How Does Foreign Tax Credit Work for U.S. Taxpayers?

Paying taxes to a foreign government while also being subject to U.S. taxes can lead to double taxation. The Foreign Tax Credit (FTC) helps offset foreign tax liabilities against U.S. taxes, ensuring taxpayers are not taxed twice on the same income.

Eligible Foreign Taxes

To qualify for the Foreign Tax Credit, a tax must be imposed by a foreign country or U.S. possession and be a legal, actual foreign tax liability. The IRS requires it to be an income tax or a tax in lieu of an income tax, meaning it must be based on net income rather than a flat fee or sales tax.

Qualifying foreign taxes include individual and corporate income taxes, as well as certain withholding taxes on dividends, interest, and royalties. For instance, if a U.S. taxpayer earns investment income in Germany and 26.375% is withheld under German tax law, that amount may be eligible for the credit. However, social security taxes, value-added taxes (VAT), and property taxes do not qualify.

The timing of payment is also important. The IRS allows taxpayers to claim the credit in the year the foreign tax is paid or accrued, depending on their accounting method. Accrual-basis taxpayers can claim the credit when the tax liability is established, even if payment occurs later, while cash-basis taxpayers can only claim it when the tax is actually paid.

Distinguishing Credit from Deduction

U.S. taxpayers can either claim a tax credit or take a deduction for foreign taxes, each with different effects.

A tax credit directly reduces the amount of tax owed on a dollar-for-dollar basis. For example, if a taxpayer has a $3,000 U.S. tax liability and qualifies for a $2,000 Foreign Tax Credit, their tax bill is reduced to $1,000. In contrast, a deduction lowers taxable income, which indirectly reduces tax liability based on the taxpayer’s marginal tax rate. A $2,000 deduction for someone in the 24% tax bracket lowers their tax bill by only $480, making the credit generally more beneficial.

The choice depends on individual circumstances. Taxpayers whose foreign taxes exceed the allowable credit limit may benefit from deducting the excess amount, especially if they have little U.S. tax liability. However, since deductions only help those who itemize rather than take the standard deduction, many find the credit more advantageous.

Basic Calculation Steps

The Foreign Tax Credit applies only to foreign income taxes, and the IRS limits how much can be claimed to prevent taxpayers from using foreign tax payments to offset U.S. taxes on domestic earnings. The limit is calculated as:

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

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

(30,000 / 100,000) × 20,000 = 6,000

Even if the taxpayer paid $8,000 in foreign taxes, they can only claim up to $6,000 as a credit. The remaining $2,000 may be carried back one year or forward up to ten years under IRS carryover rules.

Taxpayers must also categorize foreign income into separate income baskets, as required by IRS regulations. The two primary categories are general income (such as wages, salaries, and business profits) and passive income (including dividends, interest, and rental income). Excess credits from one category cannot be used to offset taxes in another.

Filing Procedures

Claiming the Foreign Tax Credit requires completing IRS Form 1116 unless an exemption applies. Taxpayers with $300 or less ($600 for married couples filing jointly) in qualified foreign taxes may be able to bypass this form and claim the credit directly on Schedule 3 (Form 1040).

Form 1116 requires taxpayers to categorize foreign income into the correct basket and convert foreign taxes paid into U.S. dollars using the appropriate exchange rate. The IRS generally allows the yearly average exchange rate, but accrual-basis taxpayers must use the rate in effect on the date the foreign tax was accrued.

Supporting documentation is necessary. Taxpayers must keep foreign tax receipts, withholding statements, or official tax assessment documents to substantiate the claim. If foreign taxes are refunded or reduced after filing, the taxpayer must notify the IRS and amend prior returns if necessary. Errors in reporting can result in penalties, interest, or denial of the credit.

Tax Treaty Effects

U.S. tax treaties with foreign countries influence how the Foreign Tax Credit applies. These agreements help prevent double taxation by allocating taxing rights between jurisdictions and sometimes reducing withholding tax rates on certain types of income.

For example, under the U.S.-U.K. tax treaty, dividends paid by a U.K. company to a U.S. resident may be subject to a reduced withholding tax rate of 15% instead of the standard 20%. If a taxpayer pays foreign taxes at a rate higher than what the treaty allows, the excess amount is not eligible for the credit. To claim treaty benefits, taxpayers often need to provide documentation, such as IRS Form 8802 to obtain a U.S. residency certification.

Some treaties override domestic tax laws, affecting credit eligibility for certain foreign taxes. Many treaties also contain a “savings clause,” allowing the U.S. to tax its citizens as if the treaty did not exist, which can limit benefits for U.S. expatriates. Taxpayers should review treaty provisions alongside IRS guidance, such as Publication 901, to ensure they are applying the correct rules when calculating their credit.