Foreign Tax Credit

What Is Foreign Tax Credit (FTC) ?

US working abroad It is a common concern for citizens to pay tax twice on the same income. The U.S. has certain safeguards, which ensure that citizens are not double taxed on the same income. Foreign tax credit is one of them, but there are a number of limits and rules that apply when claiming this credit. If you are an American and you work or live outside of the United States, you may qualify for the foreign tax credit when you file your tax return with the IRS.

The purpose of the Foreign Tax Credit is to reduce the impact of taxing the same income by both the United States and the foreign country where the income was earned. This credit can be claimed against any US federal income tax when an American also pays income tax to a foreign government. Taxpayers can claim those taxes as foreign tax credits in the foreign income tax paid by them.

The FTC is a method American expats can use to offset foreign taxes paid overseas in dollar-for-dollar terms. If you have paid income tax to a foreign country, the Foreign Tax Credit gives you a credit to use on your United States taxes, thereby reducing your United States tax liability. The maximum credit amount that can be claimed depends on the taxes you have already paid and your worldwide income.

Americans who live in the US also have a foreign income source on which they can pay foreign income tax and can claim a US tax credit up to the value of foreign taxes paid to avoid double taxation. To claim a foreign tax credit, IRS Form 1116 must be filed when filing a federal tax return.

How Does the Foreign Tax Credit Work ?

Some taxpayers may be required to pay income tax to the countries in which they live and then pay income tax to the United States on the same income. The Internal Revenue Service is aware of this double taxation situation. Generally, you can get tax exemptions for income taxes you pay to other countries. The IRS gives taxpayers the option to deduct the foreign income tax paid by them or claim it as a foreign tax credit. Your tax payer should determine your tax liability both ways so that you can choose the one that saves the most money.

U.S. possessions include, the U.S. Virgin Islands, the Northern Mariana Islands, Puerto Rico, Guam and American Samoa. File IRS Schedule 3 on Form 1040 to claim the FTC, you may also need to file Form 1116. Use Schedule A, if you choose the foreign tax deduction route.

Trusts, estates and individuals can use the FTC to reduce their income tax liability. Additionally, taxpayers can withdraw any unused foreign tax for one year and then carry forward for 10 years.

Tip :
Foreign tax is usually levied in foreign currency. Use the exchange rate on the date you made estimated tax payments, tax withheld, or foreign tax payments.

Key Facts of Foreign Tax Credit

  • The FTC is a United States tax break that offsets income tax paid to other countries.
  • The idea behind the FTC is that Americans should avoid paying income tax twice on the same income.
  • This credit is available to US residents and citizens who have paid foreign income taxes.
  • Foreign taxes on wages, interest, income, dividends and royalties generally qualify for the FTC.
  • If you paid income tax on income to another country, but you can't do both, you have the option to claim this credit or exclude your foreign income from your U.S. tax return.
  • You can also claim a deduction for income taxes paid to another country, but you cannot deduct foreign property taxes. You cannot claim both the credit and the deduction.
  • The FTC is equal to the amount of foreign tax paid by the taxpayer or US tax attributable to foreign source income, whichever is less.

FTC Special Considerations

Not all taxes can be claimed as a credit against US federal income tax. Four tests must be met for foreign tax to qualify for the credit:
  • The tax must be imposed on you from a foreign country or US occupation.
  • The tax should be an income tax or a tax instead of an income tax.
  • You must have paid or earned tax in a foreign country or possession of the US.
  • The tax must be legal and the actual foreign tax liability that you paid during the year.
You calculate the limits for the credit you can claim on Form 1116. You can claim foreign tax paid by you or less than your calculated limit. Claim the foreign tax credit on Form 1116, unless you qualify for one of the following exemptions :
  • Your only foreign source of income is passive income.
  • Your eligible foreign taxes for the year do not exceed $300.
  • Your foreign taxes and gross foreign income are reported to you on a recipient statement.
  • You choose this process for the tax year.

Who is Eligible Foreign Tax Credit ?

If you are a US citizen or resident who earns foreign income and has already paid income tax in your country of residence, you are eligible for the Foreign Tax Credit. It's important to be sure to check with your foreign tax advisor about which foreign taxes you can use to maximize your foreign tax credit.

