Foreign Tax Credit

What is foreign tax credit?

Whether you have received earned income, interest, dividends, and rental income from foreign sources, you may have to pay income taxes to foreign countries. If you are a U.S. citizen or resident, you are generally subject to U.S. income tax on your worldwide earnings.  The foreign tax credit is intended to keep you from being taxed on the same income by both the U.S. and the foreign country. Unlike foreign earned income exclusion, it does not require that you spend a certain minimum time abroad. It is available to any U.S. taxpayer and applies to any taxes on both earned income and investment income as well.

Itemized deduction or tax credit?

For each year you have foreign taxes you can choose whether to claim the itemized deduction or the foreign tax credit. You can change your choice from one year to another. But generally, you must claim either the deduction or the credit for all your foreign taxes in a given year – you cannot claim a deduction for part of them and a credit for the rest.
If you choose to take a deduction, it’s a simple enough matter. You can claim these foreign taxes as an itemized deduction on line 8 of Schedule A, along with other taxes you paid, such as real estate taxes and state and local income taxes. If you use the standard deduction, you can’t claim this deduction. Even if you use the itemized deductions, you can only reduce your taxable income. If you are hit by alternative minimum tax (AMT), the itemized deduction will be added back for the AMT purpose.
You can usually do better if you claim the foreign tax credit. A tax credit reduces your actual tax liability dollar-for-dollar, while a deduction only reduces your taxable income. Unfortunately, the foreign tax credit has limitations and requires you to fill out Form 1116. In addition, some foreign taxes do not count toward the credit. In this case, you may have to take the deduction. When you are not sure which one is better, you should calculate your tax liability using both methods and go with the one which results in a lower tax liability.
You can make or change your choice to claim a deduction or credit at any time during the period within 10 years ( rather than the normal 3 years for most amended returns)  from the regular due date for filing the return for the tax year for which you make the claim.  You make or change your choice on your amended tax returns.

Who are eligible to claim the foreign tax credit?

Only US citizens, U.S. residents or bona fide residents of Puerto Rico can claim the foreign tax credit:

  • Individual taxpayer who have earned income in a foreign country and have paid tax on that income to the foreign country but have not claimed the foreign earned income exclusion on the same income.
  • Mutual fund shareholders can claim a credit for the foreign tax that the fund allocates to its shareholders, as reported on Form 1099-DIV.
  • Members of a partnership, or shareholders in an S corporation can claim the credit for their proportionate share of foreign income taxes paid or accrued by the partnership or S corporation and passed along to them. These amounts should be reported on Schedule K-1.
  • A beneficiary of a trust or estate can claim the credit based on a proportionate share of the foreign tax on the trust or estate.

What Foreign Taxes Qualify for the Credit?

A taxpayer is allowed a credit against U.S. income and alternative minimum tax liability for income taxes imposed by, and paid or accrued to, any foreign country or U.S. possession. Foreign income taxes, for this purpose, are taxes enforced by the other jurisdiction on concepts similar to a net income concept like we have in our US tax system. They include war profits and excess profits taxes, and taxes in lieu of income taxes to local and provincial governments. But they do not include sales, value-added, real estate or luxury taxes paid to a foreign government.

Only certain taxes qualify for the foreign tax credit. The IRS lists four qualifications for a tax to qualify for a credit:

  • The tax must be imposed on you.
  • You must have paid or accrued the tax to a foreign country.
  • The tax must be the legal and actual foreign tax liability.
  • The tax must be an income tax (or a tax in lieu of an income tax).

Certain foreign taxes do not qualify for a tax credit, but do qualify for a deduction. They include:

  • Taxes on excluded income
  • Taxes you paid to foreign countries for oil-related income;
  • Taxes paid for mineral-related income;
  • Taxes resulting from an international boycott;
  • Taxes on natural-gas-related income;
  • Foreign tax paid to some governments (Syria, Sudan, North Korea, Iran or Cuba).

Those foreign taxes can still be claimed as deductions. Only in this instance would you be able to claim a foreign tax credit and take a deduction. This is an exception to the rule stated earlier about having to claim all of your foreign income tax as either a credit or a deduction.

 

How much foreign taxes have you paid?

