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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). [1] [ additional citation(s) needed ] This is generally referred to as a foreign tax credit. Amounts in excess of income tax are usually nonrefundable. [2]
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 the allowance of deductions). [3] 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. [4] It also denies FTC for taxes paid to countries requiring participation in certain boycotts [5] or taxes paid in exchange for goods or services provided by the taxing authority for services. [6] 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 [7] or as a unilateral credit. [8] Canada similarly allows credits but limits the portion of foreign tax subject to deduction with respect to an oil or gas business. [9]
Some countries do not tax persons whether resident of that country or not except on income considered to be from sources in that country or remitted to that country. Those countries tend to allow FTC only to residents and only with respect to taxes imposed on the income subject to tax in the home country. Singapore grants FTC only to residents and only with respect to income taxed in Singapore. [10]
Many systems specify the time at which a foreign levy meeting the requirements for FTC becomes eligible for such credit, such as when the levy is withheld from income or otherwise paid or settled in cash or property. [11] Some systems allow a credit when the tax would be properly chargeable under the domestic system. [12] Others allow FTC by reference to the time the foreign item of income is chargeable to home country income tax. [13] Some systems allow the credit with the tax would be recognized in financial statements. Some systems base the timing of recognition on the method of accounting of the taxpayer, possibly with an election by a cash basis taxpayer to recognize the tax at the time properly accrued. [14]
Many income tax treaties require that the governments party to the treaty grant FTC even if the domestic law of such party do not grant such credit.[ citation needed ]
Federal systems, such as those in Canada, Switzerland, and the US, may have different rules for allowing a credit for extra-jurisdictional credits at the federal and state levels. Such rules may differ among sub-federal (provincial, cantonal, state) jurisdictions. Thus, for example, Canadian and US federal governments allow credits from all foreign levels, [15] while Canadian provinces and US states tend to allow a credit for income taxes paid to other provinces and states but not for taxes paid to sovereign jurisdictions (countries). [16] Sub-federal taxes may or may not be covered by income tax treaties. [17]
Most systems limit FTC in some manner. A common limitation is based on the domestic income tax considered generated by the foreign source income subject to tax. [18] This limitation may be applied overall or at one or more of the following subsets:
Amounts in excess of this limitation may be allowed to reduce prior period taxes (and thus potentially subject to refund) or future taxes. [22] The period of carryover may be limited to a period of years or unlimited. For example, the US system, in 2009, permitted taxpayers to apply excess FTCs to reduce US federal income tax for the first prior year (carry back) and then successively for each of the next succeeding 10 years (carry forward). [23] Germany, in 2007, permitted unlimited carry forward but no carry back.[ citation needed ]
Various countries have, at one point or another, limited FTC based on type of income. UK individual income tax limits FTC by the types of income taxed separately in the UK system. Thus, foreign taxes incurred with respect to trading income are limited separately from foreign taxes incurred with respect to investment income. [24] From 1987 to 2006, the US limited FTC according to different categories or "baskets" of income, generally described as nine such baskets but in reality occasionally substantially more. [25] The definitions of such baskets were collapsed into two baskets (with exceptions) beginning 2007. The US baskets are currently passive, consisting of foreign personal holding company income (interest, dividends, rents, royalties, and certain gains, with significant exceptions) and all other (general limitation), with some exceptions generally not applicable. [26]
Countries having alternative tax regimes imposing certain minimum income taxes may modify the rules for computing FTC for those minimum taxes. [27]
Generally, where foreign taxes have been deducted or deemed deducted from income, and a credit or reduction of tax is claimed, the amount of income subject to tax is the amount before the reduction by foreign tax. [28]
Where a system imposes limits on FTC based in some manner on foreign source income (FSI), the system generally provides rules for determining whether income is foreign or domestic source. The rules may be relatively simple or quite complex. (For simplicity of wording below, the phrase "sourced to" specifies in the target the place [foreign or domestic] constituting the source of the income in the object for computing FTC limitation.) The following discussion explains US and Canadian rules and certain other variations on one of these rules to illustrate the manners in which systems define FSI and the potential level of complexity. The rules vary highly by country.
US rules are the same for individuals and entities, and for residents and nonresidents. [29] Under US rules, source is determined for gross income (sales plus other income less cost of goods sold), then expenses and deductions are allocated and apportioned to such income (see below). The source of income is determined separately for each type of income.
