Foreign Tax Credit

The Foreign Tax Credit provides a dollar-for-dollar offset for income taxes paid abroad. However, determining what constitutes a “qualified foreign tax” is a complicated matter, and there is a limit on how much of the credit you can claim in any given year. The credit is designed to avoid a double tax burden, where income taxes are paid in both the United States and the country where the income was earned. In order to qualify for the credit, you must meet two basic requirements:

• First, you must be a U.S. citizen or resident alien paying a foreign income tax.
• The second requirement is that the foreign tax must be an income tax or a tax in lieu of an income tax.

In addition, the credit can only reduce a taxpayer’s U.S. tax liability to zero or lower it to the amount of taxes paid or accrued abroad. It is important to note that not all foreign taxes qualify as credits. For example, value-added taxes, sales taxes, and tariffs do not qualify for the credit but may be deductible as an itemized deduction. As the rules are complex, it is recommended that anyone considering using the foreign tax credit speaks with an expat tax specialist to ensure they understand what is and is not eligible. A qualified advisor can also help you decide whether to use the credit or if it is preferable to take advantage of the Foreign Earned Income Exclusion instead.

How to Claim a Foreign Tax Credit?

To claim a Foreign Tax Credit, taxpayers must file Form 1116 and itemize them on Schedule A (Form 1040) if their qualified foreign taxes paid or accrued during the year exceed $300 for singles and $600 for married couples filing jointly. This form can be complex because it requires reporting foreign taxes paid by the country and figuring out the credit limit for each income category separately. It is also important to note that the foreign tax credits are limited and only apply to taxes paid or accrued during the year. Any unused credit can be carried forward for 10 years. It is also important to remember that you can only claim the Foreign Tax Credit on your qualified foreign taxes. For example, if you are a U.S. expat who pays tax in Canada on qualified passive income and you elect to use the Foreign Earned Income Exclusion, you will not be able to take advantage of the Foreign Tax Credit on that same amount of money.

How Much Foreign Tax Can I Claim?

The amount of foreign taxes you can claim is calculated based on the percentage of your taxable income that represents foreign-sourced earnings. To figure this out, you’ll divide your taxable income (before exemptions) by your total taxable income before exemptions. You can then add up the amounts of the different types of foreign taxes you’ve paid. The maximum credit you can claim is usually limited to a fraction of the U.S. income tax attributed to the foreign-sourced earnings; this limitation is discussed in detail in IRS Publication 514, Foreign Tax Credit for Individuals, and Form 1116, Foreign Tax Credit for Individuals (Individual). You can choose to adjust your credit limit each year.

Should I Choose Foreign Tax Credit or Deduction?

When it comes to filing your taxes, you have the option to choose between a foreign tax credit and a deduction. However, you cannot claim both at the same time. A credit reduces your income tax liability dollar for dollar, while a deduction only reduces your taxable income by the amount of your qualifying foreign taxes. If you are not sure which one to take, you should consult with a professional expat tax expert. They can help you calculate your foreign tax credit limit and determine which method to claim the credits is best for you. You can also use a foreign tax credit carry forward option, which allows you to apply for the excess credit in subsequent years.

Generally, a foreign tax credit is more advantageous than a foreign tax deduction. This is because the credit is applied against your income tax liability at the end of the year. At the same time, a deduction is only considered during the year it was paid. The foreign tax credit is also more advantageous when your income is earned in a high-tax country.