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Foreign Tax Credits – What’s At Stake

Foreign Tax Credits – Purpose Of The Foreign Tax Credit

The United States taxes citizens and residents on worldwide income. Even while living abroad, the other country may also tax any income earned within their borders. To offset this potential for double taxation, the US tax code provides both individuals and corporations a foreign tax credit (FTC) that can be used to offset income taxes assessed by a foreign country on the income earned there.

If you paid or accrued foreign taxes to a foreign country on foreign source income and are subject to U.S. tax on the same income, you may be able to take either a credit or an itemized deduction for those taxes. The purpose of the foreign tax credit is to minimize your combined foreign and U.S. tax obligations. The credit is designed to reduce double taxation. You do not need to live or to work in that foreign country in order to claim this benefit, like the foreign earned income exclusion .

Taken as a deduction, foreign income taxes reduce your U.S. taxable income as an itemized deduction. This generally provides the least tax benefit. However, if you cannot claim the foreign tax credit, deducting foreign taxes would be the only alternative.

Taken as a credit, foreign income taxes reduce your U.S. tax liability. In most cases, it is to your advantage to take foreign income taxes as a tax credit. A tax credit reduces your US tax liability on a dollar-for-dollar basis, and so is generally more valuable than a deduction which reduces your taxable income.

Once you choose to exclude either foreign earned income or foreign housing costs, you cannot take a foreign tax credit for taxes on income you can exclude. If you do take the credit, one or both of the choices may be considered revoked.

Compliance Issues Of The Foreign Tax Credit

The foreign tax credit laws are complex. Link to Foreign Tax Credit Compliance Tips for help in understanding some of the more complex areas of the law. Below are some of the foreign tax credit compliance issues:

  • Foreign sourced qualified dividends and/or capital gains (including long-term capital gains, collectible gains, unrecaptured section 1250 gains, and section 1231 gains) that are taxed in the U.S. at a reduced tax rate must be adjusted in determining foreign source income on Form 1116, line 1a.
  • Interest expense must be apportioned between U.S. and foreign source income.
  • Charitable contributions are not apportioned against foreign source income.
  • The amount of foreign tax that qualifies is not necessarily the amount of tax withheld by the foreign country. If you are entitled to a reduced rate of foreign tax based on an income tax treaty between the United States and a foreign country, only that reduced tax qualifies for the credit.
  • If a foreign tax redetermination occurs, a redetermination of your US tax liability is required in most situations. You must file a Form 1040X or Form 1120X. Failure to notify the IRS of a foreign tax redetermination can result in a failure to notify penalty.
  • A foreign tax credit may not be claimed for taxes on excluded income.

Why Choose The Foreign Tax Credit?

The foreign tax credit is intended to relieve you of the double tax burden when your foreign source income is taxed by both the United States and the foreign country.

The foreign tax credit can only reduce U.S. taxes on foreign source income; it cannot reduce U.S. taxes on U.S. source income.

It is generally better to take a foreign tax credit for qualified foreign taxes than to deduct them as an itemized deduction. This is because:

  • A credit reduces your actual U.S. income tax on a dollar-for-dollar basis, while a deduction reduces only your income subject to tax,
  • You can choose to take the foreign tax credit even if you do not itemize your deductions. You then are allowed the standard deduction in addition to the credit, and
  • If you choose to take the foreign tax credit, and the taxes paid or accrued exceed the credit limit for the tax year, you may be able to carry over or carry back the excess to another tax year.

Maximum Foreign Tax Credit

Your foreign tax credit cannot exceed your US tax liability multiplied by a percentage. The percentage is your total foreign-source income divided by your total worldwide income. You must figure the allowable amount by various categories of income. Examples of categories of income include general income such as wages and passive income such as interest or investment income.

Carryback and Carryover of the Foreign Tax Credit

Any foreign tax credit amount in excess of the maximum limit may be carried back to a previous tax year or carried forward to a future tax year. You can carry-back the foreign tax credit to the immediately preceding tax year, or carry-forward the credit for the next 10 tax years.

Click here to learn more about the foreign tax credit.

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Tax Samaritan is a team of Enrolled Agents with over 25 years of experience focusing on US tax preparation and representation. We maintain this tax blog where all articles are written by Enrolled Agents. Our main objective is to educate US taxpayers on their tax responsibilities and the selection of a tax professional. Our articles are also designed to help taxpayers looking to self prepare, providing specific tips and pitfalls to avoid.

When looking for a tax professional, choose carefully. We recommend that you hire a credentialed tax professional such as Tax Samaritan that is an Enrolled Agent (America’s Tax Experts). If you are a US taxpayer overseas, we further recommend that you seek a professional who is experienced in expat tax preparation, like Tax Samaritan (most tax professionals have limited to no experience with the unique tax issues of expat taxpayers).

Randall Brody is an enrolled agent, licensed by the US Department of the Treasury to represent taxpayers before the IRS for audits, collections and appeals. To attain the enrolled agent designation, candidates must demonstrate expertise in taxation, fulfill continuing education credits and adhere to a stringent code of ethics.

Every effort has been taken to provide the most accurate and honest analysis of the tax information provided in this blog. Please use your discretion before making any decisions based on the information provided. This blog is not intended to be a substitute for seeking professional tax advice based on your individual needs.



Updated: November 29, 2014

About Randall Brody

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