How to Calculate the Foreign Tax Credit

The Foreign Tax Credit is a non-refundable tax credit available to United States taxpayers who have paid or accrued income taxes to a foreign country. Its purpose is to mitigate the impact of double taxation, which occurs when the same income is taxed by both the U.S. and a foreign jurisdiction. This allows taxpayers to reduce their U.S. income tax liability on a dollar-for-dollar basis for the foreign taxes they have incurred.

This credit is an alternative to deducting foreign taxes as an itemized deduction on Schedule A. For most taxpayers, claiming the credit provides a more significant tax benefit than a deduction because a credit directly reduces the amount of tax owed, whereas a deduction only reduces the amount of income subject to tax. The choice between the credit and a deduction can be made annually.

Determining Eligibility and Creditable Taxes

To claim the foreign tax credit, both the taxpayer and the foreign tax must meet specific eligibility requirements set by the Internal Revenue Service (IRS). Individuals, corporations, estates, and trusts that have paid or accrued foreign income taxes are eligible to claim the credit. However, one cannot claim a credit for taxes paid on income that has been excluded from U.S. tax through other provisions, such as the Foreign Earned Income Exclusion claimed on Form 2555.

A foreign tax is creditable if it meets four tests:

• The tax is imposed on the taxpayer claiming the credit.
• The taxpayer paid or accrued the tax liability during the tax year.
• The tax is a legal and actual foreign tax liability, not an overpayment or refundable amount.
• The levy is an income tax in the U.S. sense (based on net income) or a tax paid “in lieu of” an income tax.

Creditable taxes include foreign income, war profits, and excess profits taxes levied on wages, dividends, interest, and royalties. Conversely, many foreign taxes do not qualify for the credit because they are not considered income taxes. These non-creditable taxes include value-added taxes (VAT), sales taxes, property taxes, and excise taxes.

Required Information for the Calculation

To calculate the foreign tax credit, a taxpayer must gather specific information for IRS Form 1116, Foreign Tax Credit. The first item needed is documented proof of the foreign taxes paid or accrued. This can include receipts, official foreign tax documents, or statements showing tax withheld.

Next, the taxpayer must determine their foreign source taxable income. “Sourcing” refers to the process of assigning income to a geographical location based on specific rules. For example, wages and other compensation are sourced to the location where the personal services are performed. Interest and dividend income are sourced based on the residence of the payer. This foreign source income must be categorized on Form 1116 into specific types, such as passive or general category income, which may require filing a separate Form 1116 for each category.

The calculation also requires the taxpayer’s total taxable income from all sources and the total U.S. income tax liability before credits. Both of these figures are found on the taxpayer’s Form 1040.

A preparatory step is converting all foreign currency amounts into U.S. dollars for Form 1116. The exchange rate to use is the one in effect on the date the tax was paid or income was received. For taxpayers using the accrual method of accounting, the average exchange rate for the tax year is used.

The Foreign Tax Credit Calculation

The foreign tax credit is the lesser of two amounts: the actual creditable foreign income tax paid or accrued, or the foreign tax credit limitation. This limitation ensures the credit only offsets the U.S. tax on foreign source income, not U.S. source income.

The limitation is calculated with the following formula: (Foreign Source Taxable Income / Total Taxable Income from All Sources) x U.S. Tax Before Credits. This calculation establishes the maximum credit allowed for the tax year.

For example, a taxpayer has $150,000 in total taxable income, with $30,000 from foreign sources. Their U.S. tax before credits is $28,000, and they paid $5,000 in creditable foreign taxes.

First, the limitation is calculated by dividing foreign source income ($30,000) by total taxable income ($150,000), which equals 0.20. This is multiplied by the U.S. tax ($28,000), resulting in a limitation of $5,600. The taxpayer then compares the limitation ($5,600) to the foreign taxes paid ($5,000). Since the foreign tax paid is lower, the credit is $5,000.

Claiming the Credit on Your Tax Return

Once the foreign tax credit has been calculated using Form 1116, the amount is reported on the appropriate tax forms. The total credit from Form 1116 is transferred to Schedule 3 (Form 1040), “Additional Credits and Payments.” The total from Schedule 3 then flows to the main Form 1040, where it directly reduces the taxpayer’s total tax liability.

Some taxpayers can claim the credit without filing Form 1116 under a de minimis exemption. To qualify, total creditable foreign taxes must not exceed $300 for single filers or $600 for those married filing jointly. All foreign source income must be passive, such as interest and dividends. This income must also be reported on a qualified payee statement like a Form 1099-DIV or 1099-INT.

If these requirements are met, the taxpayer can claim the credit directly on Schedule 3. Choosing this exemption means the taxpayer cannot carry back or carry forward any unused foreign tax credits from that year.

Managing Unused Foreign Tax Credits

If the creditable foreign taxes paid exceed the credit limitation for the year, the excess amount is not lost. These unused credits can be carried to other tax years to offset U.S. tax on foreign source income.

Taxpayers can carry unused credits back one year and then forward for up to ten years. A taxpayer can also elect to forgo the carryback and only carry the credits forward for the ten-year period.

To apply unused credits, a taxpayer must file Form 1116 for the year they are carrying the credit to. Schedule B of Form 1116 is used to track and apply these amounts. When applying credits from different years, the credits from the earliest year are used first.