The federal government imposes tax on all the worldwide income of American citizens and corporations. To avoid an unfair double taxation of earnings by multiple countries, taxpayers can claim a credit against their U.S. tax liability for any foreign income taxes paid. However, you may not actually get to realize the benefit from foreign tax credits due to a cumbersome set of regulations designed to maintain the integrity of this system.
Determine the U.S. federal income tax liability before application of foreign tax credits for a given year. Note that the IRS does not refund foreign tax payments.
Break-out total gross income into passive or general categories. Passive income generally includes dividends, interest, rents, royalties and gains from investment activities (IRC Section 954(c)). All non-passive income goes into the general category.
Break-out total foreign tax credits into passive or general categories. Foreign income taxes typically belong in the same category as the underlying income to which they relate.
Identify gross income from U.S. or foreign sources for each category. Complicated rules detailed in IRC Section 861 apply to determine the source of different types of income. For instance, generally source dividend and interest income based on the residence of the payer. The source of rent and royalty income depends on where the related property is located or being used. Gains from the sales of property may be sourced to the residence of the seller, subject to various exceptions, such as inventory (sourced to the place where title passage occurs). Also, service income comes from the location of performance in most cases.
Allocate and apportion deductions against gross income from U.S. or foreign sources for each category. Again, IRC Section 861 regulates particular treatment for various types of deductions not definitely related by point of fact to a certain type of gross income, such as interest, research and development expenses, losses from investment activities and charitable contributions. Other deductions not falling into any classification with specific rules may be split proportionally between U.S. and foreign source income.
Calculate net income before taxes for each category and source of income. As a quick double-check, note that the sum of each of these four components must equal the taxpayer's total taxable income.
Determine the percentages of total taxable income from passive and general foreign sources.
Apply these two percentages to the total tax liability before credits. The resulting amounts represent the maximum foreign tax credit allowed for each category, referred to as the foreign source income limitations (IRC Section 904).
Utilize the lesser of available or allowed foreign tax credits to reduce the total tax liability to a net amount.