Foreign Tax Credit and Double Taxation (Form 1116)

Expats are often surprised to learn that their U.S. tax obligations don’t end when they move outside the country. Because the United States continues to collect taxes from its citizens even after they have moved to another country, it is important for every expat to understand their obligations and file their returns as required. Fortunately, most expats find that they are able to reduce or even eliminate their U.S. tax liability by claiming certain tax deductions and credits. One such tax benefit available to expats is the foreign tax credit.

United States Tax Law Basics

The United States differs from most other countries in that it continues to charge its citizens tax even when they are not living and working within the country. For many expats, this comes as a surprise. This may also provoke anxiety, as many expats are also paying taxes to their new country of residence. In these cases, expats worry that they will be forced to pay taxes twice on the same income. Luckily, the United States developed the foreign tax credit to prevent this very issue.

However, in order to take advantage of the foreign tax credit, you must meet certain requirements. You must also comply with the IRS’ rules with regard to timely tax return filing and income tax payment. Because expat taxes can be so complicated, many expats choose to consult a tax professional.

Double Taxation

Most taxpayers working abroad worry about “double taxation” – paying taxes to two different countries – the U.S. and the foreign country. When someone is required to pay double the taxes, the loss can be significant. Fortunately, a U.S. taxpayer overseas may be able to reduce U.S. taxable income and “double taxation” by claiming the foreign tax credit on Form 1116. Should any foreign income not be fully offset by the foreign earned income exclusion, housing exclusion or housing deduction, the foreign tax credit paid or accrued may be used as a deduction or credit on the U.S. tax return. Taxpayers can elect to either deduct the taxes as an itemized deduction on Schedule A or claim a credit against tax. In most cases, it is to your advantage to take foreign income taxes as a tax credit.

What Is The Foreign Tax Credit?

The foreign tax credit is a credit generally limited to a taxpayer’s US tax liability on its foreign-source taxable income. This limit is intended to ensure that the credit serves the purpose of reducing or eliminating double taxation of foreign-source income without offsetting or providing a refund on US tax on US-source income. The limit is calculated based on multiplying the taxpayer’s total US tax liability for the tax year by the ratio of the taxpayer’s taxable foreign-source income to the total taxable income for the tax year.

To summarize, the foreign tax credit is a non-refundable tax credit for income taxes paid to a foreign government as a result of foreign income tax withholdings. The foreign tax credit is available to anyone who either worked in a foreign country or has investment income from a foreign source.

For more information about the Foreign Tax Credit, please read more in the Form 1116 Instructions.

Foreign Tax Credit Rules

Determining eligibility for the foreign tax credit is based on proper analysis and the individual facts of the taxpayer. To claim the foreign tax credit, you must meet specific requirements imposed by the IRS. Some of these requirements are discussed below.

Who Can Claim The Credit?

To claim the credit, you must be an individual, an estate or a trust that paid qualifying taxes to a U.S. possession or foreign country. This credit is not typically available to nonresident aliens except in limited circumstances.

What Income Counts For The Foreign Tax Credit?

Your foreign taxes will count for the purposes of the foreign tax credit only if they were paid on allowable income. According to the IRS, qualifying foreign taxes may have been paid on a variety of different types of foreign income such as:

  • Compensation for services performed outside the United States
  • Interest income from a payer located outside the United States
  • Dividends from a corporation incorporated outside the United States
  • Gain on the sale of non-depreciable personal property you sold while maintaining a tax home outside the United States, if you paid a tax of at least 10% of the gain to a foreign country

Which Taxes Count For The Foreign Tax Credit?

Foreign income taxes are income taxes the taxpayer paid to any foreign country. However, not every tax or fee you pay to another country will be considered a “qualifying tax” for the purposes of the credit. In order to be a qualifying tax, the tax must pass four separate tests.

