Foreign Tax Credit and Double Taxation
Most taxpayers working abroad worry about “double taxation” – paying taxes to two different countries – the U.S. and the foreign country. 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.
Foreign income taxes are income taxes the taxpayer paid to any foreign country. It is important to note that any foreign taxes paid on income that was excluded from U.S. income (i.e. from the foreign earned income exclusion) cannot be claimed as either a credit or a deduction. If foreign earned income was fully excluded, then no 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.
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 foreign tax 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.
Foreign Tax Credit Requirements
In order to be qualify for the foreign tax credit, an expatriate must meet all four of the following requirements:
- The tax must be imposed on you
- You must have paid or accrued the tax
- The tax must be the legal and actual foreign tax liability
- The tax must be an income tax
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
The Foreign Tax Credit
The foreign tax credit is 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 IRS instructions for the Form 1116.
Determining Eligibility For The Foreign Tax Credit
Determining eligibility for the foreign tax credit is based on proper analysis and the individual facts of the taxpayer. If you need help with filing a U.S. tax return with the foreign tax credit, please let us know.