Taxes paid to other countries are eligible for Foreign Tax Credit when :
  • You have paid taxes on your income to a provincial or local government.
  • You were legally bound to pay the tax.
  • You have already paid or earned tax.
  • There is no benefit to you by paying taxes.
The nature of the tax also matters. You may meet all of the above criteria but still not be able to claim the FTC for a few reasons. Taxes which cannot be included in Foreign Tax Credit :
  • Taxes on Income Excluded from US Gross Income.
  • Taxes paid to the accepted country.
  • Value added tax, sales tax, immovable property tax or luxury tax paid to a foreign government.
  • Taxes on foreign oil, mineral and gas income.
  • Taxes from international boycott operations.
  • Taxes related to a foreign tax split event.
  • Social Security tax accrued or paid to a foreign country with which the US has a Social Security agreement.

Requirements for the Foreign Tax Credit

To find out if you qualify for the foreign tax credit, ask yourself the following questions :
  • Is the tax imposed on you personally?
  • Have you paid tax?
  • Is the tax a legal and actual foreign tax liability?
  • Is the tax an income tax or a tax instead of an income tax?
The IRS refers to these questions as tests. If you cannot answer yes to all four of these questions, you will not qualify.

Qualifying Foreign Taxes

You can claim the credit only for those foreign taxes levied on you from the US occupation or from a foreign country. Generally, only war benefits, income and excess gains qualify for the tax credit. See Qualifying for foreign tax credits for more information.

In most cases, taking foreign income taxes as a tax credit is to your advantage. If you elect to exclude foreign housing costs or foreign earned income, you cannot charge the FTC for taxes on the income that you exclude. If you take credit, one or both elections may be considered null and void.

Foreign Tax Credit Limit

There is a limit to the amount of credit you can claim. The FTC is the amount of foreign tax you earned or paid or, if smaller, the foreign tax credit limit. You find out the foreign tax credit limit on Form 1116.

How Much is the Foreign Tax Credit Worth ?

Form 1116 can be used to calculate the amount of the FTC. This form runs through two calculations :
  • How much foreign income tax you have paid or earned.
  • How much of your US tax liability can be attributed to your foreign income.
The smaller of those two numbers is the amount of your foreign tax credit.

The Internal Revenue Service limits the foreign tax credit that you can claim by the amount of foreign taxes paid or the US tax liability on foreign income. Your foreign tax credit cannot exceed multiple times your total US tax liability. The numerator of the fraction is your taxable income from sources outside the United States. If there are foreign taxes available for credit but you cannot use them because of the foreign tax credit limit, you can carry it back to the previous tax year and carry it forward for the next 10 tax years.

For example, if you paid $350 in foreign taxes, and you owe $250 in US taxes on the same income, your tax credit would be limited to $250.

Foreign Tax Credit Carryover

One good thing about claiming foreign tax credit is foreign tax credit carryover. In short, if you don't use the full tax credit amount you've allowed, your unused amount could be carried over to the next tax year or rolled back to the previous year. If the previous years were short on credit, your balance should be withdrawn.

For example, if you have a carryover amount of $500 and you had $600 short in credits on foreign income in the previous year, you should carry that $500 back to that previous year instead of carrying it forward. If you are allowed to carry it forward, your tax credit carryover can be done for up to 10 years.

How to Claim the Foreign Tax Credit ?

If you are an individual, trust or property and you have paid or earned certain foreign taxes in a foreign country or possession of the US, file Form 1116 to claim the foreign tax credit. This form calculates the various limits imposed on the amount of tax credit you are eligible for. You cannot carry forward any unused foreign tax credit to another tax year unless you submit Form 1116. This credit is not refundable. But the balance won't go to waste if you also file Form 1116 because you can roll over the remainder to a future tax year.

Foreign Tax Credit Corporations file Form 1118 to claim the FTC.

Foreign Tax Credit Deadlines and Extensions

To claim the foreign tax credit, expats must first pay their foreign taxes. The IRS acknowledges that this may not be possible before April 15 of the tax year. For this reason, expats have an automatic US filing extension until June 15, and expats can claim an additional extension (online) until October 15, if needed. This gives nearly all expats enough time to file and pay their foreign taxes before filing their US tax return.