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 fiscalsovereignty or powers at the domestic or
international level. A commonexample is the imposition of an income tax at both the federal and
statelevel. This particular instance of double taxation of the same income ismitigated by the
availability of an itemized deduction on the federaltax return (Form 1040; Schedule A) for state and
local income taxespaid.
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 paidis narrowed but not closed by
the individual states' use ofdeductions, credits, and exemptions. [Of course, in the seven states
inwhich there is no state income tax, the issue is moot.] These aresummarized 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-o-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 Wayne Lippman 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.
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