How Does a Foreign Tax Credit Carryover Work?

Taxes on foreign income can lead to double taxation, where the same earnings are taxed by both a foreign country and the U.S. To mitigate this, the IRS allows taxpayers to claim a Foreign Tax Credit (FTC). If the credit exceeds the allowable limit in a given year, it can often be carried over to future years.

Understanding how this carryover works is essential for maximizing tax savings and ensuring compliance with IRS rules.

Qualifying Conditions for the Credit

To claim a Foreign Tax Credit, foreign taxes paid must meet specific IRS requirements. The tax must be a legal and actual foreign tax liability, meaning it was imposed by a foreign country and was not voluntary. Refundable amounts do not qualify. The tax must be an income tax or a tax in lieu of an income tax—sales taxes, value-added taxes (VAT), and property taxes do not count.

The tax must be based on income, calculated similarly to U.S. taxable income. Flat fees or other non-income-based taxes do not qualify. Additionally, the tax must be paid or accrued by the taxpayer. If it is assessed but not paid, it cannot be claimed.

Taxes paid to countries under U.S. sanctions may be ineligible. If a taxpayer receives a specific benefit from a foreign government in exchange for paying the tax, it may also be disqualified. The IRS does not allow credits for taxes paid on income excluded from U.S. taxation, such as income covered by the Foreign Earned Income Exclusion.

Determining the Carryover Amount

The Foreign Tax Credit carryover is determined by comparing total eligible foreign taxes paid to the maximum allowable credit for the year. The IRS limits the credit to ensure it does not exceed the portion of U.S. tax liability attributable to foreign income. The FTC limit is calculated using the formula:

Foreign Tax Credit Limit = (Foreign Source Taxable Income ÷ Total Taxable Income) × U.S. Tax Liability

Foreign taxes paid beyond this limit cannot be used in the current year but may be carried back one year or carried forward for up to ten years.

For example, if a taxpayer earns $100,000 in total income, with $30,000 from foreign sources, and their total U.S. tax liability is $20,000, the maximum FTC they can claim is:

($30,000 ÷ $100,000) × $20,000 = $6,000

If they paid $8,000 in foreign taxes, only $6,000 can be used that year, leaving a $2,000 excess for carryover or carryback.

The carryover amount must be tracked separately for each income category, as the IRS classifies foreign income into specific baskets, such as general income and passive income. Excess credits from one category cannot offset taxes in another. For example, unused passive income credits cannot be applied to general income tax liability.

Proper recordkeeping is essential to ensure credits are not lost. Taxpayers must maintain documentation showing the year the credit originated, the amount carried forward each year, and any portion used. The IRS requires Form 1116 to be filed annually to track these amounts. Unused credits that exceed the carryover period expire.

Carryover Period

Foreign tax credits exceeding the allowable limit can be carried forward for up to ten years. This allows taxpayers to claim the benefit when they have sufficient foreign-source income.

To use a carryover credit, a taxpayer must have foreign-source income in a future year that results in a U.S. tax liability. If foreign earnings are low or absent, the credit remains unused until a year with enough taxable foreign income arises. Taxpayers with irregular international income—such as freelancers, investors, or multinational businesses—must plan carefully to use accumulated credits before they expire.

The ten-year limit requires taxpayers to review foreign income projections. If they anticipate insufficient income to use the credit before expiration, they may need to adjust the timing of foreign income recognition or make business decisions that increase taxable foreign earnings.

Coordination with Other Tax Credits

The Foreign Tax Credit interacts with other tax provisions, requiring careful planning to maximize benefits. One key consideration is its relationship with the General Business Credit (GBC). While both reduce tax liability, the FTC is claimed separately and does not contribute to the GBC’s carryforward or carryback provisions.

The Alternative Minimum Tax (AMT) can also limit the FTC’s effectiveness. Under AMT rules, foreign tax credits cannot reduce AMT liability beyond the amount of foreign-source income included in AMT calculations. This can result in taxpayers owing AMT despite having unused foreign tax credits. Adjusting income recognition timing may help mitigate this issue.

The FTC also affects taxpayers claiming research and development (R&D) credits. Section 174 of the Internal Revenue Code requires R&D costs to be amortized over five years for domestic expenses and fifteen years for foreign expenses. Because foreign R&D amortization affects taxable income, it can indirectly influence the FTC limitation by altering the ratio of foreign versus total taxable income. Multinational corporations must align tax strategies across jurisdictions to optimize benefits.

Filing Requirements

Claiming a Foreign Tax Credit carryover requires proper documentation and adherence to IRS filing procedures. Taxpayers must report both current-year foreign taxes paid and any carryover amounts on their tax return. The primary form for this is Form 1116, which must be completed annually to track foreign tax credits. For corporations, Form 1118 serves a similar function. These forms require details such as the amount of foreign taxes paid, the country where they were incurred, and the applicable income category.

Maintaining accurate records is essential, as the IRS may request supporting documentation. Taxpayers should retain foreign tax returns, payment receipts, and correspondence with foreign tax authorities. Prior-year tax returns should be referenced to ensure the correct carryover amount is applied. Errors in tracking carryovers can lead to lost credits or IRS scrutiny. If a taxpayer amends a prior-year return affecting the FTC calculation, they must adjust the carryover amounts accordingly.