Canada follows a somewhat different approach than that above for business income. [39] Both individuals and entities may have both business and non-business income. The source of business income is determined differently for each type of business based on the place in which the business is predominantly conducted. Such determination is based on different considerations based on the nature of different businesses. For example, income from merchandise trading is sourced to where the sales are habitually completed, but other relevant factors may be considered. By contrast, income from trading intangible property such as stocks and bonds is sourced to where the decisions related to such trading are normally made.[ citation needed ]
For Canadian tax purposes, the source of non-business income varies by type of income and is determined similarly to the US approach. Non-business interest and dividends is generally sourced to residence of the payor. However, the source of dividend income is relevant only for individuals, as corporations are not eligible for FTC with respect to dividend income. Non-business income from use of property is sourced to where the property is situated, used, or exploited.[ citation needed ]
Canadian individuals determine the source of income from employment under three different approaches. [40] The default approach is such income is sourced to the primary place of employment. However, if the employment income is subject to tax in another country, the income is sourced based on the ratio of days worked in that country to total days worked. Both approaches are subject to modification under treaties.
Source of income for Canadian tax purposes, like Canadian FTC, is by country.
There are several other approaches in use to source income from sale of inventory property. In the UK, such income is sourced to the location of the trading activity giving rise to the income. [41] In the US, the source varies. Income from inventory produced by the taxpayer or certain related parties is sourced 50% to place title to the inventory passes to the purchaser and 50% based on the situs of assets used in production and distribution of the inventory. Income from sale of purchased inventory is sourced to place of title passage. [42] However, purchases from certain related parties are effectively ignored and the inventory may be considered produced by the taxpayer. [43] Various other systems have rules for determining what portion of income from inventory produced domestically and sold foreign or vice versa is sourced foreign.
Where a system limits the credit based on domestic tax generated by foreign source net income, it must provide a mechanism for determining net income subject to home country tax, including associating deductions or exclusions with income for such purpose. Such mechanisms tend to be complex [44] or rely on local accounting rules or judgments. [45] The process of associating deductions with income is referred to allocation and apportionment in some jurisdictions.
Most rules rely to some extent on factual relationships between deductions and income produced by incurring the deduction. Thus, all deductions related to producing a set of income would be allocated to that set of income. [46] To the extent a particular set of income includes both foreign and domestic income, the deductions so allocated are then apportioned in some manner in some systems. [47] Canadian rules require that deductions reasonably regarded as wholly allocable to income form a particular place be allocated thereto, as well as that portion of other deductions reasonably regarded as applicable to that income. [48] Under US rules, apportionment of most deductions may be done based on relative sales, gross income (sales less cost of goods sold), space used, headcount, or some other rational and systematic basis. [49]
The US has rules requiring that certain deductions be apportioned among all income on a formulary basis. These rules are quite complex. Interest expense must be apportioned based on relative adjusted tax basis of assets that produce or could produce the particular type of income. [50] Research and experimentation expenses must be apportioned based on either relative sales or relative gross income. Taxpayers must elect which base to use, and such election applies for five years. [51] State income taxes must be apportioned based on complex formulae. [52] Stewardship and supportive expenses must each be allocated and apportioned under one of several methods. [53] Note that few other countries have developed rules to this level of complexity and specificity.
Most systems require corrective action by taxpayers if the amount of tax previously claimed as FTC changes. Such changes could occur, for example, because of carryback of deductions, losses, or credits in the foreign country, changes on examination of returns, etc. The form of corrective action varies by jurisdiction, and may vary within a jurisdiction by type of adjustment.
US rules [54] differentiate three forms of adjustment to foreign taxes: adjustments to taxes paid by the taxpayer which did reduce actual US taxes paid, adjustments to taxes deemed paid which did not exhaust the pool of deemed paid taxes, and adjustments which did not reduce US taxes yet. Taxpayers with the first type of adjustment must amend tax returns and pay or claim a refund for the difference in tax. Only corporate taxpayers can have the second type of adjustment. Those taxpayers must reduce the pool of taxes going forward and advise the government of the change. Taxpayers with the third type of adjustments must advise the government of the change and make appropriate adjustments to unused FTC carried over.
