Relief from double taxation: The treatment of foreign tax paid for individuals at the state level.

Double taxation occurs when there is an overlap of fiscal sovereignty or powers at the domestic or international level. A common example is the imposition of an income tax at both the federal and state level. This particular instance of double taxation of the same income is mitigated by the availability of an itemized deduction on the federal tax return (Form 1040; Schedule A) for state and local income taxes paid.

Another example of double taxation is when the same items of income for the same taxable person for the same taxable period are taxed by two countries--typically the taxpayer's country of residence and the country in which the income is sourced (i.e., "earned"). Bilateral tax treaties often provide solutions to the problem of international double taxation. However, when no treaty provision is applicable, U.S. taxpayers can still gain some relief from double taxation at the federal level by using some combination of the deduction available under IRC Section 164(a)(3), the IRC Section 911 foreign earned income exemption (up to $80,000 for years after 2001), and/or the foreign tax credit (FTC; IRC Sections 901 and 906).

Double taxation exists at the state level as well. Frequently, a taxpayer will be subject to tax on certain items of income in both his/her state of residence as well as in the state in which the income was earned. As is the case on the federal level, bilateral treaties often provide the necessary relief. For example, under a reciprocal agreement between Pennsylvania and New Jersey, a Pennsylvania resident employed in New Jersey will not be subject to New Jersey income tax. Instead, the taxpayer's New Jersey employer will withhold the appropriate Pennsylvania income tax and emit the tax to the Pennsylvania Department of Revenue. When no treaty exists between the resident and source states, the most common way to deal with he situation is for the resident state to provide a credit for the taxes paid to another state. This credit is most commonly limited to taxes that were paid to me of the other United States or to U.S. Possessions, not to taxes paid to foreign countries. (1)

The gap between the federal and state treatment of foreign tax paid is narrowed but not closed by the individual states' use of deductions, credits, and exemptions. [Of course, in the seven states in which there is no state income tax, the issue is moot.] These are summarized in the accompanying exhibit.

Deductions for Foreign Taxes Paid

The relief most frequently available is an itemized deduction for foreign taxes paid on the taxpayer's State Income Tax Return. Twenty-nine states (and the District of Columbia) provide this option, with eleven states giving the taxpayer the choice of taking a deduction or a credit for these foreign taxes. It should be noted that most of these states use the taxpayer's federal itemized deductions as a starting point in determining the itemized deductions they allow on the taxpayer's state return. One of the common adjustments made to itemized deductions reported on the federal Schedule A in arriving at the deductions available on the State Income Tax Return is to subtract the State and Local Income Taxes Paid. This is to prevent the double counting of these taxes as both a deduction in arriving at the State Taxable Income and a credit against the State Income Tax.

However, since foreign taxes do not usually fall under the definition of "State and Local Taxes," no adjustment is necessary for these taxes. That being said, two states (CT, IL) do specifically require foreign taxes paid to be added back with state and local taxes in the computation of State Taxable Income, effectively negating a deduction for these items. On the other hand, five states (CO, MI, NC, ND, VT) that begin their calculation of State Taxable Income with the amount reported on the taxpayer's federal return as Federal Taxable Income, without requiring any upward adjustments for foreign taxes paid, are implicitly allowing the taxpayer a deduction for these taxes.

Credit for Foreign Taxes Paid

Sixteen states provide relief from the double taxation in the form of a credit for the foreign taxes paid, either as a sole remedy (five states) or as an alternative to a deduction (11 states). However, five states (MA, MI, MN, NY, VT) restrict the credit to taxes paid to Canada or Canadian provinces. Four states (KN, MA, MI, VT) limit the credit to the foreign taxes that were actually paid in excess of the Foreign Tax Credit allowed on the taxpayer's federal return. Indiana's credit is only available for foreign taxes paid on capital gains, interest, and dividend income.

Exemptions of Foreign Income

Iowa and Virginia are the only states that explicitly exempt foreign earned income from state income taxation. Two other states (OK, SC) specifically exempt income from out-of-state businesses and real or tangible property, but not out-of-state wage income. In addition to these specifically mentioned exemptions, any state which begins its calculations with either Federal Adjusted Gross Income (31 states) or Federal Taxable Income (5 states) from which "adjustments" are made in order to arrive at State Taxable Income implicitly recognizes the Foreign Earned Income Exclusion available under IRC Section 911. [Note: although California and Hawaii begin their calculation of the taxpayer's State Taxable Income with the Adjusted Gross Income (AGI) reported on the federal income tax return, both explicitly "adjust" (i.e., add) the Section 911 exclusion to arrive at State Taxable Income.] v Foreign Income Taxes: Treatment at State Level

Federal AGI as State Deduction Credit Exemption No Relief Starting Point AL X AK (1) AR X AZ X X X X CA X X CO X X CT X X DE X X X FL (1) GA X X X HI X X X ID X X X IL X X IN X X X IA X X X KS X X X X KY X X X LA X X X ME X X X X MD X X X MA X X MN X X X X MS X MO X X X MT X X X X NE X X X NV (1) NH (1) X NJ X NM X X X NY X X X NC X X X ND X X OH X X OK X X X OR X X X PA X RI X X X X SC X X SD (1) TN (1) X X TX (1) UT X X X VT X X X X VA X X X X WA (1) WV X X WI X X WY (1) DC X X X State AL AK (1) AR AZ CA Foreign Earned Income Exemption

added back CO Starts with Federal Taxable

Income CT DE FL (1) GA HI Foreign Earned Income Exemption

added back ID IL IN Credit for taxes paid on Capital

Gains, Int., and Div. income

only IA KS Credit is limited to excess of

foreign taxes paid over allowed

Federal Foreign Tax Credit KY LA Deduction subject to limitation-50%

of excess of Federal Standard

Deduction ME Credit for taxes paid to Foreign

Foreign jurisdiction that is analogous

to a "state" MD MA Credit limited to excess

Canadian provincial taxes over allowed

Federal Foreign Tax Credit MN Starts with Federal Taxable Income;

credit limited to Canadian provincial

taxes MS MO MT NE NV (1) NH (1) No relief from foreign tax on Int.

and Div. income NJ NM NY Credit limited to Canadian

provincial taxes NC Starts with Federal Taxable

Income ND Starts with Federal Taxable

Income OH Exclusion of income from

out-of-state business or

property OK OR PA RI SC Exclusion of non-wage,

out-of-state income SD (1) No relief from foreign

tax on Int. and Div. income TN (1) TX (1) UT VT Starts with Federal Taxable

Income; credit limited to

excess Canadian provincial

taxes over allowed Federal

Foreign Tax Credit VA Specific exclusion of foreign

source income included in

Federal AGI WA (1) WV WI WY (1) DC (1)No State Income Tax.

Endnotes

(1.) Typical of the limitation of credit for taxes paid to other States is included in the instruction to Illinois' Schedule CR: "For purposes of this schedule, 'state' means any state of the United States, the District of Columbia, the Commonwealth of Puerto Rico, any territory or possession of the United States, or political subdivision of any of these (e.g., county, city). The term 'state' does not refer to any foreign country.

W Richard Sherman, JD, LLM, CPA, is Associate Professor of Accounting at Saint Joseph's University in Philadelphia, PA. Thomas M. Brinker, Jr., JD, MS, CPA, is Associate Professor of Accounting at Arcadia University in Glenside, PA.