International Comity and the Foreign Tax Credit: Crediting Nonconforming Taxes

Abstract

The combination of expanding international trade and climbing corporate income tax rates in the early part of this century required nations to evolve methods for reducing the level of international double taxation. While most countries came to rely upon a variety of techniques, two general approaches emerged to the taxation of the income of residents derived from foreign economic activity. Some countries adopted a territorial based system in which foreign source income is normally exempted from domestic tax. That system generally leaves the taxation of foreign income to the government within whose territory the activity occurs and thus avoids double taxation entirely. Other countries, including the United States, chose to impose their tax on the world-wide income of their individual citizens and residents and domestic corporations. That approach necessitated the development of specific mechanisms to reduce double taxation when the country within whose borders the income had been derived also imposed a tax on that income.The prevailing solution to this source of double taxation is for the residence country to allow its taxpayers to credit taxes paid to foreign jurisdictions against their domestic income tax liability. The extent to which such a foreign tax credit effectively relieves double taxation, however, depends in part upon the adequacy of the description of the foreign taxes that may be credited against the domestic tax liability. If the description is overinclusive, allowing too broad a range of foreign taxes to be credited, the foreign income will be taxed too lightly. Conversely, if the description is under-inclusive, double taxation will not be fully relieved and the foreign source income will be taxed more heavily than domestic income.