Some countries grant FTC to corporations owning shares of a foreign corporation when the shareholder receives a dividend or other deemed income (for example, under controlled foreign corporation provisions) based on the dividend payor's taxes and income. [55] Under such systems, generally the amount of credit is the foreign taxes paid by the foreign corporation times the fraction of earnings distributed to the shareholder as a dividend. Generally, the amount of dividend is "grossed up" for the amount of available credit, before limitations, effectively charging the shareholder with home country tax for the income on a pre-tax basis. [56] The deemed paid credit mechanism may be applied up the chain of corporate distributions, and may be subject to ownership limitations. [57] [58]
Dividends received by resident individuals and corporations are included in taxable income by most countries. A foreign tax credit is then allowed for any foreign income taxes paid by the shareholder on the dividends, such as by withholding of tax. Where the country taxes dividends at a lower rate, the tax eligible for credit is generally reduced. For example, US tax law requires individuals to reduce the foreign income tax by the ratio of the rate differential on dividends (39.6% less 20%) to the maximum individual tax rate (39.6%). [59] Some countries have at times allowed shareholders a credit against the shareholder's tax for taxes paid by the corporations. [60] Several countries allow corporations who own significant shares of other corporations to claim a foreign tax credit for a portion of the foreign income taxes paid by the owned corporation when the shareholding corporation receives a dividend. [61]
Assume that Carpet Ltd is a UK resident company publicly-traded company which buys and sells carpets through offices in UK and Germany. Carpet Ltd's tax rate in the UK is 33% on its business net income of £1 million. Carpet Ltd is also subject to tax in Germany on the equivalent of £100,000 at a tax rate of 37%, or £37,000. The UK limits FTC to the amount of UK tax that would be on the foreign (non-UK) source income. If Carpet Ltd has no other foreign source income under UK concepts, Carpet Ltd's UK tax is £330,000 less FTC of £33,000, or £297,000. Total taxes would be £297,000 + £37,000 or £334,000. On the other hand, if Carpet Ltd had additional foreign source trading profits of £20,000, the FTC limit would be sufficient to use all of the German tax as credits, and UK tax after FTC would be £293,000. Thus, the worldwide tax rate with FTC tends to be at a minimum the home country tax rate and a maximum a foreign country tax rate, if higher.
Differences in expense allocation rules and transfer pricing can impact this result. If, in the example above, Carpet Ltd had £10,000 of expenses of the Germany operation which Germany disallowed as not allocable to German income under German concepts, the German tax would increase to £40,700 while the UK FTC limitation would remain £33,000. This would increase worldwide taxes by the German tax on the disallowed expenses, to a total of £337,300.
Assume a German 100% subsidiary of a US company has earned $1,000 of pre-tax income and paid $380 of German taxes over its history. If the Germany company pays a dividend of $100, the US company will, subject to limitations, be entitled to $38 of FTC.
Tax sparing refers to granting a home country foreign tax credit for specific foreign taxes that would have been payable but for tax exemption in the foreign country. The concept of tax sparing was once fairly widespread, but has been reconsidered by many countries. [62] The apparent intent of the provisions was for developed nations to provide economic incentives for enterprises in such nations to invest in developing nations. Under the Germany/Indonesia tax treaty of 1977 (a typical provision), Germany allowed a credit with respect to dividends, interest and royalties for Indonesian taxes that would have been paid but for the provisions of Indonesian law designed to promote economic development in Indonesia.
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The United States has separate federal, state, and local governments with taxes imposed at each of these levels. Taxes are levied on income, payroll, property, sales, capital gains, dividends, imports, estates and gifts, as well as various fees. In 2020, taxes collected by federal, state, and local governments amounted to 25.5% of GDP, below the OECD average of 33.5% of GDP.
An income tax is a tax imposed on individuals or entities (taxpayers) in respect of the income or profits earned by them. Income tax generally is computed as the product of a tax rate times the taxable income. Taxation rates may vary by type or characteristics of the taxpayer and the type of income.
A tax deduction or benefit is an amount deducted from taxable income, usually based on expenses such as those incurred to produce additional income. Tax deductions are a form of tax incentives, along with exemptions and tax credits. The difference between deductions, exemptions, and credits is that deductions and exemptions both reduce taxable income, while credits reduce tax.
Controlled foreign corporation (CFC) rules are features of an income tax system designed to limit artificial deferral of tax by using offshore low taxed entities. The rules are needed only with respect to income of an entity that is not currently taxed to the owners of the entity. Generally, certain classes of taxpayers must include in their income currently certain amounts earned by foreign entities they or related persons control.
A corporate tax, also called corporation tax or company tax, is a type of direct tax levied on the income or capital of corporations and other similar legal entities. The tax is usually imposed at the national level, but it may also be imposed at state or local levels in some countries. Corporate taxes may be referred to as income tax or capital tax, depending on the nature of the tax.