You can claim a credit only for the actual amount of foreign income tax you paid or accrued during the year. You cannot take a credit or deduction for income taxes you paid to a foreign country if it is reasonable certain that those taxes would be refunded, credited, rebated, or forgiven if you made a claim. The easiest way to find out tax you paid is to have copies of the tax stamps that the local ministry of finance or local department of revenue provides. Cancelled checks are another good one, and then also the actual local tax returns reflecting the amount for which you have the stamped documents or the cancelled checks to support.

If you had income in a foreign country, for example from investments in stocks on a foreign stock exchange, mutual funds, or partnership interests, you may have paid or been charged for foreign income tax. The foreign income tax is normally withheld in the source country from payments and distributions. A mutual fund that invests overseas, for example, may incur foreign taxes on interest or dividends. If the fund meets certain requirements, it can pass the foreign tax along to its shareholders. The foreign tax that was paid on these dividends or distributions is reported in box 6 of Form 1099-DIV – Dividends and Distributions, that you receive from your investment fund manager, or on Form 1099-INT in the case of interest income.

Exception election not to report on Form 1116

To claim a credit for foreign taxes, you would generally have to file Form 1116. But if you meet certain requirements, you may be able to avoid filing this form and report the credit directly on Form 1040. These requirements are:

  • Your only gross taxable income from foreign sources is passive income, such as investment income, including interest, dividends, annuities, rents, and royalties.
  • Your foreign income is reported on a payee statement, such as a 1099-DIV, or 1099-INT.
  • Your total foreign taxes are $300 or less, if you are single, and $600 or less, if you are married filing jointly.

If you meet these requirements, you can choose to claim the credit directly on line 44 of Form 1040 without filing Form 1116. The limitations to the foreign tax credit do not apply when this election is made. However, the foreign tax credit is still nonrefundable and is limited to the total amount of U.S. income tax liability. If it is limited in this way, there is no longer the option to carryover any unused credit. And you will not be able to carry back or carry forward any foreign tax credit that you cannot use in the current year. You would have to file Form 1040, and not 1040A or 1040EZ.

How do you figure the foreign tax credit?

If you do not meet the above requirement for the exception, your foreign tax credit is limited and you must file Form 1116.

Form 1116 first asks you to classify your foreign income into different categories. You must figure the allowable amount by various categories of income: passive income and general income:

  • Passive income category includes interest, dividend, rents royalty and annuity income.
  • General category includes wages, salary and any highly taxed passive income and other not included in any other categories.

You must complete a separate form for each type of income you have. For a taxpayer who has one type of foreign income that comes from several foreign countries, you would use one Form 1116. Up to three countries may be added to one Form 1116. If the income has been passed through a “Registered Investment Corporation” like Vanguard, you can treat the source country with “various” or “RIC” in Part I. If you have more than one category, you must calculate the limitation separately for each category of income on which foreign tax was paid. For example, if you paid foreign taxes on foreign dividend income (passive category) and on wages from a foreign source (general category). You would first calculate the ratio of foreign taxable passive category income to total taxable income. Then, you would multiply his U.S. income tax by this ratio in order to come up with the maximum foreign tax credit allowed in the passive income category. You would then separately run the same calculation on the general category income to find out how much of the foreign taxes he paid on his foreign wages would be allowed as a credit. Any unused credit is available for carryover. You also need to figure your carrybacks or carryforwards separately for each limit income category.

Your foreign tax credit is limited to the smaller of the actual foreign tax you paid, or the equivalent U.S. income tax that would apply on the foreign income at your effective U.S. tax rate in each category. These limitations generally mean that a taxpayer needs to determine the ratio of their foreign taxable income compared to their overall taxable income in the category. To figure your taxable income in each category from foreign sources. you must first classify gross income and then allocate the definitely related expenses, deductions and losses to specific glasses of gross income based on proper methods regulated by the IRS. You must apportion to your foreign income in each separate limit category a fraction of other deductions that are not definitely related to a specific class of gross income. This is completed in part I on Form 1116.

You cannot take a credit for foreign taxes paid or accrued on certain income that is excluded from U.S. gross income. You must reduce your foreign taxes available for the credit by the amount of those taxes paid or accrued on income that is excluded from U.S. income under the foreign earned income exclusion or the foreign housing exclusion. If your wages are completely excluded, you cannot take a credit for any of the foreign taxes paid or accrued on these wages. If only part of your wages is excluded, you cannot take a credit for the foreign income taxes allocable to the excluded part. The amount goes into line 12, reduction in foreign taxes, on form 1116, .

