Foreign Tax Credit (FTC)
The United States (US) government taxes worldwide income earned by its citizens, even though other countries also tax any income earned within their borders. To offset this double taxation of income by 2 different countries, the US grants both individuals and corporations a foreign tax credit (FTC) that can be used to offset income taxes assessed by a foreign country on the income earned there. Although foreign taxes can be claimed as a deduction, it is usually more advantageous to claim the credit, since it reduces tax liability dollar for dollar.
Eligible FTC Income
Income earned in a foreign country is taxed both by the foreign country and by the United States. However, the United States government offers a foreign tax credit that can be claimed both by individuals or corporations to offset double taxation. The FTC is allowable for foreign income taxes and other similar taxes, such as excess profit and war profit taxes. However, only income taxes qualify for the credit. Value-added taxes (VAT), and property, sales, and severance taxes do not qualify, although they may be deductible.
On tax returns, foreign income is reported in US currency (USD), so the taxpayer must make the conversion. There is a separate limit for both passive income and general income. If the taxpayer receives both types of income, then the limit for both must be calculated on a separate Form 1116, Foreign Tax Credit. The limit equals total United States tax liability multiplied by net foreign source taxable income (after required adjustments) divided by total taxable global income.
Claiming a deduction may be preferable to claiming the foreign tax credit if the foreign tax rate and the proportion of foreign income to United States income is high. The tax should be computed both ways to determine the larger benefit. Unless the de minimis exception applies, the FTC is calculated on Form 1116. Corporations must file Form 1118, Foreign Tax Credit — Corporations to claim the FTC. The FTC cannot be claimed if the income is not taxable in the United States. Form 1116 does, however, allow the taxpayer to exclude some income and to claim the foreign tax credit on the non-excluded income.
However, if foreign taxes are claimed as a deduction, then all foreign taxes must be claimed as a deduction; no FTC can be claimed. Either the foreign tax credit or the deduction must be claimed for all the taxes paid or accrued during the tax year. A cash basis taxpayer can elect to claim the FTC for accrued foreign taxes; however, this election becomes irrevocable for all successive years.
Choosing the credit or the deduction can be made each tax year, but the election on a joint return applies to both spouses. Individual partners or shareholders of an S corporation can make the election individually. The election can be changed within the later of 3 years from when the return was filed or 2 years from when the taxes were paid. A claim for a refund of overpayment must be filed within 10 years when the return was filed.
De Minimis Exception to Filing Form 1116
A de minimis exception is available when foreign taxes are $300 or less for individuals, or $600 for married taxpayers filing jointly, that allows the taxpayer to claim the credit directly on Form 1040 without filing Form 1116, but only if the foreign income is qualified passive income. If the de minimis exception is chosen, then the foreign tax credit limits do not apply.
Married taxpayers filing a joint return can claim a credit or deduction to all qualifying foreign taxes paid or accrued by both spouses. Separately filing spouses can claim the credit or deduction without regard to whether the other spouse is claiming the credit or taking the deduction.
The de minimis exception can only be used if the taxpayer received a Form 1099, and is only available to individual taxpayers, not to corporations, estates or trusts. A de minimis exception cannot be carried over to another tax year.
The FTC cannot be claimed by a nonresident alien or a citizen of a United States possession who was not also a United States citizen or resident, except for Puerto Rico. However, a nonresident alien can claim the credit for foreign income if it is effectively connected to a United States business.
Taxpayers who can claim the FTC include:
- United States citizens,
- resident and nonresident aliens,
- bona fide residents of Puerto Rico for the entire tax year,
- domestic and foreign corporations.
Nonresident aliens and foreign corporations can claim the credit with respect to foreign taxes paid or accrued on foreign income connected with a United States trade or business. A credit or deduction can be claimed for the proportionate share of the creditable foreign taxes that were paid by a partnership, S corporation, or a beneficiary of an estate or trust. A shareholder of a mutual fund may also claim the credit or deduction based on the foreign taxes paid by the mutual fund that passes through to the shareholders.
If the taxpayer claims the foreign earned income exclusion, then he cannot also claim the foreign tax credit. The maximum foreign earned income exclusion is adjusted annually for inflation:
The FTC that can be claimed is the lesser of the actual foreign taxes imposed or the following formula, sometimes known as the overall limitation formula:
|Maximum FTC||=||U.S. Tax Liability||×||Foreign Taxable Income |
Worldwide Taxable Income
Worldwide taxable income is computed before deducting personal and dependency exemptions.
Another limitation to claiming the credit is that the FTC cannot exceed the United States tax liability for the income if it were sourced in the US. For instance, you received $1000 in dividends from a foreign country of which you had to pay $250 of that in foreign taxes. If that same income would only be taxed at 15% if it came from US sources, then the maximum FTC that can be claimed with respect to that income would be $150. This comports with the main purpose of the FTC, which is to prevent double taxation.
Example: Foreign Income from Several Countries
During the tax year, you receive the following income (format: income, foreign taxes paid):
- Country A: $20,000, $5,000
- Country B: $10,000, $2,000
- USA Income: $50,000, $10,000
- Foreign Taxes Paid = $5,000 + $2,000 = $7,000
- Maximum FTC = $10,000 × ($20,000 + $10,000)/($20,000 + $10,000 + $50,000) = $10,000 × $30,000/$80,000 = $3,750
- FTC = Lesser of #1 or #2 = $3,750
In the above example, $3,250 ($7,000 – $3,750) of foreign income is subject to double taxation. However, if the entire FTC cannot be claimed in 1 year, then the balance can be carried back 1 year and then carried forward 10 years. For example, suppose that, in the following year:
- Foreign Taxes Paid = $2,000
- Maximum FTC = $3,000
- FTC = Lesser of #1 or #2 = $2,000
- Unused FTC = Maximum FTC – Foreign Taxes Paid = $3,000 – $2,000 = $1,000
In the above case, the $1,000 of unused FTC could be carried back to reduce the double taxation amount of $3,250 to $2,250.
On Form 1116, the 2 main categories of income that applies to most taxpayers are:
- passive category income, which is investment income, and
- general category income, which usually consists of wages or other compensation for work.
If a taxpayer has more than 1 category of income, then a separate Form 1116 must be filled out for each type of income. On the Form 1116 for which the largest FTC is being claimed, Part IV must be filled out, which totals all the credits on all Form 1116s.
|Passive Category Income||☑|
|Foreign Country or US Possession||RIC||Regulated Investment Company|
|Foreign Gross Income: Dividends||$1,000|
|Direct Expenses Incurred to Earn Income||0|
|Pro Rata Share of Expenses |
Not Definitely Related to Income
|Itemized Deductions or Standard Deduction||$5,950|
|Pro Rata Share Deductions Total||$5,950|
|Total Gross Income||$50,000||Gross income from all sources.|
|Foreign Gross Income Percentage||0.02||= Foreign Gross Income/Total Gross Income|
|Pro Rata Share Deduction||$119||= Pro Rata Share Deductions Total × Foreign Gross Income Percentage|
|Foreign Gross Income Minus Deductions||$881||= Foreign Gross Income – Direct Expenses – Pro Rata Share Deduction|
|U.S. Tax Liability||$6,000|
|Maximum Foreign Tax Credit||$120||= U.S. Tax Liability × Foreign Gross Income Percentage|
|Total Foreign Taxes Paid or Accrued||$100|
|FTC||$100||= Lesser of Maximum Foreign Tax Credit or Foreign Taxes Paid or Accrued|