The foreign tax credit is the primary mechanism the US uses to prevent double taxation of income earned and taxed abroad. Without it, a US citizen working in Germany paying 42% German income tax would also owe US tax on the same income - an effective rate potentially exceeding 70%. The credit eliminates that double taxation, but only up to the amount of US tax that would otherwise apply to that foreign income. The mechanics of the limitation, the income baskets, and the interaction with GILTI/NCTI are where most of the complexity lives.
A taxpayer can either deduct foreign taxes paid as an itemized deduction (IRC §164) or claim them as a credit (IRC §901). The credit is almost always more valuable - a $10,000 foreign tax deduction at the 37% rate saves $3,700; a $10,000 credit saves $10,000. The deduction can be used without limitation; the credit is subject to the FTC limitation. Even so, the credit wins in virtually all cases. The election to take the deduction instead is made on the return and can be changed year to year.
The foreign tax credit cannot exceed the amount of US tax that would have been owed on the foreign income. This prevents the credit from offsetting US tax on US-source income. The limitation is calculated separately for each income basket.
If foreign taxes paid in a basket exceed the limitation, the excess is a credit carryback (1 year) and carryforward (10 years). If foreign taxes paid are less than the limitation, the unused limitation carries forward and can absorb future excess credits from the same basket.
The FTC limitation is computed separately for each income basket. Foreign taxes in one basket cannot offset the limitation in another basket. This prevents high-taxed income in one category from sheltering low-taxed income in another.
| Basket | What It Contains | Key Planning Note |
|---|---|---|
| General | Most foreign-source earned income, wages, business income not in another basket | The catch-all basket; most working expats use this primarily |
| Passive | Foreign dividends, interest, rents, royalties, capital gains (unless high-taxed) | Separated to prevent high passive taxes from sheltering active income |
| GILTI/NCTI | Global intangible low-taxed income (now Net CFC Tested Income) from CFCs | Separate basket; 80% foreign tax credit limitation applies; high-tax exclusion available |
| Foreign Branch | Income from foreign branches of US corporations | Separated post-TCJA to prevent blending with general basket |
| Section 901(j) | Income from countries designated as supporting terrorism or under sanction | No FTC allowed; deduction only |
Under Treas. Reg. §1.951A-2(c)(7), a CFC's income that bears a foreign effective tax rate exceeding 18.9% (90% of the 21% US corporate rate) can be excluded from the NCTI/GILTI inclusion entirely via the high-tax exclusion (HTE) election. This is a per-CFC, per-item election made on the US shareholder's return.
The HTE prevents the anomalous result where a US company's CFC pays high foreign taxes on its income but the US parent must include the same income in NCTI and then apply a limited FTC (80% cap in the NCTI basket) - potentially resulting in net US tax on already-heavily-taxed income. By electing out, the income stays offshore and the US parent avoids the inclusion entirely.
Individuals, estates, and trusts use Form 1116 to claim the foreign tax credit. Corporations use Form 1118. The individual Form 1116 must be filed separately for each basket - a taxpayer with foreign wages (general basket) and foreign dividends (passive basket) files two Form 1116s. A simplified election under IRC §904(j) allows taxpayers with $300 or less ($600 MFJ) of passive basket foreign taxes and no general basket foreign taxes to claim the credit directly on Schedule 3 without Form 1116.
Corporate US shareholders of CFCs can claim a deemed paid credit under IRC §960 for foreign taxes paid by the CFC on income that is included in the US shareholder's income (Subpart F income, NCTI). The deemed paid credit is limited to 80% of the foreign taxes in the NCTI basket. The credit represents foreign taxes attributable to the inclusion - the US shareholder is treated as having paid those taxes.
Individual US shareholders of CFCs generally cannot claim deemed paid credits under §960 directly - they can make a §962 election to be taxed as a corporation on CFC income, which then allows access to the §960 deemed paid credit. See the Section 962 Election guide for details.
Excess FTCs in any basket (foreign taxes paid exceed the limitation) can be carried back 1 year and forward 10 years to offset limitations in years where taxes paid are less than the limitation. The carryback and carryforward are tracked separately by basket and by year. Carryforwards that expire unused after 10 years produce a permanent tax cost - they cannot be deducted after expiration.