Foreign Tax Credit: Definition, How It Works, and Who Can Claim It

The foreign tax credit (FTC) is a U.S. tax relief that offsets income taxes you paid to a foreign country or U.S. possession, reducing the risk of double taxation on the same income. It applies to both earned and unearned income and generally lowers your U.S. tax liability dollar-for-dollar.

Key points
– The FTC reduces U.S. tax liability for foreign income taxes paid or accrued.
– Qualifying taxes generally include income, war profits, and excess profits taxes — and taxes on wages, dividends, interest, and royalties.
– Most FTCs are non-refundable (they can reduce tax to zero but won’t generate a refund).
– Claiming the FTC typically requires filing Form 1116 unless you qualify for an exception.

How the FTC works
– You can either take an itemized deduction for foreign income taxes (Schedule A) or claim the FTC. You cannot mix methods for the same taxes: all qualified foreign taxes must be claimed either entirely as credits or entirely as deductions.
– The credit directly reduces your U.S. tax liability; a deduction only reduces taxable income.
– To claim the credit, complete and attach Form 1116 to your Form 1040 unless you meet an exception (see Exceptions below).
– The IRS requires the foreign levy to be similar to a U.S. income tax and not a payment for a specific economic benefit.

What qualifies
– Qualifying taxes:
* Income taxes (or taxes in lieu of income tax)
* War profits and excess profits taxes
* Taxes on wages, dividends, interest, royalties
– Non-qualifying taxes:
* Foreign real and personal property taxes (may be deductible on Schedule A in some cases)
* Taxes that are payment for a specific benefit rather than a general income tax
– Currency: Foreign taxes must be converted to U.S. dollars using the exchange rate in effect when the tax was paid, withheld, or estimated payments were made.

Who can claim the FTC
– U.S. citizens and resident aliens who pay foreign income taxes and are subject to U.S. tax on the same income.
– Estates and trusts may also use the FTC.
– Nonresident aliens can qualify in limited situations (for example, bona fide residents of Puerto Rico for the entire tax year or foreign taxes connected to a U.S. trade or business).

Limit on the credit and exceptions
– The credit is limited: you can generally claim the lesser of (a) foreign taxes paid or accrued, or (b) the limit computed on Form 1116.
– Exceptions (no Form 1116 required; claim directly on Form 1040) apply if:
* Your only foreign source income is passive and your foreign taxes meet the rules for the exception, or
* Your qualified foreign taxes for the year are below $300 ($600 if married filing jointly), or
* Your foreign income and taxes are reported to you on a payee statement (e.g., Form 1099-DIV or 1099-INT) and you elect this procedure for the year.
– Carryover rules: unused foreign tax credits can be carried back one year and forward up to ten years.

Interactions and limitations
– Foreign Earned Income Exclusion (FEIE): If you claim the FEIE or foreign housing exclusion, you cannot claim the FTC for taxes on the excluded income. Electing both for the same income can invalidate the election.
– You must choose either credit or deduction for all qualified foreign taxes — you cannot split some taxes as credits and others as deductions.
– Most FTCs are non-refundable: they can reduce tax to zero but won’t produce a refund beyond your U.S. tax liability. Unused credit amounts may be carried as noted above.

Claiming the credit
– Complete Form 1116 (unless you qualify for an exception) and attach it to your Form 1040.
– Keep documentation of foreign tax payments and how you converted the amounts to U.S. dollars.
– If unsure about eligibility, limit calculations, or interactions with FEIE, consult a tax professional or the IRS instructions for Form 1116.

Bottom line
The foreign tax credit helps prevent double taxation by offsetting U.S. tax with taxes paid to foreign governments on the same income. It’s usually more beneficial than a deduction because it directly reduces tax owed, but it requires meeting eligibility tests, following limit rules, and, in many cases, filing Form 1116.