How Does a US Corporation Utilize Foreign Tax Credits?
- One set of accounting requirements that corporate taxpayers must undertake in order to utilize foreign tax credits deals with identifying all items of income as either passive or general in nature. Passive income consists of investment-type earnings, such as dividends, interest, rents or royalties. Income belonging in the general basket usually arises from active business undertakings, such as manufacturing automobile brake pads or providing computer warranty repair services. Foreign governments often asses different levels of tax on these two basic types of income (similar to the capital gains tax rate differential for individuals in the U.S.), so the Code requires this segregation to prevent the perceived abusive behavior of shifting credits from high-taxed general income to cover U.S. liabilities on low-taxed passive income.
- Another rigorous tracking requirement deals with determining whether earnings come from U.S. or foreign sources. As a matter of principle, income generated wholly within the U.S. and not subject to foreign taxation does not qualify for reduced U.S. tax benefits via the foreign tax credit mechanism. Therefore, corporate taxpayers must isolate income from foreign business activities in order to demonstrate eligibility to utilize foreign tax credits. The Code also limits the extent to which foreign tax can offset U.S. tax on a given amount of foreign source income. For example, the Japanese impose a corporate income tax equal to approximately 41 percent of income, which exceeds the regular U.S. tax rate of 35 percent, meaning that a foreign tax credit typically cannot be utilized for the 6 percent excess Japanese tax rate differential.
- Aside from these rules regarding categorizations and limitations, the Code also requires that corporate taxpayers retain documentation in support of tax payments made to foreign authorities. The payment must not only be made to an appropriate government revenue collection agency but must also constitute payment of a tax explicitly levied on income. In other words, the Code does not allow a foreign tax credit for value-added tax, consumption tax, sales tax, capital tax, stamp tax nor other kinds of payments for foreign government-issued licenses or permits. Foreign withholding tax on the cross-border payment of dividends or royalties, however, does qualify as creditable against U.S. tax liabilities.
- Aside from the critical aspects of foreign tax credit utilization mentioned herein, several technical nuances in the Code also exist that may impede or prevent corporations from realizing the full amount of potential benefits. Consultation with an experienced tax attorney or certified public accountant may prove well worth the expense.