Foreign Tax Credit
Double taxation on foreign income is a problem that US expatriates and Green Card Holders face each year when they file their US income tax returns. Fortunately, there are several ways to avoid double taxation on your foreign income: the Foreign Earned Income Exclusion (FEIE) and the Foreign Tax Credit (FTC). Each method (and, yes, even a combination of both) can provide US expats with a valuable benefit that is intended to reduce the double tax burden that would otherwise arise when their foreign source income is taxed by both the United States and the foreign country from which the income is derived.
But be aware that the foreign tax credit laws are complex and tax treaties complicate matters even more. That is the main reason that expats should always consult international tax professionals such as American Tax Group when preparing their income tax returns.
Why choose the Foreign Tax Credit?
The Foreign Tax Credit is beneficial to many taxpayers living and paying income taxes overseas. If you are an expat that resides in a foreign country that has the same or a higher income rate than the US rate, the Foreign Tax Credit is almost always more advantageous to take than the Foreign Earned Income Exclusion. With the Foreign Tax Credit you can:
- Reduce your actual US income tax on a dollar for dollar basis.
- If the taxes paid or accrued exceed the credit limit for that year, you may be able to carry back the excess to the prior tax year or carry it forward for up to 10 years.
- You do not have to meet the bona fide residence or physical presence tests.
- You may more easily qualify for tax benefits such as the Child Tax Credit or the ability to make a contribution to a Roth IRA
Who can qualify for the Foreign Tax Credit?
- You may be able to take the credit if you paid foreign income tax and are subject to US tax on your foreign sourced income and you are
- A US citizen or
- A resident alien or
- A nonresident alien if you
- Were a bona fide resident of Puerto Rico during the entire tax year or
- You pay or accrue tax to a foreign country or U.S. possession on income from foreign sources that is effectively connected with a trade or business in the United States. But if you must pay tax to a foreign country or U.S. possession on income from U.S. sources only because you are a citizen or a resident of that country or U.S. possession, do not use that tax in figuring the amount of your credit.
How do I qualify for the Foreign Tax Credit?
A taxpayer must meet the following four tests to qualify for the credit:
- The tax must be imposed on you
- You must have paid or accrued the tax
- The tax must be a legal and actual foreign tax liability, and
- The tax must be an income tax
Which income taxes or taxes in lieu of an income tax qualify for the foreign tax credit?
Generally, you can take the credit or deduction for
- Income, war profits, and excess profits taxes (income taxes)
- Foreign taxes on wages
- Foreign taxes on dividends
- Foreign taxes on interest
- Foreign taxes on royalties
And if the
- income taxes were paid or accrued to a foreign country or a U.S. possession, or
- taxes were paid or accrued to a foreign country or U.S. possession in lieu of an income tax
Which foreign taxes are not eligible for the foreign tax credit?
You cannot take the Foreign Tax Credit on
- Taxes on excluded income (such as income excluded under the Foreign Earned Income Exclusion)
- Taxes for which you can only take an itemized deduction
- Taxes on foreign mineral income
- Taxes from international boycott operations
- A portion of taxes on combined foreign oil and gas income
- Taxes of U.S. persons controlling foreign corporations and partnerships who fail to file required information returns, and
- Taxes related to a foreign tax splitting event
However, these foreign taxes may be eligible as part of your itemized deductions on Schedule A.
Which tax form do I use to claim the foreign tax credit?
You must file the Form 1116 to claim the foreign tax credit, however, several Form 1116s may have to be filed for each year depending if you have different categories of income. The complexity of the form itself and its 23 pages of instructions can be overwhelming. Not only does the Foreign Tax Credit need to be calculated for regular tax purposes for each category of income, but also for Alternative Minimum Tax (AMT) purposes. That is why it is wise to hire an international tax expert to help you with your tax returns.