US taxpayers who have received an earned income, interest, dividends, or rental income from a source outside of the United States may be obligated to pay income tax to the foreign country where the income originated from. US citizens and residents are subject to be taxed on their worldwide earnings. The foreign tax credit works towards ensuring that the taxpayer is not being taxed on the same income by the United States and the foreign country. This differs from the foreign earned income exclusion (FEIE) in that an American expat does not need to prove a certain amount of time spent living and working abroad. All US taxpayers are eligible if they have foreign earned income or investment income from a foreign source.
What is Foreign Tax Credit?
Itemized Deduction or Tax Credit?
For every year a taxpayer has foreign taxes to consider, s/he can choose whether to claim the itemized deduction or the foreign tax credit. Changing how they are claimed is allowed from year to year, but either one or the other must be chosen. A taxpayer is typically not permitted to claim a deduction for one portion and a tax credit for the rest.
The deduction is fairly simple to process. Foreign taxes are listed as an itemized deduction on line 8 of Schedule A, along with other taxes paid. These include real estate, local and state taxes. Taxpayers who use the standard deduction cannot claim this deduction. Even when itemized deductions are used, only the taxable income will be reduced. If the individual is subject to alternative minimum tax (AMT), then that itemized deduction will added back for the purpose of the AMT.
Most taxpayers will get more benefit by claiming the foreign tax credit. This reduces the tax liability dollar for dollar as opposed to reducing taxable income. There are limitations to consider and it requires that Form 1116 be filled out. Plus, there may be some foreign taxes that do not count towards the credit. If this is the case, the taxpayer will be advised to take the deduction. If unsure, the tax liability can be calculated using both methods to determine which one gives the better result.
Changes may be made for up to ten years after filing, as opposed to the normal three year time limit for amended returns. This should be done by the regular due date for filing an expat tax return for the tax year in which the amendment is requested. It is the responsibility of the taxpayer to make or change the choice on amended tax returns.
Who is Eligible to Claim the Foreign Tax Credit?
US citizens, US residents and bona fide residents of Puerto Rico can claim the foreign tax credit. Any one of the following circumstances must exist in order for the taxpayer to be in compliance with current tax laws:
- Be an individual taxpayer who has earned income in a foreign country and has paid taxes on said income to the foreign country from where it originated, but not Foreign Earned Income Exclusion on the same income.
- A mutual fund shareholder is permitted to claim a credit for the foreign tax that the fund allocates to shareholders. This will be reported on Form 1099-DIV.
- A member of a partnership or shareholder in an S corporation is allowed to claim the foreign tax credit in proportion to their share of the foreign income taxes paid or accrued by the partnership or S corporation and passed onto them. These amounts will be reported on Schedule K-1.
- Beneficiaries of a trust or estate from a foreign country can claim the credit based only on the portion of the foreign tax they paid as their proportionate share.
What Foreign Taxes Qualify for the Credit?
Taxpayers are permitted a credit against their US income and alternative minimum tax liability for income taxes imposed by and paid or accrued to any foreign country or US possession. For this purpose, foreign income taxes are those that are enforced by another tax jurisdiction on concepts similar to the net income tax concept of the US tax system. This includes war profits and excess profits taxes along with taxes in lieu of income taxes to local and provincial governments. This does not include sales, value-added, real estate or luxury taxes paid to a foreign government.
There are only certain taxes that can qualify for the foreign tax credit. There are four qualifications listed by the IRS that must be met in order to take advantage of the foreign tax credit:
- The tax must have been imposed on the individual claiming the tax credit.
- The tax must have been paid or accrued to the foreign country.
- The tax must be the legal and actual foreign tax liability.
- The tax must be an earned income tax or a tax imposed in lieu of an income tax.
There are some foreign taxes that will not qualify for a tax credit, but will qualify for the deduction. These include:
- Taxes on excluded income.
- Taxes paid by a taxpayer to a foreign country for oil related income.
- Taxes paid by a taxpayer to a foreign country for mineral related income.
- Taxes resulting from an international boycott.
- Taxes paid by a taxpayer for natural gas related income.
- Foreign taxes paid to certain governments, including Syria, Sudan, North Korea, Iran, and Cuba.
