What is Foreign Tax Credit?
As a US citizen or US permanent resident tax payers receiving earnings from foreign countries or US possessions, you may be obligated to pay taxes to foreign country for those earnings. Additionally, you are also subject to US income tax for same foreign income as well. Yes, US citizen or permanent resident is taxed on their worldwide income even when you have paid foreign tax. In order to avoid double taxation of the same income, IRS provides you foreign tax credits for actual tax paid to foreign country against foreign earning to lower your US tax liability.
Who can claim foreign tax credits?
If you are a domestic corporation, a US citizen or a US resident, you can claim FTC (Foreign Tax Credit) under the section 901(B). If you belong to the alien resident category, you can still ask for the tax refund with some limitations.
- Foreign tax must be paid or accrued
- for joint return filings, credit can be claimed on total foreign income earned by you and your spouse
- for combined incomes of 2 or more persons, each person can claim appropriate credits on their portion of the combined income
- as a mutual fund shareholder, you can claim credit on your portion of foreign income tax paid by the fund (possible only if fund allows credits to be claimed by shareholders) – Relevant form: FORM 1099-DIV.
- Only legal and “Actual” foreign tax liability can be used to claim credit. Here “Actual” refers to foreign tax minus any refundable tax amounts issued by foreign government or US possession.
To better understand, let’s look at an example: “Mark is a U.S citizen who is sent to Country ‘C’ to work for 1 week by his US employer. He earns $1500 as a result and pays $300 in tax withholding. Mark files a return in county “C” and gets a refund of $100. Actual tax paid by Mark in country “C” is $200 ($300 withholding -$100 refund). When Mark files a US tax return, he then would be able to claim $200 since this is actual tax paid as a foreign tax credit against foreign earned income”
Computing and claiming your foreign tax credit
The foreign tax credits that can be claimed is (a) equivalent to foreign tax paid or accrued or, if lesser, (b) Credit limit.
Credit Limit calculation:
Your credit limit = US tax liability x Taxable Foreign Income( Total Foreign taxable income/ Total Income before Expemtions)
In order to claim your tax credits, as an (a) individual you must file Form 1116 and as a (b) Corporation you must file Form 1118. If however, you qualify the following criteria for the elected tax year, you may be exempt from the foreign tax credit limit and filing of Form 1116:
- your total foreign income in that tax year is passive (defined by Publication 514 – Separate limit income)
- foreign tax shown to claim credit is not more than $300 ($600 in joint filings)
- total foreign income and taxes are documented through forms such Form 1099-DIV or 1099-INT
In this case, you are required to file only Form 1040X- Amended US income tax return.
Foreign tax Carryover and Carryback
As stated in, due to the credit limit, if some portion of paid or accrued taxes cannot be used in that tax year* to claim credit, then it may be carried back to the first preceding year or carried over through the next succeeding 10 years.
*(A tax year is defined as a period of less than 12 months for which you file your tax return)
Electing Tax Credits or deductions?
You may choose to elect only EITHER tax credits OR deductions for your total foreign income for that tax year, NOT both. Electing tax credits in most cases tips the scale of benefits to you as:
- it impacts your US tax liability and not your income subject to tax like deductions do
- you are eligible to avail standard deduction in addition to your credits (This is not possible with itemized deductions)
- unused foreign taxes can be carried over or back to other tax years
Also read Report of Foreign Bank and Financial Accounts (FBAR)