How does the foreign tax credit work?
Generally available; the limitation and baskets decide the amount
IRC §901 allows a credit for foreign income taxes paid or accrued, and §904 limits it to the U.S. tax on foreign-source taxable income, computed separately for each category: net CFC tested income (NCTI, formerly GILTI), foreign branch, passive, and general. Excess credits carry back one year and forward ten, except NCTI-category credits, which cannot be carried. The One Big Beautiful Bill Act changed NCTI rules starting in 2026.
Reviewed by Ebot Mbi, CPA, EA · Last reviewed · Law and figures current as of September 17, 2026
Key takeaways
- The credit offsets U.S. tax dollar for dollar, up to the §904 limit for each category.
- Categories: NCTI (formerly GILTI), foreign branch, passive, and general.
- Excess general, passive, and branch credits carry back 1 year and forward 10; NCTI credits cannot be carried at all.
- For tax years beginning after 2025, corporations are deemed to pay 90% of NCTI-related foreign taxes, and only directly allocable deductions and the §250 deduction are allocated to the NCTI category.
- You choose the credit or a deduction each year; the credit is usually worth more, but not always.
What it is
U.S. citizens, residents, and domestic corporations are taxed on worldwide income. When a foreign country also taxes that income, the foreign tax credit reduces the U.S. tax so the same income is not taxed twice in full.
The credit is limited to the U.S. tax on the foreign income in each category, which keeps foreign taxes from reducing U.S. tax on U.S. income. Understanding the categories and the carryover rules is where most of the planning happens.
What the law says
IRC §901(a) allows taxpayers who choose its benefits a credit, subject to §904, for foreign income taxes, and in the case of a corporation for taxes deemed paid under §960. Only income, war profits, and excess profits taxes (and taxes in lieu of them) qualify; payments for specific economic benefits do not.
IRC §904(a) limits the credit to the same proportion of U.S. tax that foreign-source taxable income bears to entire taxable income. Section 904(d)(1) applies the limit separately to amounts included under §951A (other than passive income), foreign branch income, passive category income, and general category income. Section 904(c) carries excess credits back one year and forward ten years, but by its terms does not apply to taxes paid or accrued with respect to the §951A category.
The One Big Beautiful Bill Act (P.L. 119-21) renamed global intangible low-taxed income as net CFC tested income for tax years beginning after December 31, 2025. It raised the deemed-paid credit for these inclusions to 90% under §960(d), reduced the §250 deduction for them to 40%, and limited the deductions allocated to that category to the §250 deduction and deductions directly allocable to the income. Treas. Reg. §1.904-4 defines the categories.
Requirements and tests
The credit depends on:
- Whether the foreign levy is a creditable income tax under §901 and the regulations.
- The source and category of each item of foreign income.
- Allocation and apportionment of deductions to each category.
- Whether you choose the credit or the deduction for the year (the choice applies to all foreign taxes for that year).
- Carryovers from prior years and whether they can be used in the current category.
- For individuals, Form 1116; for corporations, Form 1118. Individuals with $300 or less ($600 joint) of creditable foreign taxes from qualified passive income reported on payee statements can generally claim the credit without Form 1116.
How it works
For each category, you compute foreign-source taxable income, multiply your U.S. tax by the ratio of that income to total taxable income, and compare the result with the foreign taxes in that category. The credit is the smaller amount.
Excess credits in the general, passive, and branch categories are carried back one year and then forward up to ten years, for use in the same category. Excess NCTI-category credits are lost, which makes the allocation of expenses to that category important.
A deduction for foreign taxes reduces taxable income instead. It can be better in rare cases, such as when there is no foreign-source income in the category to absorb the credit, but the choice applies to all foreign taxes for the year.
Individuals living abroad should also compare the credit with the foreign earned income exclusion, because the two interact.
Documentation is essential. Keep foreign returns, proof of payment, and exchange rate records, because the IRS can disallow credits that are not substantiated. If a foreign tax is later refunded or adjusted, U.S. reporting must be updated, and the rules for foreign tax redeterminations can require amended returns or notifications. Track carryovers by category and year so none expire unused.
Assumptions: Tax year 2026; a domestic C corporation whose only income is $300,000 of foreign-source general category taxable income (after allocated expenses); U.S. tax rate 21%.; Foreign income tax paid is $100,000 and is fully creditable; no prior carryovers; state taxes ignored.
| U.S. tax before credit ($300,000 × 21%) | $63,000 |
|---|---|
| §904 limit ($63,000 × $300,000 ÷ $300,000) | $63,000 |
| Credit allowed | $63,000 |
| Excess credit carried back 1 year, then forward up to 10 years ($100,000 − $63,000) | $37,000 |
| Total tax with the credit ($100,000 foreign + $0 U.S.) | $100,000 |
| Deduction instead: U.S. tax (($300,000 − $100,000) × 21%) | $42,000 |
| Total tax with the deduction ($100,000 + $42,000) | $142,000 |
| If this were NCTI-category income: carryover of the excess | $0 (cannot be carried) |
The credit eliminates the U.S. tax and banks $37,000 for other years in the general category, while a deduction would leave $42,000 of U.S. tax; in the NCTI category the excess would be lost.
Illustration only; not a projection of your results.
Risks and IRS scrutiny
The IRS examines the creditability of foreign levies, the sourcing of income, expense allocation, and carryover tracking. Foreign tax refunds and redeterminations require amended reporting. Claiming credits in the wrong category is a common error that can permanently strand credits.
Who it is not for
The credit does little for taxpayers with no foreign-source income in the category. It does not apply to foreign payments that are fees for specific benefits rather than income taxes. And it is not a planning area for anyone who treats the categories as interchangeable.
How ebotCPA helps
We determine creditability and categories, allocate expenses, track carryovers by category, and prepare Form 1116 or Form 1118 so available credits are claimed and documented.
Book a $497 Case Analysis to have Ebot Mbi, CPA, EA review your facts before you act.
Frequently asked questions
Can foreign tax credits be carried forward?
Yes, for 10 years (after a 1-year carryback) in the general, passive, and foreign branch categories. Credits in the NCTI (formerly GILTI) category cannot be carried back or forward.
What is NCTI?
Net CFC tested income, the new name the One Big Beautiful Bill Act gave to global intangible low-taxed income for tax years beginning after 2025.
Is a credit always better than a deduction?
Usually, because it reduces tax dollar for dollar. A deduction can be better in unusual cases, such as when the §904 limit would leave credits unused and unable to be carried.
Which form do I use?
Individuals, estates, and trusts use Form 1116; corporations use Form 1118.
Have facts like these?
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