All You Need to Know About Foreign Tax Credit
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What is Foreign Tax Credit?

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Foreign Tax Credit (FTC) is a nonrefundable tax credit that provides some relief for taxpayers who have tax obligations to foreign governments as well as the United States. It allows U.S. taxpayers to offset the taxes paid in foreign countries against their U.S. tax liability. This ensures they are not taxed twice on the same income – once by the foreign country where the income is earned and again by the U.S.

Eligibility for Foreign Tax Credit

The basic eligibility requirements for the FTC are straightforward:

Paid or Accrued Tax

A fundamental requirement to qualify for the FTC is that you must have actually paid or accrued the tax during the current tax year. This must be a legitimate tax liability, and not merely an anticipated one.

Income-Based Tax

The tax must be levied on income, war profits, or excess profits. This important distinction means that not every tax paid abroad qualifies for the FTC. Taxes on purchases, property, or wealth are not eligible, for instance.

Legitimate Foreign Tax

You must have a real obligation to pay the tax to a foreign government. The tax must constitute a legal and actual foreign tax liability.

Foreign-Sourced Income

The FTC is only available to those with foreign income. This applies to both U.S. resident individuals and corporations, regardless of whether or not they reside abroad.

Exceptions to the FTC

Another significant aspect of FTC eligibility is understanding which countries are exceptions to the rule. The FTC is not available for income taxes paid to certain countries with which the U.S. does not maintain diplomatic relations or countries identified by the U.S. as sponsors of terrorism.

In addition, the FTC is prohibited for any taxes paid to a foreign government that the U.S. has identified as participating in an international boycott not sanctioned by the U.S. government.

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How is the Foreign Tax Credit Calculated?

the process of calculating the FTC to help you better understand how this credit is determined.

1. Determining the FTC Limit

Before calculating the FTC, it is essential to determine the limit on the credit amount. To calculate the FTC limit, follow these steps:

  • Allocate Foreign-source Income

Determine the portion of your total income that is considered foreign-source income. This can be done using various methods, such as the specific foreign tax allocation method or the pro-rata allocation method.

  • Calculate U.S. tax on Foreign-source Income

Determine the U.S. tax liability exclusively on the foreign-source income using the regular U.S. tax rates and rules.

  • Determine the Taxable Income Limit

Adjust the U.S. tax liability on foreign-source income by applying the ratio of foreign-source taxable income to total taxable income. This step ensures that only a proportionate amount of the U.S. tax liability is eligible for the FTC.

Once the FTC limit is determined, calculate the amount of the credit using the following steps:

2. Determine Total Foreign Taxes Paid or Accrued

Collect all relevant documentation, such as foreign tax returns or statements, to determine the total foreign taxes paid or accrued during the tax year.

3. Convert Foreign Taxes to U.S. Dollars

Since the FTC is calculated in U.S. dollars, you need to convert the foreign taxes paid or accrued into U.S. currency using the average exchange rate for the tax year.

4. Multiple Foreign Tax Credits by FTC Limit

Multiply the total foreign taxes paid or accrued (converted to U.S. dollars) by the FTC limit determined earlier. The result is the allowable FTC.

5. Compare Allowable FTC With U.S. Tax Liability

Compare the allowable FTC with the U.S. tax liability on foreign-source income. If the FTC amount is lower than the U.S. tax liability, you can claim a credit for the full allowable FTC. However, if the FTC exceeds the U.S. tax liability, you may carry forward any excess credit to future tax years or elect to carry back the excess credit to previous tax years.

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Additional Considerations

To accurately calculate the FTC, consider the following additional factors:

Separate Limitation for Specific Categories of Income

The FTC may be subject to separate limitations for certain categories of income, such as passive income or general limitation income. These limitations can impact the FTC calculation.

FTC for Controlled Foreign Corporations (CFCs)

The FTC calculation for CFCs involves additional complexities, including the Subpart F inclusion and the GILTI (Global Intangible Low-Taxed Income) provisions. It is advisable to consult a tax professional with expertise in international tax law to ensure correct calculations.

Foreign Tax Credits From Carryovers

If you have any unused foreign tax credits from previous years, integrate them into the FTC calculation. The carryover credits can be used to offset U.S. tax liability on foreign-source income in the current year.

Claiming the Foreign Tax Credit

To claim the FTC, you need to complete IRS Form 1116 and attach it to your U.S. individual income tax return, whether it is Form 1040 or Form 1040-SR. Some individuals may be eligible to claim the FTC directly on Form 1040 without filing Form 1116, but certain conditions must be met.

Challenges of Claiming the Foreign Tax Credit

Despite the beneficial relief claimants can enjoy from the FTC, it does come with complexities and challenges. For instance, the carryback and carryforward provisions require a taxpayer to use them in the first year they can, which may prevent the taxpayer from carrying them over to a year where it could negate a higher tax obligation. 

Also, there are cases where the foreign tax refund can cause previously claimed FTCs to become subject to U.S. tax.

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Understanding the complexity of the Foreign Tax Credit isn’t easy, but with this basic understanding, you are now better equipped to navigate the initial confusion that might accompany earning income abroad. 

It is always recommended to engage the services of a tax professional or advisor who is experienced in international tax laws to ensure you are properly complying with all tax requirements and maximizing your credit claim. Additionally, the IRS provides interpretations and examples in Publication 514, “Foreign Tax Credit for Individuals”, which can be helpful for further information.

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