XVII.   Foreign Tax Credit

For purposes of the foreign tax credit, taxpayers that account for foreign taxes on the accrual basis generally can translate foreign income taxes accrued into U.S. dollars at the average exchange rate for the tax year to which the taxes relate. Foreign taxes not eligible for translation at the yearly average exchange rate must be translated using the exchange rate for the date of payment.

The separate foreign tax credit limitation category for financial services income includes passive income, determined before the high-taxed income exception for passive income is applied. Thus, high-taxed income is not excluded from the separate foreign tax credit limitation for financial services income.

The foreign tax credit is intended to relieve U.S. taxpayers of the double tax burden that might arise when their foreign-source income is taxed both by the U.S. and the foreign country in which the income arises. Generally, as a result of claiming the foreign tax credit, if the foreign tax rate is higher than the U.S. tax rate, there will be no U.S. tax on the foreign income. If the foreign tax rate is lower than the U.S. tax rate, U.S. tax on the foreign income will be limited to the difference between the rates.

Taxpayers can choose either to take all qualified foreign taxes as a credit or as an itemized deduction.

While no one rule covers all situations, it is generally better to take a credit for qualified foreign taxes than to deduct them as an itemized deduction. This is so because a credit reduces the U.S. income tax on a dollar-for-dollar basis, while a deduction reduces only the income subject to tax. Also, the deduction could be limited by Sec. 68, depending on the taxpayer's AGI. Note that taxpayers are allowed the standard deduction in addition to the credit.

However in both cases the foreign earned income exclusion reduces the amount of the credit / deduction.

To qualify for credit, the foreign levy must be an income tax (or a tax in lieu of income tax). Simply because the levy is called an income tax by the foreign taxing authority does not make it an income tax for this purpose. To determine if a foreign levy is an income tax, it must be compared with the U.S. income tax.

Therefore, a foreign levy is an income tax only if:

• It is a tax; that is, it is not payment for a special economic benefit, and
• The predominant character of the tax is that of an income tax in the U.S. sense.

There is a limit on the amount of credit taxpayers can claim (see below). This limit and the credit are calculated on Form 1116. The taxpayer's credit is the amount of foreign tax paid or accrued, or the limit, whichever is smaller.

If taxpayers have foreign taxes available for credit but they cannot use them because of the limit, they can generally carry them back to the two prior years and forward to the succeeding five tax years.

The limit treats all foreign income in several separate categories of income as a single unit and limits the credit to the U.S. income tax attributable to the taxable income in that category from all sources outside the U.S.

Under the limit in each category, operating losses in one foreign country will offset income from another foreign country.

The maximum US tax credit can be expressed by the following formula:

Taxable income from sources outside U. S. in category (not in excess of total taxable income) x U.S. income tax

Total taxable income from all domestic and foreign sources

Note: If, in the tax year, none of the taxpayer's foreign income was subject to U.S. tax, the numerator of this fraction would be zero and the taxpayer would have no foreign tax credit in that year.

The limit must be applied on a separate basis to each of the following categories of income

* Passive income;
* High withholding tax interest;
* Financial services income;
* Shipping income;
* Certain dividends from a domestic sales corporation (DISC) or former DISC;
* Certain distributions from a foreign sales corporation (FSC) or former FSC attributable to foreign trade income; and
* All other income not included in the above categories (general limitation income)
* Excluded extraterritorial income

With effect from 1/1/1998, individual taxpayers may elect not to file form 1116 and still obtain the tax credit. However, the condition is basically that the credit must relate to passive income, be reported on a form 1099 and the total creditable foreign taxes must be less than $300 for an individual. This election is not automatic.