  1. The foreign tax liability must be “legal and actual”. Legal and actual taxes are taxes you actually owe and actually paid. You cannot claim the foreign tax credit for taxes that you don’t really owe or that you could have remedied. Under IRS law, you are responsible for taking advantage of all available remedies to reduce the tax you owe. If you fail to do so, the excess amount won’t be a qualifying tax. Likewise, you cannot count toward this credit any taxes for which you received a refund or could receive a refund.
  2. The tax must be imposed on you. Qualifying taxes are taxes that have been imposed specifically on you. They cannot be taxes you paid on behalf of another party.
  3. You must have paid or accrued the tax. To count a foreign tax toward the income tax credit, you must be able to show that you have already paid or will have to pay the taxes in question as a result of your earning activities in the country.
  4. The tax must be an income tax. The IRS requires you to use only income taxes or taxes imposed in lieu of an income tax for the purposes of the foreign tax credit. You cannot include other taxes imposed by foreign taxing authorities, such as property taxes, for the purposes of this credit.

Several types of taxes you may pay are specifically excluded from the foreign tax credit.

According to the IRS, none of the following taxes will count toward this credit:

  • Refundable taxes.
  • Any tax that provides a subsidy to you or a relative.
  • Taxes you could have legally avoided paying.
  • Taxes accrued to or paid to governments that are not recognized by the United States.
  • Taxes paid to governments that have been designated as in support of terrorism.

Determining whether the taxes you have paid qualify for the foreign tax credit can be confusing. Consulting an Expat Tax Professional in these cases is recommended.

Choosing Between A Credit And A Deduction

The IRS allows taxpayers to claim qualifying taxes as an itemized deduction instead of the foreign tax credit if they so choose. Before you can decide which of these options will be best in your situation, you need to understand the difference between a credit and a deduction. A tax deduction is a benefit that allows you to reduce your taxable income by a certain amount. For example, if your gross income for the tax year was $50,000 and you have a $5,000 tax deduction, your income tax will be calculated as a percentage of $45,000.

A tax credit, on the other hand, is subtracted directly from the amount of tax you owe. For example, if your income tax is originally calculated as $5,000 and you have a $1,000 tax credit, you will pay only $4,000 in income tax. Tax credits can be refundable or non-refundable. While a refundable credit allows you to receive a refund when your credits exceed your tax liability, non-refundable credits do not. It is important to note that the foreign tax credit it non-refundable.

Making The Choice

While a deduction reduces the amount of income on which your income tax will be calculated, a credit reduces your income tax dollar for dollar. In most cases, taking a credit is the better option. However, some taxpayers may still elect to take a deduction instead.

To claim a deduction instead of a tax credit for the foreign taxes you have paid, you must itemize your deductions on Schedule A. Keep in mind that you cannot “split” your qualifying taxes between a deduction and a credit. If you choose to claim an itemized deduction, you must claim the deduction for all foreign taxes you accrued or paid during the year.

It is important to note that any foreign taxes paid on income that was excluded from U.S. income cannot be claimed as either a credit or a deduction. If foreign earned income was fully excluded, then no foreign tax credit or deduction will be available. If the foreign earned income was only partially excluded, the foreign taxes must be allocated between the income excluded and the income not excluded. The most common situations in which foreign income has already been excluded involve the foreign earned income exclusion and the foreign housing exclusion.

The Foreign Tax Credit And The Foreign Earned Income Exclusion

The foreign tax credit is not the only tax benefit available to people who earn income in a foreign country. The IRS also allows taxpayers to exclude income they earn in a foreign country from their U.S. taxable income under the foreign earned income exclusion. In many cases, the foreign earned income exclusion will be more beneficial than the foreign tax credit.

It is important to note that the IRS will not allow you to claim both the foreign earned income exclusion and the foreign tax credit for the same income. The reason for this restriction lies in the fact that, if you are able to exclude your income from your U.S. tax return, there is no double taxation. Thus, you do not need the tax credit.

When choosing between the foreign earned income exclusion and foreign tax credit, it is an easy choice to use the exclusion if no foreign taxes were paid. However, if you are working in a country where the tax rate is the same or higher than the U.S, it may be more advantageous to claim the credit only. Further, depending on your income and the rate of tax in your resident country, it may make more sense to use a combination of the exclusion and credit; then again it may not. Either way, a proper analysis and comparison is recommended to determine what is based on the individual situation.