Tax exemption is the reduction or removal of a liability to make a compulsory payment that would otherwise be imposed by a ruling power upon persons, property, income, or transactions. Tax-exempt status may provide complete relief from taxes, reduced rates, or tax on only a portion of items. Examples include exemption of charitable organizations from property taxes and income taxes, veterans, and certain cross-border or multi-jurisdictional scenarios.
Double taxation is the levying of tax by two or more jurisdictions on the same income, asset, or financial transaction.
Three key types of withholding tax are imposed at various levels in the United States:
The Modified Accelerated Cost Recovery System (MACRS) is the current tax depreciation system in the United States. Under this system, the capitalized cost (basis) of tangible property is recovered over a specified life by annual deductions for depreciation. The lives are specified broadly in the Internal Revenue Code. The Internal Revenue Service (IRS) publishes detailed tables of lives by classes of assets. The deduction for depreciation is computed under one of two methods (declining balance switching to straight line or straight line) at the election of the taxpayer, with limitations. See IRS Publication 946 for a 120-page guide to MACRS.
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For households and individuals, gross income is the sum of all wages, salaries, profits, interest payments, rents, and other forms of earnings, before any deductions or taxes. It is opposed to net income, defined as the gross income minus taxes and other deductions.
The United States federal government and most state governments impose an income tax. They are determined by applying a tax rate, which may increase as income increases, to taxable income, which is the total income less allowable deductions. Income is broadly defined. Individuals and corporations are directly taxable, and estates and trusts may be taxable on undistributed income. Partnerships are not taxed, but their partners are taxed on their shares of partnership income. Residents and citizens are taxed on worldwide income, while nonresidents are taxed only on income within the jurisdiction. Several types of credits reduce tax, and some types of credits may exceed tax before credits. Most business expenses are deductible. Individuals may deduct certain personal expenses, including home mortgage interest, state taxes, contributions to charity, and some other items. Some deductions are subject to limits, and an Alternative Minimum Tax (AMT) applies at the federal and some state levels.
International taxation is the study or determination of tax on a person or business subject to the tax laws of different countries, or the international aspects of an individual country's tax laws as the case may be. Governments usually limit the scope of their income taxation in some manner territorially or provide for offsets to taxation relating to extraterritorial income. The manner of limitation generally takes the form of a territorial, residence-based, or exclusionary system. Some governments have attempted to mitigate the differing limitations of each of these three broad systems by enacting a hybrid system with characteristics of two or more.
Tax consolidation, or combined reporting, is a regime adopted in the tax or revenue legislation of a number of countries which treats a group of wholly owned or majority-owned companies and other entities as a single entity for tax purposes. This generally means that the head entity of the group is responsible for all or most of the group's tax obligations. Consolidation is usually an all-or-nothing event: once the decision to consolidate has been made, companies are irrevocably bound. Only by having less than a 100% interest in a subsidiary can that subsidiary be left out of the consolidation.
Income taxes in Canada constitute the majority of the annual revenues of the Government of Canada, and of the governments of the Provinces of Canada. In the fiscal year ending March 31, 2018, the federal government collected just over three times more revenue from personal income taxes than it did from corporate income taxes.
The United States Internal Revenue Service (IRS) uses forms for taxpayers and tax-exempt organizations to report financial information, such as to report income, calculate taxes to be paid to the federal government, and disclose other information as required by the Internal Revenue Code (IRC). There are over 800 various forms and schedules. Other tax forms in the United States are filed with state and local governments.
Corporate tax is imposed in the United States at the federal, most state, and some local levels on the income of entities treated for tax purposes as corporations. Since January 1, 2018, the nominal federal corporate tax rate in the United States of America is a flat 21% following the passage of the Tax Cuts and Jobs Act of 2017. State and local taxes and rules vary by jurisdiction, though many are based on federal concepts and definitions. Taxable income may differ from book income both as to timing of income and tax deductions and as to what is taxable. The corporate Alternative Minimum Tax was also eliminated by the 2017 reform, but some states have alternative taxes. Like individuals, corporations must file tax returns every year. They must make quarterly estimated tax payments. Groups of corporations controlled by the same owners may file a consolidated return.
Taxation of illegal income in the United States arises from the provisions of the Internal Revenue Code, enacted by the U.S. Congress in part for the purpose of taxing net income. As such, a person's taxable income will generally be subject to the same federal income tax rules, regardless of whether the income was obtained legally or illegally.
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