 Hello and welcome to this session in which we will discuss the foreign tax credit. It's very important to understand the purpose of a credit because once you understand its purpose, it's easier to understand its computation. So you'll have more an intuitive sense of how to compute this credit without memorizing the specific rules. What is the foreign tax credit? It's basically a relief mechanism, a way to do what? To facilitate trade, to facilitate movement of people across boundaries to work in other countries. It allows individuals and businesses to offset taxes they paid to a foreign government on foreign sourced income against their domestic liability. So let's assume you are a USA citizen and you travel to Asia to work in Asia. When you work in Asia, let's assume you're working in Japan. You're going to have to pay taxes in Japan. What's going to happen is this, the taxes that you pay in Japan because you have to report your worldwide income in the US, you have to report this income in the US. So any money you earn in Japan, you have to report in the US. Since you paid taxes in Japan, you can use those taxes paid as a credit to offset your tax bill. So this is the general idea. So you are not, what's the overall idea? The overall idea, if you have paid money to a foreign government on income earned abroad, you may be eligible to claim a credit. Now why you may? It's not, you can, you know, the country cannot be on the terrorist list or anything like this. And the US will have to have an agreement with them, some sort of a mutual agreement. Okay. So you pay the taxes over there. You can claim credit on your domestic tax bill or get some of the taxes paid back. There's a limitation. And this basically helps avoid what we know in accounting double taxation. So the money is not taxed twice. It's not taxed in Japan. They're also taxed in the US. The purpose is to do what? To promote, to encourage people, to go work abroad, to promote international trade because foreign tax credit applies to individual as well as corporation. Now, obviously the foreign tax credit is subject to certain limitations. So not everything you pay in Japan in terms of federal income tax, you will be giving credit for. Now, this is a basic introduction course. And what I'm going to be covering here is good enough for a basic accounting, basic tax course or the CPA exam. If you want more topics, advanced topic, I do have an international accounting course where I dive a little bit more into this topic. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true false questions as well as exercises. Go ahead, start your free trial today. Let's talk about the limitation of foreign tax credit. The limitation of foreign tax credit, foreign tax credit, FTC is the lesser of. Wherever you paid, foreign taxes incurred or the federal income tax paid on the double taxed income. So what does that mean? That's wherever you paid in the US, the lesser of that amount or you have to look at another amount, how much you would have paid for that money in the US, which is so you're not subject to double taxation. And don't worry, we'll work a few examples. So let's assume green, a US based company sells gadget in Mexico and the profit for this US company in Mexico totaled 8 million. Now green is subject to a 30% US tax rate. In Mexico, green is only responsible for 20%. Here's what's going to happen. Green tax bill, if we compute green tax bill in the US, which is 2 million times 30%, green's tax bill will be 6 million. And green, since they operate in Mexico, they have to also compute their taxes in Mexico. They have to pay their tax bill in Mexico 2 million times 20%, they're going to have to write a $400,000 bill to the Mexican government. So how much would green end up paying in the US? Well, the tax bill is $600,000. Since green paid $400,000 in Mexico, what's left is $200,000. If you notice, green corporation recovered the full taxes paid in Mexico. Why? Because the foreign taxes paid are lesser, the $400,000 are lesser than if that income was taxed in the US. If that income was taxed in the US, they would have to pay $600,000. Let's take a look at this, change this example a little bit. Let's assume Mexican tax rate was 40%. Well if Mexican tax rate was 40%, we made $2 million in profit. We have to send the Mexican government a check for $800,000. That's the tax liability. Well, the US tax is only $600,000. So what's going to happen is this, the credit is the lesser of taxes paid or if that money was taxed in the US, it will be $600,000. The lesser of these two is $600,000. What does that mean? It means green did not enjoy the full recovery of taxes paid in Mexico. How much was not enjoyed $200,000? So the gadget profit are subject to a $200,000 double tax this year because what happened is we paid that $200,000 in Mexico, we cannot recover it in the US. So that's what happened even when we applied the foreign tax credit to only give us $600,000. Now did we lose this $200,000 forever? Not at all. What you can do is this. You can take and go back one year, amend your taxes, get it back one year, and then forward 10 years. So you can