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IRS Foreign Tax Credit for Individuals

Last Update Date : October 08, 2018

IRS Foreign Income Tax Credit

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.

What is Foreign Tax Credit?

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.

Eligibility Criteria for Claiming Foreign Tax Credit

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 foreign taxes paid were levied on your income
  • You paid those taxes under legal obligation
  • You did not made any financial gain by paying them, and
  • The U.S. has not sanctioned the country where taxes were paid

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.

U.S. Tax Filing Experts in India

How to Claim Foreign Tax Credit?

To claim FTC, form 1116 must be attached to your annual U.S. tax return.

Form 1116 Instructions

Click the above image to download Form 1116

Overview of Form 1116

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.

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.

Cash Method

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.

Carry Forward/Backward FTC

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?]

Foreign Tax Credit Calculation with Example

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.

Reporting Foreign Income with Form 1116

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.

  • Passive income: This includes your income from dividend, interest, annuity or royalty for which you received a form 1099. This form indicates the amount of taxes you paid (in Box 6) and the country to which you paid it (in Box 7).
  • General limitation: This category includes your income from salary, wages and any other highly taxed passive income. IRS considers an income as highly taxed if the foreign country’s tax rate is higher than the tax rate applicable to you in the U.S.
  • Section 901(j): This section is for reporting money earned in the countries sanctioned by the U.S.
  • Lump-sum distribution: this category is applicable to income earned from foreign sourced income plan.
  • Resourced by treaty: If the U.S. has a special agreement with the foreign country where you earned income, about how it taxes your income as a foreigner then all your income from both the countries will come under this category.

How to Fill Form 1116?

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.

Foreign Tax Credit without Form 1116

There are various situations under which you can claim foreign tax credit without filing Form 1116. Let’s understand these situations:

  • If all your foreign earned income was Form 1099 reported foreign income (like interest and dividends), you do not need to file Form 1116 to claim FTC. But, such dividend income must have been earned from a stock owned by you for at least 16 days.
  • If you are a single filer who paid $300 or less in foreign taxes or a married joint filer who paid $600 or less in foreign taxes, then you can claim your credit without filing Form 1116. However, if you have paid excess tax which cannot be claimed this year then filing Form 1116 is beneficial. Filing it will allow you to carry forward any unused credit.

FTC not Eligible for Credit

You can’t take a credit for the following foreign taxes:

  • If you have paid foreign taxes which you don’t owe legally, including the tax refunds you are eligible for cannot be claimed as FTC. So, it’s on you to avoid paying unnecessary tax or get a refund of excess tax from foreign country. Also, the amount of tax withheld by a foreign country is not necessarily fully creditable. Example. Country X withholds $25 of tax from a payment made to you. Under the income tax treaty between the United States and Country X, you owe only $15 and can claim a refund from Country X for the other $10. Only $15 is eligible for the foreign tax credit (whether or not you apply for a refund).
  • There are some countries with which the U.S. does not favourable relations. You cannot claim FTC if you have paid taxes to such countries. These countries could be those designated by the Secretary of State as countries which continuously support acts international terrorism, or does not have diplomatic relations with the U.S., or are not recognized by the U.S. Such countries also include the ones which aren’t eligible to purchase defence articles or services under the Arms Export Control Act.
  • FTC can’t be claimed on Foreign taxes withheld on a dividend from a corporation, if you haven’t held the stock for at least 16 days within the 31-day period that begins 15 days before the ex-dividend date. This required holding period is greater for preferred-stock dividends attributable to periods totalling more than 366 days.
  • It can also not be claimed on Foreign taxes withheld on a dividend to the extent that you have to make related payments on positions in substantially similar or related property. E.g. You receive a dividend subject to foreign withholding tax. You are obligated to pay someone else an amount equal to all these dividends you receive. You can’t claim a foreign tax credit for the withholding tax on these dividends.
  • Foreign taxes withheld on income or gain (other than dividends) from property if you haven’t held the property for at least 16 days within the 31-day period that begins 15 days before the date on which the right to receive the payment arises.
  • Foreign taxes withheld on income or gain (other than dividends) from property to the extent you have to make related payments on positions in substantially similar or related property can’t be claimed as FTC.
  • Such foreign taxes which come back to you in the form of subsidy are ineligible.
  • Taxes paid or accrued to a foreign country in connection with the purchase or sale of oil or gas extracted in that country if you don’t have an economic interest in the oil or gas, and the purchase price or sales price is different from the fair market value of the oil or gas at the time of the purchase or sale.
  • Foreign taxes paid or accrued on income for which you are claiming an exclusion on Form 8873, Extraterritorial Income Exclusion. However, see section 943(d) for an exception for certain withholding taxes.
  • The disqualified portion of any foreign tax paid or accrued in connection with a covered asset acquisition. Covered asset acquisitions include certain acquisitions that result in a stepped-up basis for U.S. tax purposes. You can’t take a credit for any interest or penalties you must pay.

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.

FTC Eligible for Credit

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.

Advantages of Claiming Foreign Tax Credit

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:

  1. Credit reduces the taxes while if you use the foreign tax deduction then in that case it reduces your income.
  2. If you use FTC as credit then in that case you can claim credit as well as avail the benefit of standard deduction or itemized deduction.
  3. If the credit is more than taxes paid then the remaining credit can be carried forward or back to another year.

Difference between Foreign Tax Credit and Deductions

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.

Claiming Foreign Earned Income Exclusion and Foreign Tax Credit

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.

How H&R Block can help you?

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.

Not sure how to file your U.S. Tax Return? Let H&R Block help you file your taxes.

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