In some cases, even after choosing the foreign earned income exclusion, a taxpayer may have earned more total income than he or she was able to exclude with this method. In this case, the taxpayer may be able to claim a partial tax credit for any tax that can be attributed to the excess income.

Situations in which the taxpayer must choose or allocate income between the tax credit and the foreign earned income exclusion can be complicated. For this reason, it is best for expats to consult a professional tax preparer for guidance and assistance.

Foreign Tax Credit And Foreign Housing Exclusion

The foreign housing exclusion or deduction is another popular tax benefit available to United States taxpayers who live and work overseas. If you paid for qualifying housing expenses with employer-provided funds, you may be able to exclude a portion of these amounts from your taxable income for U.S. purposes. If you paid for qualifying housing expenses with self-employment income, you may be able to claim a deduction for a portion of these amounts on your United States tax return.

Just as you cannot use the foreign tax credit for taxes based on income you excluded under the foreign earned income exclusion, you cannot claim the credit for any taxes based on income excluded under the foreign housing exclusion or deduction.

How To Claim The Foreign Tax Credit

In most cases, you must file Form 1116 in order to claim the foreign tax credit. However, if you meet certain requirements established by the IRS, you may be able to claim the foreign tax credit without filing this form. In order to elect to claim the foreign tax credit without Form 1116:

  • You must not be filing on behalf of a trust or an estate.
  • Your qualifying foreign taxes must not exceed the limit for your filing status, as listed in Form 1040 instructions.
  • You must have only passive foreign source income, such as dividends and interest.
  • All of your foreign income taxes and foreign source income must appear on a qualified payee statement, such as Schedule K-1, Form 1099-DIV or Form 1099-INT.

Keep in mind that claiming the foreign tax credit without filing Form 1116 will prevent you from carrying back or carrying forward any unused foreign taxes.

Completing Form 1116

The top of Form 1116 requires you to supply basic information about yourself and your income, such as your name, identifying number and country of residence. You will also need to indicate the category of income you receive. Keep in mind that, if you receive more than one type of foreign income, you will need to complete a separate Form 1116 for each category of income.

In Part I and Part II of the form, you will input more specific information about the income you earned and the taxes you paid. If you received income and/or paid income taxes to more than one country, you should input this information on a country-by-country basis. You will also list certain deductions and expenses on this part of the form.

Calculating The FTC

When using Form 1116 to compute the FTC, the total credit will be the smaller of the U.S. tax that can be attributed to your foreign source income or the total amount of foreign tax you accrued or paid. The form itself includes detailed line-by-line instructions to help you calculate the specific credit you can claim. Additional instructions are available in a separate document published by the IRS. However, many taxpayers find these instructions confusing and complicated. If you are struggling to calculate the proper foreign tax credit, consider contacting an expat tax professional for assistance.

Foreign Tax Credit Carryback And Carryover

In some cases, the qualifying foreign taxes you paid during a given year may exceed the limit imposed on your foreign tax credit. If you are in this situation, you may be able to carry back the unused foreign income tax to a previous tax year and/or carry over the unused foreign income tax to a future tax year. The IRS allows a one-year carryback only, but you can carry unused taxes forward for up to 10 years. Keep in mind that you cannot use carrybacks or carryovers if you do not file Form 1116. If you think you may have any excess tax credit, it is best to file this form.

Amending Your Tax Return For The Foreign Tax Credit

If you were eligible to claim a foreign tax credit for a previous year that would have resulted in a refund but you claimed an itemized deduction instead, you can resolve the issue by amending the return. To amend the return, you must file Form 1040X. To receive a refund related to an amended return, the return must be filed within 10 years of the original return’s due date. This is different from the three-year restriction on amended tax returns that usually applies. You can also amend your previous return using this method if you need to correct the calculations you made on a foreign tax credit you previously claimed.

