Foreign Tax Credit Limitation Rules and FTC Baskets

U.S. corporations offset domestic tax on foreign earnings only up to a ceiling tied to foreign-source taxable income. Separate limitation categories, expense-apportionment mechanics, and carryover periods govern how much relief survives each year.

The overall limitation formula caps credit use.

A corporation multiplies its worldwide U.S. tax liability by the ratio of foreign-source taxable income to worldwide taxable income. The result is the maximum credit claimed for the year; any excess foreign tax becomes a carryback or carryforward rather than an immediate offset.

Foreign-source taxable income starts with gross foreign income, then subtracts properly allocated deductions. Treasury regulations allocate definitely related expenses first (e.g., foreign withholding taxes against royalty income), then apportion other costs—interest, stewardship, R&D—under specific formulas. The intricate allocation schedule shifts income between foreign and domestic baskets, raising or lowering the annual ceiling.

Four principal baskets segregate credits.

Post-2017 law maintains the general, passive, GILTI, and foreign branch categories; each applies its own limitation. Credits cannot cross baskets, so excess in one category cannot absorb U.S. tax on another. A high-tax election may move GILTI income to the general basket, but only when the effective foreign rate exceeds 90 percent of the U.S. rate. Once elected, consistency rules hold for every tested unit in the same jurisdiction.

Passive income basketed under § 904(d)(2)(B) includes dividends, interest, rents, and royalties unless the payer is a CFC whose income qualifies for look-through treatment. The branch basket covers business income earned through foreign disregarded entities, while the general basket captures residual active income and Subpart F inclusions that fail look-through.

Interest expense apportionment often drives the limitation.

Regulations use the tax-book value method by default, allocating U.S. interest expense between domestic and foreign income in proportion to asset values. Multinationals may elect to compute interest on a worldwide basis and apply a separate affiliated group allocation, but the election is binding for five years and requires extensive data. Capitalizing R&D under § 174 shifts less expense offshore, raising the foreign-source income numerator and expanding the limitation, yet increases CAMT book income.

Illustration—general basket limitation in 2025.

Foreign-source taxable income equals $150 million after expense apportionment; worldwide taxable income equals $500 million; U.S. tax liability at 21 percent equals $105 million. The limitation is $105 million × (150/500) = $31.5 million.

If foreign taxes allocated to the general basket total $40 million, the corporation claims $31.5 million this year, carries back up to $10 million to the previous year, and carries the remainder forward up to ten years.

Journal entry — year-end

Dr Income Tax Expense $31 500 000

Cr Foreign Tax Credit $31 500 000

Excess credits create a deferred-tax asset only when future limitation capacity appears probable; valuation allowances apply when forecasts show persistent shortfalls.

Carrybacks and carryforwards interact with rate changes.

Foreign-source income fluctuations, currency shifts, and U.S. rate changes alter the limitation in adjacent years, so credit planning runs multi-year models. A rate hike raises the limitation dollar-for-dollar, allowing bigger carryforward absorption, while a rate cut strands more credits. Section 904(c) forbids carrying credits between baskets or beyond ten forward years, so management prioritizes jurisdictions and baskets most likely to generate future taxable income.

Look-through rules soften double taxation within CFC structures.

Dividends, interest, rents, and royalties received from a CFC adopt the same basket as the CFC’s underlying income. Cash pooling interest from a general-basket CFC remains general; royalties from a passive-basket CFC remain passive. Accurate CFC earnings records and timely elections prevent mis-basketting that could trap credits.

Financial-statement impact extends beyond the tax line.

ASC 740 records deferred-tax assets for excess credit carryforwards, nets them against valuation allowances, and discloses separate basket balances. IFRIC 23 requires uncertain-tax-position reserves when expense-apportionment methods face challenge. Effective-tax-rate bridges explain how limitation adjustments and carryforward lapses moved the rate each quarter.

Planning strategies center on expense location and elective relief.

Shifting R&D personnel to high-tax jurisdictions raises foreign-source income, while issuing external debt in foreign subsidiaries moves interest expense abroad. Electing the foreign branch basket for losses, then recapturing them with future profits, smooths limitation volatility. Timing dividends to years of high limitation capacity or pairing them with capital gains also maximizes credit use.

Careful tracking of basket balances, forecasting of expense-apportionment ratios, and judicious use of high-tax elections remain crucial for turning foreign tax credits into real cash-tax savings rather than stranded deferred-tax assets.

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