Foreign Tax Credit

The foreign tax credit is intended to reduce the double tax burden that would otherwise arise when foreign source income is taxed by both the United States and the foreign country from which the income is derived.

Four tests must be met for the tax to qualify for the credit:

• The tax must be a legal and actual foreign tax liability
• The tax must be imposed on you
• You must have paid or accrued the tax, and
• The tax must be an income tax (or a tax in lieu of an income tax)

Generally, only income taxes paid or accrued to a foreign country or a U.S. possession, or taxes paid or accrued to a foreign country or U.S. possession in lieu of an income tax, will qualify for the foreign tax credit. Qualified foreign taxes do not include taxes that are refundable to you, that are used to provide a subsidy to you or someone related to you, that are not compulsory because you could have avoided paying the taxes to the foreign country, or that are paid or accrued to any country if the income giving rise to the tax is for a period (the sanction period) during which:

• The Secretary of State has designated the country as one that repeatedly provides support for acts of international terrorism,
• The United States has severed or does not conduct diplomatic relations with the country, or
• The United States does not recognize the country’s government, unless that government is eligible to purchase defense articles or services under the Arms Export Control Act.

You can choose to take the amount of any qualified foreign taxes paid during the year as a foreign tax credit or as an itemized deduction. To choose the deduction, you must itemize deductions on Form 1040, Schedule A (PDF). To choose the foreign tax credit you generally must complete Form 1116 (PDF) and attach it to your Form 1040 (PDF), or Form 1040NR (PDF). If you are a cash basis taxpayer you can only take the foreign tax credit in the year you pay the qualified foreign tax unless you elect to claim the foreign tax credit in the year the foreign taxes are accrued. Once you make this election, you cannot switch back to claiming the taxes in the year paid in later years.

You can claim the credit for qualified foreign taxes without filing Form 1116 if all of the following requirements are met:

• All of your foreign source income is passive income, such as interest and dividends,
• All of your foreign source income and the foreign income taxes are reported to you on a qualified payee statement, such as Form 1099-INT (PDF) or Form 1099-DIV (PDF), and
• The total of your qualified foreign taxes is not more than the limit given in the Form 1040 Instructions for the filing status you are using, or in the Form 1040NR Instructions (if you file Form 1040-NR).

If you claim the credit directly on Form 1040 or Form 1040-NR without filing Form 1116, you cannot carryback or carryover any unused foreign tax to or from this year.

If you claim an itemized deduction in a year for qualified foreign taxes, you can choose instead to claim a foreign tax credit for that year by filing an amended return on Form 1040X (PDF) within 10 years, if claiming the foreign tax credits results in a refund of income tax to you. Also, if you claim a foreign tax credit, and realize you made a mistake in calculating the foreign tax credit, you can file an amended return on Form 1040X within 10 years to correct the mistake. Finally, if the foreign income taxes you claimed as a credit are refunded or otherwise reduced, you must file an amended return on Form 1040X reporting the reduced foreign tax credit. There is no time limit on this requirement.

If you use Form 1116 to figure the credit, your foreign tax credit will be the smaller of the amount of foreign tax paid or accrued, or the amount of United States tax attributable to your foreign source income. This limit is currently computed separately for passive income, income resourced under a tax treaty, income derived from sanctioned countries, and all other income.

If you cannot claim a credit for the full amount of qualified foreign income taxes you paid or accrued in the year, you are allowed a carryback and/or carryover of the unused foreign income tax. You can carryback for one year or carryover for 10 years the unused foreign tax. For more information on this topic (including taxes paid or accrued in years before 2005) see Publication 514, Foreign Tax Credit for Individuals.

You may not take either a credit or a deduction for taxes paid or accrued on income you exclude under the foreign earned income exclusion or the foreign housing exclusion. There is no double taxation in this situation because that income is not subject to United States tax.

For more complete information on the foreign tax credit (including information on whether a particular tax is eligible for the credit), refer to the Form 1116 Instructions, or refer to Publication 514, Foreign Tax Credit for Individuals. If the information you need is not addressed in the instructions or in Publication 514, you may call the IRS International Tax Law hotline at 267-941-1000, Monday – Friday 6:00 a.m.- 11: 00 p.m. Eastern Time. This is not a toll-free number.

Source: Internal Revenue Service
Last reviewed: September 22, 2013