Taxpayers working abroad are given the option to claim the foreign earned income exclusion or a credit for the taxes paid to a foreign country, the foreign tax credit. Moreover, if the taxpayer decides for the foreign earned income exclusion, and the earned income is not 100% excluded, the taxpayer may claim a foreign tax credit for taxes paid on the non-excludable foreign source income.
The foreign tax credit is intended to relieve taxpayers of a double tax burden when their foreign source income is taxed by both the United States and the foreign country. In most cases, if the foreign tax rate is higher than the U.S. rate, there will be no U.S. tax on the foreign income. If the foreign tax rate is lower than the U.S. rate, U.S. tax on the foreign income will be limited to the difference between the rates. The foreign tax credit can only reduce U.S. taxes on foreign source income; it cannot reduce U.S. taxes on U.S. source income.
Claiming the Foreign Tax Credit
You can claim a credit only for foreign taxes that are imposed on you by a foreign country or US possession. Generally, only taxes imposed on income qualifies for the credit.
You cannot take a credit for foreign income taxes paid on earnings you exclude under the foreign earned income exclusion and the foreign housing exclusion. If your wages are completely excluded, you cannot take a credit for any of the foreign taxes paid on your wages. If only part of your wages is excluded, you cannot take a credit for the foreign income taxes allocable to the excluded part.
The foreign income tax for which you can claim a credit is the amount of legal and actual tax liability you pay or accrue during the year. The amount for which you can claim a credit is not necessarily the amount withheld by the foreign country. You cannot take a foreign tax credit for income tax you paid to a foreign country that would be refunded by the foreign country if you made a claim for refund.
Foreign Tax Credit Requirements
In most cases, only foreign income taxes qualify for the foreign tax credit. Other taxes, such as foreign real and personal property taxes, do not qualify. But you may be able to deduct these other taxes as an itemized deduction on Schedule A (Form 1040) even if you claim the foreign tax credit for foreign income taxes.
Generally, the following four tests must be met for any foreign tax to qualify for the credit:
- The tax must be imposed on you
- You must have paid or accrued the tax
- The tax must be the legal and actual foreign tax liability
- The tax must be an income tax (or a tax in lieu of an income tax)
Foreign Tax Credit Limit
There is a limit on the credit you can claim in a tax year. The foreign tax credit is limited to the part of your total U.S. tax that is in proportion to your taxable income from sources outside the United States compared to your total taxable income. The allowable foreign tax credit cannot be more than your actual foreign tax liability. If your qualified foreign taxes exceed the credit limit, you may be able to carry over or carry back the excess to another tax year
The amount of foreign income tax not allowed as a credit because of the limit can be carried back 1 year and carried forward 10 years.
Credit for Taxes Paid or Accrued
You can claim the credit for a qualified foreign tax in the tax year in which you pay it or accrue it.
If you choose to take a credit for foreign taxes in the year they accrue instead of the year they are paid, you must follow it in all later years and take a credit for foreign taxes in the year they accrue. In addition, the choice to take the credit when foreign taxes accrue applies to all foreign taxes qualifying for the credit. You cannot take a credit for some foreign taxes when paid and take a credit for others when accrued.
If you make the choice to take the credit when foreign taxes accrue and pay them in a later year, you cannot claim a deduction for any part of the previously accrued taxes.
Option for a Credit or Deduction
You can take either a credit or a deduction for income taxes paid to a foreign country or a U.S. possession. Taken as a deduction, foreign income taxes reduce your taxable income. Taken as a credit, foreign income taxes reduce your tax liability. You must treat all foreign income taxes the same way. If you take a credit for any foreign income taxes, you cannot deduct any foreign income taxes. However, you may be able to deduct other foreign taxes.
In most cases, it is to your advantage to take foreign income taxes as a tax credit, which you subtract directly from your U.S. tax liability, rather than as a deduction in figuring taxable income. The foreign tax credit is claim on Form 1116 while the deduction is claim as part of your itemized deductions on Schedule A.