Taxes: What Is The Foreign Tax Credit?

If you paid income to a foreign country last year you may be eligible for a credit on your U.S. return. Read this article to find of if you qualify.

The idea of working abroad is appealing to many Americans. Living in a foreign country, experiencing another culture, and sampling international cuisines are all perks of international business. But when it comes down to tax time, international income can get downright hairy. Most likely, if you worked in another country, you had to pay income tax to the country in which you worked. Yet, you have to report this income on your United States income tax form as well. Does this mean you have to pay taxes twice on your foreign income? Fortunately, thanks to the Foreign Tax Credit, the answer is no.

The foreign tax credit is a credit given by the IRS to recognize the fact that you as a foreign-based employee already had to pay income tax to your host country on the income you made there. U.S. citizens and resident aliens who paid income tax to a foreign country or U.S. possession have a choice of taking this amount as a deduction or credit - the deduction will lower your total taxable income while a credit will lower your liability. For almost everybody, taking a credit is always better than taking a deduction. However, some foreign taxes do not count toward the credit, so if this is the case, you may take the deduction. If you choose to take a deduction, though, bear in mind that you have to take a deduction for all of the foreign taxes you paid (the same goes for taking a credit). If you choose to take a deduction, you will need to itemize your deductions on Schedule A of Form 1040. If you take a credit, you will need to file Form 1116. For the purposes of this article, it will be assumed that most people will take the credit.

Only certain taxes qualify for the foreign tax credit. In general, the IRS lists four qualifications for a tax to qualify for a credit. The tax must be imposed on you (not your employer, for example); you must have paid, or owe, the tax to a foreign country; the tax must be legal; and the tax must be on income you earned. Even if the foreign country withheld taxes from your wages based on definitions of income that the United States does not include (and would not be considered income tax in the U.S.), you can count this as income tax paid.

Some taxes do not qualify for the foreign tax credit. Under some circumstances, foreign income you make does not count toward your U.S income tax. This is known as excluded income, and even if you paid a foreign tax on this income, since it is excluded from your U.S. return, you cannot take a credit for it. For example, if you have income derived from Puerto Rico, you may not have to pay U.S. income tax on this, and therefore cannot claim any tax you paid on it as a tax credit. For more information about what is included in excluded foreign income, see IRS publication 54. Other taxes which do not qualify for the credit are rather specialized: Taxes you paid to foreign countries for oil-related income; taxes paid for mineral-related income; taxes resulting from an international boycott; and taxes on natural-gas-related income. Most people don't have to worry about this, but if you did earn income from these sources last year, contact the IRS for more information about how to handle the income and taxes paid.

Certain foreign taxes do not qualify for a tax credit, but do qualify for a deduction. This is an exception to the rule stated earlier about having to claim all of your foreign income tax as either a credit or a deduction. If you have any of these qualifying foreign income taxes, you may take them as a deduction separately from any foreign income taxes you are taking as a credit. The largest category of these is foreign taxes paid to governments on the U.S sanction list. For 2004, this list included Cuba, Iran, Iraq, Libya, North Korea, Sudan, and Syria. If you worked in any of these countries during the year and paid income tax, you can only treat those taxes paid as an itemized deduction.

If you qualify for the credit, you will need to file Form 1116. There is a limit to the amount of the credit you can take. This limit is calculated by your total tax liability multiplied by a fraction made up of your total foreign income divided by your total income from foreign and U.S. sources. For example, let's say your tax liability is $1,000, and you made $22,000 from foreign-based income for 2004, along with another $48,000 from U.S. sources. To figure the limit, you take your total foreign income ($22,000) and divide it by the total income from all sources ($22,000+$48,000). This gives you a fraction of .314. Multiply this by your total tax liability. $1,000 x .314= $314. This is the limit on your foreign tax credit.

Now, taking the same example, let's say you made no additional money from U.S. sources. In this case you would divide the total foreign income ($22,000) by the total income from all sources ($22,000, since you had no U.S. income). This gives you a fraction of 1. Multiply this by your total tax liability, and you have $1,000.

You can take the credit up to your total tax liability, but not more than it. If your foreign tax credit is higher than your limit, you may be able to carry the credit over to the next year, or even apply it to one of the previous two years.

© High Speed Ventures 2011