A foreign tax credit (FTC) is generally offered by income tax systems that tax residents on worldwide income, to mitigate the potential for double taxation. The credit may also be granted in those systems taxing residents on income that may have been taxed in another jurisdiction. The credit generally applies only to taxes of a nature similar to the tax being reduced by the credit (taxes based on income) and is often limited to the amount of tax attributable to foreign source income. The limitation may be computed by country, class of income, overall, and/or another manner.
Most income tax systems therefore contain rules defining source of income (domestic, foreign, or by country) and timing of recognition of income, deductions, and taxes, as well as rules for associating deductions with income. For systems that separately tax business entities and their members, a deemed paid credit may be offered to entities receiving income (such as dividends) from other entities, with respect to taxes paid by the payor entities with respect to the income underlying the income recognized by the member. Systems with controlled foreign corporation rules may provide deemed paid credits with respect to deemed income inclusions under such rules. Some variations on the credit provide for a credit for hypothetical tax to encourage foreign investment (sometimes known as tax sparing).
Detailed rules vary among taxation systems. Examples below are given for illustration purposes only and may not reflect the rules in a particular tax system.
Credit for foreign income taxes A reduction of tax (credit) is often provided in income tax systems for similar income taxes paid to other countries (foreign taxes).For the US, see . For the UK, see Part XVII of Chapter IV Income and Corporation Tax Act of 1988, beginning at section 788, (hereafter UK ICTA88/Sxxx) as amended. For Canada, see Income Tax Act (referring to a "deduction from the tax for the year") (hereafter, Canada ITA Section xx). For Singapore, see Sections 50 and 50A of the Income Tax Act (hereafter Singapore ITA section 50 or 50A). For detailed rules on each country's system of taxation, see the article for that country. This is generally referred to as a foreign tax credit. Amounts in excess of income tax are usually nonrefundable., .
The credit is generally limited to those taxes of a nature similar to the tax against which the credit is allowed (for example, taxes on net income after the allowance of deductions). and , which provides all of the detail rules below except conditions imposed by levying body. Also, see Canada ITA section 126(4). Rules defining taxes eligible for credit may refer to one or more of the following characteristics of such tax: Nature of the foreign levy (compulsory, payment for services, optional, discretionary as to rate, etc.), Whether the foreign country allows a similar credit, Whether the two countries have a tax treaty, Nature of the base on which the levy is imposed (gross receipts, income net of deductions, deemed profits, property, or other basis), Form in which payments are made (withholdings, payment by check or giro, or payments in kind), Political considerations (boycotts by taxing country, etc.), Conditions imposed by levying body on taxpayers (information disclosure, etc.), or Services or property provided by levying body or related persons as a result of the tax.
For example, the system in the United States allows FTC, subject to limitations, for foreign compulsory levies based on net income or withheld from gross receipts.. It also denies FTC for taxes paid to countries requiring participation in certain boycotts(j), or taxes paid in exchange for goods or services provided by the taxing authority for services.(f) and , among others. The United Kingdom allows FTC, subject to limitations, for foreign taxes of a nature similar to the income or corporation tax. This is allowed under tax treatiesICTA88/S788. or as a unilateral credit.ICTA88/S790. Canada similarly allows credits but limits the portion of foreign tax subject to deduction with respect to an oil or gas business..
Some countries do not tax persons whether resident of that country or not except on income considered to be from sources in that country or remitted to that country. Those countries tend to allow FTC only to residents and only with respect to taxes imposed on the income subject to tax in the home country. Singapore grants FTC only to residents and only with respect to income taxed in Singapore.Singapore Income Tax Act Sections 50 and 50A .
Many systems specify the time at which a foreign levy meeting the requirements for FTC becomes eligible for such credit, such as when the levy is withheld from income or otherwise paid or settled in cash or property.(a), . Some systems allow a credit when the tax would be properly chargeable under the domestic system.This is implicit in the UK system. Others allow FTC by reference to the time the foreign item of income is chargeable to home country income tax.India Income Tax Act section 91(1). Note that India imposes tax based on income of the preceding year. Some systems allow the credit with the tax would be recognized in financial statements. Some systems base the timing of recognition on the method of accounting of the taxpayer, possibly with an election by a cash basis taxpayer to recognize the tax at the time properly accrued.(a), .
Many income tax treaties require that the governments party to the treaty grant FTC even if the domestic law of such party do not grant such credit.
