Foreign Tax Credits

Mitigate double taxation on foreign source income.

Income tax systems provide the foreign tax credit (FTC) to mitigate double taxation on foreign source income. A tax reduction (credit) is offered for similar income taxes paid to foreign countries.

It is available to those earning income through foreign investment or international trade. The credit generally applies to income tax or taxes in place and is often restricted to the amount of available credit. 

Tax credits generally work this way: you owe the government $3,000 in taxes and a $1,000 tax credit, so you end up paying only $2,000. FTC gives you credit to use on your taxes, lowering your tax liability.

The tax paid in one country is used to offset the tax liability in another country. FTC is one of the methods to eliminate double taxation. It helps businesses operate smoothly within existing tax systems.

Amounts over the income tax are generally non-refundable. As a result, most systems attempt to limit FTC in some manner. For example, the maximum credit allowed to be claimed on the tax liability generated by foreign source income and the tax already paid.

The following criteria must be met To qualify for claiming a foreign tax credit:

  • The tax must be income tax
  • The tax must be an FTC and legal
  • The tax must be imposed on the individual, and the same individual must have accrued or paid the tax.

Form 1116 must be filed to claim a foreign tax credit in the US as an individual, trust, or estate if certain foreign taxes have been accrued or paid to an external country or US possession. Before completing form 1116, the external taxes must be converted into US dollars.

The concept of double taxation

Double taxation is the levying of tax by two or more income tax systems on the same income, asset, or transaction. For example, income may be taxed in the country where it arises and in the home country where it is remitted simultaneously. 

In some cases, the total tax is so high that it makes international business infeasible. Double taxation is an incidental repercussion of tax laws, hence why tax authorities seek to avoid it whenever possible.

The Double Tax Avoidance Agreement (DTAA) is a tax treaty signed between two or more countries to help taxpayers avoid paying double taxes on the same income. 

A DTAA becomes applicable in cases where an individual is a resident of one nation but earns income in another country. For example, double taxation occurs in international deals or through an investment when the same income is taxable in two countries. 

Countries may avoid double taxation either by providing an exemption from taxation of external source income or an FTC for tax paid on external source income. FTC is used by countries that tax residents on income, irrespective of where it arises. 

The FTC method requires the home country to allow a credit against domestic tax liability where the person or company pays foreign income tax.

How does foreign tax credit (FTC) work?

The income generated by a resident taxpayer for the services provided in an external country is called foreign source income. 

Some taxpayers may have to pay tax in their home country and then spend the tax on the same earnings in the external source income country. The tax systems are aware of the double taxation in such cases. 

Therefore, the tax systems allow the taxpayers to claim FTCs or deduct the tax paid on foreign income. Usually, claiming FTC proves to be more beneficial than going for a deduction. 

However, taxpayers must check their tax liability in both scenarios and choose an option suitable for them. 

How to claim a foreign tax credit?

To claim FTC in the United States, you may have to file form 1116 and IRS schedule 3 on form 1040. In addition, you may also have to report to the IRS your assets overseas via IRS form 8938.

The schedules of form 1040 require the taxpayers to disclose their annual income to evaluate if additional taxes are required to be paid or if they will receive a refund.

Qualifying foreign taxes

Credit for foreign taxes can be claimed if the tax is imposed on the individual or business by an external country or domestic country's possession. 

The following four tests must be answered affirmatively for any foreign tax to qualify for foreign credit:

  1. The tax must be levied on you
  2. It must be an income tax or its substitute
  3. The tax must have arisen or paid by you
  4. The tax must be legal and actual external tax liability

The Internal Revenue Service (IRS) refers to these questions as tests. Therefore, you cannot qualify if your answer is not "yes" to all these questions.

The actual foreign tax liability paid or accrued during the year constitutes part of qualified foreign tax. The amount of foreign tax qualified for FTC is not unquestionably the amount of tax retained by the foreign country. 

The amount of the foreign tax that qualifies for the FTC must be deducted by any refunds of foreign tax made by the foreign country's government or the domestic country's possession.

You can select any amount of qualified foreign taxes paid during the year as a credit or a deduction. However, it would help if you chose the FTC or itemized deduction for all external taxes paid or accrued during the year. It is an annual choice.

To claim it as a deduction, you must list the deductions on Schedule A of form 1040. To claim it as FTC, you generally must complete Form 1116 and attach it to your Form 1040Form 1040-SR, or Form 1040-NR

Foreign taxes that do not qualify for FTC

To claim the FTC, you must have paid income taxes to an external country. There are some foreign taxes on which one cannot take credit for foreign tax. The IRS says the following types of external taxes are not eligible for the FTC:

  • Refundable tax
  • Taxes on excludable income (foreign earned income exclusion)
  • Taxes that are returned to you in the form of a subsidy to you or someone related to you
  • Taxes on mineral income
  • A part of taxes on combined oil and gas income from overseas
  • Taxes from international boycott operations
  • Taxes on itemized deduction
  • Taxes of US citizens managing overseas corporations, businesses, and partnerships who do not file the required returns
  • Taxes under a foreign tax splitting event

Foreign tax credit carryover

The taxpayer can carry over the unused foreign income tax if he can't claim a credit for the total amount of qualified foreign income taxes you paid or arisen in the year. 

