How to Substantiate a Foreign Tax Credit

Under Section 901(b)(1) of the Internal Revenue Code, U.S. citizens and U.S. corporations are entitled to a foreign tax credit for “the amount of any income, ware profits, and excess profits taxes paid or accrued during the tax year to any foreign country or to any possession of the United States.” U.S. noncitizen residents may also be entitled to a credit for such taxes. There are a number of hurdles that taxpayers are required to overcome in order to claim a foreign tax. One such hurdle is substantiation. Under Treasury Regulation Section 1.905-2(b)(3), a foreign tax credit must be properly substantiated. Treasury Regulation Section 1.905-2(b)(3) warns taxpayers that in the event of an Internal Revenue Service (“IRS”) audit, taxpayers must be prepared to properly substantiate the payment of the foreign tax for which a foreign tax credit is being claimed.

Treasury Regulation Section 1.905-2(a)(2) requires that a taxpayer provide “upon request” the receipt or the tax return that verifies payment of tax if a credit is sought. If a foreign tax return is being utilized to substantiate a foreign tax payment in an audit, the regulations state that the foreign tax return provided to the IRS must either be the original, a duplicate original or a duly certified or authentic copy. The foreign tax return should also be translated to English by a certified translator. If a receipt for the payment of a foreign tax or foreign withholding tax is being provided to the IRS to substantiate the payment of a foreign tax, a certified copy of the proof of the foreign tax should be provided to the IRS in an audit. The Regulations authorize the IRS to accept secondary evidence of foreign tax payments in cases in which the taxpayer has satisfactorily established that it is impossible to produce a receipt for the payment of tax. See Treas. Reg. Section 1.905-2(b).

The Regulations discuss secondary evidence that a taxpayer may provide in an audit to substantiate a foreign tax credit in the event primary forms of evidence are “impossible to furnish.” In cases where primary evidence is impossible to furnish, the IRS may accept a photocopy of a check showing the amount and payment date to substantiate the payment of a foreign tax or foreign withholding tax along with a certification from the foreign tax agency identifying it with the foreign tax claimed to be creditable. See Treas. Reg. Section 1.905-2(b)(1). It should be noted that the IRS has wide discretion in accepting or rejecting secondary forms of evidence, as it must be established that primary forms of evidence are “impossible to furnish” before secondary forms can be considered. In order to avoid the possibility of an IRS disallowance of a deduction of a foreign income tax or foreign withholding tax, a U.S. individual or U.S. business claiming a foreign tax credit should build a detailed record-keeping system to substantiate the foreign income tax or foreign withholding tax paid being claimed as a foreign tax credit. This record keeping should include translated, certified, and authenticated copies of all foreign tax returns and proof of payment records for foreign income tax or foreign withholding tax.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony, based in San Francisco, California, maintains a national and international tax practice, focusing on most areas of federal income tax, state income tax, and federal gift and estate tax law. Anthony is the author of a number of published articles addressing cross-border taxation. Anthony also frequently provides continuing educational programs regarding various international tax topics.

Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.