What Is the Foreign Tax Credit?
The foreign tax credit is a U.S. tax credit used to offset income tax paid abroad. U.S. citizens and resident aliens who pay income taxes imposed by a foreign country or U.S. possession can claim the credit. The credit can reduce your U.S. tax liability and help ensure you aren't taxed twice on the same income.
Key Takeaways
- The foreign tax credit is a U.S. tax break that offsets income tax paid to other countries.
- The credit is available to U.S. citizens and residents who earn income abroad and have paid foreign income taxes.
- Foreign taxes on income, wages, dividends, interest, and royalties generally qualify for the foreign tax credit.
How the Foreign Tax Credit Works
If you paid taxes to a foreign country or U.S. possession and are subject to U.S. tax on the same income, you can take an itemized deduction or a credit for those taxes.
Reported as a deduction on Schedule A of your 1040 or 1040-SR, the foreign income tax reduces your U.S. taxable income. Conversely, the foreign income directly reduces your U.S. tax liability if you take the credit. If you opt for the tax credit, you must complete Form 1116 and attach it to your U.S. tax return.
You must take a credit or a deduction for all qualified foreign taxes. You can't take the credit for some of your foreign taxes and a deduction for others, and you can't claim both a credit and a deduction for the same tax.
Taking the credit usually makes financial sense because the amount reduces your actual tax bill instead of just lowering your taxable income. The tax break reduces the double tax burden that would otherwise arise if you were taxed on the same income twice.
Generally, only income, war profits, and excess profits taxes are eligible for the credit. Foreign taxes on wages, dividends, interest, and royalties also qualify. The IRS specifies that "the tax must be a levy that is not payment for a specific economic benefit," and it must be similar to a U.S. income tax.
You can also claim the credit on foreign taxes that aren't imposed under a foreign income tax law if the tax is "in lieu" of income, war profits, or excess profits tax. In this situation, the tax must be imposed in place of an income tax the country otherwise imposes.
Foreign tax is typically imposed in a foreign currency. Use the exchange rate in effect on the date you paid the foreign tax, the tax was withheld, or you made estimated tax payments.
Other foreign taxes, such as foreign real and personal property taxes, do not qualify for the foreign tax credit, but you may be able to deduct these other taxes on Schedule A of your income tax return even if you also claim the foreign tax credit. You can deduct foreign real property taxes unrelated to your trade or business. However, other taxes must be expenses you incur in a trade or business.
Individuals, estates, and trusts can use the foreign tax credit to reduce their income tax liability. Additionally, taxpayers can carry any unused foreign tax back for one year and then forward up to 10 years.
Do I Qualify for a Foreign Tax Credit?
Not all taxes paid to a foreign government can be claimed as a credit against the U.S. federal income tax. For the foreign tax to qualify for the credit:
- The tax must be imposed on you by a foreign country or U.S. possession.
- You must have paid or accrued the tax to a foreign country or U.S. possession.
- The tax must be the legal and actual foreign tax liability you paid or accrued during the year.
- The tax must be an income tax or a tax instead of an income tax.
There is a limit on the amount of credit you can claim, which you calculate on Form 1116. You can claim the smaller of the foreign tax you paid or your calculated limit unless you qualify for one of these exemptions:
- Your only foreign source income for the tax year is passive.
- Your qualified foreign taxes for the year are less than $300 or $600 if married and filing jointly.
- Your gross foreign income and the foreign taxes are reported to you on a payee statement such as Form 1099-DIV or 1099-INT.
- You elect this procedure for the tax year.
If you qualify for an exemption, claim the tax credit directly on Form 1040.
If you claim the foreign earned income exclusion and/or the foreign housing exclusion, you can't take a foreign tax credit for taxes on the income you excluded (or could have excluded). If you do, the IRS could revoke one or both of your choices.
Refundable vs. Non-refundable Tax Credits
Tax credits can be either refundable or non-refundable. A refundable tax credit is a refund if the tax credit is more than your tax bill. If you apply a $3,400 tax credit to a $3,000 tax bill, you will receive a $400 refund.
A non-refundable tax credit won't provide a refund because it only reduces the tax owed to zero. If the $3,400 tax credit was non-refundable, you would owe nothing to the government. However, you would also forfeit the $400 that remained after the credit was applied. Most tax credits, including the foreign tax credit, are non-refundable.
