Direct vs. indirect FTCs, Form 1118, and IRS audit traps
Double Taxation: The Silent Erosion of Capital Efficiency
For any CFO overseeing international operations, few issues appear more deceptively “solved” than foreign tax credits. After all, the concept is straightforward: if a company pays taxes abroad, it should not have to pay those taxes again at home. The IRS agrees in principle. And yet in practice, double taxation continues to gnaw away at earnings, misalign cash flow, and distort tax provisioning.
The gap between principle and practice lies in the nuanced mechanics of foreign tax credit (FTC) regimes—how credits are earned, classified, limited, and applied. This complexity is amplified in fast-growth environments, where tax teams are lean, systems are fragmented, and reporting deadlines arrive before intercompany accounts are reconciled.
Drawing from decades of experience working with high-growth companies operating across Asia, Europe, and Latin America, I have seen how even well-capitalized CFOs underestimate the judgment and precision required to manage FTCs effectively. The costs of neglect—missed credits, denied claims, audit adjustments—are substantial and recurring. Worse, they are often avoidable.
This blog dissects the architecture of foreign tax credits through a CFO’s lens, focusing on their practical application, strategic timing, and common pitfalls. It also outlines how to operationalize credit tracking, maximize utilization, and anticipate IRS scrutiny.
Why Foreign Tax Credits Exist: The Economic and Legal Rationale
At its core, the FTC mechanism is a tool of international tax neutrality. Without it, U.S.-based companies would be discouraged from investing abroad, knowing that foreign-source income would face two layers of tax—one from the host country and one from the IRS.
Congress designed the FTC regime to provide relief from this double tax burden. The mechanism operates by allowing U.S. taxpayers to claim a dollar-for-dollar credit for certain foreign income taxes paid or accrued. But the system is not without limits. The IRS does not allow an open checkbook. Credits are constrained by income type, foreign-source thresholds, and carryforward rules.
What matters for CFOs is this: the theoretical credit is not automatic. It must be earned through careful classification, recorded properly, disclosed on Form 1118, and defended with documentation. And the way a company manages these steps determines whether cash flow is preserved or eroded.
The Two Types of Foreign Tax Credits: Direct vs. Indirect
To navigate this landscape, CFOs must understand the two primary types of credits:
Direct FTCs are claimed by the U.S. parent company on taxes it pays directly to a foreign government. This typically applies to branch income, licensing revenues, or foreign service fees where the U.S. entity is the legal taxpayer abroad. These credits are reported directly on the U.S. return and are relatively straightforward to trace.
Indirect (or deemed-paid) FTCs are more complex. These apply when a U.S. company owns at least 10 percent of a foreign subsidiary and receives dividends from that entity. The U.S. parent is deemed to have paid a portion of the foreign income taxes paid by the subsidiary and can claim those taxes as credits. However, this is only permitted under specific conditions, and the computation requires a careful analysis of the foreign entity’s earnings, profits (E&P), and tax pools.
In the post-TCJA era, deemed-paid FTCs interact heavily with the GILTI regime. While the Section 245A dividends received deduction eliminates tax on certain foreign dividends, it also nullifies the ability to claim FTCs on those amounts. As a result, companies must weigh the trade-off between exempt income and foreign tax recoverability.
The Limits of FTC Utilization: Baskets, Calculations, and Constraints
The IRS does not allow foreign tax credits to reduce U.S. tax without bounds. Instead, credits are limited to the portion of U.S. tax attributable to foreign-source income. This is known as the FTC limitation, and it is calculated by income category—also known as baskets.
There are several distinct income baskets, each with its own credit limitation:
- General income (e.g., active foreign business income)
- Passive income (e.g., interest, dividends, royalties)
- Foreign branch income
- GILTI (separately basketed post-TCJA)
Each basket stands alone. A surplus credit in one basket cannot offset a deficit in another. This is one of the most common traps in FTC planning. A company may have paid $5 million in foreign tax on active income, but if its passive basket shows excess limitation, that $5 million is stranded.
To make matters more intricate, credits must be computed and disclosed by country and by income type on Form 1118. Errors in this allocation can trigger audit adjustments or disallowance.
Another limitation arises from the expense allocation rules under Treasury Regulation §1.861. U.S. interest, R&D, and SG&A expenses are allocated across domestic and foreign income, reducing the foreign-source denominator and, consequently, the FTC limitation.
Carryforwards and Carrybacks: A Strategic Timing Tool
Unused FTCs do not disappear immediately. The IRS allows a one-year carryback and a ten-year carryforward period. This feature creates an opportunity for CFOs to sequence foreign income and credit claims strategically.
For example, if a foreign jurisdiction imposes a large one-time tax in Year 1 but the U.S. company has no foreign-source income that year, it can carry the credit forward to apply against future foreign income. Conversely, if a company has U.S. tax liability in Year 2 but no FTCs, it can carry credits back from Year 3 if foreign income arises then.
