The US reduces your income tax liability dollar for dollar for any taxes paid to a foreign government. This comes in especially handy when your wages exceed the foreign earned income exclusion, but there are several points to keep in mind, as the “dollar for dollar” part of the definition can’t unfortunately be taken verbatim. It was intended to avoid double taxation of US taxpayers.
If your local country’s tax rate is higher than the graduated rates you are subject to as an American citizen, your foreign tax credit will likely offset any taxes due to the US. If the foreign rate is lower, then you can expect to pay the difference to the USA.
The calculation goes something like this:
First your total foreign taxes paid get reduced by any amounts that are attributable to any income that was already excluded under the foreign earned income exclusion:
Total foreign earned income excluded divided by total foreign earned income. This gives you an allocation ratio which you then apply to the foreign taxes paid.
The resulting number is then reduced by any taxes paid that are related to foreign earned income excluded in a prior year – following the same calculation above.
Another reduction will result from the participation in international boycott operations
There are 5 different categories of income in the eyes of the IRS (It used to be !!!). Taxes paid will need to be reported in each of the categories for the calculation of the foreign tax credit, and cannot be used to offset taxes in another category.
Explained: If you earned $120K wages abroad, excluded $91.4K, and from the above calculation it results that you owe $3,000 in income taxes, and you paid $3,000 in taxes to a foreign country on dividends received, you cannot use the $3K resulting from Dividend taxes paid to a foreign country to offset the $3,000 US taxes on your wages. (Again, using the calculation above). In this scenario, you would have to pay $3k to the USA for income taxes resulting from earned income, and you would have a $3k credit to use in following years for any US taxes resulting from foreign dividends.
Those 5 categories are :
- Passive income – Interest, dividends, etc.
- General category income – This is where your earned income goes)
- Section 901(j) Income – Income resulting from activities in a sanctioned country, which by the way are only egible to be claimed as a deduction not for a tax credit. Sanctioned countries are: Iran, Libya, Cuba, North Korea, Sudan, Syria. Iraq and Libya have some special periods, so you should see the IRS website for an updated list whenever you are completing form 1116.
Deduction or Credit?
You have the option of claiming the credit as described above, or you can count foreign taxes paid towards your itemized deductions on Schedule A. While it is generally more beneficial to claim the credit, be sure to have your CPA review both scenarios when preparing your returns. For example, although the foreign tax credit can be carried over 10 years and back to the preceding year, in a particular scenario those time limits may expire before the credit is used up. If you claim a deduction instead, you create a Net Operating Loss which can be carried over 20 years.
The election to claim the credit or deduction for creditable foreign taxes must be made each tax year. It may be exercised or changed at any time while the statute of limitations to claim any refund or credit remains open for the year in question (Code Sec. 6511(d)(3); Reg. §1.901-1(d) and (e)).
The foreign tax credit is not available if you paid taxes to a foreign country that the USA:
- Does not recognize as a sovereign state
- Has Severed diplomatic relations with
- Does not conduct diplomatic relations with
- Has designated as a country that supports terrorism.
It is also unavailable for taxpayers that participate in international boycotts. (See the list of countries above).
Even when the foreign tax credit is unavailable, you can still claim the deduction.
This is a brief overview of the foreign tax credit – a great tool for American Expats filing their expatriate tax returns. Be sure to consult us if you have US Taxes due, we may be able to eliminate them with tools such as this one.
Tax Planner CPA is a team of Certified Public Accountants and Enrolled Agents with over 25 years of experience focusing exclusively on the taxation of US taxpayers living abroad. Our services include preparing tax returns that can take advantage of the foreign tax credit. We maintain this knowledgebase where all articles are written by CPA’s, Enrolled Agents, or attorneys (Except for those on Expat Life – which have proven to be a popular read with fun facts on different cities!). Our main objective is to educate Americans abroad on their tax responsibilities, so that they can look for planning alternatives on time. They are also designed to help taxpayers looking to self prepare, providing specific tips and pitfalls to avoid. If you found this article helpful, you’ll likely benefit from our future ones as well – so we encourage you to avoid pitfalls and join our mailing list:
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