IRC 2011: Claiming the Foreign Tax Credit

The Foreign Tax Credit (FTC) is a feature of the U.S. tax code that allows taxpayers to reduce their U.S. income tax liability for income taxes paid to foreign governments. This mechanism is designed to mitigate the issue of double taxation, where the same income is taxed by both the United States and a foreign country. While the term “IRC Section 2011” is sometimes associated with this topic, the primary rules for the FTC are in Internal Revenue Code Section 901. The credit provides a dollar-for-dollar reduction of your U.S. tax.

The purpose of the FTC is not to eliminate U.S. tax on foreign income but to ensure that the combined U.S. and foreign tax paid on that income does not exceed the higher of the two tax rates. It is a complex area of tax law that requires careful attention to sourcing rules, income categories, and specific limitations.

Determining Eligibility for the Foreign Tax Credit

Eligibility for the Foreign Tax Credit extends to U.S. citizens, resident aliens, domestic corporations, and certain estates and trusts. U.S. citizens and resident aliens can claim the credit for foreign taxes paid on earned income, like wages, and unearned income, such as dividends and interest. The fundamental requirement is that the taxpayer must have paid or accrued qualifying income taxes to a foreign country or a U.S. possession. Nonresident aliens are generally not eligible to claim the Foreign Tax Credit.

A central component of eligibility revolves around the nature of the foreign tax itself. To be creditable, the payment must be a compulsory tax legally owed to a foreign government and must be a tax on income, war profits, or excess profits. This means the tax must be based on net income or gain, similar to the U.S. income tax system. Taxes paid voluntarily or those for which the taxpayer does not have a legal obligation do not qualify.

Certain foreign taxes are explicitly not creditable. These include:

• Value-added taxes (VAT)
• Sales taxes
• Property taxes
• Customs duties

The determination of whether a foreign tax is creditable can also be influenced by existing tax treaties between the United States and the foreign country. Taxpayers must ensure the taxes they intend to claim are not refundable by the foreign government and meet all the criteria established under U.S. tax law.

Calculating the Foreign Tax Credit Limitation

The amount of the Foreign Tax Credit you can claim in a given year is subject to a limitation. This limitation ensures that the credit only offsets the U.S. tax liability on your foreign source income, not your U.S. source income. The credit you can claim is the lesser of the actual foreign income taxes you paid or accrued, or your overall foreign tax credit limitation.

The overall limitation is calculated using a specific formula: (Foreign Source Taxable Income / Total Taxable Income) U.S. Tax Before Credits. “Foreign Source Taxable Income” is the numerator and represents your gross income from sources outside the U.S. minus any deductions that are directly allocable to that income. “Total Taxable Income” is the denominator and includes your income from all sources, and the “U.S. Tax Before Credits” is your total U.S. tax liability for the year before applying any tax credits.

A key step in this calculation is correctly sourcing your income. Sourcing rules determine whether income is considered from a U.S. source or a foreign source. For example, compensation for services is generally sourced to the location where the services are performed. Interest and dividend income are typically sourced based on the residence of the payer.

The complexity of the calculation is increased by the requirement to separate foreign income into different categories, often referred to as “baskets.” Taxpayers must calculate a separate FTC limitation for each category of foreign income. The primary categories include passive category income (like interest and dividends) and general category income (like wages and business profits).

For instance, if you have both foreign rental income (passive category) and foreign salary income (general category), you cannot simply lump them together. The taxes paid on passive income can only be used to offset the U.S. tax on passive income, and the same rule applies to general category income.

Required Information and Forms

To claim the Foreign Tax Credit, taxpayers must gather information and complete specific IRS forms. The primary form for individuals, estates, and trusts is Form 1116, Foreign Tax Credit. Corporations use Form 1118, Foreign Tax Credit—Corporations.

The information required includes detailed records of gross income from each foreign source and country. You must also have documentation for all deductions that are allocable to that foreign income, as these are needed to calculate your net foreign source taxable income. You need proof of the foreign taxes you paid or accrued, which can include tax receipts or statements from foreign tax authorities. While these documents are not typically submitted with the return, they must be retained for several years in case of an IRS audit.

Part I of Form 1116 is where you report your taxable income from sources outside the United States, separated by the income categories. You must list the income on a country-by-country basis within each category. This part of the form directly feeds into the numerator of the limitation formula.

Part II of Form 1116 is where you list the foreign taxes you paid or accrued. You must report these taxes in their original foreign currency and then convert them to U.S. dollars using the appropriate exchange rate for the date the taxes were paid. The totals from Part I and Part II are then used in Part III to calculate the final credit limitation. The final allowable credit is then transferred from Form 1116 to your main tax return, such as Form 1040.

Claiming the Credit or Taking a Deduction

When dealing with foreign taxes, taxpayers face a choice: claim a credit or take an itemized deduction. The foreign taxes that are eligible for the credit can also be claimed as a deduction on Schedule A of Form 1040. However, a taxpayer cannot do both for the same taxes in the same year. The decision to claim a credit or a deduction is made annually and can be changed for a particular year by filing an amended return.

Claiming the Foreign Tax Credit is more advantageous for most taxpayers. A tax credit provides a dollar-for-dollar reduction of your U.S. tax liability. In contrast, a deduction only reduces your taxable income. A $1,000 deduction for a taxpayer in the 24% tax bracket would only save $240 in tax.

Claiming the credit involves attaching the completed Form 1116 or Form 1118 to your annual income tax return. The calculated credit amount from the form is entered on the appropriate line of your main tax return. For individual filers, this is found on Schedule 3 (Form 1040), Additional Credits and Payments.

There is a limited exception for individuals that allows them to claim the credit without filing Form 1116. This option applies if your total creditable foreign taxes are not more than $300 ($600 for married filing jointly) and all your foreign income is passive category income reported on a qualified payee statement like a Form 1099-DIV. Choosing this option means you cannot carry back or carry over any unused foreign taxes from the current year.

Carryback and Carryover of Unused Credits

It is common for the amount of creditable foreign taxes paid in a year to be greater than the calculated Foreign Tax Credit limitation. When this occurs, the portion of the foreign tax that cannot be used in the current year is referred to as an “excess foreign tax credit.” These unused credits are not lost; instead, they can be carried to other tax years to offset U.S. tax on foreign source income in those years.

The rules for carrying these excess credits are specific. An unused foreign tax credit must first be carried back one year. This is done by filing an amended return, such as Form 1040-X, for that prior year. The carryback can only be used to the extent that you had an “excess limitation” in that prior year, meaning your FTC limitation was higher than the foreign taxes you paid in that year.

After carrying the credit back one year, any remaining unused foreign tax credit can be carried forward for up to ten years. The credits are used in chronological order against any excess limitation in those future years. It is the taxpayer’s responsibility to track these carryover amounts, as the IRS does not do it for you.

To claim a carryback or carryover, you must file a Form 1116 for the year to which you are carrying the credit and complete Schedule B (Form 1116), Foreign Tax Credit Carryover and Carryback. The unused credits retain their original character, meaning a credit from the general category can only be used to offset U.S. tax on general category income in the carryback or carryover year. There are also specific rules that disallow carrybacks or carryovers for certain newer categories of income.