The Foreign Tax Credit: How to Avoid Paying Tax Twice on the Same Income

 

If you earn income abroad or own a stake in a foreign business, there's a good chance you're paying tax on that income twice: once to the foreign government, and again to the IRS. The Foreign Tax Credit (FTC) under Internal Revenue Code Section 901 exists specifically to prevent that. Used correctly, it can eliminate double taxation almost entirely. Used incorrectly or ignored it can quietly cost a business or individual six figures a year.

 

Here's what every business owner, investor, and advisor should understand about how it works, and what changed for 2026.

 

What the Foreign Tax Credit Actually Does

 

The U.S. taxes its citizens, green card holders, and residents on worldwide income, regardless of where it's earned. Most other countries tax income earned within their own borders. That overlap means the same dollar of income can be taxed twice: once where it's earned, and again by the U.S.

 

The FTC lets a taxpayer offset their U.S. tax liability, dollar for dollar, by the amount of foreign income tax they've already paid up to a limit. It's claimed on Form 1116 for individuals or Form 1118 for corporations.

 

Direct vs. Indirect Credit — Why Ownership Structure Matters

 

This is where things get expensive if they're set up wrong.

 

• Direct credit: available when a U.S. person pays foreign tax directly, or earns income through a foreign branch.

 

• Indirect (deemed-paid) credit: available when a U.S. corporation owns a foreign corporation and the foreign corporation pays foreign tax; the credit "flows up" to the U.S. shareholder.

 

Here's the trap: an individual who owns shares of a foreign corporation directly generally cannot claim a credit for the foreign corporation's taxes. The corporation pays foreign tax on its earnings, and then the individual is separately taxed again in the U.S. on dividends or inclusions from that same income, with no offsetting credit available at the individual level. That mismatch is one of the most common (and most expensive) structuring mistakes we see with foreign-owned businesses.

 

The fix, in many cases, is straightforward: interpose a U.S. holding company between the individual and the foreign corporation. That converts the individual's direct ownership into indirect ownership, which makes the deemed-paid foreign tax credit available at the U.S. corporate level — often eliminating the double tax entirely.

 

The Limitation: You Can't Credit More Than Your U.S. Tax on That Income

 

The FTC isn't unlimited. Section 904 caps the credit at the amount of U.S. tax attributable to the foreign-source income, calculated separately by category ("basket") — general category, passive category, and (formerly) GILTI. Foreign tax rates higher than the U.S. rate can generate excess credits that go unused in the current year.

 

Excess credits in most baskets can be carried back one year and forward ten years.

 

Excess credits tied to the GILTI basket (see below) have historically not been eligible for any carryback or carryforward — a use-it-or-lose-it rule that made planning around this category especially important.

 

What Changed for 2026 Under the One Big Beautiful Bill Act

 

The One Big Beautiful Bill Act (OBBBA), signed into law in July 2025, made several changes to the foreign tax credit rules effective for tax years beginning after December 31, 2025:

 

GILTI is renamed NCTI (Net CFC Tested Income), and the related foreign tax credit "haircut" drops from 20% to 10% — meaning corporations can now credit up to 90% of foreign taxes deemed paid on this income, up from 80%.

 

Fewer expenses are allocated against foreign-source income in this category. Interest expense and R&E expenditures are no longer allocable to NCTI for purposes of the Section 904 limitation, which increases the foreign tax credit taxpayers can actually use.

 

A drafting correction to Section 904(d)(2) now assigns foreign tax on certain "base difference" items to the general limitation basket instead of the foreign branch basket, preserving credits that previously could be lost entirely.

 

A new sourcing rule allows up to 50% of income from U.S.-produced inventory sold abroad to be treated as foreign-source income for purposes of the FTC limitation, a meaningful benefit for U.S. exporters.

 

Taken together, these changes are generally taxpayer-favorable, but they also change the math on prior planning. Structures that were optimized for the old 80% haircut and heavier expense allocation rules should be re-modeled for 2026.

 

The Takeaway

 

The foreign tax credit is one of the most powerful tools in the code for avoiding double taxation, but it only works if the ownership structure is designed to use it. A U.S. person who directly owns foreign company shares, receives foreign-source income through the wrong entity, or hasn't revisited their structure since the OBBBA changes may be leaving real money on the table, or worse, paying tax twice on the same income without realizing it.

 

If you have clients with foreign business interests, foreign investments, or recent changes in U.S. residency status, it's worth a conversation before the return is filed, not after.