What Is the Foreign Tax Deduction?
The foreign tax deduction is one of the itemized deductions that may be taken by American taxpayers to account for taxes already paid to a foreign government, and are typically classified as withholding tax.
The foreign tax deduction is usually taken in lieu of the more common foreign tax credit if the deduction is more advantageous to the taxpayer than the credit.
- The foreign tax deduction allows American taxpayers to reduce their taxable income by a portion of the amount of income tax paid to foreign governments.
- The goal is to prevent American citizens from being subject to double taxation for the same income.
- The foreign tax deduction would be taken instead of the foreign tax credit, given that the deduction is more advantageous for a taxpayer.
Tax Deductions Vs. Tax Credits
The Basics of the Foreign Tax Deduction
To avoid double taxation in the U.S. and a foreign country, a taxpayer has the option of taking the amount of any qualified foreign taxes paid or accrued during the year as a foreign tax credit or as an itemized deduction. The foreign tax credit is applied to the amount of tax owed by the taxpayer after all deductions are made from his or her taxable income, and it reduces the total tax bill of an individual dollar to dollar.
The foreign tax deduction reduces the taxable income of an individual that opts for this method. This means that the benefit of a tax deduction is equal to the reduction in taxable income multiplied by the individual's effective tax rate. The foreign tax deduction must be itemized, that is, listed out on the tax return. The sum of the listed items is used to lower a taxpayer’s adjusted gross income (AGI). A taxpayer that chooses to deduct qualified foreign taxes must deduct all of them, and cannot take a credit for any of them. Itemized deductions are only beneficial if their total value of the itemized expenses falls below the tax credit available.
The foreign tax deduction may be more advantageous if the foreign tax rate is high and only a small amount of foreign income relative to domestic income has been received. In addition, claiming a deduction requires less paperwork than the foreign tax credit, which requires completing Form 1116 and may be complex to complete, depending on how many foreign tax credits claimed. If the foreign tax deduction is taken, it is reported on Schedule A of Form 1040.
Example of the Foreign Tax Deduction
In most cases, the foreign tax credit will provide greater benefits than the deduction. For example, let’s assume an individual receives $3,000 in dividends from a foreign government and pays $600 foreign tax on the investment income. If she falls in the 25% marginal tax bracket in the U.S., her tax liability will be 25% x $3,000 = $750. If she is eligible for a $500 tax credit, she can reduce her U.S. tax bill to $750 - $500 = $250. If she claims a $500 deduction instead, her taxable dividend income will be reduced to $3,000 - $500 = $2,500, and her tax liability will be 25% x $2,500 = $625.
For more information on foreign taxes paid by Americans, see IRS Publication 514.