United States persons are subject to U.S. income tax on foreign-source as well as U.S.-source income. Subject to applicable limitations, U.S. persons with foreign-source income may credit income taxes imposed by foreign jurisdictions against their U.S. income tax liability on foreign-source income.
In contrast to certain tax credits that are intended to create an incentive for taxpayers to invest in certain activities, the foreign tax credit is designed to reduce the disincentive for taxpayers to invest abroad that would be caused by double taxation. In other words, the foreign tax credit is intended to preserve neutrality between the U.S. and foreign investment and to minimize the effect of tax consequences on taxpayers’ decisions about where to invest and conduct business. (Source: Notice 98-5 Foreign Tax Credit Abuse)
As mentioned above, several limitations exist on foreign tax credits and the ability to claim these in the U.S. tax return.
Four key elements
The four key elements which define whether or not a payment of tax may be considered for a claim against the U.S. income tax liability are:
1. The tax must be a foreign tax and have been imposed on the taxpayer.
2. The tax must actually be paid or accrued for payment by the taxpayer.
3. The tax needs to be the legal and actual foreign tax liability.
4. The tax must be an income tax or a tax in lieu of an income tax.
who can claim?
What should also be included in the above framework is that only U.S. persons, including U.S. citizens and resident aliens, qualify to claim foreign tax credits.
Non-resident aliens cannot claim a credit for foreign taxes paid. This is because the U.S. income tax return of a non-resident alien should contain only U.S.-source income, and no foreign-source income.
Some of the limitations which exist include the following.
1. Only the amount of tax attributable to foreign-source income can be claimed. Accordingly, the foreign tax credit calculation includes the ratio of foreign-source to total gross income.
2. Itemized and standard deductions are rateably adjusted downwards to remove a portion of the deduction which is apportionable to U.S.-source income.
3. The time limit for claiming refunds is ten years, in the event that a larger foreign tax credit is available than what was previously claimed.
This may come about through a math error in calculating the amount of foreign tax credit claimable, or not having claimed foreign tax credits in a filed return, or changes to gross worldwide income.
4. A reduction in foreign tax credits available is required for income associated with the late filing of a return, for example, Form 5471 Information Return of U.S. Persons With Respect to Certain Foreign Corporations.
5. Foreign tax credits must be reduced by the amount allocable to foreign earned income which is excluded from gross income on Form 2555 Foreign Earned Income Exclusion.
New Zealand
Specific to New Zealand is that imputation credits on dividends received aren’t claimable as foreign tax credits in a U.S. income tax return.
This is because the tax has not been paid by or imposed upon the recipient of the dividend. Rather, it is the corporation which has incurred the tax and imputed it to the shareholder.
Corporates
There is one situation through which the tax paid by a corporation can give rise to a claimable foreign tax credit.
In the event that a refund of tax paid to a foreign corporation is received by a taxpayer, upon which a withholding tax is imposed, the withholding tax is claimable as a foreign tax credit.
The refund of tax received is includible in gross income.