Optimality of the Foreign Tax Credit System: Separate vs. Overall Limitations

Foreign tax credit systems limit the extent to which foreign tax credits can be used to offset tax liability in the taxpayer’s home country. We examine how two methods of limiting foreign tax credits, separate limitations based on type or source of income or an overall limitation aggregating across all foreign income, affect the optimal allocation of capital. We show that when investment opportunities exist in both low-tax and high-tax countries, a separate limitation method will always result in an inefficient allocation of capital. In some circumstances, an overall limitation can result in the optimal allocation of capital. In other cases, both limitation methods will result in an inefficient allocation of capital. In these cases either limitation method can be relatively more efficient. Simulations show that the potential differences in economic welfare under the alternative limitation methods can be significant. We consider the limitation methods in multiple settings, including the presence of pre-existing foreign income and allocation rules, such as interest allocation.