U.S. Foreign Tax Credit Explained

Published on November 6, 2023
by Clark Stott

Clark Stott has been with Expat Tax Online since 2015. Being a dual national based in the UK, Clark has unique experience helping US citizens (and Accidental Americans) become tax compliant via the Streamlined Tax Amnesty program. Clark likes to help Americans in the UK keep their tax situations as simple as possible to avoid harsh IRS treatment.

How Does U.S. Foreign Tax Credit Work?

The United States is unique in that it taxes its citizens on their global income. That’s where the Foreign Tax Credit (FTC) comes into play. The FTC serves as a non-refundable credit designed to offset the taxes you’ve paid to a foreign government, thereby reducing your U.S. tax burden. The aim is to ensure you’re not double-taxed on the same earnings.

So, how does this mechanism function? Let’s say you reside in another country and have fulfilled your tax obligations there. Those foreign taxes can be claimed as a credit when you file your U.S. tax return, effectively lowering the amount you owe to the U.S. government.

Who Can Claim the FTC and What Taxes Qualify

Wondering who can take advantage of this credit? The following groups are eligible:

  • Americans residing overseas
  • U.S. resident aliens
  • Domestic corporations, estates, and trusts

However, it’s crucial to note that not every tax paid to a foreign government is eligible for the FTC. So, what kinds of taxes are eligible for this credit?

  • Taxes on foreign income
  • Withholding taxes on overseas interest and dividends
  • Taxes on earnings from employment in a foreign country

Is it possible to claim the FTC for both income and withholding taxes from a foreign source? Absolutely. Whether you’ve had taxes withheld from your foreign interest and dividends or you’ve directly paid income taxes to another country, both scenarios qualify for the FTC.

There’s more to the story, though. The FTC comes with certain limitations. For example, if you find yourself in a country with higher tax rates than the U.S., the FTC could be your best option. On the other hand, if you’re in a country with lower tax rates, the FTC may not fully offset your U.S. tax obligations.

So, does the FTC wipe out all your U.S. tax obligations on foreign earnings? Not exactly. The FTC functions as a credit rather than a deduction, meaning it can only minimize your U.S. tax liability up to the amount you’ve paid in foreign taxes on the same income.

Limitations and Calculations of the FTC

The Foreign Tax Credit is computed based on the foreign taxes you’ve either paid or accrued over the fiscal year. To make the calculations, you’ll need to convert these foreign amounts into U.S. dollars, using the prevailing exchange rate at the time you made the payment.

Is there a ceiling on how much you can claim? Absolutely. The FTC comes with its own set of limitations. Specifically, the credit you claim can’t exceed what you owe in U.S. taxes on the income you’ve earned abroad. To put it mathematically, you multiply your U.S. tax obligation by a fraction—your foreign-earned income goes in the numerator, and your total global income is the denominator.

You may ask, can this credit lead to a tax refund? Generally speaking, the FTC is non-refundable. It can bring your tax liability down to zero, but it won’t generate a refund. However, some unclaimed credits can be carried back for one year and carried forward for up to a decade.

Required Forms and Documentation

What paperwork will you need to fill out? The cornerstone for claiming the FTC is Form 1116. For U.S. corporations, Form 1118 is the go-to document. These forms assist you in determining your eligible credit and help you track any amounts that can be carried over.

So, what are the foundational requirements to claim this credit?

  • Presence of foreign-earned income
  • Payment or accrual of foreign income taxes
  • Legitimate and actual foreign tax obligation
  • The tax must be levied on income

Don’t underestimate the importance of keeping thorough records. It’s important to maintain documentation of the foreign taxes you’ve paid, which could include official forms or statements from the foreign government. Additionally, evidence of your foreign-earned income is essential, and this could be substantiated through pay stubs, foreign tax returns, or financial statements.

It’s often wise to seek the guidance of a tax expert. They can steer you through the complex numbers, making sure you claim all eligible credits while staying compliant with IRS regulations. If you find yourself overwhelmed, perhaps it’s time to consult a professional.

Carryover Provisions for Unused Credits

So you’ve got some leftover credits—what happens to them? You can indeed carry these unused foreign tax credits both back for one year and forward for up to a decade. This offers you a bit of leeway in managing your U.S. tax obligations over several years.

But how does this credit play with other international tax measures? It’s worth noting that the FTC can be combined with other international tax tools like the Foreign Earned Income Exclusion (FEIE), but they can’t be applied to the same chunk of income.

And as for where you can claim this credit, is it globally applicable? For the most part, yes. The FTC can be claimed for taxes paid to a wide range of foreign countries and even some U.S. territories. However, countries under U.S. sanctions, such as North Korea and Iran, are exceptions.

Types of Income and Business Entities

Let’s look at some unique scenarios. How do you go about claiming the FTC for passive and general category income? Passive income encompasses elements like dividends, interest, and rental income. For these, you’ll typically use Form 1116, similar to active income, but you’ll have to fill out a distinct Form 1116 for each income category.

But what if you’re a business entity, not an individual? How does the FTC relate to corporations and other organizational structures? Corporations are also eligible for the FTC, but they’ll use Form 1118, not Form 1116. While the general principles are alike, there are some variations, and corporations have their own set of rules for carrying unused credits forward and backward.

If you find the world of international taxation a bit daunting, consulting a tax expert, particularly one well-versed in expatriate taxation, can be a game-changer. They can help you ensure you claim all the credits you’re entitled to while staying in compliance with the law. If you’re feeling a bit overwhelmed, it might be time to seek professional guidance.

Common Obstacles

The FTC is undoubtedly beneficial, but it’s not without its challenges. For example, what if you’ve paid taxes in more than one foreign country? Or perhaps you’ve paid taxes on income that the U.S. doesn’t consider taxable? These are just some of the things that can make the FTC a bit tricky to apply.

And then there’s the matter of currency conversion. The IRS expects all figures in U.S. dollars, requiring you to convert any foreign taxes you’ve paid into USD. The IRS does provide guidelines on which exchange rate to use, adding another layer to the process.

So, how do you manage all this? One effective way is to consult a tax expert who specializes in expatriate taxation. They can help you steer through the rules, ensuring you claim the FTC accurately.

Best Practices and Potential Pitfalls

Let’s discuss the advantages. Why choose the FTC over other international tax options like the Foreign Earned Income Exclusion (FEIE)? The FTC can offer a one-to-one reduction in your U.S. tax liability, making it a potent tool for reducing your tax burden.

But how do you avoid claiming the FTC for taxes you’ve already claimed under another provision? The answer lies in diligent record-keeping and a thorough understanding of the types of income and taxes each provision covers. Double-claiming can result in penalties, so accuracy is key.

What happens if you get a foreign tax refund after claiming the FTC? This can add a layer of complexity. You may have to revise your U.S. tax return to account for the refunded amount, potentially increasing your U.S. tax liability.

Managing the FTC is a balancing act that requires keen attention to detail and a solid backup plan. A tax professional can be your guide, helping you navigate the complexities, maximize your benefits, and stay compliant.