Which States Allow Foreign Tax Credit on State Taxes?
Understand how different states handle the foreign tax credit on state taxes, including eligibility factors and key variations in state tax policies.
U.S. taxpayers earning income abroad often face double taxation, where both a foreign country and their home state impose taxes on the same earnings. To ease this burden, some states offer a Foreign Tax Credit (FTC) that offsets state tax liabilities with taxes paid to other countries. However, not all states provide this benefit, and those that do have varying rules on eligibility and application.
Eligibility Factors for State-Level Credits
States that offer a Foreign Tax Credit (FTC) impose specific conditions for qualification. One key factor is the type of income being taxed. Some states allow the credit only for earned income, such as wages and self-employment earnings, while others extend it to passive income like dividends, interest, and capital gains. This distinction is crucial because foreign investment income is often subject to withholding taxes, which may not be eligible for credit in certain states.
The foreign tax must be mandatory and legally imposed. States generally require that the tax be a direct obligation of the taxpayer rather than a voluntary payment or a fee that does not qualify as an income tax. For instance, foreign social security taxes are often considered payroll taxes rather than income taxes, making them ineligible for credit in many states.
Credit calculation methods vary. Some states allow a dollar-for-dollar offset, while others impose a cap based on a percentage of state taxable income. A common limitation is that the credit cannot exceed the state tax due on the same income, preventing taxpayers from eliminating their entire state tax liability.
Documentation requirements also play a role. States typically require proof of foreign taxes paid, such as official tax assessments, payment receipts, or foreign tax returns. Some mandate that the foreign tax be final and not subject to refund or adjustment. If a taxpayer later receives a refund from the foreign government, they may need to amend their state return and repay the credit.
Variations Among States That Recognize the Credit
States that permit a Foreign Tax Credit (FTC) differ in how they structure the benefit. New York allows a credit for taxes paid to foreign jurisdictions but only if the income is also taxed at the federal level. This means taxpayers benefiting from the Foreign Earned Income Exclusion (FEIE) may not be able to claim a credit at the state level.
California does not allow a credit for foreign taxes at all. Residents who pay taxes to another country must still meet their full state tax liability without any offset. This can be especially burdensome for high-income earners, given California’s progressive tax structure, where top marginal rates reach 13.3%.
Arizona and Indiana provide a limited FTC but often restrict it to specific types of foreign income, sometimes requiring that the foreign country have a tax treaty with the U.S. Maryland allows a credit but only for full-year residents, meaning those who move in or out of the state during the year may only claim a prorated amount. Virginia has reciprocity agreements with certain foreign jurisdictions, which can affect whether a credit is available or if an alternative relief mechanism applies.
The process for claiming the credit also varies. New Jersey requires taxpayers to complete a state-specific form detailing the foreign tax paid, while Wisconsin integrates the credit calculation directly into the state tax return. Some states require additional disclosures, such as attaching copies of foreign tax returns or providing translations if the documents are not in English. Failure to meet these requirements can result in the credit being disallowed, leading to higher tax liabilities and potential penalties.
Special Considerations for Mixed Income Sources
Taxpayers with both foreign and domestic income often face additional challenges when claiming a Foreign Tax Credit (FTC) at the state level. Some states require a clear segregation of income types, meaning foreign business taxes can only be credited against state tax on business income, not against other earnings like dividends or royalties. This can be problematic if a taxpayer’s foreign tax burden is high but their state tax liability primarily stems from domestic sources, limiting the usefulness of the credit.
Differences in tax treatment between jurisdictions further complicate calculations. Many countries impose value-added taxes (VAT) on business revenues, which are not always recognized as income taxes by U.S. states. If a taxpayer’s foreign earnings are subject to both income tax and VAT, only a portion of their total foreign tax payments may qualify for the credit.
Another issue arises when foreign income is taxed on a different accounting basis. Some countries tax income when it is earned, while certain states tax it when it is received. This mismatch can lead to timing differences where a taxpayer pays foreign taxes in one year but incurs state tax liability in another, potentially disqualifying them from claiming the FTC in the year it would be most beneficial.