The Foreign Tax Credit Can Reduce Double Taxation
The foreign tax credit, which is claimed on Form 1116, is intended to reduce the double tax burden that would otherwise arise when foreign source income is taxed by both the United States and the foreign country from which the income is derived.
The foreign tax credit laws and Form 1116 are complex. Below are some of the complex 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 1116Interest 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 an amended return. 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.
In general, four tests must be met for the tax to qualify for the credit and to claim on Form 1116:
- The tax must be a legal and actual foreign tax liability.
- The tax must be imposed on you
- You must have paid or accrued the tax, and
- The tax must be an income tax (or a tax in lieu of an income tax)
Tax Must Be the Legal and Actual Foreign Tax Liability
The amount of foreign tax that qualifies to be reported on Form 1116 is not necessarily the amount of tax withheld by the foreign country. Only the legal and actual foreign tax liability that you paid or accrued during the year qualifies for the credit. The amount of the deductible foreign tax must be reduced by any refunds of foreign tax made by the government of the foreign country.
Tax Must Be Imposed on You
You can claim a credit only for foreign taxes that are imposed on you by a foreign country. For example, a tax that is deducted from your wages is considered to be imposed on you.
Tax Must Be Paid or Accrued
You can claim a credit on Form 1116 only for foreign taxes that have been paid or accrued.
Tax Must Be an Income Tax
Generally, only income, war profits, and excess profits taxes (income taxes) qualify for the foreign tax credit to be reported on Form 1116. Foreign taxes on wages, dividends, interest, and royalties generally qualify for the credit. Furthermore, foreign taxes on income can qualify even though they are not imposed under an income tax law if the tax is in lieu of an income, war profits, or excess profits tax.
Foreign Tax Refund
You cannot claim a foreign tax credit on Form 1116 for income taxes paid to a foreign country if it is reasonably certain the amount would be refunded, credited, rebated, abated, or forgiven if you made a claim.
For example, the United States has tax treaties or conventions with many countries allowing U.S. citizens and residents reductions in the rates of tax of those foreign countries. However, some treaty countries require U.S. citizens and residents to pay the tax figured without regard to the lower treaty rates and then claim a refund for the amount by which the tax actually paid is more than the amount of tax figured using the lower treaty rate. The qualified foreign tax is the amount figured using the lower treaty rate and not the amount actually paid, since the excess tax is refundable.
While the resulting foreign tax credit may not always appear to be a “dollar for dollar” reduction in income tax liability for taxes paid to a foreign government on Form 1116. It is. The reason for this is that an allocation ratio is applied that accounts for a reduction of only that portion of your total taxable income that was not excluded and that which is foreign income. In other words, 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.
Ineligible Foreign Taxes The foreign tax credit is not available if you paid taxes to a foreign country that the United States:
- Does not recognize as a sovereign state
- Has Severed diplomatic relations with
- Does not conduct diplomatic relations with
- Has designated as a country that supports terrorism
Foreign Tax Credit – Categories Of Income Reported On The Form 1116
There are five different categories of income for purposes of the Foreign Tax Credit that are reported on a Form 1116. Foreign taxes paid will need to be reported on a separate Form 1116 to report and calculate the credit for each category of foreign source income. Foreign taxes from one category cannot be used to offset taxes in another category.
The five categories of income are:
- Passive Category Income includes passive income and specified passive category income such as Interest, dividends, and capital gains.
- General category income typically includes wages, salary and self-employment income.
- Section 901(j) Income : No credit is allowed for foreign taxes imposed by and paid or accrued to certain sanctioned countries. However, income derived from each such country is subject to a separate foreign tax credit limitation. Therefore, you must use a separate Form 1116 for income derived from each such country.
- Certain Income Re-Sourced by Treaty : If a sourcing rule in an applicable income tax treaty treats U.S. source income as foreign source, and you elect to apply the treaty, the income will be treated as foreign source.
- Lump-Sum Distributions : This category is used to take a foreign tax credit for taxes you paid or accrued on a foreign source lump-sum distribution from a pension plan.
Foreign Tax Rate
If your local country’s tax rate is higher than the graduated rates you are subject to as a U.S. citizen or resident, your foreign tax credit will likely offset any taxes due to the US. If the foreign rate is lower, then you can expect to pay the difference to the USA.
Foreign Tax Credit Or Foreign Tax Deduction
You can choose each tax year to take the amount of any qualified foreign taxes paid or accrued during the year as a foreign tax credit or as an itemized deduction on Schedule A. However as a general rule, you must choose to take either a credit or a deduction for all qualified foreign taxes. If you choose to take a credit for qualified foreign taxes, you must take the credit for all of them. You cannot deduct any of them. Conversely, if you choose to deduct qualified foreign taxes, you must deduct all of them. You cannot take a credit for any of them.
While it is generally more beneficial to claim the credit, be sure to have a tax professional review both scenarios when preparing your returns. The election to claim the credit or deduction for creditable foreign taxes must be made each tax year. It may be exercised or changed at any time while the statute of limitations to claim any refund or credit remains open for the year in question.
Carryback and Carryover of the Foreign Tax Credit On Form 1116
Any foreign tax credit amount in excess of the maximum limit as reported on the prior year Form 1116 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.
How To Claim The Foreign Tax Credit Or Deduction
To choose the deduction, you must itemize deductions on Form 1040, Schedule A. To choose the foreign tax credit you generally must complete Form 1116 and attach it to your Form 1040. If you are a cash basis taxpayer you can only take the foreign tax credit in the year you pay the qualified foreign tax unless you elect to claim the foreign tax credit in the year the foreign taxes are accrued. Once you make this election, you cannot switch back to claiming the taxes in the year paid in later years.
This is a brief overview of the foreign tax credit and the Form 1116 that is used to claim the credit – it is a great tool for American Expats filing their expatriate tax returns. Be sure to consult us if you have US taxes due, we may be able to eliminate them with the foreign tax credit and other tax items available you as a U.S. expat.
Click here to learn more about the foreign tax credit.
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