Foreign Tax Credit (FTC): If you are earning some taxable income from a foreign country and you are not a legal resident of that country, then you are subjected to pay relevant taxes to that foreign country, further to this the country where you are permanently residing and of which you are a legal citizen, will charge you on your world wide income, according to their tax rules.
As a result, taxpayers who are having taxable earnings outside the residential country will end up paying tax two times for their foreign earnings. To address this problem several countries, have laws to exempt the earned foreign income from the total tax liability of taxpayers, if it is already filed in the country from where the income is earned. In this case, you will be eligible to claim a deduction or credit of taxes paid based on the tax rules of the country and this is called a “foreign tax credit”.
Eligibility Criterion To Claim For Foreign Tax Credit:
You must satisfy certain eligibility criterion to qualify and claim for foreign tax credit. To qualify, first you should be a legal United States citizen or U.S. resident and you need to qualify on at least one of the below mentioned conditions:
- If you have paid foreign tax for your shareholdings on certain mutual funds then you can claim the credit against that, this amount will be reported on form 1099-DIV.
- If you have earned some taxable income on a foreign country and you have already paid the applicable taxes to that country and that related foreign income is not a part of “Foreign Earned Income Exclusion” list.
- If you are a part of a foreign trust or estate and the foreign trust or estate had paid some tax to the foreign country, then you may be eligible for foreign tax credit based on your proportion of share in the trust or estate.
- If An organization claimed credits on the tax spent and the credit is not received, and you are a partner or shareholder of that foreign organization you can also claim for foreign tax credit which should be proportional to your shareholding part on the due amount. You need to report this amount on Schedule K-1.
Which One To Choose Tax Credit or Tax Deduction?
You have the flexibility to choose, if you want to get a tax credit or tax deduction for the qualified foreign taxes you already paid or accrued during a tax year and you have the flexibility to change your choice each year. In most of the cases it is a better idea to take a tax credit instead of a tax deduction, because a tax credit directly reduces the amount of tax you owe and thus reduces your tax dollar for dollar, on the other hand tax deduction will reduce your taxable income and heavily dependent on the tax slab you are in. so, if you are in a comparatively higher tax slab you can consider availing a tax deduction.
If you are eligible to choose any one between tax credit and tax deduction for a single tax expend, then it will be always good for you to take some time and do the calculations to check which option is giving you the most benefit out of the two. You cannot take a credit or deduction for all type of taxes that you paid to a foreign country, there are some limitations.
Taxes That Are Qualified For Foreign Tax Credit
Not all your paid taxes on a foreign country are eligible for claiming as foreign tax credit, there are certain fixed rules that your paid tax should meet in this regard. If your foreign paid tax is complied with all the below mentioned four rules, you are eligible to claim for foreign tax credit.
- The tax must be paid by you to a foreign country for eligible incomes.
- The tax paid must be paid or accrued by yourself and not any other individual.
- The tax paid must be an actual and legal foreign tax liability.
- Only income tax or taxes that are paid by you in lieu of income tax are eligible.
Non-Qualified Taxes For Foreign Tax Credit:
There are certain paid foreign taxes that does not qualify for the foreign tax credit, below are the list of such non-qualified taxes:
- Tax paid for any foreign mineral income.
- Your paid tax to a foreign country falls under “foreign earned income exclusion”.
- If your paid tax is not eligible for any standard deduction and you can only take itemized deductions for the paid tax.
- If the tax paid is related to any boycott activities on a foreign country.
- If the actual related income cannot be counted or taken into consideration for the tax paid.
- Certain taxes originated from foreign gas income and foreign oil income.
- If you are earning some income with a foreign entity, and that entity failed to provide the required information while filing tax, you cannot claim any foreign tax credit for that tax.
- Your paid tax is related to providing social security for a foreign country which is in a social security agreement with U.S.
It may be possible to exclude all or some of your foreign earned income from your final federal income tax return, but this is to keep in mind that for the same income you can not claim both foreign earned income and foreign tax credit exclusions.
Important Things To Know For The Foreign Tax Credit Limits Calculations
The limit of tax credit is dependent on your total foreign income and total taxable income that you earned from United States, but in any case, the credit utilized cannot be more than the U.S. tax owed. The following formula is applicable for the calculation:
Foreign tax credit limit = Total applicable U.S. tax that you need to pay x (The taxable income you earned from any foreign source / Your total worldwide taxable income that includes both U.S. tax and any other foreign tax).
