What Is the Foreign Tax Credit?
The foreign tax credit is a U.S. tax credit used to offset income tax paid abroad. U.S. citizens and resident aliens who pay income taxes imposed by a foreign country or U.S. possession can claim the credit. The credit can reduce your U.S. tax liability and help ensure you aren't taxed twice on the same income.
- The foreign tax credit is a U.S. tax break that offsets income tax paid to other countries.
- The credit is available to U.S. citizens and residents who earn income abroad and have paid foreign income taxes.
- Foreign taxes on income, wages, dividends, interest, and royalties generally qualify for the foreign tax credit.
How the Foreign Tax Credit Works
If you paid taxes to a foreign country or U.S. possession—and are subject to U.S. tax on the same income—you can take an itemized deduction or a credit for those taxes. For foreign tax credit purposes, U.S. possessions include Puerto Rico, the U.S. Virgin Islands, Guam, the Northern Mariana Islands, and American Samoa.
Taken as a deduction (on Schedule A of your 1040 or 1040-SR), the foreign income tax reduces your U.S. taxable income. Conversely, the foreign income directly reduces your U.S. tax liability if you take the credit. If you opt for the tax credit, you must complete Form 1116 and attach it to your U.S. tax return.
You must take either a credit or a deduction for all qualified foreign taxes. For example, you can't take the credit for some of your foreign taxes and a deduction for others. And, of course, you can't claim both a credit and a deduction for the same tax.
Taking the credit usually makes financial sense because the amount comes straight off your actual tax bill instead of just lowering your taxable income. Either way, the tax break reduces the double tax burden that would otherwise arise if you were taxed on the same income twice—in the U.S. and abroad.
Generally, only income, war profits, and excess profits taxes are eligible for the credit. Foreign taxes on wages, dividends, interest, and royalties also qualify. However, the IRS specifies that "the tax must be a levy that is not payment for a specific economic benefit," and it must be similar in character to a U.S. income tax.
You can also claim the credit on foreign taxes that aren't imposed under a foreign income tax law— provided the tax is "in lieu" of income, war profits, or excess profits tax. In this situation, the tax must be imposed in place of—and not in addition to—an income tax the country otherwise imposes.
Foreign tax is typically imposed in a foreign currency. Use the exchange rate in effect on the date you paid the foreign tax, the tax was withheld, or you made estimated tax payments.
Other foreign taxes, such as foreign real and personal property taxes, do not qualify for the foreign tax credit. Still, you may be able to deduct these other taxes on Schedule A of your income tax return even if you also claim the foreign tax credit. You can deduct foreign real property taxes unrelated to your trade or business. However, other taxes must be expenses you incur in a trade or business or to produce income.
Individuals, estates, and trusts can use the foreign tax credit to reduce their income tax liability. Additionally, taxpayers can carry any unused foreign tax back for one year and then forward for up to 10 years.
Not all taxes paid to a foreign government can be claimed as a credit against the U.S. federal income tax. In general, you must meet four tests for the foreign tax to qualify for the credit:
- The tax must be imposed on you by a foreign country or U.S. possession.
- You must have paid or accrued the tax to a foreign country or U.S. possession.
- The tax must be the legal and actual foreign tax liability you paid or accrued during the year.
- The tax must be an income tax or a tax in lieu of an income tax.
There is a limit on the amount of credit you can claim, which you calculate on Form 1116 (it can't be more than your total U.S. tax liability multiplied by a specific fraction). You can claim the smaller of the foreign tax you paid or your calculated limit. In general, you claim the foreign tax credit on Form 1116 unless you qualify for one of these exemptions:
- Your only foreign source income for the tax year is passive income.
- Your qualified foreign taxes for the year don't exceed $300 ($600 if married filing jointly).
- Your gross foreign income and the foreign taxes are reported to you on a payee statement (e.g., Form 1099-DIV or 1099-INT).
- You elect this procedure for the tax year.
If you qualify for an exemption, claim the tax credit directly on Form 1040.
If you claim the foreign earned income exclusion and/or the foreign housing exclusion, you can't take a foreign tax credit for taxes on the income you excluded (or could have excluded). If you do, the IRS could revoke one or both of your choices.
Refundable vs. Non-refundable Tax Credits
Tax credits can be either refundable or non-refundable. A refundable tax credit results in a refund if the tax credit is more than your tax bill. So, if you apply a $3,400 tax credit to a $3,000 tax bill, you will receive a $400 refund.
On the other hand, a non-refundable tax credit won't provide a refund because it only reduces the tax owed to zero. Following the example above, if the $3,400 tax credit was non-refundable, you would owe nothing to the government. However, you would also forfeit the $400 that remained after the credit was applied. Most tax credits, including the foreign tax credit, are non-refundable.
What Is the Difference Between Tax Credits and Tax Deductions?
Tax credits reduce the amount of tax you owe, while tax deductions lower your taxable income. While both save you money, credits are more valuable because they come straight off your tax bill. For example, a $1,000 tax credit reduces your tax bill by that same $1,000. Conversely, a $1,000 tax deduction lowers your taxable income—the amount of income on which you owe taxes—by $1,000. So, if you're in the 22% tax bracket, a $1,000 deduction would shave $220 off your tax bill.
How Do the Foreign Tax Credit and Foreign Earned Income Exclusion Differ?
Two ways to avoid double taxation on the income you earn while living abroad are the foreign tax credit and the foreign earned income exclusion. A key difference is the income to which each applies. The foreign tax credit applies to both earned and unearned income, such as dividends and interest. Conversely, the foreign earned income exclusion applies only to earned income.
Who Can Claim the Foreign Tax Credit?
If you are a U.S. citizen, the U.S. taxes your worldwide income, no matter where you live. To avoid double taxation, the U.S. lets you tax a credit for foreign taxes you pay or accrue. U.S. citizens and resident aliens who paid foreign income tax and are subject to U.S. tax on that same income can take the foreign tax credit. A nonresident alien can take the credit if they were a bona fide resident of Puerto Rico for the entire tax year or paid foreign income taxes connected to a trade or business in the U.S.