However, tracking these credits requires meticulous recordkeeping—by jurisdiction, income type, and year. Many startups fail to do this during early-stage expansion, only to discover during diligence that they cannot substantiate carryforward balances.
The Form 1118 Challenge: Substance Over Form
Form 1118 is the IRS filing through which corporations report their foreign tax credits. It is not merely a disclosure. It is an audit roadmap. It requires granular detail:
- Country-by-country breakdown of taxes paid
- Type of tax and legal basis for creditability
- Allocation of expenses across baskets
- Adjustments to E&P and tax pools
Mistakes on Form 1118 are common—and costly. Misstating the basket, applying the wrong exchange rate, or failing to trace the underlying income can all lead to disallowed credits.
Moreover, not all foreign taxes qualify. To be creditable, the tax must be a compulsory levy on net income. This excludes withholding on services, VAT, or non-income-based franchise taxes. In some countries, hybrid taxes may not be recognized as creditable without additional support.
Common Mistakes and How to Avoid Them
From my vantage point advising scaling companies, several recurring errors appear in FTC execution:
- Failing to classify income properly between passive and general baskets
- Not applying expense allocation rules, overstating the limitation
- Ignoring GILTI interactions, resulting in lost credits
- Omitting Form 1118 or submitting it without detailed substantiation
- Assuming foreign withholding taxes on services are creditable when they are not
These are not clerical issues. They lead to material restatements, penalties, and increased audit scrutiny. They also erode trust in financial reporting and complicate IPO or M&A timelines.
What Best-in-Class Practice Looks Like
World-class FTC management begins not with the tax return, but with systems and collaboration. Key practices include:
- Integration of tax provisioning software with ERP systems to trace foreign income and taxes by jurisdiction
- Real-time expense allocation modeling to manage FTC limitations throughout the year
- Documentation of intercompany pricing, dividend policies, and foreign E&P tracking
- Coordination between FP&A, treasury, and tax to anticipate withholding exposures and credit timing
- Periodic review of carryforward balances and expiration timelines
In high-performing companies, tax and finance teams hold quarterly FTC reviews, flagging potential stranded credits and modeling how entity structure or repatriation methods affect utilization.
A Case Study: Credit Salvage Through Strategic Restructuring
A U.S. biotech firm I advised had accumulated over $10 million in FTC carryforwards from operations in Europe and Latin America. However, due to excessive R&D allocations and narrow FTC baskets, it was using less than 30 percent of them annually. By realigning intercompany service agreements, recharacterizing certain payments from royalties to cost-sharing, and re-evaluating expense allocation, the company expanded its FTC limitation and recovered over $6 million in credits over three years. The changes also improved its GILTI exposure, reducing the blended effective tax rate from 24 percent to 17 percent.
Conclusion: Foreign Tax Credits are a CFO-Level Concern
Managing foreign tax credits is not a technical footnote. It is a capital allocation strategy. The effectiveness of FTCs affects after-tax earnings, repatriation decisions, and how a company tells its tax story to investors. CFOs who treat FTCs as a year-end tax team exercise are leaving real money on the table.
To avoid double taxation, preserve credits, and reduce audit exposure, CFOs must prioritize three things: visibility into foreign income, disciplined documentation of taxes paid, and a working understanding of how the U.S. tax system treats each jurisdiction and income type.
FTC strategy, at its best, is not about chasing refunds—it is about preserving value. And in high-growth companies, where every dollar of retained earnings fuels the next stage of expansion, that preservation is mission-critical.
Insight
Foreign tax credits are meant to solve a simple problem: avoid double taxation of income earned abroad by U.S. corporations. But as any CFO operating across borders can attest, the simplicity of the concept quickly unravels in the real world. Despite the IRS’s intent to promote tax neutrality, the system through which credits are calculated, claimed, and applied introduces layers of complexity that often result in missed credits, stranded balances, and unintended tax costs. In fast-growth companies, where tax teams are lean and systems may not yet be fully integrated, these complications frequently go unnoticed until they materialize as audit adjustments or reduced earnings.
The foreign tax credit (FTC) system in the United States functions by allowing corporations to offset U.S. tax liability with taxes paid to foreign jurisdictions, but only under specific, and often stringent, conditions. There are two fundamental types of FTCs: direct and indirect. Direct credits are associated with taxes the U.S. parent pays directly to a foreign government. These often arise from branches or licensing activities where the U.S. entity is directly taxable overseas. Indirect, or deemed-paid, credits occur when a U.S. company owns a foreign subsidiary and receives a dividend. In that case, the U.S. company is allowed to claim a proportionate share of the taxes that the subsidiary paid on the income generating the dividend.
