How Do Foreign Tax Credits Work for U.S. Businesses?

Did you know U.S. companies paid $161 billion in foreign income taxes last year? Every dollar paid overseas can often offset federal liability at home—if you claim the foreign tax credit correctly. The rules seem simple, but even minor mistakes can lead to lost savings. Here’s a clear breakdown so individuals and businesses can keep more of their income and stay fully compliant with international tax requirements.

 

Table of Contents

 

1. Defining the Foreign Tax Credit

2. Who Qualifies for the Credit?

3. Calculating the Credit Limit

4. Carryback and Carryforward Rules

5. Recordkeeping and Forms

6. Planning with an Expert

7. Why Work with Anu Agrawal CPA Inc.

8. Key Takeaways

9. FAQs

 

Defining the Foreign Tax Credit

 

The foreign tax credit (FTC) allows a U.S. taxpayer to subtract income taxes paid to another country from U.S. tax due on that same income. It helps prevent double taxation.

 

This credit only applies to income taxes, not value-added or sales taxes. To claim the credit, the foreign tax must be considered an income tax in substance, and the taxpayer must have actually paid or accrued it.

 

Claiming a credit is often better than deducting foreign taxes as an expense. A credit reduces taxes dollar for dollar, while a deduction only lowers taxable income. Some taxpayers try to use both methods. Smart planning applies the credit in high-tax countries and deductions in low-tax ones for better savings.

 

Who Qualifies for the Credit?

 

Any U.S. individual or corporation that earns income abroad and pays foreign income tax may qualify for the FTC. For example, if a company earns royalties from Canada, those taxes may be eligible for a U.S. tax credit.

 

Pass-through entities, like partnerships or S corporations, pass foreign taxes to their owners. The owners then choose to credit or deduct those taxes individually.

 

To use the credit, the foreign-sourced income must also be subject to U.S. tax. Exempt income, such as earnings excluded under a treaty or the foreign earned income exclusion, doesn’t qualify.

 

Also, taxpayers must separate income into “baskets”—passive, general, and foreign branch. Mixing these categories can reduce the allowed credit. Tax professionals use Form 1116 (for individuals) or Schedule A of Form 1118 (for corporations) to allocate income properly.

 

Calculating the Credit Limit

 

The IRS uses this formula to cap the FTC:

 

Foreign Tax Credit ≤ (Foreign Taxable Income ÷ Worldwide Taxable Income) × U.S. Tax

 

Here’s an example: Suppose a company earns $500,000 abroad and $500,000 in the U.S. The U.S. tax on $1 million might be $210,000. In that case, the credit limit is $105,000. If the company paid $120,000 in foreign taxes, it can credit $105,000 this year and carry forward the extra $15,000.

 

Foreign taxes paid in local currency must be converted to U.S. dollars using the average yearly exchange rate. Failing to do this step properly can lead to IRS penalties. Using automated tools or working with an experienced advisor can help avoid conversion errors.

 

Carryback and Carryforward Rules

 

Foreign tax credits that aren’t used in the current year don’t go to waste. You can carry them back one year or forward up to ten years.

 

For example, if a business has low profits in one year and can’t use the full credit, it may apply the unused amount to the prior year’s return for a refund. Or, it can carry the credit into future years when profits are higher.

 

Keeping accurate records is essential. A log of source country, tax year, amounts, and income baskets helps ensure you can use carry forwards correctly. Many taxpayers lose out on old credits simply because they forget or misplace the data.

 

Recordkeeping and Forms

 

To claim the FTC, corporations must file Form 1118, while individuals file Form 1116. Each form must include:

 

1. Foreign tax assessments or receipts

2. Proof of payment (e.g., wire transfer confirmations)

3. Foreign income statements in English

4. Currency conversion worksheets

 

Organized records reduce audit risk. Cloud-based storage can simplify documentation and make retrieval easier during filing or audits. Tagging files by tax year and country helps maintain clarity.

 

Planning with an Expert

 

Complex situations arise when income falls under GILTI, subpart F, or foreign branch rules. Skilled professionals can model different strategies to improve tax outcomes, such as:

 

1. Electing to include GILTI in the general income basket

2. Choosing to deduct foreign taxes when credits exceed limits

3. Separating treaty-favored passive income for better treatment

For example, an ecommerce company selling in Europe might benefit from shifting intellectual property to a treaty-friendly country. Proper planning aligns U.S. and foreign rules to reduce overall tax liability.

 

Why Work with Anu Agrawal CPA Inc.

 

At Anu Agrawal CPA Inc., technology and tax planning come together. Our cloud system links tax forms, foreign bank data, and client records in one place. Clients receive real-time updates on their credit limits and tax status.

 

Our monthly check-ins also help adjust estimated payments—so clients don’t get surprised during tax season. From filing Forms 1116/1118 to deciding between credits and deductions, we guide businesses and individuals every step of the way.

 

Key Takeaways

 

1. The foreign tax credit reduces U.S. tax dollar for dollar

2. You must prove the foreign taxes are income taxes

3. Income must be subject to U.S. tax to qualify

4. Credits can be carried back one year or forward ten

5. Accurate records and clear basket tracking are crucial

6. A knowledgeable tax advisor helps maximize credit use

 

Frequently Asked Questions (FAQs)

 

Q1. Can both individuals and businesses claim the foreign tax credit?

Yes. U.S. citizens, resident aliens, and U.S.-based businesses can claim the credit if they paid income tax to a foreign government on income that is also taxed in the U.S.

Q2. Is the foreign tax credit available for taxes other than income taxes?

No. Only income taxes (or taxes in place of income taxes) qualify. Sales, VAT, or property taxes are not eligible.

Q3. What forms are needed to claim the credit?

Individuals use Form 1116, and corporations use Form 1118. Supporting documentation includes receipts, translations, and exchange rate reports.

Q4. Can unused foreign tax credits be used in future years?

Yes. You can carry unused credits back one year or forward ten years to apply them when needed.

Q5. Does the foreign tax credit reduce state tax?

No. The credit only applies to federal tax. States generally don’t allow a foreign tax credit.