Foreign Tax Credit

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Foreign Tax Credit

What Is the Foreign Tax Credit?

The overseas tax credit is a tax credit available in the United States that is used to offset income tax paid abroad. The credit is available to U.S. citizens and resident aliens who pay income taxes levied by a foreign government or a U.S. territory. The credit might help you decrease your US tax obligation and avoid being taxed twice on the same income.

Key Takeaways

  • The international tax credit is a tax deduction in the United States that balances income tax paid to other nations.
  • The credit is accessible to US citizens and residents who earn money overseas and pay foreign taxes.
  • In general, foreign taxes on income, wages, dividends, interest, and royalties are eligible for the foreign tax credit.

How the Foreign Tax Credit Works

If you paid taxes to a foreign nation or a US territory and are liable to US tax on the same income, you may claim an itemized deduction or credit for those taxes. Puerto Rico, the US Virgin Islands, Guam, the Northern Mariana Islands, and American Samoa are all considered US possessions for foreign tax credit purposes.

The foreign income tax, when taken as a deduction (on Schedule A of your 1040 or 1040-SR), decreases your taxable income in the United States. If you accept the credit, your international income immediately decreases your US tax burden. If you want to take the tax credit, you must fill out Form 1116 and submit it to your US tax return.

All qualifying foreign taxes must be either credited or deducted. For example, you cannot claim a credit for certain international taxes while deducting others. You can’t, of course, claim both a credit and a deduction for the same tax.

Taking the credit typically makes financial sense since the money is deducted directly from your tax bill rather than merely decreasing your taxable income. In either case, the tax credit decreases the double tax burden that would otherwise occur if you were taxed twice—once in the United States and once elsewhere.

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Only income, war profits, and excess profits taxes are generally eligible for the credit. Foreign salary, dividends, interest, and royalties are also eligible. The IRS, on the other hand, stipulates that “the tax must be a levy that is not payment for a particular economic benefit,” and that it must be of the same kind as a US income tax.

You may also claim the credit for foreign taxes that aren’t levied under a foreign income tax legislation, as long as they are “in lieu” of income, war profits, or excess profits taxes. In this case, the tax must be levied instead of, rather than in addition to, the country’s existing income tax.

Foreign taxes are often levied in foreign currency. Use the currency rate in force on the day the foreign tax was paid, withheld, or projected tax payments were made.

Foreign real and personal property taxes, for example, are not eligible for the foreign tax credit. Even if you claim the foreign tax credit, you may be eligible to deduct these additional taxes on Schedule A of your income tax return. Foreign real estate taxes unrelated to your trade or industry might be deducted. Other taxes, on the other hand, must be costs incurred in a trade or company or in order to generate profits.

Individuals, estates, and trusts may all utilize the foreign tax credit to decrease their taxable income. Furthermore, taxpayers may carry back any unused foreign tax for one year and then forward for up to ten years.

Special Considerations

Not all taxes paid to foreign governments are deductible from federal income taxes in the United States. To qualify for the overseas tax credit, you must generally fulfill four criteria:

  1. The tax must be levied by a foreign government or a US possession.
  2. The tax must have been paid or accumulated in a foreign nation or US possession.
  3. The tax must represent the legal and real foreign tax obligation you incurred or paid during the fiscal year.
  4. The tax must be either an income tax or a tax substitute for an income tax.
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There is a credit limit that you must compute on Form 1116 (it cannot be higher than your total US tax obligation multiplied by a particular percent). You may deduct the lesser of your international tax paid or the estimated limit. In general, unless you qualify for one of the following exemptions, you claim the foreign tax credit on Form 1116:

  • Passive income is your sole foreign source income for the tax year.
  • Your total qualifying foreign taxes for the year are less than $300 ($600 if married filing jointly).
  • A payee statement shows you your gross overseas income and foreign taxes (e.g., Form 1099-DIV or 1099-INT).
  • This technique is chosen for the tax year.

If you are eligible for an exemption, claim the tax credit on Form 1040.

If you claim the foreign earned income and/or foreign housing exclusions, you cannot claim a foreign tax credit for taxes paid on the income you excluded (or could have excluded).If you do, the IRS may withdraw one or both of your options.

Refundable vs. Non-refundable Tax Credits

Refundable or non-refundable tax credits are available. If your tax credit is more than your tax bill, you will get a refund. As a result, if you apply a $3,400 tax credit to a $3,000 tax bill, you will get a $400 refund.

A non-refundable tax credit, on the other hand, does not give a refund since it merely decreases the tax owing to zero. In the above example, if the $3,400 tax credit was non-refundable, you would owe the government nothing. You would, however, lose the $400 that remained after the credit was applied. The majority of tax breaks, including the foreign tax credit, are not refundable.

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What Is the Difference Between Tax Credits and Tax Deductions?

Tax credits decrease your tax liability, but tax deductions reduce your taxable income. While both save money, credits are more significant since they are deducted directly from your tax statement. A $1,000 tax credit, for example, decreases your tax burden by $1,000. A $1,000 tax deduction, on the other hand, reduces your taxable income (the amount of income on which you owe taxes) by $1,000. So, if you’re in the 22% tax rate, a $1,000 deduction would save you $220.

How Do the Foreign Tax Credit and Foreign Earned Income Exclusion Differ?

The overseas tax credit and the foreign earned income exclusion are two strategies to avoid double taxation on income earned while residing abroad. The income to which each applies is a fundamental distinction. Earned and unearned income, such as dividends and interest, are both eligible for the overseas tax credit. In contrast, the overseas earned income exclusion solely applies to earned income.

Who Can Claim the Foreign Tax Credit?

If you are a US citizen, you must pay taxes on your global income, regardless of where you reside. To prevent double taxation, the United States allows you to claim a credit for foreign taxes paid or accrued. Overseas tax credits are available to U.S. citizens and resident aliens who paid foreign income tax and are liable to U.S. tax on the same income. A nonresident alien may claim the credit if they were a bona fide resident of Puerto Rico for the whole tax year or if they paid foreign income taxes related to a trade or company in the United States.

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