a. Purpose of Limitation
The purpose of the foreign tax credit limitation is to confine the effects of the credit to mitigating double taxation of foreign-source taxable income.
The limitation accomplishes this by preventing U.S. persons operating in high tax foreign countries from offsetting those higher foreign taxes against the U.S. tax on U.S.-source taxable income.
Example # 1
Facts: USAco is a domestic corporation. During the current year, USAco has $ 200 of U.S.-source taxable income and $ 100 of foreign-source taxable income that is subject to foreign income taxation. Assume that the foreign tax rate is 45% and the U.S. tax rate is 35%.
If the foreign tax credit is limited to the U.S. tax on foreign source income (i.e., .35 x $ 100 = $ 35), the total tax on USAco’s $ 300 of worldwide income is $ 115, computed as follows:
a. Foreign tax return
i. Taxable income: $ 100
ii. Foreign tax rate: 45%
iii. Foreign tax: $ 45
b. U.S. tax return
i. Taxable income: $ 300
ii. U.S. tax rate: 35%
iii. Pre-credit tax: $ 105
iv. Foreign tax credit: ($ 35)
v. U.S. tax: $ 70
b. Formula for foreign tax credit limitation
1. Pre-credit U.S. tax x (Foreign source taxable income/Worldwide taxable income)
2. With a single foreign tax credit limitation, all foreign-source income, regardless of its character (e.g., active business versus passive investment) or country of origin (e.g., low-tax country versus high-tax country), is commingled to arrive at a single limitation.
c. Importance of Relative Tax Rates
The relation of U.S. and foreign tax rates is a major determinant of whether a taxpayer is in an excess limitation or an excess credit position.
Taxpayers are in an excess limitation position when the foreign tax rate (25%) is lower than the U.S. rate (35%).
Taxpayers are in an excess credit position when the foreign tax rate (45%) is higher than the U.S. rate (35%).
Example # 2
Facts: USAco is a domestic corporation. It has foreign-source taxable income of $ 100 and no U.S.-source taxable income. Assume the U.S. tax rate is 35%.
Case 1: Foreign tax rate is 30%, 5% less than U.S. tax rate
a. If all of the foreign-source taxable income is subject to foreign income tax at a rate of 30%, USAco can claim a credit for the entire $ 30 of foreign income taxes paid. Because the taxpayer is in a low-tax jurisdiction, he is entitled to a credit for the complete amount of foreign income taxes paid. Of course, in the U.S., the taxpayer must still pay $ 5 to Uncle Sam. Why? Because the pre-credit tax liability is $ 35, making the effective tax rate 35%.
b. Foreign tax return
i. Taxable income: $ 100
ii. Foreign income tax rate: 30%
iii. Foreign income tax: $ 30
c. U.S. tax return
i. Taxable income: $ 100
ii. U.S. tax rate: 35%
iii. Pre-credit tax: $ 35
iv. Foreign tax credit: ($ 30)
v. U.S. tax: $ 5
Case 2: Foreign tax rate is 40%, 5% greater than U.S. tax rate
a. If a foreign income tax rate of 40% applies to all of the foreign-source taxable income, the foreign tax credit limitation (which equals the U.S. tax of $ 35 on USAco’s $ 100 of foreign-source income) will prevent USAco from claiming a credit for $ 5 of the $ 40 of foreign income taxes paid, as follows:
b. Foreign tax return
i. Taxable income: $ 100
ii. Foreign income tax rate: 40%
iii. Foreign income tax: $ 40
c. U.S. tax return
i. Taxable income: $ 100
ii. U.S. tax rate: 35%
iii. Pre-credit tax: $ 35
iv. Foreign tax credit: ($ 35)
v. U.S. tax: $ 0
d. Foreign tax credit is the lesser of:
i. FITs ($ 40), or
ii. Limit ($ 35)
iii. Foreign tax credit is the limit of $ 35
In this situation, we really care about reducing our foreign income taxes. If we got the foreign tax rate down to 37%, our effective tax rate would be 37%. We want to try to get that foreign tax rate down to 35% when we’re in a high tax country.
d. Planning Implications
i. When a taxpayer is in an excess limitation position, foreign taxes do not represent an out-of-pocket tax cost since the cost of paying those taxes is entirely offset by the U.S. tax savings associated with the credit. Therefore, tax planning focuses on reducing the residual U.S. tax due on foreign-source income.
ii. In contrast, when a taxpayer is in an excess credit position (i.e., creditable foreign taxes exceed the limitation), no U.S. tax is collected on foreign-source income because the credit fully offsets the pre-credit U.S. tax on that income.
In addition, the non-creditable foreign income taxes increase the total tax burden on foreign-source income beyond what it would have been if only the U.S. had taxed that income. Therefore, planning focuses on reducing those excess credits.