subject to the alternative minimum tax, the credit cannot exceed 90% of the alterna-
tive minimum tax.
The economic effect of claiming a foreign tax as a credit rather than as a deduc-
tion can be seen from the following example. Assume that T, a U.S. corporation, de-
rives $1,000 of income from foreign sources. Further assume that this income is sub-
ject to a $200 foreign tax. T’s total tax is determined as follows:
Tax Deduction Tax Credit
Foreign taxable income $1,000 $1,000Foreign tax paid __ (^200) __
Taxable income—U.S. purposes $ 800 $1,000
U.S. tax @ 35% ____$ 280 $ 350
Less: foreign tax credit __ 200
Resultant U.S. tax ____$ 150
Total tax burden ____$ 480 ____$ 350
Effective tax rate 48% 35%
A credit is granted only for income taxes paid or accrued to a foreign country or a
U.S. possession. To qualify as an income tax, a tax must be a tax on income as that
term is used in U.S. tax laws. Although a tax based on estimated income or gross re-
ceipts is not creditable, taxes withheld from dividends, royalties, and interest are con-
sidered taxes in lieu of income taxes and are therefore creditable.
The purpose of the foreign tax credit is to avoid double taxation of foreign source
income. It is not intended to reduce U.S. tax on U.S. source income. Thus, the for-
eign tax credit is limited to the U.S. tax attributable to foreign source income. The tax
credit is limited to the proportion of the U.S. tax that the taxpayer’s taxable income
from foreign sources bears to its entire taxable income for the year. The following
formula is used:
Foreign tax credit limitation
The formula can be applied to the following fact pattern. T earned $1,000 of for-
eign source taxable income and $9,000 of U.S. source taxable income. It paid $400
of foreign income taxes. Its foreign tax credit limitation is computed as follows:
The foreign tax credit is the lesser of the foreign income taxes paid or accrued (i.e.,
$400) and the foreign tax credit limitation (i.e., $350) or $350.
A separate foreign tax credit limitation applies to taxes on the following types of
income:
- Passive income
- High withholding tax interest
- Financial services income
$1,000
$1,000$9,000 $3,500 1 $10,000 35% 2 $350Foreign source taxable income
Worldwide taxable income U.S. tax before credits30 • 10 INTERNATIONAL TAXATION