Federal tax law provides the foreign tax credit to relieve taxpayers of the double tax burden imposed when their foreign income is taxed by both the United States and the foreign country where their income originated. Usually, if the foreign tax rate is higher than the U.S. tax rate, there will be no resulting U.S. tax on this foreign income. If the foreign tax rate is lower than the U.S. tax rate, the U.S. tax on the foreign income will be the difference between the two tax rates. Keep in mind that the foreign tax credit reduces U.S. taxes on foreign source income, but never reduces U.S. taxes on U.S. source income.
Despite the fact that different rules may apply to different situations, often the best course of action is taking a credit for qualified foreign taxes rather than treating them as an itemized deduction. One reason for this is that a credit reduces actual U.S. income tax on a dollar-for-dollar basis, while a deduction reduces only the income subject to tax. Also, taxpayers may choose to take the foreign tax credit even if deductions are not itemized. In this case, a taxpayer may take the standard deduction in addition to the credit. Another reason is if the taxes paid or accrued exceed the credit limit for the tax year, a taxpayer may be able to carry over or carry back the excess to another tax year.
Taxpayers may change their choice from year to year. To choose the foreign tax credit, Form 1116 must be completed and attached to the U.S. tax return. There is an exception that allows a taxpayer to claim the foreign tax credit without using Form 1116. To choose to claim the taxes as an itemized deduction, a taxpayer should use Schedule A (Form 1040), Itemized Deductions.
A smart course of action for taxpayers is to compute their tax both ways, claiming the credit and claiming the deduction. Whichever method yields the most tax savings is the obvious, proper choice. Regardless, the general rule is that this choice applies to all qualified foreign taxes. If a taxpayer chooses to take the credit, he or she must take the credit for all foreign taxes and may not deduct any of them. If the choice is to deduct qualified foreign taxes, all must be deducted and the credit may not be used in any way.
As with just about any tax law or regulation, there are exceptions for foreign taxes not allowed as a credit. Under certain circumstances, taxpayers that claim a credit for other foreign taxes may deduct any foreign tax that is not allowed as a credit. These exceptions include paying a tax to a country for which a credit is not allowed because it provides support for acts of international terrorism, or because the United States does not have or does not conduct diplomatic relations with it. There are other exceptions as well. Applying an exception to invoke maximum benefit of the law is complex and requires the assistance and counsel of an experienced and knowledgeable tax attorney.
Only foreign income taxes qualify for the foreign tax credit. Foreign real and personal property taxes do not qualify but may be deducted if they are expenses incurred in a trade or business. Also, foreign real property taxes that are not trade or business expenses may be deducted as an itemized deduction on Schedule A (Form 1040).
Because the amount of the credit is limited in a tax year, any qualified foreign taxes that exceed the credit limit may be carried over or carried back to another tax year. While the limitations period for refund claims relating to a foreign tax credit generally runs parallel to the election period, the limitations period for refund claims relating to a deduction of foreign tax does not, and may expire before the end of the election period.
If you have any questions about the foreign tax credit and whether you should deduct or take a credit for foreign taxes, call THE TAX EXPERTS at the Thorgood Law Firm www.thorgoodlaw.com. For a FREE consultation call 212-490-0704.
