About Foreign Tax Credit - Tax Professionals Member Article By Rosovich & Associates, Inc.
Posted by Rosovich & Associates, Inc.

About Foreign Tax Credit

About Foreign Tax Credit

What is a foreign tax credit?

A foreign tax credit is a United States tax credit that is used to offset income tax paid abroad. United States citizens and resident aliens who pay income taxes imposed by a foreign country or US possession can apply for the credit. The foreign tax credit can reduce your US tax liability and help you avoid double taxation on the same income.


How the foreign tax credit works

If you paid taxes for a foreign country or possession in the United States and are subject to US income tax on the same income, you can get an itemized deduction or credit for those taxes. For foreign tax credit purposes, US possessions include the US Virgins Islands, the Northern Mariana Islands, Puerto Rico, Guam, and American Samoa.

Considered a deduction (in Table A of 1040 or 1040-SR), foreign income tax reduces US taxable income. On the other hand, the income from abroad directly reduces the taxes you have to pay in the United States if you obtain the credit. If you elect to take the tax credit, you must complete Form 1116 and attach it to your US tax return.

A credit or deduction must be obtained for all allowable foreign taxes. For example, you cannot get credit for some of your foreign taxes and a deduction for others. And, of course, you cannot claim credit and a deduction for the same tax.

Taking the credit generally makes financial sense because the amount comes directly from the tax bill rather than simply reducing taxable income. Either way, the tax exemption reduces the burden of double taxation that would otherwise arise if you were to pay double taxation on the same income, both in the United States and abroad.

Only income taxes, war gains, and excess profits are eligible for the credit. Foreign taxes on dividends, interest, wages, and royalties are also eligible. However, the Internal Revenue specifies that "the tax must be a levy other than the payment of a special economic benefit" and similar to an American income tax.

Also, you can claim a foreign tax credit that is not required by a foreign income tax law, as long as the tax is "in lieu" of income, war gains, or excessive profits taxes. In this case, the tax should be levied instead of and not in addition to any income tax imposed by the country.

Foreign taxes are generally levied in a foreign currency. Use the exchange rate on the date you paid foreign taxes, withheld taxes, or made estimated tax payments.

Other foreign taxes, such as foreign taxes on real estate and personal property, are not eligible for the foreign tax credit. However, you can deduct these other expenses from Schedule A on your tax return, even if you claim the foreign tax credit. You can deduct foreign property taxes unrelated to your business or business, but other taxes must be expenses incurred in a business or trade or to generate income.

Individuals, estates, and funds can use the foreign tax credit to reduce their income tax. In addition, taxpayers can reclaim any unused foreign tax for one year, then forward it for up to 10 years.


Special Considerations

Any taxes paid to a foreign government cannot be claimed as a federal income tax credit in the United States. In general, to qualify for the credit, you must complete four foreign tax tests:

  • The tax must be collected in a foreign country or the United States possession.

  • Must have paid or accrued taxes for a foreign country or US possession.

  • The tax must be the actual and statutory foreign tax you paid or accrued during the year.

  • The tax must be a tax on income rather than an income tax.

There is a limit to the amount of credit you can claim, which you calculate on Form 1116 (cannot be greater than total US tax payable multiplied by a certain fraction). You can claim the lesser foreign taxes you have or the limit you calculate. Generally, you cannot claim the foreign tax credit on Form 1116 unless you qualify for one of these exemptions: 

  • Allowable foreign taxes for the year do not exceed $300 ($600 if you are married filing jointly).

  • You elect this procedure for the fiscal year.

  • Your gross foreign taxes and foreign income are shown on a payee statement (Form 1099-DIV or 1099-INT).

  • Your only foreign source of income for the year is passive income.

If you are eligible for an exemption, claim the tax credit directly on Form 1040.

If you are claiming the foreign income exclusion and/or the foreign property exclusion, you will not be able to claim a foreign tax credit for income taxes that you have excluded (or could have excluded). If so, the IRS may revoke one or both of these options.


Refundable and non-refundable tax credits

Tax credits can be refundable or non-refundable. A refundable tax credit gives rise to a refund if the tax credit is greater than the tax account. Thus, if you apply a tax credit of $4,300 to a tax bill of $3,400, you will receive a refund of $900.

A non-refundable tax credit, on the other hand, does not provide for a refund because it only reduces the tax owing to zero. Following the example above, if the $4,300 tax credit is non-refundable, you owe the government nothing. However, you will lose the remaining $900 after applying for the credit. Most tax credits, including foreign tax credits, are non-refundable.


What is the difference between tax deductions and tax credits?

Tax credits reduce the amount of taxes owed, while tax deductions reduce taxable income. While both save you money, the credit is more valuable because it comes directly from your tax bill. For example, a tax credit of $1,000 reduces the tax bill by the same $1,000. On the contrary, a $1,000 tax deduction reduces taxable income - the amount of income on which you owe taxes by $1,000. So, if you fall into the 22% tax bracket, a $1,000 deduction will deduct $220 from your tax bill.


What is the difference between a foreign tax credit and foreign earned income exclusion?


Two means of avoiding double taxation of income generated while living abroad are the foreign tax credit and foreign earned income exclusion. A key difference is an income to which each applies. The foreign tax credit applies to earned and unearned income, such as dividends and interest. On the other hand, excluding income received abroad only applies to income received.


Who can claim a foreign tax credit?

If you are a US citizen, the United States taxes your income worldwide, regardless of where you live. The United States allows you to receive a credit for foreign taxes paid or owing to avoid double taxation. US citizens and resident aliens who have paid foreign income tax and are subject to the same income tax are eligible for the foreign tax credit. A nonresident alien can claim a credit if they are a bona fide resident of Puerto Rico for the tax year or paid foreign income tax related to a business or enterprise in the United States.

Summary

  • Foreign taxes on income, wages, dividends, interest, and royalties generally qualify for the foreign tax credit.

  • The credit is available to US citizens and residents who have foreign income and have paid foreign income taxes.

  • The foreign tax credit is a US tax exemption that offsets income tax paid in other countries.


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