If you are getting some qualified dividends from a legal foreign source, you may be required to do some adjustments on the earned income before considering that as a foreign source income, and before doing the above calculation to check the limit. These adjustments are made depending on the percentage of tax on your foreign sourced income. Below rules are applicable for the adjustment:
- You should not include those incomes in your foreign income which are taxed at 0% rate.
- If your foreign incomes are taxed at 15% rate, then you should multiply your foreign income by 0.3788 and you should use the resulted amount as your foreign sourced income.
- If your foreign incomes are taxed at 20% rate, then you should multiply your foreign income by 0.5051 and then you should use the calculated final amount as your foreign sourced income.
Form 1116 can be used by trusts, estates or individuals to claim the credit for the income tax paid to a foreign country, although it is not mandatory. Individuals need not to file form 1116, in certain qualified cases. However, for estates or trusts it is necessary to file form 1116 to claim for foreign tax credit.
To file this form, you need to showcase the information like, on which country the tax was paid, the amount and the type of income for which you are claiming the credit. Also, a proper valid calculation is required on the qualified payment of tax, to be eligible to claim the return.
You need to convert all your foreign taxes that you paid, to US dollar, before mentioning those to form 1116. IRS prefers that while converting any currency to US dollar we should use the exchange rate of that date when the transaction originally happened. However, if you have an excessive number of qualified transactions that need to be credited or if the exchange rate is not readily available, then you can use the annual average foreign exchange rate which is readily available at IRS website.
If in case you fail to file this form, there are no penalties, however you will lose the opportunity to avail the credit.
Claiming Without Filing Form 1116
You may be able to claim for credit even if you do not file 1116, in such case you need to do a proper election by entering your foreign tax credit line in your tax return form 1040. This is to be noted that no carry forward is allowed on the elected paid tax which you want to claim through this process. You will be eligible to do this election only if you meet all the following conditions:
- All the gross income including the interest or dividend earned by you from a foreign country should be of “passive category income”.
- The amount you are going to claim for credit should not exceed $300 for individual return and $600 if you are filing a “married filing joint” return.
- You should have a qualified payee statement for all the foreign income earned and foreign tax paid for those income.
What If You Are A Non-Resident Alien?
Generally, you will not be able to claim any foreign tax credit if you are a non-resident alien, because non-resident aliens are not charged any tax on their income generated from foreign source. But the non-resident aliens also can claim this credit in the certain following cases:
- During the entire tax year, you were a resident of Puerto Rico.
- If you are paying or accruing tax to a foreign country or U.S. possession for income that is effectively connected with a trade or business in the United States.
Carry Back and Carry Forward For Foreign Tax Credit
Foreign tax credit is a non-refundable type of tax credit. If your qualified foreign tax credit amount is more than the credit limit that is allowed by IRS for a particular year, you may be eligible to carry back the unused amount for 1 year and then carry forward for 10 years. It is necessary to mention the carry forward amount and attach a computation for the same to your tax return, you should use form 1116, in part III line 10 you can mention the amount that you are carrying over from the previous year. If you are carrying back the amount you should file an amended return. In case if you are unable to use your carry forward amount within 10 years, no exception will be made, and the unused amount will be expired.
If you have paid or accrued foreign taxes on your income related to oil and gas to a foreign country then it is a special case and will be treated separately for carry forward your tax credits, in this case a special transition rule will be applied to the carry forward amount of pre-2009 unused oil and gas extraction taxes to years beginning after 2008.
If you have some carry over foreign tax credit from a prior year and at the same time you are also having foreign tax credit for the current year, then according to the rule you should always use your current year tax credit first, the carried over credit can only be used only if the current year tax credit is exhausted.
If you earned some credit on the tax paid and the tax falls under Global Intangible Low-taxed Income (GILTI), then you are not eligible for any carry back or carry forward of the credit amount.
Alternative Minimum Tax: In a tax year, you may have some liability for “alternative minimum tax (AMT)” apart from your regular income tax liabilities and based on your eligibility you may be able to claim foreign tax credit for this tax. But there are some restrictions on the maximum amount that can be claimed as foreign tax credit, the maximum amount you can claim for credit is equals to the alternative minimum tax and any excessive amount will be ignored in this case.
Tax Treaties: You may be eligible to claim an additional tax credit on the part of the foreign tax amount that is being imposed to you by a foreign country if that foreign country is in a tax treaty with U.S. You need to file an extra form to claim this extra benefit. Additionally, if you are claiming foreign tax credit using a treaty provision you may have to report certain required information with your tax return.