Combating Double Taxation: Foreign Tax Credits and Tax Treaties
The foreign tax credit and its application is complex and can vary widely when looking at state tax liabilities and the application of tax treaties against state liabilities. A taxpayer that earns income abroad may be subject to double taxation, making the foreign tax credit and tax treaties an important part of the tax filing process.
Double taxation occurs when income is taxed by more than one taxing jurisdiction. This is most often seen when income is taxed by the government of the location where the income is earned and the location where the income earner is considered a resident. For example, if a U.S. citizen earns income in Canada, they will be subject to tax in Canada and the U.S. on that same income.
Foreign Tax Credit
The main mechanism in place to combat double taxation at the federal level is the foreign tax credit. This credit is a dollar for dollar reduction in U.S. taxes associated with the foreign source income (i.e., the income earned in Canada from the example above). It is important to note that the foreign tax credit is a federal tax concept and can only offset U.S. taxes imposed on foreign source income. Generally, it does not offset U.S. taxes imposed on U.S. source income.
When looking at foreign tax credits and state tax liabilities the analysis can become very complicated. Each state has the ability to decide whether it will provide relief to its taxpayers from double taxation on foreign source income. There are a few approaches in this scenario, including:
- The state could allow a credit.
- The state could disallow a credit but allow a deduction.
- The state could completely disallow a credit or deduction for foreign taxes paid.
Below highlights how Indiana, the immediately surrounding states, and New York approach the foreign tax credit.
- Indiana does allow taxpayers to claim a foreign tax credit. A taxpayer must file Schedule CR with their Indiana return and attach Internal Revenue Service (IRS) Form 1116 to the return to claim the Indiana foreign tax credit. The credit is limited to the lesser of the foreign taxes paid to the foreign country, the Indiana state income tax on the foreign source income, or the taxpayer’s total tax due to Indiana.
- Illinois allows no credit or deduction for foreign taxes paid.
- Kentucky allows no credit or deduction for foreign taxes paid.
- Michigan allows taxpayers to claim a foreign tax credit, but the allowable credit in Michigan is limited to taxes paid to Canadian provinces that result in an excess credit at the federal level.
- Ohio allows no credit or deduction for foreign taxes paid.
- New York allows taxpayers to claim a foreign tax credit, but the allowable credit in New York is also limited to taxes paid to Canadian provinces that result in an excess credit at the federal level. Additionally, there is an adjustment in the future if the excess Canadian provincial taxes that were used as a credit on the New York return are carried forward and utilized on the federal return. In that scenario, the credit must be added back in the year of the carryforward.
Another mechanism to combat double taxation is the application of tax treaties. The U.S. has entered into income tax treaties with more than 60 countries, however, it is important to note that the U.S. federal government has entered into these agreements with foreign governments. The individual states are under no obligation to honor the terms of any treaties.
Many states do honor the terms of many of the treaties, including Indiana, Illinois, Michigan, New York, and Ohio. Unfortunately, many of the treaties include a “savings clause” that allows the U.S. government to tax U.S. persons as though the treaty was not in force. Accordingly, treaty-based relief from state double taxation is unusual for U.S. persons (generally U.S. citizens are U.S. residents). There may be some relief (depending on the type of income) for non-U.S. persons.
Foreign tax credits at the state level as well as the application of U.S. income tax treaties when looking at state tax liabilities can be very complicated. Taxpayers earning income abroad should familiarize themselves with the various approaches individual states can take and mechanisms in place to help combat potential double taxation. If you need specific information regarding a different state, please reach out to your advisor.
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