If you have foreign source qualified dividends or foreign source capital gains (including any foreign source capital gain distributions) or losses, you may be required to make certain adjustments to
those amounts before taking them into account on line 1a (gross income) or line 5 (losses from foreign source) and line 17 (taxable income before exemptions) as well.

How do you deal with the unused credit?

If your US tax liability were the same or higher than the foreign tax paid, you would be eligible to claim the full credit. In other words, you avoid double-taxation but always end up paying tax at the highest tax rate. If you paid more foreign tax during the current year than you can claim as a credit, For example, if you pay $650 in foreign tax but only owe $550 in US tax on the same amount, you would have $100 in unused foreign tax that you can carry back the excess for one year (you need to file an amended return for the previous tax year) or forward the excess for 10 more years. However, the ability to carry back or carry forward any unused tax credit only applies if you file Form 1116, and is restricted by the amount of excess limit available in those carry-back or carry-forward years. The unused credit carries over to the same “basket” of income to the carryover year and you need to have excess to use in those tax years for the same category. During the calculation of the foreign tax credit carryovers used in the tax year, taxes paid in the current tax year are used first. Foreign tax credit carryovers are only used after using all allowable current taxes paid. Then, carryovers are used in the order they were generated. Should the sum of the carryovers in any one category exceed the allowable credit for that category, that year’s remaining credit will automatically forward with the correct remaining balance available.

For example, you have worked abroad for 8 year in a country with heavy taxation. If you claimed the foreign tax credit, you may have built up a massive foreign tax credit as it has carried forward. When you return to the US, you file form 1116 in the year of return. If you don’t use it, the foreign tax credit will expire after being carried over 10 years. The only way to use up the “FTC” is to take another overseas job in a lower tax country than the US until you recoup your FTC carryover.

Foreign Tax credit and AMT

If you’re subject to the AMT, the alternative minimum tax foreign tax credit, AMTFTC, may be claimed for tentative minimum tax. The AMT foreign tax credit is similar to the foreign tax credit for regular income tax purposes, except that AMTFTC is used to reduce your tentative AMT tax. If you made an election to claim the foreign tax credit on Form 1040, without filing Form 1116 for regular tax purpose, your AMTFTC is the same as the foreign tax credit on Form 1040, line 47. Enter that amount on Form 6251, line 33. Since there is no foreign tax credit limitation and you cannot claim a carryover or carryback to that tax year.

If you paid more than $300 ($600 if married) in foreign tax, your foreign tax credit may be limited and you must re-calculate your AMTFTC using an AMT version of form 1116 using AMT adjusted amount in the computation. The limitation is calculated by comparing foreign AMT taxable income to total AMT taxable income. You probably want to use the simplified method. The simplified foreign tax limitation is an election to figure the AMT foreign tax credit limitation based on the ratio of foreign-source regular taxable income to AMTI. The election must be made in the first year that AMT foreign tax credit is claimed and applies to all future years. the IRS consent is required to revoke. If you did not elect to use the simplified method, you need to recalculate Foreign Tax Credit using AMT rules. Then use the AMTFTC to offset tentative AMT in Part II, Form 6251. Any unused AMT Foreign Tax Credit may be carried back one year and carried forward ten years, according to the similar carryover rule for the regular tax purpose. Even if no AMT is due, you will still need to calculate the AMT foreign tax credit for carryback and carryover purposes.

Seems complicated? Indeed, It is. It turns out the elections related to foreign income taxes are very complex for many taxpayers. When you are making your tax planning, you need to figure out how much other income you will be receiving, as well as any deductions you could take. You’ll then be in a position to know how much taxable income you have, and which tax rates will apply. You also need to predict how much tax you will be likely to pay for the next several years.
Our services at DU JH & Associates include preparing tax returns that can take foreign earned income exclusion, foreign housing exclusion or deduction, as well as foreign tax credit or deduction. We keep up our knowledge on tax law so that we can look for tax planning alternatives on time. Our main objective is to help taxpayers looking to self prepare, providing specific tips and avoiding pitfalls.

One Comment

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