Corporate foreign tax credit
Although foreign tax credit is available to individuals with foreign source income (including wages earned abroad), the great bulk of foreign tax credits goes to U.S. corporations with operations abroad. U.S. corporations earn foreign source income by operating branches abroad and by operating or investing in affiliates incorporated abroad. Foreign source income earned through a foreign branch is subject to U.S. tax in the tax year in which it was earned. The tentative U.S. tax is simply the U.S. tax rate times the income of the branch. A credit is given for foreign income taxes and for any foreign withholding taxes that are levied when the branch remits the income to its U.S. parent. Losses a foreign branch incurs can be deducted from the corporation’s domestic income to reduce the corporation’s U.S. income tax. However, if the branch becomes profitable in succeeding years, its income is treated as U.S. source income, and no foreign tax credit can be claimed on it until the U.S. Treasury recovers the reduction in tax revenue caused by the branch’s initial losses.
If the foreign source income is earned through a foreign affiliate that is a separate company incorporated abroad, the income generally is subject to U.S. tax only when it is remitted as dividends to the U.S. parent corporation. The U.S. tax on unremitted earnings is thus deferred until the earnings are repatriated. This is advantageous to the corporation because of the benefits of deferring tax.
To be eligible for a foreign tax credit on the affiliate’s income, the U.S. parent must own at least 10 percent of the affiliate. A foreign affiliate that is separately incorporated abroad and that is at least 10 percent owned by the U.S. parent is called a foreign subsidiary. A subsidiary distributes dividends to the U.S. parent from earnings and profits after foreign income taxes. To determine the tentative U.S. tax and the foreign tax credit for the dividends, it is necessary to construct the foreign source income from which the dividends were derived. The formula for the tentative U.S. tax (TA) on the underlying foreign source income is
where D is dividends, tUS is the U.S. tax, and tF is the foreign income tax rate used for calculating the foreign tax credit (foreign income taxes paid divided by the subsidiary’s earnings and profits as measured using the U.S. definition of taxable income). From the tentative U.S. tax, the U.S. corporation subtracts the sum of the foreign income taxes paid on the income underlying the dividends plus the foreign withholding taxes on the dividends. If the difference is positive, the U.S. corporation owes a residual U.S. tax. If the difference is negative, the U.S. corporation is said to have excess foreign tax credits.
In general, the U.S. parent corporation is allowed to sum the foreign source income and foreign taxes from all of its foreign operations, both branches and subsidiaries, when calculating foreign tax credit and residual U.S. tax. To be lumped together, however, the foreign source income must be within the same category of income (or income "basket"), as defined by the Internal Revenue Code. The main income baskets are for passive income (primarily interest, dividends, royalties, rents, or annuities received by the subsidiary), financial services income (income earned in banking, insurance, or finance), shipping income (income earned in international shipping), and general limitation income (primarily income earned abroad in the active conduct of a trade or business other than financial services, shipping, or income in the passive basket). Income in each of these baskets is subject to a separate foreign tax credit limitation. The maximum foreign tax credit that can be claimed in any basket (the foreign tax credit limitation) is the tentative U.S. tax. Any excess credits can offset
residual U.S. tax on foreign source income earned during the previous two years or the following five years, but credits that cannot be used within that period are lost.
The separate income baskets help discourage U.S. corporations from moving offshore highly mobile investments (such as international shipping, financial services, and portfolio loans) that can easily be located in low-tax countries. Subpart F of the Internal Revenue Code denies deferral for income from such investments, but U.S. corporations might still have a tax incentive to locate these activities abroad if they were allowed to combine the income and foreign taxes from these investments with those from other, less mobile, business activities that often generate excess foreign tax credits. The separate income baskets remove this incentive.
The foreign tax credit offsets most of the U.S. tentative tax on foreign source income. For example, in 2000, total taxable income of U.S. corporations was about $174.6 billion. Foreign taxes on this income (income taxes and withholding taxes) amounted to $61.5 billion, of which $48.4 billion was creditable against the U.S. tax. The residual U.S. tax on the income was $12.7 billion.
Credits versus deductions for foreign taxes
Taxpayers prefer receiving a credit for foreign taxes rather than a deduction, even if the foreign tax rate exceeds the U.S. rate and they are unable to credit all of the foreign taxes they pay. A simple example shows why. Denote foreign source income as Y, the U.S. tax rate as tUS, and the foreign tax rate as tF. With a deduction for foreign income taxes, the U.S. tax is tUS(1 - tF)Y, whereas with a credit the residual U.S. tax is (tUS - tF)Y. From these formulas, we see that if foreign income taxes are deducted, the rate of U.S. tax on the income would equal tUS (1 - tF), which always exceeds the rate of residual U.S. tax after the foreign tax credit, (tUS - tF). If tF is greater than tUS, there is no residual U.S. tax after the credit, but a U.S. tax payment would be required if the foreign income taxes were deducted.
Foreign tax credit and economic efficiency
According to conventional wisdom, for a capital-exporting country (a country that invests more abroad than it receives as inward foreign investment), a deduction for foreign taxes promotes national neutrality and maximizes the domestic income, whereas a foreign tax credit promotes capital export neutrality and maximizes the global income. Early statements of the conventional wisdom can be found in Richman (1963), Musgrave (1969), and Feldstein and Hartman (1979). These early statements are based on an analysis that assumes, among other things, that capital is homogeneous and either flows into or out of a country. Today, it is widely recognized that most countries (including the United States) experience simultaneously both significant inflows and outflows of capital. However, more recent research provides no definitive grounds for rejecting the notion that a foreign tax credit is the best tax policy for maximizing global income.
- Feldstein, Martin. "Tax Rules and the Effect of Foreign Direct Investment on U.S. National Income." In Taxing Multinational Corporations, edited by Martin S. Feldstein, James R. Hines Jr. and R. Glenn Hubbard (13-20). Washington, DC: National Bureau of Economic Research, 1994.
- Feldstein, Martin, and David Hartman. "The Optimal Taxation of Foreign Source Investment Income." The Quarterly Journal of Economics 93 (November 1979): 613-29.
- Musgrave, Peggy B. United States Taxation of Foreign Investment Income: Issues and Arguments. Cambridge, MA: The Law School of Harvard University, 1969.
- Richman (Musgrave), Peggy B. Taxation of Foreign Investment Income: An Economic Analysis. Baltimore: Johns Hopkins Press, 1963.
- Rousslang, Donald J. "Deferral and the Optimal Taxation of International Investment Income." National Tax Journal (September 2000): 589-600.