U.S. taxpayers that have paid or accrued foreign taxes to a foreign country or U.S. possession, while subject to U.S. tax on the same income, may be able to take either a credit or an itemized deduction for these payments for foreign taxes. The foreign tax credit intends to reduce the double tax burden that would otherwise arise when foreign source income is taxed by both the United States and the foreign country from which the income is derived.
Qualifying Foreign Taxes
Taxpayers may only claim a credit for foreign taxes that are imposed by a foreign country or U.S. possession. The tax must meet four tests to qualify for the credit:
- The tax must be a legal and actual foreign tax liability,
- The tax must be imposed on the taxpayer,
- The taxpayer must have paid or accrued the tax, and
- The tax must be an income tax, or tax in lieu of an income tax.
Generally, only income taxes paid or accrued to a foreign country or a U.S. possession (U.S. territory), or taxes paid or accrued to a foreign country or U.S. possession in lieu of an income tax, will qualify for the foreign tax credit.
Qualified foreign taxes do not include:
- Taxes refundable to the taxpayer.
- Taxes used to provide a subsidy to the the taxpayer or a relative of the taxpayer.
- Taxes not required by law, and thus the taxpayer could have avoided paying the taxes to the foreign country.
- Taxes that are paid or accrued to a country if the income giving rise to the tax is for a period (the sanction period) during which:
- The Secretary of State has designated the country as one that repeatedly provides support for acts of international terrorism,
- The United States has severed or does not conduct diplomatic relations with the country, or
- The United States does not recognize the country’s government, unless that government is eligible to purchase defense articles or services under the Arms Export Control Act.
- Note: These taxes may be claimed as an itemized deduction.
Credit or Deduction?
Taxpayers have a choice annually to choose either the foreign tax credit or itemized deduction for all foreign taxes paid or accrued during the year. They may choose to take the amount of any qualified foreign taxes paid during the year as a foreign tax credit or as an itemized deduction. To choose the deduction, it must be itemized on Form 1040, Schedule A. To choose the credit, generally Form 1116 must be completed and attached to Form 1040 or Form 1040NR.
Claiming the Foreign Tax Credit
Taken as a deduction, foreign income taxes reduce your U.S. taxable income. Deduct foreign taxes on Schedule A (Form 1040), Itemized Deductions. Taken as a credit, foreign income taxes directly reduce your U.S. tax liability. In most cases, it is to your advantage to take foreign income taxes as a tax credit. If you choose to exclude either foreign earned income or foreign housing costs, you cannot take a foreign tax credit for taxes on income you can exclude. If you do take the credit, one or both of the choices may be considered revoked.
File Form 1116, Foreign Tax Credit, to claim the foreign tax credit if you are an individual, estate or trust, and you paid or accrued certain foreign taxes to a foreign country or U.S. possession.
Corporations must file Form 1118, Foreign Tax Credit—Corporations, to claim a foreign tax credit.
If you have paid foreign income tax and have any questions regarding whether you may be entitled to claim a foreign tax credit or deduction for your federal income taxes, call THE TAX EXPERTS at the Thorgood Law Firm www.thorgoodlaw.com. For a FREE consultation call 212-490-0704.
