What is the Foreign Tax Credit and How Does Foreign Tax Credit Work?

What is the Foreign Tax Credit and How Does Foreign Tax Credit Work?
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Understanding the Basics

If you read about taxation processes, you will be welcomed by heavy jargon from everywhere. Nobody understands your situation more than we do! We have been dealing and fighting with this jargon for ages and pledged to make sure nobody else goes through the same problem.

Let’s break this heavy term (Foreign Tax Credit) into basic understandings. Imagine that you decided to move to Canada on some busy day in the U.S. and wanted to get a teaching job there. Everything is perfect here. You moved out, got the job, and started to teach your outstanding students.

Months passed, and you were getting a decent salary as well. The Canadian government made sure to get its share as well. They started to deduct taxes from your income.

After some time, you decided to get back to the U.S. Once you moved inside your country (the U.S.), it asked you to declare all the income you earned in the foreign country.

Following the legalities, you declared the income, and suddenly you got to know that all the income you earned in a foreign country is taxable. Taking dollars out of your pocket, which resulted from intense hard work, is very frustrating.

You immediately decided to consult a cross-border tax expert, and he/she told you that the income tax you paid in a foreign country was counted under Foreign Credit. Moreover, by using foreign credit, you can lower your taxes in the U.S.

To conclude, FTC (Foreign Tax Credit) is a credit you can use to take off U.S. taxes. This is mainly obtained from the income tax you pay in a foreign country.

Foreign Tax Credit has its limitations and rules. You are required to fulfill its eligibility requirements as well to obtain it. We have discussed its aspects in the coming section of the article.

Are Foreign Tax Credit and Tax Deduction the Same Terms?

Both are different concepts. In the tax deduction, your taxable income gets reduced. For example, in 2021, your taxable income was $20,000. You’re given a tax deduction of $10,000. This would make your taxable income $10,000, and you are liable to pay taxes in this bracket.

Moreover, Tax Credit directly takes off the amount you pay in taxes. For example, in 2021, the U.S. government asks you to pay a $35,000 tax. In your tax credit, you hold $5,000. You will be liable to pay $30,000 of tax. Your $5,000 (Tax Credit) has been reduced from your original taxed amount ($35,000).

explaining tax credit vs tax deduction

Eligibility Requirements for FTC

The FTC does NOT apply to all your foreign country-paid taxes. In short, you follow some of the guidelines to list your foreign paid tax in the Foreign Tax Credit.

We have mentioned some of the general rules over here:

  • You are bound to pay the taxes, which have been regulated on you by the foreign country.
  • You must pay the tax to consider it as a Foreign Tax Credit.
  • It should be legal.
  • The foreign tax should be imposed on your income.
  • In a tax year, passive income should be the source of income.
  • Qualified foreign taxes have limitations. They should NOT exceed $300 (filing individually) and $600 (filing jointly).
  • The taxes you paid in a foreign country should come to you on a statement, for example, like Form 1099.

We have also given some great insights about the foreign tax credit. These guidelines can help you while filings your taxes.

Type of Foreign Tax Credit

There are two types of foreign tax credit. The first one is called Refundable, while the second is called Non-refundable.

Refundable Tax Credit implies that you can get a refund if the tax credit limit exceeds your yearly tax. For example, in 2021, you are liable to pay $4,000 in taxes to the U.S. government. Moreover, you have a refundable $5,000 foreign tax credit. In such cases, you are liable to get a refund of $1,000.

This situation is different in Non-Refundable Foreign Tax Credit. Even if your tax credit exceeds your yearly tax, you won’t get any refund in such cases.

Forms You May Need to Submit & Deadlines You Need to Know

To claim the foreign tax credit, you need the IRS Form 1116 and your tax returns.

The due date to submit the form is April 15th. However, expats are given automatic deadline extensions to June 15th.

Moreover, we have written a complete dedicated article to explain how to calculate your foreign credit tax.

Claim Your Foreign Tax Credit Today

If you feel burdened by a lot of information, we are here to help you. We, at AkifCPA, maintained years of professionalism while filing taxes and making sure that people save money with us.

Contact us now and get your taxes reported quickly.

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