Source of income can have significant impact on calculation of foreign tax credit limitation.
Formula for foreign tax credit limitation
= Pre-credit U.S tax x foreign source taxable income
Worldwide taxable income
If a U.S person’s creditable foreign taxes are less than the limitation, foreign taxes are offset by U.S tax savings.
If U.S person’s creditable foreign taxes exceed the limitation the non-creditable foreign income taxes can increase the U.S person’s tax burden.
Creditable foreign taxes in excess of the limitation cannot be taken in the current year.
Creditable foreign taxes in excess of the limitation may be carried back one year and carried forward up to ten years.
Computation of the foreign tax credit limitation helps us determine if foreign taxes have an incremental effect on a U.S person’s world wide tax costs.
Example:
We have a U.S domestic corporation that has taxable income of USD 100. This income is earned through foreign branch. We assume U.S tax rate = 40% and foreign tax rate = 30%
Case 1 = Operating in low tax foreign country
|
Foreign Tax Return Taxable income = 100 Tax rate = 30% Foreign tax payable = 30
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U.S Tax Return Taxable income = 100 Tax rate = 40% Pre-credit tax = 40 Foreign tax credit = 30 U.S tax liability = 10
|
Total tax burden for the corporation = 30 + 10 = 40
Case 2 = Operating in high tax country
Assume U.S tax rate = 30% and foreign tax rate = 40%
|
Foreign Tax Return Taxable income = 100 Tax rate = 40% Foreign tax payable = 40
|
U.S Tax Return Taxable income = 100 Tax rate = 30% Pre-credit tax = 30 Foreign tax credit = 40 U.S tax liability = Nil
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A domestic corporation will compute its foreign source income on schedule A or form 1118. According to code section 904 (d), foreign tax credit limitations are computed separately for passive category income and general category income. Separate 1118 forms are used for each category of foreign taxable income. Same rules apply to individuals who take foreign tax credit on form 1116.
Tax rate for a foreign person’s U.S source investment type income is 30%b flat.
A foreign person having a net income effectively connected with the conduct of U.S trade or business is taxed at graduated rates.
Example 1:
Allen is a non-resident alien who owns 500 shares of a U.S domestic corporation XYZ. If XYZ pays a dividend of $100, it is considered a U.S source investment income. This income may be subject to withholding tax.
Example 2:
Allen is a non-resident alien who travels to U.S in summer and stays in a hotel room in New York. He buys and sells gift items from his hotel room in New York. Assuming Allen’s activities constitute the conduct of trade or business with in the United States, the net amount of income connected with the U.S trade or business is subject to U.S taxes at regular graduated rates.
Disclaimer:
This information is for educational purposes only. It does not constitute any legal advice or opinion. Please do not use any of its contents without seeking a professional advice.
References:
www.jct.gov/publications.html
http://www.law.cornell.edu
http://www.irs.gov/publications
U.S Taxation of International Transactions by Robert J. Misey, Michael S. Schadewald
Introduction to United states International Taxation by Paul R. McDaniel, Hugh j. Ault and James R. Repetti
International Taxation by Joseph Isenbergh
International Taxation in a nutshell by Richard L. Doernberg.
International Income Taxation, Code and Regulations by Robert J. Peroni – CCH
Mansoor Suhail (Mani)
Accountant
BSBA – EA – ICIA – RA
Tax for Canada and U.S.A
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