Keep in mind that you must file an amended return if you ultimately receive a refund or reduction of the foreign taxes you used to calculate the credit. Because this type of amendment typically requires you to pay more taxes to the United States, it applies even after 10 years have passed.

Most Common Mistakes

Making a mistake when dealing with the foreign tax credit can have a variety of consequences. Depending on the nature of the mistake, you may simply lose money, or you may even get in trouble with the IRS. Thus, it is important to avoid mistakes as often as you can. Some of the most common foreign tax credit mistakes include:

  1. Missing out completely. Some taxpayers simply aren’t aware of the foreign tax credit and may miss out on its benefits entirely. In such cases, the taxpayer pays more tax than necessary. If you have missed out on the foreign tax credit, you may be able to amend your tax return. Some expat taxpayers may even fail to file their returns altogether because they are unaware of the foreign tax credit and other benefits available to U.S. taxpayers living and working outside the country. However, failing to file a required tax return is never a good idea. The IRS has a lot of resources it can use to identify and track down taxpayers who have not filed their returns. Once the IRS becomes aware of your delinquent returns, you will face penalties related to your failure to file, as well as any tax you owe. For this reason, it is always better to file a tax return if you meet the filing threshold.
  2. Double dipping. Some taxpayers may use the same income to qualify for the foreign earned income exclusion and the foreign tax credit, leading to problems with the IRS. An amendment to your tax return will be required in this case.
  3. Choosing the wrong tax benefit. If you are eligible for both the foreign earned income exclusion and the foreign tax credit, you must choose which of these benefits to claim for the majority of your income. Making the wrong decision can lead to significant financial losses. In the past, the foreign earned income exclusion was the preferred benefit for most taxpayers. Today, however, there are more circumstances in which the foreign tax credit can provide a greater benefit. For this reason, consulting a professional is recommended.
  4. Failing to consider the possibility of a child tax credit or Roth IRA. Making the wrong choices with regard to the foreign tax credit can impact your ability to collect other tax benefits. For example, if you use the foreign earned income exclusion to exclude all of your income instead of claiming the foreign tax credit, you will lose the ability to contribute your after-tax dollars to a Roth IRA (since you won’t have an after-tax dollars). Likewise, if you exclude all of your earned income with the foreign earned income exclusion instead of claiming the foreign tax credit, you may miss out on the refundable child tax credit as well.
  5. Calculating the foreign tax credit incorrectly. Intricate and complex calculations are required. Although the form you file when claiming this credit includes instructions intended to help you calculate the credit, many taxpayers make mistakes. If you make a mistake in the calculation of this credit, you may either pay too much or too little in taxes. Either situation can cause unintended consequences.

All of the mistakes above can be avoided by seeking professional expat tax help.

Getting Help

Like many topics related to expat taxes, the foreign tax credit can be complicated. There are many rules associated with this credit, as well as many decisions you must make when you qualify for it. For example, if you qualify for both the foreign earned income exclusion and the tax credit, you must decide which benefit to rely on. In some cases, you may even be better off using a combination of these benefits. In some cases, you may need to decide whether you will carry back or carry forward excess credits. You may also need to decide whether you will claim the credit by completing Form 1116 or elect to claim it without filing this form.

Each of these decisions can have a considerable impact on your tax liability and/or your ability to qualify for other tax benefits. To make the best decisions, you must look at all possible options while taking the intricate details of your unique tax situation into consideration. For this reason, consulting an expat tax professional is highly recommended for anyone who may qualify for the foreign tax credit.

Tax Samaritan is a boutique tax firm that specializes in tax preparation for Americans who live and work abroad. We have been helping expats prepare their tax returns for several years, and we have the knowledge and experience necessary to help you make the right choices. If you trust Tax Samaritan to handle your tax needs, we will consider all aspects of your situation carefully so you can minimize your tax liability and maximize your wealth. We will also help you make sure you are always in compliance with all IRS requirements so you can avoid penalties, interest and any other complications.

In addition to helping with the foreign tax credit, Tax Samaritan offers comprehensive tax preparation, tax resolution and wealth management services to expats. Please contact us today to find out more about the services we offer.