After the 2017 Tax Cuts and Jobs Act, the rules around FTCs changed dramatically. For instance, the Section 245A dividends received deduction allows many foreign dividends to be received tax-free in the United States. While that sounds beneficial, the trade-off is significant: those dividends then become ineligible for FTCs. In other words, a company must now choose between excluding income from tax or applying credits against it. This creates a nuanced decision point for CFOs. The best choice depends on timing, jurisdiction, the effective foreign tax rate, and whether the dividend creates an exposure to Subpart F or Global Intangible Low-Taxed Income (GILTI) inclusion.
Even when FTCs are available, they are not limitless. The IRS imposes a foreign tax credit limitation that caps the credit at the proportion of U.S. tax liability attributable to foreign-source income. This limitation is not computed on a company-wide basis but rather within separate income “baskets.” These baskets include general income, passive income, foreign branch income, and GILTI. A surplus in one basket cannot offset a deficit in another. For example, taxes paid on active business income (general basket) cannot be used to offset taxes on foreign dividends (passive basket). This separation often results in stranded credits—foreign taxes that the company paid but cannot use.
The IRS requires that credits be reported and substantiated using Form 1118, a detailed and highly scrutinized form that breaks down credits by country, income type, and legal classification. The form demands documentation of tax payment, the foreign law under which the tax was imposed, and calculations that tie back to the U.S. tax return. Any error—misreporting an income type, applying the wrong exchange rate, or omitting required detail—can result in disallowed credits.
Another complication arises from the required allocation of expenses. Under Treasury regulations, a portion of U.S.-based expenses (like R&D, SG&A, and interest) must be allocated against foreign-source income, which reduces the amount of foreign income eligible for credits. This effectively lowers the FTC limitation, causing even valid credits to become unusable. Expense allocation is a moving target, often misunderstood or oversimplified. It requires a deep understanding of tax regulations and consistent coordination between tax and FP&A teams.
Fortunately, unused credits can be carried back one year and carried forward up to ten years. But this only helps if records are kept meticulously. Companies must track credits by year, by basket, and by jurisdiction. In practice, many early-stage global companies do not maintain this level of granularity, making it difficult to substantiate carryforwards during audits or diligence.
Common mistakes abound. Among the most frequent are failing to separate income into proper FTC baskets, omitting foreign-source allocations of U.S. expenses, assuming foreign withholding taxes on services are creditable (they usually are not), and failing to file or properly complete Form 1118. These are not harmless errors. They often lead to amended returns, penalties, and tension with auditors. More subtly, they reflect a breakdown in the CFO’s tax infrastructure—one that becomes increasingly difficult to fix as the company grows and cross-border complexity intensifies.
Best-in-class FTC management begins long before the tax return is filed. It is grounded in proactive systems and strategic integration. Tax teams must have access to ERP data that breaks out foreign income and tax payments by jurisdiction. Expense allocations must be modeled quarterly, not annually. Intercompany agreements and dividend policies must be aligned with credit utilization strategies. And most importantly, finance leadership must view FTCs as an active component of capital planning—not just a tax compliance issue.
I have seen firsthand how these principles play out. In one instance, a U.S.-based biotech firm had accumulated over $10 million in FTC carryforwards from operations in multiple countries. But due to structural mismatches between expense allocation, entity classification, and dividend timing, they were utilizing less than one-third of those credits. By strategically adjusting their intercompany service agreements, reclassifying certain income types, and restructuring their E&P pools, they were able to unlock over $6 million in credits and reduce their effective tax rate by seven percentage points. This was not a one-time benefit—it created a repeatable system that enhanced both financial reporting and cash flow planning.
Ultimately, foreign tax credits should be viewed as part of a CFO’s playbook for preserving after-tax earnings. They are not merely technical nuances buried in a return. They represent real capital that can either be reclaimed or lost based on operational discipline and tax strategy. In an environment where every basis point of tax efficiency matters—especially during IPO prep, M&A negotiations, or secondary offerings—overlooking FTCs is not just a missed opportunity. It is a failure of capital stewardship.
To manage FTCs effectively, CFOs must ask sharper questions: Do we know which jurisdictions are generating general versus passive income? Are we monitoring foreign E&P and tax pools in real time? Are we aligning our repatriation strategy with FTC availability and limitations? And are we continuously updating our expense allocation models to reflect changes in our business?
Getting this right requires collaboration across tax, finance, legal, and operations. But the rewards are substantial: reduced tax leakage, improved financial optics, and stronger internal control over one of the most misunderstood aspects of cross-border taxation. In high-growth environments, where speed is essential but missteps are costly, building a disciplined FTC system is not just smart policy—it is strategic necessity.
Disclaimer: This blog is for informational purposes only and does not constitute legal, tax, or financial advice. Please consult a qualified tax advisor or legal professional before applying any of these principles to your specific situation.
Discover more from Insightful CFO
Subscribe to get the latest posts sent to your email.