Foreign Tax Credit
Definition
A Foreign Tax Credit is a tax provision that allows taxpayers to reduce their domestic tax liability by the amount of income taxes paid to a foreign government on the same income.
Detailed Explanation
The Foreign Tax Credit (FTC) is designed to mitigate the double taxation that can occur when income is taxed both by the country where it is earned and by the taxpayer’s home country. This situation commonly affects individuals and businesses that earn income abroad but are also subject to taxation in their country of residence on worldwide income.
When you pay income taxes to a foreign government on income also subject to domestic tax, the FTC allows you to subtract the amount of foreign tax paid from your domestic tax liability. However, the credit is generally limited to the amount of domestic tax attributable to the foreign income. This means you cannot use the FTC to reduce your domestic tax liability below what you would owe on your foreign income if it were taxed at your home country’s rates.
To claim the FTC, taxpayers must file specific forms and provide documentation of the foreign taxes paid. In the United States, for example, individuals use Form 1116, while corporations use Form 1118. The FTC is non-refundable—it can reduce your tax liability to zero but cannot result in a tax refund.
It’s important to note that you cannot claim both a tax credit and a tax deduction for the same foreign taxes paid. Generally, the tax credit is more advantageous because it provides a dollar-for-dollar reduction of your tax liability, whereas a tax deduction only reduces your taxable income.
Example
Suppose Sarah, a U.S. citizen, earns $20,000 from consulting work she performed in Country X. Country X taxes her income at 25%, so she pays $5,000 in foreign taxes. In the U.S., her tax rate on this income is 22%, resulting in a $4,400 tax liability.
By claiming the Foreign Tax Credit, Sarah can reduce her U.S. tax liability on the foreign income by the amount of tax she paid to Country X, up to the U.S. tax liability on that income. Therefore, she can claim a credit of $4,400, reducing her U.S. tax owed on the foreign income to zero. The remaining $600 of foreign taxes paid ($5,000 foreign tax minus $4,400 U.S. tax liability) may be carried back one year or carried forward up to ten years to offset future tax liabilities on foreign income.
Key Articles Related To Foreign Tax Credits
Related Terms
Double Taxation: The imposition of two taxes on the same income by different jurisdictions.
Foreign Earned Income Exclusion (FEIE): A provision that allows qualifying U.S. taxpayers to exclude a certain amount of foreign-earned income from U.S. taxation.
Foreign Income: Income derived from sources outside one’s home country.
Foreign Tax: Taxes imposed by a foreign government on income earned within its jurisdiction.
Global Income: The total income earned worldwide, regardless of where it is generated.
Nonresident Alien: For U.S. tax purposes, a non-U.S. citizen who does not meet residency requirements and is taxed only on U.S.-source income.
Resident Alien: A non-U.S. citizen who meets residency requirements and is taxed on worldwide income like a U.S. citizen.
Tax Credit: A dollar-for-dollar reduction in the amount of tax owed to the government.
Tax Treaty: An agreement between two countries to resolve issues of double taxation and tax evasion.
Worldwide Taxation: A tax system where residents are taxed on their global income, regardless of where it is earned.
FAQs
Who is eligible to claim the Foreign Tax Credit?
Taxpayers who have paid or accrued foreign taxes on income that is also subject to domestic taxation can claim the Foreign Tax Credit.
Can I claim both the Foreign Tax Credit and the Foreign Earned Income Exclusion?
Generally, you cannot claim the Foreign Tax Credit on income that you have excluded using the Foreign Earned Income Exclusion.
How do I calculate the Foreign Tax Credit limit?
The credit is limited to the amount of domestic tax attributable to your foreign income, calculated by multiplying your total U.S. tax liability by the ratio of foreign taxable income to total taxable income.
What forms are required to claim the Foreign Tax Credit?
In the U.S., individuals file Form 1116, and corporations file Form 1118 to claim the Foreign Tax Credit.
Can unused Foreign Tax Credits be carried over to other tax years?
Yes, unused credits can generally be carried back one year or carried forward up to ten years.
Is the Foreign Tax Credit refundable?
No, it’s a non-refundable credit; it can reduce your tax liability to zero but cannot result in a refund.
Do all foreign taxes qualify for the Foreign Tax Credit?
Only income taxes (or taxes in lieu of income taxes) qualify. Other taxes like sales or value-added taxes do not.
How does a tax treaty affect the Foreign Tax Credit?
Tax treaties may alter how the credit is calculated or limit the types of income eligible for the credit.
Can I choose between deducting foreign taxes and taking the Foreign Tax Credit?
Yes, you can either deduct foreign taxes as an itemized deduction or claim them as a credit, but not both.
What happens if I don’t claim the Foreign Tax Credit?
Failing to claim the credit may result in paying more tax than necessary due to double taxation.
Editor: Colin Graves