Federal systems, such as those in Canada, Switzerland, and the US, may have different rules for allowing a credit for extra-jurisdictional credits at the federal and state levels. Such rules may differ among sub-federal (provincial, cantonal, state) jurisdictions. Thus, for example, Canadian and US federal governments allow credits from all foreign levels,Canada ITA section 126(6)(a), (a). while Canadian provinces and US states tend to allow a credit for income taxes paid to other provinces and states but not for taxes paid to sovereign jurisdictions (countries).See, for example, New York State personal income tax form IR-112-R. Sub-federal taxes may or may not be covered by income tax treaties.Taxes covered by the treaty tend to be explicitly defined in each treaty. For instance, the US/Switzerland treaty, Article 2, defines Swiss covered taxes as "the federal, cantonal, and municipal taxes on income" but limits US taxes to taxes under the Internal Revenue Code, which does not include state taxes.
Limitation on credit Most systems limit FTC in some manner. A common limitation is based on the domestic income tax considered generated by the foreign source income subject to tax.; UK ICTA88/S796 and 797; Singapore Income Tax Act Section 50(3) and (5). This limitation may be applied overall or at one or more of the following subsets: By countryCanada ITA section 126(6)(b), but mitigated by section 126(2.3). See also IT270R3 in the summary. or region By type of income(d), and other provisions differentiating various categories of income; , differentiating business from non-business income. By member of a groupSee, for example, UK group relief, which excludes foreign tax credits, at UK ICTA88/S402, et seq. Contrast to US consolidated return rules which treat all group members as a single entity for determining FTC, at . By sub-type of domestic tax.
Amounts in excess of this limitation may be allowed to reduce prior period taxes (and thus potentially subject to refund) or future taxes.(c), and ; permitting carry back of 3 years and forward of 10 years, but only for business income taxes. The period of carryover may be limited to a period of years or unlimited. For example, the US system, in 2009, permitted taxpayers to apply excess FTCs to reduce US federal income tax for the first prior year (carry back) and then successively for each of the next succeeding 10 years (carry forward).(c). Germany, in 2007, permitted unlimited carry forward but no carry back.
Various countries have, at one point or another, limited FTC based on type of income. UK individual income tax limits FTC by the types of income taxed separately in the UK system. Thus, foreign taxes incurred with respect to trading income are limited separately from foreign taxes incurred with respect to investment income.See INTM163040. From 1987 to 2006, the US limited FTC according to different categories or "baskets" of income, generally described as nine such baskets but in reality occasionally substantially more.(d) as enacted by the Tax Reform Act of 1986, prior to amendments in 2004 by PL 108-357. The definitions of such baskets were collapsed into two baskets (with exceptions) beginning 2007. The US baskets are currently passive, consisting of foreign personal holding company income (interest, dividends, rents, royalties, and certain gains, with significant exceptions) and all other (general limitation), with some exceptions generally not applicable.(d) not yet fully reflected in regulations. However, see for definitions related to categories of income, which definitions still apply to the extent not repealed.
Countries having alternative tax regimes imposing certain minimum income taxes may modify the rules for computing FTC for those minimum taxes. provides a special foreign tax credit for the minimum tax applicable to individuals. The special credit takes into account all business foreign income taxes but only 2/3 of non-business foreign income taxes. (a) modifies, for the alternative minimum tax, the foreign tax credit limit of based on differences between regular and alternative minimum taxable income.
Generally, where foreign taxes have been deducted or deemed deducted from income, and a credit or reduction of tax is claimed, the amount of income subject to tax is the amount before the reduction by foreign tax.See, for example, UK ICTA88/S795, and .
Defining foreign source income Where a system imposes limits on FTC based in some manner on foreign source income (FSI), the system generally provides rules for determining whether income is foreign or domestic source. The rules may be relatively simple or quite complex. (For simplicity of wording below, the phrase "sourced to" specifies in the target the place [foreign or domestic] constituting the source of the income in the object for computing FTC limitation.) The following discussion explains US and Canadian rules and certain other variations on one of these rules to illustrate the manners in which systems define FSI and the potential level of complexity. The rules vary highly by country.
US approach US rules are the same for individuals and entities, and for residents and nonresidents.Note, however, that foreign persons may be subject to US tax on foreign source income effectively connected with the conduct of a US trade or business. See and . Under US rules, source is determined for gross income (sales plus other income less cost of goods sold), then expenses and deductions are allocated and apportioned to such income (see below). The source of income is determined separately for each type of income. Interest and dividends are sourced to the tax residence of the payor of the income. Exceptions are provided for income effectively connected with a trade or business, which is sourced to the place of such trade or business. The US provides exceptions for certain interest and dividend income.(a)(1) and (2), (a)(1) and (2). (d). Note that the US may tax foreign source income of a foreign person if that income is effectively connected with a US trade or business. Income from the use of property (rents and royalties) is sourced to the place the property from which the income is derived is used.(a)(4) and (a)(4).