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Foreign Tax Credit

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Foreign Tax Credit and Form 1116

Double taxation on foreign income is a problem that U.S. expatriates and Green Card Holders face each year when they file their US income tax returns. Fortunately, there are several ways to avoid double taxation on your foreign income: the Foreign Earned Income Exclusion (FEIE) and the Foreign Tax Credit (FTC). Each method (and, yes, even a combination of both) can provide US expats with a valuable benefit that is intended to reduce the double tax burden that would otherwise arise when their foreign source income is taxed by both the United States and the foreign country from which the income is derived.

The good news is many taxpayers can receive a bigger tax benefit from the Foreign Tax Credit than from claiming the Foreign Earned Income Exclusion. It has, for good reason, become a preferred method of avoiding double taxation.

But be aware that the foreign tax credit laws are complex and tax treaties complicate matters even more. That is the main reason that expats should always consult international tax professionals such as the experts at US Expat Tax Help when preparing their income tax returns.

The benefits of the Foreign Tax Credit.

The Foreign Tax Credit is beneficial to many taxpayers living and paying income taxes overseas. If you are an expat that resides in a foreign country that has the same or a higher income rate than the US rate, the Foreign Tax Credit is almost always more advantageous to take than the Foreign Earned Income Exclusion. With the Foreign Tax Credit you can:

  • Reduce your actual US income tax on a dollar for dollar basis
  • If the taxes paid or accrued exceed the credit limit for that year, you may be able to carry back the excess to the prior tax year or carry it forward for up to 10 years.
  • You do not have to meet the bona fide residence or physical presence tests
  • You may more easily qualify for tax benefits such as the Child Tax Credit or the ability to make a contribution to a Roth IRA
Qualifying for the Foreign Tax Credit?
  • You may be able to take the credit if you paid foreign income tax and are subject to US tax on your foreign sourced income and you are
  • A US citizen or
  • A resident alien or
  • A nonresident alien if you
·        Were a bona fide resident of Puerto Rico during the entire tax year or
·        You pay or accrue tax to a foreign country or U.S. possession on income from foreign sources that is effectively connected with a trade or business in the United States. But if you must pay tax to a foreign country or U.S. possession on income from U.S. sources only because you are a citizen or a resident of that country or U.S. possession, do not use that tax in figuring the amount of your credit.
Test for the Foreign Tax Credit.
A taxpayer must meet the following four tests to qualify for the credit:
1.       The tax must be imposed on you
2.       You must have paid or accrued the tax
3.       The tax must be a legal and actual foreign tax liability, and
4.       The tax must be an income tax
Income taxes or taxes in lieu of an income tax qualify for the foreign tax credit.
Generally, you can take the credit or deduction for
  • Income, war profits, and excess profits taxes (income taxes)
  • Foreign taxes on wages
  • Foreign taxes on dividends
  • Foreign taxes on interest
  • Foreign taxes on royalties
And if the
·        income taxes were paid or accrued to a foreign country or a U.S. possession, or
·        taxes were paid or accrued to a foreign country or U.S. possession in lieu of an income tax
Generally, only income taxes paid or accrued to a foreign country or a U.S. possession (also referred to as a U.S. territory), or taxes paid or accrued to a foreign country or U.S. possession in lieu of an income tax, will qualify for the foreign tax credit. Qualified foreign taxes do not include:
·       Taxes refundable to you.
·       Taxes used to provide a subsidy to you or someone related to you.
·       Taxes not required by law, because you could have avoided paying the taxes to the foreign country.
·       Taxes that are paid or accrued to a country if the income giving rise to the tax is for a period (the sanction period) during which:
o   The Secretary of State has designated the country as one that repeatedly provides support for acts of international terrorism,
o   The United States has severed or does not conduct diplomatic relations with the country, or
o   The United States does not recognize the country's government, unless that government is eligible to purchase defense articles or services under the Arms Export Control Act.
o   Note: These taxes may be claimed as an itemized deduction.
Choosing a Credit or a Deduction
You can choose to take the amount of any qualified foreign taxes paid during the year as a foreign tax credit or as an itemized deduction. To choose the deduction, you must itemize deductions on Form 1040, Schedule A (PDF). To choose the foreign tax credit you generally must complete Form 1116 (PDF) and attach it to your Form 1040 (PDF) or Form 1040NR (PDF). You must choose either the foreign tax credit or itemized deduction for all foreign taxes paid or accrued during the year. This is an annual choice.
If you are a cash basis taxpayer you can only take the foreign tax credit in the year you pay the qualified foreign tax unless you elect to claim the foreign tax credit in the year the taxes are accrued. Once you make this election, you cannot switch back to claiming the taxes in the year paid in later years.
Foreign taxes are not eligible for the foreign tax credit.
You cannot take the Foreign Tax Credit on
·        Taxes on excluded income (such as income excluded under the Foreign Earned Income  Exclusion)
·        Taxes for which you can only take an itemized deduction
·        Taxes on foreign mineral income
·        Taxes from international boycott operations
·        A portion of taxes on combined foreign oil and gas income
·        Taxes of U.S. persons controlling foreign corporations and partnerships who fail to file required information returns, and
·        Taxes related to a foreign tax splitting event
However, these foreign taxes may be eligible as part of your itemized deductions on Schedule A.
Tax form to claim the foreign tax credit.
You must file the Form 1116 to claim the foreign tax credit, however, several Form 1116s may have to be filed for each year depending if you have different categories of income. The complexity of the form itself and its 23 pages of instructions can be overwhelming. Not only does the Foreign Tax Credit need to be calculated for regular tax purposes for each category of income, but also for Alternative Minimum Tax (AMT) purposes. That is why it is wise to hire an international tax expert to help you with your tax returns.
You must file the Form 1116 with your income tax return for each of the following categories of income for which you are claiming a credit unless you meet one of the exceptions.
·        Passive category income.
·        General category income.
·        Section 901(j) income.
·        Income re-sourced by treaty.
·        Lump-sum distributions.
The exceptions include:
·        Your only foreign source gross income for the tax year is passive category income. For purposes of this rule, high taxed income and export financing interest are also passive category income.
·        Your qualified foreign taxes for the tax year are not more than $300 ($600 if married filing a joint return).
·        All of your gross foreign income and the foreign taxes are reported to you on a payee statement (such as a Form 1099-DIV or 1099-INT).
·        You elect this procedure for the tax year
·        If you are a shareholder of a controlled foreign corporation and chose to be taxed at corporate rates on the amount you must include in gross income from that corporation.
Computing the Credit When Using Form 1116
If you use Form 1116 to figure the credit, your foreign tax credit will be the smaller of the amount of foreign tax paid or accrued, or the amount of United States tax attributable to your foreign source income. Compute the limit separately for passive income, income resourced under a tax treaty, income derived from sanctioned countries, and all other income.
Amending Your Return to Claim the Tax Credit
If you claimed an itemized deduction for a given year for qualified foreign taxes, you can choose instead to claim a foreign tax credit that will result in a refund for that year by filing an amended return on Form 1040X (PDF) within 10 years from the original due date of your return. The 10-year period also applies to calculation corrections of your previously claimed foreign tax credit.
If the foreign income taxes you claimed as a credit are refunded or otherwise reduced, you must file an amended return on Form 1040X reporting the reduced foreign tax credit. There is no time limit on this requirement.
Carryback and Carryover of Unused Credit
If you cannot claim a credit for the full amount of qualified foreign income taxes you paid or accrued in the year, you are allowed a carryback and/or carryover of the unused foreign income tax. You can carry back for one year and then carry forward for 10 years the unused foreign tax. For more information on this topic (including taxes paid or accrued in years before 2007), see Publication 514, Foreign Tax Credit for Individuals.
You may not take either a credit or a deduction for taxes paid or accrued on income you exclude under the foreign earned income exclusion or the foreign housing exclusion. There is no double taxation in this situation because that income is not subject to United States income tax.