The continued expansion of the global marketplace is creating many new avenues for investors seeking opportunities outside American borders. Of course, the U.S. government assesses tax on all income earned from foreign sources. Domestic taxpayers with direct holdings in foreign investments must therefore pay taxes not only to Uncle Sam, but possibly also to the foreign country in which their investment is located. However, the foreign tax credit is available for those who realize income from foreign sources. In this article, we will examine the major provisions of this credit and who is eligible to receive it. (For background reading, see How do I file taxes for income from foreign sources?)
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Who Is Eligible?
Any investor who must pay taxes to a foreign government on investment income realized from a foreign source may be eligible to recoup some or all of the tax paid via this credit. Of course, the foreign tax credit cannot be claimed for any taxes that are paid on income that is excluded from taxation by the Internal Revenue Service (IRS). It must also be noted that the foreign tax credit only applies to investment income. Taxpayers who earn income in a foreign country must apply for the foreign tax exclusion and are ineligible for the credit. Furthermore, the credit is disallowed for nonresident aliens, unless they were residents of Puerto Rico for a full taxable year or were engaged in a U.S. business or line of work that paid them direct income. Citizens living in a U.S. territory other than Puerto Rico are likewise excluded. Finally, no credit is available for investment income realized from any source within a country that has been designated as harboring terrorist activities (IRS Publication 514 provides a list of these countries.)
Deduction vs. Credit
Any taxpayer who is eligible to claim the foreign tax credit has a choice between taking the credit, or deducting the foreign tax paid as a miscellaneous itemized deduction. In most cases, it is probably more beneficial to take the credit, although there may be certain situations where the deduction should be taken instead. However, only one option can be used in any given year. All foreign tax paid must either be completely deducted or taken as a credit; the election cannot be split between the two choices. Cash-basis taxpayers (who deduct expenses or taxes in the year in which they are actually paid) can claim the credit for foreign taxes that have accrued. However, they must continue using the accrual method from then on. (For more information, check out our Income Tax Guide.)
Reporting Foreign Income and Claiming the Credit
All foreign investment income is reported on Form 1040 in U.S. dollars. The foreign tax credit can be claimed by completing IRS Form 1116, unless you qualify for the de minimus exemption. This exemption allows taxpayers who paid $300 or less of creditable foreign taxes ($600 if you are married filing jointly) to skip Form 1116 and simply deduct the taxes paid on Line 51 of the Form 1040. In order to qualify for this exemption, the foreign income earned on the taxes paid must be qualified passive income. (Form 1116 has instructions on how to make this election.)
What Taxes Qualify for This Credit?
The foreign tax credit can only be taken by taxpayers who have paid foreign income taxes, excess profit taxes or other similar taxes. Taxes that are paid for sales, production or personal property cannot be claimed. According to IRS Publication 514, the credit can be used for the following types of taxes:
- Taxes that resemble U.S. income tax
- Any taxes that are paid by a domestic taxpayer as a substitute for income tax that would ordinarily be required by a foreign country
- Foreign income tax that is measured in terms of production because of inability to determine basis or income within the country
- Pension, unemployment or disability funds from a foreign country (some foreign social security-type income is excluded)
Limitations on the Credit
The total amount of foreign tax credit that you may claim is limited to your total income tax liability multiplied by a fraction. The numerator is your aggregated taxable foreign income; the denominator is your total taxable income from all sources. Only foreign income that is eligible for the credit should be included in the numerator. Once your tax liability has been multiplied with the resulting percentage, the result will be the actual maximum possible dollar amount that you can take as a credit. Any excess and/or unused credit can be carried back one year or forward for ten years.
The Bottom Line
This article has only covered the major provisions of this credit. Filers who need to claim the foreign tax credit should consult their tax advisors or visit the IRS website for more information.
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