Foreign Tax Credit

The foreign tax credit relieves double taxation by allowing US taxpayers to credit income taxes paid or accrued to foreign countries against their US tax liability on the same income. Because the United States taxes citizens, residents, and domestic corporations on worldwide income, without the credit the same dollar of foreign earnings would be taxed twice.

The credit is limited to the US tax attributable to foreign-source income - computed as US tax before credits multiplied by the ratio of foreign-source taxable income to total taxable income. The purpose of the limitation is to prevent foreign taxes from offsetting US tax on US-source income. The limitation is applied separately within baskets, principally general category, passive category, foreign branch, and GILTI income, which prevents high-taxed passive income from absorbing credits usable against low-taxed active income. Excess credits in the general and passive baskets carry back one year and forward ten; GILTI basket credits neither carry back nor forward.

Sourcing and expense allocation drive the outcome. Interest expense, research and experimental expenditures, and stewardship costs must be apportioned between US and foreign-source income under detailed regulations, and that apportionment reduces the foreign-source income in the numerator - which is why taxpayers with substantial domestic borrowing or research spending often find themselves in an excess credit position despite paying meaningful foreign tax.

Only taxes that qualify as income taxes in the US sense are creditable, and regulations issued in recent years narrowed that definition in ways that raised questions about digital services taxes and certain withholding regimes, prompting subsequent relief guidance. Individuals claim the credit on Form 1116, corporations on Form 1118. Taxpayers may alternatively deduct foreign taxes, which is occasionally preferable when credits would otherwise expire unused.