The Arbitrary Foreign Tax Credit

The foreign tax credit is a cornerstone of the United States’ international tax regime and enjoys broad bipartisan support. Yet despite its enduring popularity, careful analysis reveals that the foreign tax credit is surprisingly arbitrary. Taxes are creditable in their entirety or not at all, and only “pure” income taxes receive a credit. Even a slight deviation from the law’s narrow definition of an income tax renders a foreign tax completely uncreditable. The current approach is clearly problematic. It is a fundamental tenet of tax policy that the law should treat items based on their economic substance, but the credit’s all-or-nothing approach does not. Nor do the policy rationales underlying the foreign tax credit support starkly different treatment for pure income taxes compared to all other taxes. We identify principles to reform the foreign tax credit in accordance with economic substance and the policy goals underlying the credit. We then use those principles to evaluate various possible reforms. Depending on which goals policymakers choose to prioritize, plausible options range from eliminating the credit to greatly expanding its scope. But in any event, the way forward involves abandoning the credit’s sharp, arbitrary distinction between pure income taxes and all other taxes.