What Is Foreign Tax Credit?
The foreign tax credit is a non-refundable tax credit for income taxes paid to a foreign government as a result of foreign income tax withholdings. The foreign tax credit is available to anyone who either works in a foreign country or has investment income from a foreign source.
Tax Deductions Vs. Tax Credits
- The foreign tax credit is a tax break provided by the government to reduce the tax liability of certain taxpayers.
- The foreign tax credit applies to taxpayers who pay tax on their foreign investment income to a foreign government.
- While some or all of the foreign earned income can be excluded from federal income tax, a taxpayer cannot claim both foreign earned income and foreign tax credit exclusions on the same income.
Understanding the Foreign Tax Credit
The foreign tax credit is a tax break provided by the government to reduce the tax liability of certain taxpayers. A tax credit is applied to the amount of tax owed by the taxpayer after all deductions are made from their taxable income, and it reduces the total tax bill of an individual dollar to dollar. If an individual owes $3,000 to the government and is eligible for a $1,100 tax credit, they will only have to pay $1,900 after the credit is applied. A tax credit can be either refundable or non-refundable. A refundable tax credit usually results in a refund check if the tax credit is more than the individual's tax bill. A taxpayer who applies a $3,400 tax credit to their $3,000 tax bill will have their bill reduced to zero, and the remaining portion of the credit, that is $400, refunded to them.
On the other hand, a non-refundable tax credit does not result in a refund to the taxpayer as it will only reduce the tax owed to zero. Following the example above, if the $3,400 tax credit was non-refundable, the individual will owe nothing to the government, but will also forfeit the amount of $400 that remains after the credit is applied. The most commonly claimed tax credits are non-refundable, one of which is the foreign tax credit.
The foreign tax credit applies to taxpayers who pay tax on their foreign investment income to a foreign government. Generally, only income, war profits, and excess profits taxes qualify for the credit. The credit can be used by individuals, estates, or trusts to reduce their income tax liability. In addition, taxpayers can carry unused amounts forward to future tax years, up to ten years.
Not all taxes paid to a foreign government can be claimed as a credit against the U.S. federal income tax. A taxpayer is not eligible for a foreign tax credit if they did not pay or accrue the tax, the tax was not imposed on the taxpayer, the tax is not a legal and actual foreign tax liability, or the tax is not based on income. So, an American taxpayer that has the U.K. government impose a legal and actual property tax on them will not be able to claim this tax as a foreign tax credit because it is not an income tax.
The foreign tax credit is claimed on Form 1116, unless the taxpayer qualifies for the de minimis exception, in which case, they can claim the tax credit for the full amount of foreign taxes paid directly on Form 1040. The credit can only be claimed on income that is also subject to domestic taxation. For example, if some of the taxpayer's foreign income is taxable and some of the income is exempt, then the taxpayer must be able to break down the taxes paid on the foreign income only, and only claim the credit for taxes paid on that foreign income.
While some or all of the foreign earned income can be excluded from federal income tax, a taxpayer cannot claim both foreign earned income and foreign tax credit exclusions on the same income. If the taxpayer chooses to exclude either foreign earned income or foreign housing costs, they cannot take a foreign tax credit for taxes on the income you can exclude. If they take the credit, one or both of the choices may be considered revoked by the Internal Revenue Service (IRS).