What Is the Difference Between Tax Credits and Tax Deductions?
Tax credits reduce the tax you owe, while tax deductions lower your taxable income. While both save you money, credits are more valuable because they reduce your tax bill. A $1,000 tax credit reduces your tax bill by $1,000. Conversely, a $1,000 tax deduction lowers your taxable income. If you're in the 22% tax bracket, a $1,000 deduction saves $220 on your tax bill.
How Do the Foreign Tax Credit and Foreign Earned Income Exclusion Differ?
Two ways to avoid double taxation on the income you earn while living abroad are the foreign tax credit and the foreign earned income exclusion. A key difference is the income to which each applies. The foreign tax credit applies to earned and unearned income, such as dividends and interest. Conversely, the foreign earned income exclusion applies only to earned income.
Who Can Claim the Foreign Tax Credit?
If you are a U.S. citizen, the U.S. taxes your worldwide income, no matter where you live. To avoid double taxation, the U.S. lets you tax credit for foreign taxes you pay or accrue. U.S. citizens and resident aliens who paid foreign income tax and are subject to U.S. tax on that same income can take the foreign tax credit. A nonresident alien can take the credit if they were a bona fide resident of Puerto Rico for the entire tax year or paid foreign income taxes connected to a trade or business in the U.S.
The Bottom Line
The foreign tax credit is a U.S. tax break that offsets income tax paid to other countries. To qualify, the tax must be imposed on you by a foreign country or U.S. possession and you must have paid the tax. Taxes on income, wages, dividends, interest, and royalties generally qualify for the foreign tax credit.
As an expert in taxation and international finance, I can provide a comprehensive understanding of the concepts outlined in the article about the Foreign Tax Credit. My expertise stems from years of practical experience, extensive research, and a deep understanding of the intricacies of global taxation systems. Let's delve into the key concepts presented in the article:
Foreign Tax Credit Overview:
The Foreign Tax Credit (FTC) is a valuable U.S. tax benefit designed to offset income tax paid to foreign countries. This credit is available to U.S. citizens and resident aliens who earn income abroad and have paid foreign income taxes.
Qualified Foreign Taxes:
Various types of taxes qualify for the FTC, including those on income, wages, dividends, interest, and royalties. It's important to note that only specific taxes, such as income, war profits, and excess profits taxes, are eligible for the credit.
How the FTC Works:
When individuals are subject to both foreign and U.S. taxes on the same income, they can choose between an itemized deduction and a credit for the foreign taxes paid. Opting for the credit, as opposed to a deduction, is generally more advantageous as it directly reduces U.S. tax liability rather than just lowering taxable income.
Claiming the FTC:
To claim the FTC, individuals must complete Form 1116 and attach it to their U.S. tax return. It's crucial to take either a credit or a deduction for all qualified foreign taxes, and a mix of both is not allowed.
Limitations and Exemptions:
There are limits on the amount of credit that can be claimed, calculated on Form 1116. Exemptions exist for individuals with passive foreign source income, those with qualified foreign taxes under a certain threshold, and those with income reported on specific payee statements.
Refundable vs. Non-refundable Tax Credits:
The FTC is a non-refundable tax credit, meaning it reduces the tax owed to zero but doesn't provide a refund if the credit exceeds the tax liability.
Qualification for the FTC:
To qualify for the FTC, certain conditions must be met, including that the tax must be imposed by a foreign country or U.S. possession, and it must be the legal and actual foreign tax liability paid during the year.
Foreign Earned Income Exclusion (FEIE):
The article highlights the difference between the FTC and the Foreign Earned Income Exclusion (FEIE). While the FTC applies to both earned and unearned income, the FEIE applies only to earned income.
Applicability to Different Taxpayers:
The FTC is available to U.S. citizens, resident aliens, and nonresident aliens meeting specific criteria, such as being a bona fide resident of Puerto Rico for the entire tax year or paying foreign income taxes related to a trade or business in the U.S.
Bottom Line:
In conclusion, the Foreign Tax Credit is a vital tool for individuals navigating the complexities of international taxation. It serves to prevent double taxation, reduce U.S. tax liability, and ensure fairness in the treatment of income earned abroad. Understanding the nuances of this credit is essential for individuals with international financial activities.
