Foreign Tax Deduction Definition

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Foreign Tax Deduction Definition

What Is the Foreign Tax Deduction?

The foreign tax deduction is one of the itemized deductions that American taxpayers may claim to account for taxes previously paid to a foreign government, which are usually categorised as withholding tax.

If the foreign tax deduction is more favorable to the taxpayer than the credit, it is frequently taken instead of the more common foreign tax credit.

Key Takeaways

  • The foreign tax deduction enables American taxpayers to deduct a part of the income tax paid to foreign governments from their taxable income.
  • The idea is to avoid American residents from getting taxed twice on the same income.
  • Given that the foreign tax deduction is more favorable for a taxpayer, it would be used instead of the foreign tax credit.

Tax Deductions Vs. Tax Credits

The Basics of the Foreign Tax Deduction

To avoid double taxation in the United States and a foreign nation, a taxpayer may claim the amount of any eligible foreign taxes paid or incurred during the year as a foreign tax credit or an itemized deduction. The overseas tax credit is applied to the amount of tax owing by the taxpayer after all deductions from taxable income are made, and it decreases an individual’s overall tax bill dollar for dollar.

The overseas tax deduction decreases an individual’s taxable income if they choose this route. This indicates that the tax deduction’s benefit is equal to the decrease in taxable income multiplied by the individual’s effective tax rate. The foreign tax deduction must be itemized, or shown separately on the tax return. The total of the things mentioned is used to reduce a taxpayer’s adjusted gross income (AGI).If a taxpayer elects to deduct qualifying foreign taxes, he or she must deduct all of them and cannot claim a credit for any of them. Itemized deductions are only useful if the total amount of the itemized costs is less than the applicable tax credit.

  Tax Deferred Definition

If the international tax rate is high and there is only a modest amount of overseas income compared to domestic income, the foreign tax deduction may be more favorable. Furthermore, claiming a deduction involves less paperwork than claiming a foreign tax credit, which requires completing Form 1116 and may be complicated depending on the number of foreign tax credits claimed. If you claim the foreign tax credit, it is stated on Schedule A of Form 1040.

Example of the Foreign Tax Deduction

In most circumstances, the foreign tax credit will be more advantageous than the deduction. Assume a person gets $3,000 in dividends from a foreign government and pays $600 in foreign tax on the investment income. In the United States, if she falls into the 25% marginal tax band, her tax payment will be 25% x $3,000 = $750. If she is qualified for a $500 tax credit, her US tax payment will be $750 – $500 = $250. If she instead takes a $500 deduction, her taxable dividend income is reduced to $3,000 minus $500 = $2,500, and her tax burden is 25% x $2,500 = $625.

See IRS Publication 514 for further information on overseas taxes paid by Americans.

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