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A foreign tax credit is used to reduce or eliminate double taxation. Because the tax laws from differing countries may overlap, or conflict with one another, situations can arise where the same income is subject to tax in multiple countries at the same time. In order to eliminate double taxation, a tax treaty determines which of the countries has the primary entitlement to tax that income. The amount of tax normally payable to each country is calculated without regard to the fact that another country may also be taxing it. Then, after the tax has been paid to the primary country, the secondary country will allow the earner to take a credit for the amount of tax paid to the primary country, against the tax owed to the secondary country, but only up to the amount of tax paid to the primary country or the amount of tax due to the secondary country, whichever is less. If the tax paid to the primary country is equal to or more than the tax imposed by the secondary country, then the tax payable to the secondary country is eliminated. If the tax paid to the primary country is less than the tax imposed by the secondary country, then the secondary country will receive the difference between the two taxes. The credit is considered non-refundable in that if the tax paid to the primary country exceeds the tax due to the secondary country, the earner is only allowed to claim a credit in the secondary country up to the amount of tax that would be paid there. Although the foreign tax credit will eliminate double taxation, it also ensures that the earner ultimately pays the higher amount of tax imposed.

For example: If a person lives in Country A, but has income sourced in Country B, he may find that both countries want to tax that income. Country A wants to tax the income because they tax the income of their residents. Country B wants to tax the income because they tax any income generated within their borders. To eliminate double taxation, the two countries have established a tax treaty saying that the country where the income is generated has the primary claim on the tax, in this case Country B. The earner would calculate and then pay tax to Country B. Next, he would calculate the amount of tax normally payable to Country A, but then reduce that tax by using the foreign tax credit to subtract the amount of tax already paid to Country B. Country A would only receive any tax if the amount paid to Country B was lower than the Country A tax, and the tax payable would be the difference between the two amounts. If the Country B tax was higher than the Country A tax, then there would be no tax paid to Country A.