However, no carryback or carryover is allowed for foreign tax on income included under section 951A. 

One of the best things about claiming the FTC is the foreign tax credit carryover. You can carry back the unused credit for one year and then forward it for ten years. 

Choosing to take tax credit or deduction

The taxpayer can choose to take any amount of the qualified foreign taxes paid during the year as a foreign tax credit or as an itemized deduction. The choice can be changed for each year's taxes. 

As a general rule, the taxpayer must choose to take either a credit or a deduction for all qualified foreign taxes. You're not allowed to do both in a single year. If you opt to take credit for qualified foreign taxes, you must take credit for all of them. You cannot deduct any of them. 

Similarly, if you choose to deduct qualified foreign taxes, you must remove all of them. You cannot take credit for any of them.

Reasons to choose credit (FTC)

The foreign tax credit relieves the taxpayer of the double tax burden when their external source income is taxable by both the home country and the outer country.

It is generally better to take an FTC for qualified foreign taxes than to claim a deduction and reduce the liability as an itemized deduction. 

  1. An FTC reduces your actual income tax on a dollar-for-dollar basis, while a deduction reduces only your taxable income.
  2. You can opt to take the foreign tax credit even if you do not itemize your deductions.
  3. If you choose to take the foreign tax credit and the taxes paid or accrued exceed the credit limit for the tax year, you can carry the excess credit to another tax year.

In most cases, the tax credit is the best choice. The only drawback to the tax credit is that extra paperwork is required. 

As per the Internal Revenue System (IRS), if your FTC is more than $300 for a single person ($600 for married couples filing jointly), you must prepare Form 1116 to claim the credit. 

This form can be complicated to prepare, depending on how many FTCs you claim.

Foreign tax credit vs. foreign earned income exclusion

The foreign tax credit and the foreign earned income exclusion are both devised to provide relief from double taxation, but they achieve this objective very differently. 

The FTC is used for the taxes already paid to an overseas government, which reduces your tax liability. In addition, the foreign earned income exclusion prevents double taxation by excluding income taxed in an overseas country from U.S. taxation.

To claim the foreign earned income exclusion, you must have foreign earned income, your business or employment must be located in a foreign country, and you must be one of the following to pass a bona fide residence test:

  • A US citizen who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year,
  • A US immigrant who is a citizen or national of a country with which the United States has an income tax treaty in effect and who is a bona fide resident of an external country for an uninterrupted period that includes an entire tax year
  • A US citizen or an immigrant who is physically present in an external country or country for at least 330 full days for 12 consecutive months.

The foreign earned income exclusion (FEIE) is an excellent method to save on taxes. 

The following are some situations in which claiming foreign earned income exclusion may help you:

  1. Your foreign taxes are lower than the US tax rate: If you pay less tax abroad than you would in the US, the FEIE would generally be the better option.
  2. You do not pay foreign income tax: In this situation, claiming the FEIE is the best way to ensure you get to save maximum.
  3. You have an Income-Driven Repayment (IDR) plan for a US student loan: For expats who have an IDR plan and do not earn more than the FEIE threshold limit of about $100,000 and do not have any other source of income, the adjusted gross income would be reduced to zero.

Hence, the monthly repayments, which are calculated based on adjusted gross income, would also be reduced to zero. This exclusion can benefit US ex-pats with student loan debt significantly. 

limitations

Many residents abroad wonder whether there's a limit on the amount of FTCs that can be claimed.

Consequently, another provision by the Internal Revenue Service (IRS) called the Foreign Earned Income Exclusion, an alternative that Americans living abroad can claim to reduce their US tax bill, has an upper limit.

The FTC limitation is intended to prevent a taxpayer from obtaining an offset of external taxes against US tax on US-source income. Therefore, the maximum credit is limited to the amount of the US tax on external income.

Income is categorized depending on its nature, and a credit limitation amount is evaluated separately for each type.

The taxpayer's foreign tax credit cannot be more than your fraction multiplied by the total US tax liability. 

The fraction's numerator is your taxable income from sources outside the US. The fraction's denominator is your combined taxable income from US and external sources.

If you have external taxes available for credit but cannot use them because of the FTC limit, you may be able to carry them back to the previous tax year and forward to the next ten tax years. 

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Researched and authored by Sumedha Vasadi | LinkedIn

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