The concept of foreign tax credit in U.S. taxation was introduced to save expats from paying double taxes. In this guide by H&R Block India, you will find out how you can claim foreign tax credit by filing the Form 1116.
Being a U.S. citizen, you are liable to pay tax on all your income irrespective of your location on the globe. U.S. expats earn money outside the U.S. which is taxed by the country where they earn this money, as well as by the U.S. This leads to double taxation which means they can end up paying more than the fair share of their taxes. To prevent this, the U.S. tax laws allow them to take credit of excess tax paid. Expats can do this in two different ways. They can either claim it like a tax deduction by deducting their foreign taxes on Schedule A just like other common deductions. Or, they can file Form 1116 to claim a tax credit and subtract the taxes they paid to other country from their U.S. tax liability. If the credit exceeds your U.S. tax liability, you can carryover the excess amount to reduce your future tax outgo.
If you are an expat who has paid taxes in other countries, you are eligible to claim foreign tax credit if you satisfy the following conditions:
The taxes you paid to the local and provincial government can be claimed as foreign tax credit. But, taxes like sales, value added, real estate and luxury paid to the foreign government are excluded.
e.g., if Michael owns a home in the foreign country and has to pay property taxes, he cannot avail of FTC, because the tax imposed while legal and paid, it isn’t on income earned.
To claim FTC, form 1116 must be attached to your annual U.S. tax return.
As discussed earlier, you need to file a separate Form 1116 for each category of income. So, if you have only one type of income, you need to file only one Form 1116. You must choose how you want to regard your income, There are two ways to do this: cash method or accrual method.
You can use this method if your budget doesn’t recognize income until you receive it. By choosing this method, you are limited to using it in the year for which the taxes are owed.
You can choose this method if your budget records income at the time of earning it rather than receiving it. This method allows you to use the credit in the year the taxes are paid or carry the credit forward/back to the year it is owed in.
Any unused credit can be carried forward for a period of ten years and carried back to the previous year. With US citizens who have lived abroad for long periods of time, carrybacks and carryforwards of foreign tax credits can be very important. If you are eligible for a foreign tax credit larger than your U.S. expat income tax liability, the credit can be carried back to the tax year immediately preceding the current, or carried forward for the next ten years. This means that you can use the excess credit to try to obtain a refund from the prior year where you did not have enough credits to offset your US tax liability, or choose to offset your future years’ tax liability. Most taxpayers will retain a schedule attached to their annual U.S. tax return that includes all of the foreign tax carryovers for which they are eligible.
[Read more: How to file U.S. tax return?]
You can only use FTC on actual income earned in the foreign country, including income from investments. The credit utilized cannot exceed the amount of U.S. taxes owed. Credit is always depending upon the ratio of foreign taxable income and US source income. The credit is determined as follows:
Foreign taxable income / Total income Foreign as well as US x Total U.S. tax = U.S. taxes owed on Foreign income.
When you fill the Form 1116, the step is to classify your foreign income. You must fill a separate form for each type of income. Let us understand the various categories of foreign income.
The Form 1116 consists of 4 parts:
Part I: In this section of the form, you need to calculate your taxable income from one to three countries excluding the U.S.
Part II: In this section, you need to list down all the taxes you paid, i.e. U.S. and foreign taxes. Part II of Form 1116 asks the taxpayer to report the amount of taxes that were actually paid (or accrued) by the taxpayer in the current tax year. Please note that this section also asks for foreign taxes paid to be reported in the foreign currency amount, as well as the US dollar amount. When reporting this information, the IRS also requests that the taxpayer add a statement to the tax return that includes the foreign currency conversion rate.
Part III: In this part, you need to figure out your foreign tax credit for the category of income for which you are filling the form. You need to compute the amount of credit eligible to be claimed on the taxpayers US tax return. Each line of Part III is essentially math calculations, and the instructions associated with each line on the form will walk the taxpayer through its completion.
Part IV: Finally, in this part of the form, you need to add all the foreign tax credits from all your income categories. This portion of Form 1116 simply asks the taxpayer to summarize the foreign tax credits claimed on other Forms 1116 for the current tax year.
There are various situations under which you can claim foreign tax credit without filing Form 1116. Let’s understand these situations:
You can’t take a credit for the following foreign taxes:
Even though these taxes can’t be claimed for the purposes of the Foreign Tax Credit, they can be claimed as an itemized deduction on Schedule A.
You can take a credit for income, war profits, and excess profits taxes paid or accrued during your tax year to any foreign country or U.S. possession, or any political subdivision (for example, city, state, or province) of the country or possession.
This includes taxes paid or accrued in lieu of a foreign or possession income, war profits, or excess profits tax that is otherwise generally imposed. For purposes of the credit, U.S. possessions include Puerto Rico and American Samoa. U.S. citizens living in certain treaty countries may be able to take an additional foreign tax credit for foreign tax imposed on certain items of income from the United States of America.
While, the FTC was introduced to avoid double taxation, there are several benefits in opting for FTC, versus deductions. By opting for FTC on income earned in the foreign country:
Foreign Tax Deductions are the itemized deductions that reduce your taxable income by utilizing the deductions available such as medical expense, state and local taxes paid, mortgage interest paid, gift or donation, etc. whereas, FTC reduces the total tax payable.
Whether self-employed or earning a salary in the foreign country, you cannot avail of both Foreign Earned Income Exclusion (FEIE) and FTC on the same income. For the income that was taxed in the foreign country, you can avail of FTC on the U.S. taxes payable. You can claim FTC on balance income that was not excluded from FEIE or Foreign Housing Exclusion.
Filing your annual income taxes in normal situations is already a complex process. When you mix foreign earned income into the mix, filing your income tax to include FTC, can give cause for headaches. To ensure your taxes are filed accurately while availing of every deduction and savings available to you, enlist the aid of U.S. Expat tax experts at H&R Block India.