Understanding Foreign Tax Credits: A Comprehensive Guide

Foreign tax credits are non-refundable tax credits for income taxes that were paid to a foreign government as a result of income taxation. The foreign tax credit is available to those who work internationally or those with investment incomeCapital GainA capital gain is an increase in the value of an asset or investment resulting from the price appreciation of the asset or investment. In other words, the gain occurs when the current or sale price of an asset or investment exceeds its purchase price. from a foreign source. Taxpayers within the United States who also pay or accrue taxes in a foreign country may be entitled to a credit or a deduction for such taxes.

Summary

• Foreign tax credits are non-refundable tax credits for income taxes that were paid to a foreign government as a result of income taxation.
• To qualify for foreign tax credits, the following criteria must be met: (1) the tax must be imposed on you, (2) you must have accrued or paid the tax, (3) the tax must be the legal and actual foreign tax liability, and (4) the tax must be an income tax.
• Claiming a foreign tax credit in the United States as an individual, estate, or trust, and when you’ve paid or accrued certain foreign taxes to a foreign country or U.S. possession, requires the filing of Form 1116, Foreign Tax Credit.

Foreign Taxes that Qualify for the Foreign Tax Credit

For a foreign tax to qualify as a foreign tax credit, the following criterion must be met:

1. The tax must be imposed on the individual

A taxpayer can only claim credits when foreign taxes are imposed by a foreign country or a United States possession. U.S. possessions include American Samoa and Puerto Rico. Foreign countries are considered to be a foreign state and their relevant political subdivisions.

War profits, income, and excess profits taxes paid or accrued to a foreign city or province qualify for the foreign tax credit treatment. Additionally, all qualified taxes paid to U.S. possessions are considered foreign taxation.

2. The individual must have accrued or paid the tax

Credits can only be claimed if the tax is paid or accrued to a foreign country or the United States possession. The three primary ways the taxes are paid and accrued are through (1) joint returns, (2) combined income, (3) as a mutual fund shareholder.

3. The tax must be the legal and actual foreign tax liability

The qualified foreign tax must be the only legal and actual foreign tax liability that was paid or accrued during a year. The amount of foreign income tax liabilityIncome Tax PayableIncome tax payable is a term given to a business organization’s tax liability to the government where it operates. The amount of liability will be based on its profitability during a given period and the applicable tax rates. Tax payable is not considered a long-term liability, but rather a current liability, that qualifies does not necessarily equal the amount withheld by the foreign government.

4. The tax must be an income tax (or a tax in lieu of income tax)

Usually, only war profits, income, and excess profits taxes qualify for foreign tax credits. However, foreign taxes on wages, interest, and dividendsDividendA dividend is a share of profits and retained earnings that a company pays out to its shareholders. When a company generates a profit and accumulates retained earnings, those earnings can be either reinvested in the business or paid out to shareholders as a dividend. also generally qualify for the credit. The tax credit can also be applied on foreign taxes on income even though they are not imposed under an income tax law if the tax is in lieu of war profits, income, or excess profits tax.

The tax must be a foreign levy that is not payable for an already received economic benefit. Moreover, it must be a tax imposed in place of, and not in addition to, an income tax otherwise normally imposed.

Difference in Tax Treatment Between a Deduction and a Credit

A tax deduction reduces the amount of income that is subject to income tax, but a tax credit lowers the amount of tax owed. For example, if you qualify for a $1,000 tax credit and you owe $2,000 in taxes, the credit will reduce your tax liability by $1,000. You may qualify for a tax refund; however, not all tax credits are refundable.

How to Claim a Foreign Tax Credit

Claiming a foreign tax credit in the United States as an individual, estate, or trust, and when you paid or accrued certain foreign taxes to a foreign country or U.S. possession, requires the filing of Form 1116, Foreign Tax Credit.

If you are filing on behalf of a corporation, you must file Form 1118, Foreign Tax Credit – Corporations. Any corporation that elects the benefits of foreign tax credits under section 901 needs to complete and attach Form 1118 to its income tax return.

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