Avoiding Double Taxation: When Is A Foreign Tax Credit Allowed?

Daniel Janovitz is an Associate in Holland & Knight's Fort Lauderdale office

The United States is one of the few countries in the world that taxes its citizens and residents on their worldwide income. This contrasts with the majority of countries which only tax only income that is earned in the country. As a result, U.S. taxpayers have the potential for being taxed twice on the same income. For example, if a U.S. citizen is working in in London, the income earned by that individual will be subject to tax in the United Kingdom, which will tax the person's income since services were performed there, and in the United States, which will tax the individual's worldwide income. Fortunately, to avoid double taxation, the United States permits taxpayers to credit certain taxes paid to a foreign government against their U.S. income tax liability. This article discusses the rules for determining which taxes levied by foreign governments are creditable for U.S. income tax purposes. 1

Amounts Eligible for the Foreign Tax Credit

Overview. To determine whether an amount paid is creditable as a foreign tax credit, a taxpayer must identify each levy. Each levy will then be tested separately.2 It is important to understand that the same income may be subject to multiple taxes in the foreign jurisdiction. For example, assume Country A imposes a national income tax on income earned in Country A, and City B, located within Country A, also imposes a tax on the income earned in City B. These are two separate levies. To be considered a single levy, the levy must be imposed by a single taxing authority.3

A levy is treated as separate if the base of the levy differs in kind.4 However, it is possible for the base of a single levy to vary in degree. For example, the United Kingdom may tax active income on a net basis and passive income on a gross basis. Incidentally, these would be two separate levies, one on active income and one on passive income.

Compulsory Payment. A levy is creditable in the United States if it is a "tax" and either has the "predominant character" of an income tax in the U.S. sense or is "in-lieu of" an income tax.5 Subject to exceptions for "soak-up" taxes and "dual capacity" taxpayers, once a levy is found to be creditable, the full amount of the tax is creditable for all taxpayers subject to that foreign levy.6

To qualify as a tax, the levy must (i) require compulsory payment and (ii) be made pursuant to a country's taxing authority.7 These requirements are fairly straightforward. A tax is compulsory to the extent the taxpayer cannot eliminate it through the application of foreign law or interpretation.8 Only the compulsory levy is creditable. As such, a taxpayer must take reasonable steps to pay no more tax than is legally required. For example, if a person can reduce the rate of tax imposed by the foreign government by electing to apply a treaty, the amount that is considered a tax is limited to the amount that would be imposed if the taxpayer elected to apply the treaty.

If the individual makes a payment...