There’s a lot of confusion about how foreign tax credits (FTCs) work when computing US tax liability. Questions about FTC come up regularly in our Facebook group, so it’s time to publish a quick primer that covers the basic concepts of FTC computation. Note that this post is necessarily a simplification of what is a very complex topic.
The big picture is that you compute FTC in a five step process:
- Allocate your US taxable income into categories
- Use that allocation to apportion your US tax liability before FTC
- Allocate your Foreign taxable income into categories
- Use that allocation to apportion your foreign taxes
- Compare the result of steps 2 and 4 to determine FTC allowed
Let’s look at each step in turn.
First you allocate your US taxable income into categories or baskets. What goes into each category?
General Income – this is a residual category – whatever’s left over is classified as general. (Note that there are a few other minor categories for income from sanctioned countries or income re-sourced by treaty.) The General category would include salary/wages sourced outside the US.
Passive Income – this is essentially portfolio income. It might include income such as dividends, interest, rents and royalties (though it is possible that some of these might constitute business income, and small amounts of passive income inside a CFC may be treated as general category income).
GILTI – this is the inclusion under §951A of the Internal Revenue Code. These blog posts explain how GILTI is computed. Note that if you make an election under §962 to be taxed at corporate rates on GILTI, then both the tax and FTC on GILTI are computed completely separately from the rest of your US tax and FTC (which is beyond the scope of this post).
Foreign Branch Income – if you’re running a non-US business which is not classified as a corporation (CFC) for US tax purposes, then you may have to consider whether your business is a Qualified Business Unit (IRS definition). A QBU is a separate trade or business that keeps separate books and records. A QBU that is headquartered outside the US is considered a foreign branch, and foreign tax credits are computed separately.
Technically, you start with gross income in each category, then allocate deductions that are related to that category. So, if you have deductions for expenses related to managing your share portfolio, those deductions reduce passive income. Any deductions that aren’t related to any specific category of income (such as the standard deduction), are apportioned based on the net income in each category. That is, if general category foreign income is 40% of your income before the standard deduction, then 40% of the standard deduction is deducted from general category foreign income. When you add up the net income allocated to each of the foreign source categories plus the US source income, the total should equal your total US taxable income.
Note that each category is reported on a separate Form 1116. The form walks you through the allocation of deductions, but you must first have allocated the gross income between categories to determine what goes on line 1a.
Once you know how much US taxable income is allocated to each category, you use that information to allocate your US tax liability (before FTC) proportionally to each category. If 20% of your US taxable income is allocated to foreign-source general income, then up to 20% of your US tax liability can be offset by foreign taxes allocable to that income. That is, the apportioned US tax serves as a limit on the FTC available in that category.
Once you know the limit for FTC, you need to compute the amount of foreign taxes available for the credit. If all of the income taxed by a foreign country is foreign sourced income in a single category (common for US residents with foreign investments), then you can allocate 100% of that foreign tax to the relevant category and skip to Step 5 below.
For US citizens living outside the US, the typical situation is that all of your worldwide income is taxed by your country of residence, so your foreign taxable income will include two or more of the FTC categories. In this case there are two steps to determining foreign taxes available for credit in each FTC category (and for each Form 1116).
The first step is to allocate your foreign taxable income (that is, what’s taxable under foreign tax rules) between the US FTC categories. You start by dividing gross income between the categories, then subtract any deductions that are directly attributable to each category. For example, if you have foreign source investment income, any investment expenses allowed as a deduction on your foreign tax return would be used to reduce that investment income. Finally, if there are any indirect deductions (things that are deductible on your foreign return but don’t relate to specific income such as charitable contributions or a standard deduction) these are allocated pro rata among the various categories of income taxed on your foreign return (whether or not US FTC would be available for that category).
Once you’ve allocated the income, you use the percentage in each category to allocate the foreign tax paid (or accrued). All of these computations regarding foreign taxable income and foreign tax paid or accrued should be done using foreign currency. You convert to USD at the end. The resulting number for each FTC category is the amount of foreign taxes available to use as a credit against US tax. These are the numbers that go into part II of Form 1116.
Finally, you compare the FTC limit computed in step 2 to the foreign tax available for credit computed in step 4. Your FTC is the lower of these two numbers and is computed separately for each FTC category. If the foreign tax available is greater than the limit, then (except for the GILTI category) the excess can be carried back one year or forward 10 years. (Note that the GILTI category is even more complex as there is a 20% haircut on foreign taxes available for credit and there are no carrybacks or carryforwards of unused credits.)
Foreign tax credit computations can be very complex. The overview in this post is necessarily a simplification. For more detail see IRS Publication 514. Hopefully, once you have the general concepts down, you will be better equipped to understand the nuances in the IRS instructions.