Foreign Tax Credit: What Is It?
The foreign tax credit is a U.S. tax credit used to offset income tax paid abroad. The credit is available to American citizens and resident aliens who pay income taxes levied by another nation or an American territory. The credit can lower your tax obligation in the United States and prevent you from paying taxes on the same income twice.
Key Aspects
- A tax break offered by the United States that reduces income tax paid to other nations is the foreign tax credit.
- Citizens and residents of the United States who have paid foreign income taxes and earn money overseas are eligible for the credit.
- The foreign tax credit is normally available for foreign taxes paid on income, wages, dividends, interest, and royalties.
How Does The Foreign Tax Credit Work?
You can claim an itemized deduction or credit for taxes you paid to a foreign country or an American possession if you are also liable for tax in the United States on the same income. American Samoa, Guam, the Northern Mariana Islands, Puerto Rico, and the U.S. Virgin Islands are considered U.S. possessions for the purposes of the foreign tax credit.
The foreign income tax is deducted from your taxable income in the United States (on Schedule A of your 1040 or 1040-SR). If you claim the credit, on the other hand, the foreign income directly lowers your U.S. tax obligation. Form 1116 must be filled out and attached to your U.S. tax return if you choose to claim the tax credit.
For all qualifying foreign taxes, you must claim a deduction or a credit. You cannot, for instance, claim a deduction for part of your overseas taxes and a credit for others. Of course, you cannot deduct the same tax and also claim a credit.
Since the credit directly reduces your tax liability rather than just lowering your taxable income, taking it usually makes financial sense. In either case, the tax cut lessens the double tax burden that would otherwise develop if you were taxed twice—in the United States and abroad—on the same income.
In general, the credit is only available for taxes on income, war earnings, and excess profits. Furthermore admissible are foreign taxes on royalties, interest, dividends, and wages. The tax, however, must be equivalent to a U.S. income tax in character and “the tax must be a levy that is not payment for a specific economic benefit,” according to the IRS.
If a foreign tax is levied “in lieu” of an income, war profits, or excess profits tax and is not imposed pursuant to a foreign income tax statute, you may also be eligible to claim the credit. In this case, the tax must be levied in place of the nation’s existing income tax, not in addition to it.
Foreign tax is typically imposed in a foreign currency. Use the exchange rate that prevailed on the day that you made your estimated tax payments, paid your international tax, or had tax withheld from your paycheck.
The foreign tax credit is not applicable to other foreign taxes, such as foreign real estate and personal property taxes. Even if you also claim the foreign tax credit, you might still be allowed to deduct these additional taxes on Schedule A of your income tax return. Foreign real estate taxes that have no connection to your trade or industry can be written off. The costs of other taxes, however, must be incurred in a trade or business or in order to generate money.
The foreign tax credit can be used by individuals, estates, and trusts to lower their income tax obligations. Taxpayers may also carry any unused international tax credits back for a period of one year and then forward for a maximum of ten years.
Factors To Consider
Not all taxes paid to foreign governments may be deducted from federal income taxes in the United States. Generally, in order to be eligible for the credit for the foreign tax, you must pass four requirements:
- The tax must be levied on you by a foreign nation or an American possession.
- The tax must have been accrued or paid to a foreign nation or an American possession.
- The tax must be the legitimate and actual foreign tax liability that you owed for the year and either paid or incurred.
- The tax must be an income tax or a tax in lieu of an income tax.
The maximum credit you can receive is calculated on Form 1116 and cannot exceed your entire U.S. tax burden multiplied by a particular percentage. The amount you can deduct is the lesser of your determined limit or the foreign tax you paid. Unless you are eligible for one of the following exclusions, you must generally claim the foreign tax credit on Form 1116:
- For the tax year, passive income is the sole foreign source of your income.
- You have no more than $300 ($600 if married filing jointly) in eligible foreign taxes for the year.
- On a payee statement, your gross foreign income and foreign taxes are reported to you (e.g., Form 1099-DIV or 1099-INT).
- For the tax year, you choose this process.
Use Form 1040 to claim the tax credit immediately if you are eligible for an exemption.
You cannot claim a foreign tax credit for taxes on the income you excluded if you use the foreign earned income exclusion or the foreign housing exclusion (or could have excluded). If you do, either one or both of your decisions could be revoked by the IRS.
Refundable Versus Non-refundable Tax Credits
Tax credits come in refundable and non-refundable varieties. A refundable tax credit results in a refund if the tax credit is more than your tax bill. Hence, you will get a $400 refund if you apply a $3,400 tax credit to a $3,000 tax bill.
A non-refundable tax credit, on the other hand, just lowers the tax due to zero and won’t result in a refund. Using the previous example, you would not owe any money to the government if the $3,400 tax credit was non-refundable. The $400 that remained after the credit was applied would be forfeited as well. The foreign tax credit is non-refundable, as are the majority of tax credits.
Tax Credits and Tax Deductions: What Is the Difference Between Them?
While tax deductions lessen your taxable income, tax credits reduce the amount of tax you owe. While both help you save money, credits are more beneficial because they are deducted directly from your tax statement. For instance, a $1,000 tax credit results in a $1,000 reduction in your tax obligation. On the other hand, a $1,000 tax deduction results in a $1,000 reduction in your taxable income—the amount of income that is subject to taxation. Hence, if your tax rate is 22%, a $1,000 deduction would result in a $220 tax savings.
Foreign Tax Credit and Foreign Earned Income Exclusion: How Do They Differ?
The foreign tax credit and the foreign earned income exclusion are two strategies to prevent paying taxes twice on income earned while residing abroad. The gap in income for each is a significant factor. Dividends and interest are examples of unearned income that is eligible for the foreign tax credit. On the other hand, the exclusion for overseas earned income solely covers earned income.
Who Is Eligible To Claim The Foreign Tax Credit?
No matter where you live, the United States taxes your worldwide income if you are a citizen. The U.S. allows you to claim a tax credit for foreign taxes you pay or accumulate in order to avoid double taxation. The foreign tax credit is available to both U.S. citizens and resident aliens who paid foreign income tax and are subject to U.S. tax on the same income. If a nonresident alien paid foreign income taxes related to a trade or business in the United States or was a legitimate resident of Puerto Rico for the whole tax year, they are eligible to claim the credit.
