Domestic corporations that have paid or accrued qualified foreign income taxes to a foreign country or U.S. possession may generally credit those against their U.S. income tax liability on foreign source income.
The goal of the foreign tax credit is to keep a U.S. taxpayer’s worldwide effective tax rate from exceeding the U.S. statutory tax rate, which is accomplished through the foreign tax credit limitation.
You can claim a credit only if your foreign taxes are qualified:
The tax must be imposed on you: you can claim a credit only for foreign taxes that are imposed on you by a foreign country or U.S. possession.
You must have paid or accrued the tax: You could claim a credit only if you paid or accrued the foreign tax to a foreign country or U.S. possession.
Your qualified foreign tax is only the legal and actual foreign tax liability that you paid or accrued during the year. The amount of the foreign tax that qualifies for the credit must be reduced by any refunds of foreign tax made by the government of the foreign country or the U.S. possession.
To be eligible for the credit, te foreign levy must predominantly have the nature of an income tax in the U.S. sense.
Corporations use Form 1118 to compute their foreign tax credit for certain taxes paid or accrued to foreign countries or U.S. possessions.
The foreign tax credit is calculated as follows:
Step1: Determine the qualified foreign income taxes paid or accrued for the tax year.
Step2: Compute the foreign tax credit limitation. This is done by multiplying the amount of pre-credit U.S. tax paid in a year by the ratio of foreign source taxable income earned to income earned from both foreign and domestic sources (worldwide taxable income).
Step3: Determine the lesser of qualified foreign taxes paid (step 1) or the foreign tax credit limitation (step 2).
Any unused foreign tax credits can be carried back one year and then carried forward for 10 years.
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