Foreign tax credit

A foreign tax credit (FTC) is generally offered by income tax systems that tax residents on worldwide income, to mitigate the potential for double taxation. The credit may also be granted in those systems taxing residents on income that may have been taxed in another jurisdiction. The credit generally applies only to taxes of a nature similar to the tax being reduced by the credit (taxes based on income) and is often limited to the amount of tax attributable to foreign source income. The limitation may be computed by country, class of income, overall, and/or another manner.

Most income tax systems therefore contain rules defining source of income (domestic, foreign, or by country) and timing of recognition of income, deductions, and taxes, as well as rules for associating deductions with income. For systems that separately tax business entities and their members, a deemed paid credit may be offered to entities receiving income (such as dividends) from other entities, with respect to taxes paid by the payor entities with respect to the income underlying the income recognized by the member. Systems with controlled foreign corporation rules may provide deemed paid credits with respect to deemed income inclusions under such rules. Some variations on the credit provide for a credit for hypothetical tax to encourage foreign investment (sometimes known as tax sparing).

Detailed rules vary among taxation systems. Examples below are given for illustration purposes only and may not reflect the rules in a particular tax system.

A reduction of tax (credit) is often provided in income tax systems for similar income taxes paid to other countries (foreign taxes). This is generally referred to as a foreign tax credit. Amounts in excess of income tax are usually nonrefundable.

The credit is generally limited to those taxes of a nature similar to the tax against which the credit is allowed (for example, taxes on net income after allowance of deductions). Rules defining taxes eligible for credit may refer to one or more of the following characteristics of such tax:

For example, the system in the United States allows FTC, subject to limitations, for foreign compulsory levies based on net income or withheld from gross receipts. It also denies FTC for taxes paid to countries requiring participation in certain boycotts or taxes paid in exchange for goods or services provided by the taxing authority for services. The United Kingdom allows FTC, subject to limitations, for foreign taxes of a nature similar to the income or corporation tax. This is allowed under tax treaties or as a unilateral credit. Canada similarly allows credits but limits the portion of foreign tax subject to deduction with respect to an oil or gas business.

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