An individual taxpayer may only claim those taxes as deductions. These foreign taxes comprise the exception to the above mentioned rule of not being able to claim the credit and have a foreign income deduction in the same tax year. If subjected to one of them the taxpayer has no choice but to claim it as a deduction, but may use the foreign tax credit for other income earned in a foreign country during the same tax period.
How Much Foreign Taxes Have You Paid?
A taxpayer can claim a foreign tax credit only for the exact amount of foreign income tax that was paid or accrued in the tax year. A credit or deduction will not be accepted if it is reasonable to assume that those taxes will be refunded, credited, rebated, or forgiven if a claim by the taxpayer was made. Taxes that have been paid can be proven using copies of the tax stamps issued by the local ministry of finance or local department of tax revenue. Cancelled checks are also acceptable as well as the actual local tax return reflecting the amount for which the stamped documents or cancelled checks support.
An example of this is with investment income from foreign stocks, mutual funds or partnership interests. Taxpayers with these types of foreign holdings may have paid or been charged a foreign income tax. That tax is normally withheld at the source country from the payments or distributions to investors. For example, a mutual fund that invests overseas may incur foreign taxes on interest and dividends. Barring that the fund meets certain requirements, it can pass foreign tax along to its shareholders. That foreign tax which was paid on the dividend or distribution is reported in box 6 of Form 1099-DIV-Dividends and Distributions that is received from the investment fund manager or on Form 1099-INT when income was incurred from interest.
Exception Election Not to Report on Form 1116
In order to claim the foreign tax credit, Form 1116 generally must be filed along with the tax return. Certain circumstances will allow for the taxpayer to avoid filling out this form and report the credit on Form 1040. These requirements are:
- The only gross taxable income from a foreign source is passive, such as investment income, interest income from investments, dividends, annuities, rent and royalties.
- The foreign income is being reported as a payee statement, such as a 1099-DIV or 1099-INT.
- The total foreign taxes paid are $300 or less for individual filers or $600 or less if married and filing jointly.
If one of those requirements is met, the taxpayer has the choice to claim the credit on line 44 of Form 1040 without filing Form 1116. There are no limitations applied if this is the elected choice. The foreign tax credit will still be non-refundable and limited to the total amount of US income tax liability. In the event that it is limited in this way the taxpayer will not have the option of carrying over any unused credit. Plus they would not be able to carry back or carry forward any foreign tax credit that cannot be used for the current year. The taxpayer would have to file Form 1040, not 1040A or 1040EZ.
How do you Deal With the Unused Foreign Tax Credit Credit?
When the US tax liability is the same or higher than the foreign tax paid, a taxpayer is eligible to claim the full foreign tax credit. Double taxation is always avoided, but the highest tax rate is the one recognized. When more was paid in foreign tax during the tax year than can be claimed as a credit, for example if $650 was paid in foreign tax but only $550 is owed to the IRS on the same amount, there would be a surplus of $100 in unused foreign tax credit. That excess can be carried back to the prior year using an amended tax return. It could also be carried forward for ten years. This is only applicable when Form 1116 is filed, and is restricted by the amount of excess limit available in those carry-back or carry-forward tax years. The unused credit is carried over to the same “basket” of income to the carry-over year and there will need to be an excess to use in those tax years for the same category.
When calculating the foreign tax credit carryovers used in the tax year, the taxes which were paid in the current year will be used first. The foreign tax credit excess is only used after all allowable current taxes have been accounted for. The carryovers can then be added in the order in which they were generated. If the sum of the carryovers in any one category exceeds the allowable credit for that category, that year’s remaining credit will automatically forward with the correct remaining balance available.
An individual who has worked abroad for eight years in a country with high income tax rates for example would have built up a large foreign tax credit if claimed from being carried forward. Once that individual returns to the US they will file a Form 1116 for the return year. If not used, that excess foreign tax credit will expire after being carried over for ten years. The only way of being able to use that up before it expired would be to take another job overseas in a country where the income taxes are considerably lower than in the US.
Do you have more questions about Foreign tax credit?
US citizens, green card holders, US residents and Americans expats living abroad should contact an expat tax accountant if they have additional questions about the foreign tax credit and other expat tax issues. Expat tax professionals at Artio Partners will be happy to assist you.