Since U.S. companies which do business overseas have to abide by those countries’ tax laws, they have a means of avoiding being doubly taxed by the U.S. by filing Form 1118 and claiming foreign tax credits against the income tax they have already paid. How much foreign credit they can earn can be limited depending on the type of income and the particular county’s tax rate.
Foreign tax credits are determined based on a company’s separate passive and active income. Passive income is income from a stock sale, dividend, or interest, according to the IRS. Active income, on the other hand, stems from business activities including banking, insurance, and financing corporations.
While foreign companies can use U.S. tax credits for taxes they pay on income earned while doing business in the U.S., this does not apply if they do not earn business or trade income from the country.
Limits exist to how much foreign tax a U.S. company can offset. IRS regulations prohibit a company from taking a foreign tax credit which is more than its corporate tax rate. To take credits in the first place, corporations need to pay tax which is specifically related to earned income to the appropriate foreign taxing authority.
Foreign tax credits do not apply to value-added taxes, or goods and services taxes. Neither do they apply to license or permit taxes, consumption tax, sales, or capital tax.