Publication 514: Foreign Tax Credit for Individuals

IRS Publication 514, “Foreign Tax Credit for Individuals,” is a guide for U.S. taxpayers who have paid or accrued income taxes to a foreign country. The foreign tax credit’s purpose is to mitigate double taxation, which occurs when both the United States and a foreign jurisdiction tax the same income. This publication provides the framework for determining eligibility, calculating the credit, and reporting it on a U.S. income tax return.

Determining Your Eligibility for the Credit

To claim the foreign tax credit, you must be a U.S. citizen, a resident alien, or a nonresident alien who is a bona fide resident of Puerto Rico for the entire tax year. The credit is also available to estates and trusts. The tax must be an income tax in the U.S. sense, or a tax paid in lieu of a generally imposed foreign income tax. This excludes other foreign taxes, such as value-added (VAT), sales, property, or inheritance taxes.

To be creditable, a foreign tax must meet four tests:

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

You cannot claim a credit for taxes paid on foreign income exempt from U.S. tax under the foreign earned income exclusion. If you receive a refund of foreign taxes paid, you cannot claim a credit for the refunded amount. Taxes paid to countries the U.S. government has sanctioned are also not creditable.

Choosing Between a Credit and a Deduction

Taxpayers with qualified foreign income taxes can take the amount as either a credit against their U.S. tax liability or as an itemized deduction on Schedule A (Form 1040). This decision is made annually and applies to all qualified foreign taxes for that year. If you choose the credit, you cannot deduct any foreign taxes, and vice versa.

A tax credit provides a dollar-for-dollar reduction of your final U.S. tax bill. A deduction only reduces your taxable income, and its value depends on your marginal tax rate. For example, if a taxpayer in the 24% tax bracket deducts $1,000 in foreign taxes, their U.S. tax is reduced by $240, whereas a $1,000 tax credit reduces their U.S. tax by the full $1,000.

Because a credit is a direct reduction of your tax, it almost always results in a greater tax saving than a deduction. The choice to take the credit is made by completing and attaching Form 1116 to the tax return.

Calculating the Foreign Tax Credit Limitation

The amount of foreign tax credit you can claim is limited. This limit ensures the credit only offsets the U.S. tax on your foreign-source income, not your U.S.-source income. The credit you can claim is the lesser of the actual foreign tax you paid or the calculated limitation amount.

The limitation is calculated with a formula: (Foreign Source Taxable Income / Total Taxable Income Before Exemptions) x U.S. Tax Before Credits. To use this formula, you must source your income, classifying it as either from the U.S. or a foreign country. For example, wages are sourced to where services are performed, while interest income is sourced to the residence of the payer.

This calculation must be performed separately for different categories of foreign income, such as passive income like interest and dividends, and general income like wages and business profits. This prevents using excess credits from a high-tax category to offset U.S. tax on low-taxed foreign income. Each category requires its own Form 1116.

Required Information and Form Completion

To claim the foreign tax credit, you must complete Form 1116, Foreign Tax Credit. You will need organized records of your foreign income and the corresponding foreign taxes you paid or accrued during the tax year. The form and its instructions are available on the IRS website.

You must report your gross foreign source income, separated into the required categories. You also need records of the foreign taxes paid for each category, translated into U.S. dollars. The exchange rate used should be the one in effect on the date the tax was paid.

Form 1116 is structured to walk you through the credit calculation for a single category of income. It helps you determine your taxable income from foreign sources, list the foreign taxes paid, and compute the final credit limitation for that category.

Filing and Post-Filing Considerations

Once completed for each income category, Form 1116 must be attached to your U.S. income tax return, such as Form 1040. The total credit is entered on Schedule 3 (Form 1040), where it reduces your U.S. tax. An exception exists for filing Form 1116 if your total creditable foreign taxes are $300 or less ($600 for married filing jointly) and all your foreign income is passive.

If your creditable foreign taxes for a year exceed the limitation, the unused credits are not lost. The IRS allows you to carry the excess credit back to the prior tax year and then carry any remaining amount forward for up to 10 years. This allows you to use the excess credits in years with a higher limitation.

To claim a carryback, you must file an amended return (Form 1040-X) for the prior year, attaching a new Form 1116. For a carryforward, you will include the amount in the calculation on Form 1116 for a future tax year.