There are actually two ways to avoid double taxation when dealing with two taxing jurisdictions. The first is the foreign tax credit and the second is a deduction of foreign income taxes.
Generally speaking, a credit against the tax ordinarily will result in a greater tax benefit than a deduction from gross income. However, in a few instances the limitation on the allowable credit will cause the deduction to be of greater benefit.
Calculating the Credit
The credit is equal to the lesser of the actual tax paid to the foreign country or in some cases a limitation. It is the taxpayer’s responsibility to compute the limitation on the amount of foreign tax that can be used to reduce U.S. tax under the overall limitation.
Once the taxpayer totals the taxes paid to all foreign countries and possessions the total is subjected to a limitation computed by multiplying the U.S. tax liability by a fraction consisting of taxable income from foreign sources over the worldwide taxable income.
For individuals, worldwide taxable income is generally computed as adjusted gross income less total itemized deductions or the standard deduction, depending on which the taxpayer chooses to use.
Unused Foreign Taxes
In the event there is left over foreign taxes, these taxes may be carried back on year and then forward for ten years. The credit is first carried to the earliest year and then to the next earliest year.