have this credit, this $200,000 tax credit to offset future years. This is an example of a corporation. Let's take a look at an example for individuals. Let's take a look at Maggie. Her taxable income was $88,900 that included $10,000 in foreign source income. So that's her total US, but that included $10,000 in income. Maggie's computed her tax liability in the US and her tax liability was $18,000. So Maggie paid $2,500 on her foreign interest income. Well let's kind of real quick back of an envelope computation. Let's see what was her foreign tax rate. Her foreign tax rate, whatever that country she got that income from, $2,500 and she earned $10,000. The foreign tax rate is 25%. Let's take a look at her US-based tax income, the effective rate. She paid $18,000 and that's based on $78,900. So her tax rate is approximately 22.81%. So notice this is, again, back of the envelope computation. Don't rely on this, it's just back of the envelope. Notice she paid 25% in the foreign country. Her tax rate in the US is only 22.81. Let's simply put it's lower than her, even if you used $88,000, let's assume you used $88,000. If you took $18,000 divided by the $88,900, I took that money out. It's approximately, just to be more technical, let's include everything, $88,900 in the denominator. So her US tax rate is 20.24%. So the point is, any way you look at it, again, this is not the proper computation but I want you to see that Maggie paid more in taxes on her income. So how do you compute exactly the amount then? Well here's how you do. You'll take your foreign source taxable income and you'll divide it by your worldwide taxable income, then you multiply this number to find out what are you doing with this computation. This computation is figuring out how much of your income was, what percentage of your income is foreign income, which is your foreign income divided by worldwide taxable income. Then you will take this percentage, multiplied by the US income tax liability before taking into account the foreign tax credit, which is $18,000. And this is the US income tax attributed to the foreign tax. So this is how much you should have paid if you earn this money in the US. So $10,000 divided by $88,900, let's find the percentage. If we take $10,000 divided by $88,900, and that's going to be approximately 11.24%. So 11.24% of Maggie's income was foreign income, therefore, and her total tax bill was $18,000. Therefore, her taxes, her US income tax attributed to foreign tax is $2,024. Now Maggie paid $2,500. How much credit are we going to give Maggie? We're only going to give Maggie $2,024. The lesser of what she paid $2,500 and how much she should have paid $2,024. Now, what's going to happen with the difference? Well, what can Maggie do? She could go back one year and use that credit, which is 476, or she can carry this credit for the next 10 years. Let's take a look at another example. Sarah paid foreign income tax of $1,400 on her foreign income of $8,400. Now real quick, if you want to, you can take $1,400 divided by $8,400. And we'll find out that Sarah is paying almost 16.66%, which is $1,400 divided by $8,400. Sarah's worldwide taxable income was $90,500, that included everything. And her US tax bill was $22,800. Again, you can take $22,800 real quick, divided by $90,400. So $22,800 divided by $90,400. And that's going to give us approximately 25.19, or 25.2%. Notice her US tax rate is higher. I would say, when we use the formula, she's going to recapture all her credit. So if we take foreign income, which is $8,400 divided by her worldwide income, $90,500, we can see that 9.28% of her income is a foreign income. If we multiply this by the total tax bill that she paid in the US, we would see that if she was in the US, she would have to pay $2,116. She would have to pay this. However, because she paid $1,400, she's going to get the full credit. So she was able to recover her full credit of $1,400. And I kind of knew this at the beginning because her tax rate is lower than the US. So the tax credit is fully recoverable. Let's assume that Sarah paid $2,500 in foreign taxes. What will be her allowed foreign tax credit? What will be her allowed foreign tax credit? Real quick, if she paid $2,500 on that $8,400, real quick, it's back of the envelope computation, $2,500 divided by $8,400, her foreign tax rate was 29.76%. She paid too much. Now, if we do the same computation, well, the same computation will give us $2,116. She paid $2,500. What's her foreign tax credit? Well, it's only $2,116, but she paid $2,500. That's fine. The difference between $2,500 and $2,116, which is $2,500 minus $2,116, is unused $2,500 minus $2,116. This is $384 that's unused. You can carry back one year, carry forward 10 years. What should you do now? Go to Farhad Lectures, look at additional MCQs, true, false questions that can help you understand the concept of foreign tax credit as well as tax credits in general. If you're studying for your CPA exam, income tax scores, the enrolled agent, you have to have a good understanding of these tax credit. How do they work? Work examples. Good luck. Study hard and, of course, stay safe.