What is Foreign Tax Credit?

The foreign tax credit abbreviated FTC is a non-refundable tax credit claimed on Form 1116 for income taxes paid to a foreign government as a result of foreign income tax withholdings. The FTC is available to anyone who either works in a foreign country or has investment income from a foreign source.

When an American pays income tax to a foreign government, that tax can be claimed as a credit against his U.S. federal income tax.

The purpose of the FTC is to reduce the impact of having the same income taxed by both the United States and by the foreign country where the income was earned.

Do I qualify for the FTC?

Not all taxes paid to a foreign government can be claimed as credit against the U.S. federal income tax. In most cases, the following four tests must be met for any foreign tax to qualify for the credit.

1. The tax must be imposed on you.

2. You must have paid or accrued the tax. (tax on proportionate)

For example, if some of your foreign income is taxable and some is exempt, then you must be able to break down the taxes paid on the foreign income only, and only claim the credit for taxes paid on that foreign income.

3. The tax must be the legal and actual foreign tax liability. (eg, no refunded, credited, rebated, contested)

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

Other taxes that are not income taxes such as foreign real and personal property taxes do not qualify. However, they may be deducted as itemized deduction (Foreign real property taxes can be deducted even if they are not trade or business expenses but others can be deducted only if they are expenses incurred in a trade or business).

When can I claim the FTC?

You can claim the credit in the year you actually pay the tax or accrue the tax, depending on your accounting method in the tax year. If you use the accrual method of accounting, you can only claim the credit in the tax year you accrue the tax. If you use the cash method of accounting, you can claim the credit either in the tax year you pay the tax or in the year you accrue the tax. Once you choose to take the credit when the foreign taxes accrue, you have to follow it to the all later years. Most taxpayers choose the cash method.

How is the FTC calculated?

Before calculating your FTC, the following items should be reduced from the foreign taxes you want to claim for credit:

• Foreign Earned Income Exclusion and Foreign Housing Exclusion/Deduction filed on Form 2555.
• Taxes on income from Puerto Rico exempt from U.S. tax.
• Taxes on income from American Samoa excluded on Form 4563.
• Taxes on combined foreign oil and gas income.
• Taxes on foreign mineral income.
• Reduction for failure to file Form 5471 and 8865.
• Reduction of taxes or credit due to international boycott operations.
• Taxes related to a FTC splitting event.

You can claim a FTC the lesser of the actual foreign tax imposed or the following formula, sometimes known as the overall FTC limitation formula:

    Foreign Tax Credit for each category

                  <=Total U.S. Tax liability *Foreign Taxable Income/Total Worldwide Taxable Income

Total Worldwide taxable income is computed before deducting personal and dependency exemptions. To determine the limit, you must separate your foreign source income into categories. The limit treats all foreign income and expenses in each separate category as a single unit and limits the credit to the U.S. income tax on the taxable income in that category from all sources outside the United States.

Example 1 :

In 2018, Frank has earned $50,000 of wages from China (converted from Chinese RMB to US dollars) and $3,000 in interest from his Chinese bank account. He reported on his U.S. return this income as well as $2,000 of dividends from a U.S. company. He is single and have no other itemized deductions.

Frank paid $15,000 in taxes to China on his salary and another $1000 on his interest income.

Step 1: Frank must allocate his income into the two categories: general and passive.

In his case, $50,000 of salary is allocated to the general income category and total of $3,000 of interest is allocated to the passive income category.

Step 2: Complete a Form 1116 for each category of income.

General category: $50,000 foreign income. The percentage is calculated by dividing the $50,000 foreign earned income by $55,000 in gross income from all sources, for a result of 90.91%. We must multiply the tax liability of $8039.5 by 90.91% to arrive at the allowable FTC of $7308.64 for general income.

Passive category: $3,000 foreign interest. The percentage is calculated by dividing the $3,000 in foreign interest by $55,000 in gross income from all sources, for a result of 5.45%. We must multiply the tax liability of $8039.5 by 5.45% to arrive at the allowable FTC of $438.52 for passive income.

Step 3: Calculate the FTC carryover.

General category: Of the $15,000 in FTC available, the maximum amount Frank can use this year is $7308.64. The difference of $7691.36 is carried over.

Passive category: Of the $1000 in FTC available, the maximum amount Frank can use is $438.52. The difference of $561.48 is carried over.

Step 4: Add the total FTC and reduce US taxes.

Total US tax liability $8039.5.

Total FTC: $7747.16

With the FTC, Frank now will only own $292.34 in US tax. This amount is still owed because Frank could only use the FTC to offset the tax due on foreign income. He still owes tax on the $2,000 in US dividends.

FTC  VS Itemized Deduction?

You can choose whether to take the amount of any qualified foreign taxes paid or accrued during the year as a FTC  or as an itemized deduction. You can change your choice for each year's taxes stated.

In most cases the Credit is better than the Deduction and can create greater tax benefit because:

1. The credit reduces your U.S. income tax on a dollar-to-dollar basis with the foreign income tax you paid or accrued while the itemized deduction only reduces the taxable income subject to your U.S. tax.

2. If you choose to credit the foreign income tax, you can itemize no deduction and take the standard deduction.

3. You can do carrybacks and carryovers for the excess tax you paid or accrued to other tax years.

Example 2:

Assume the same facts as in Example 1. 

Option 1: He chooses to take the itemized deduction for the foreign tax,

• his taxable income would be $39,000 ($50,000 + $3,000 + $2,000 − $15,000 − $1000) and
• his tax liability would be $4,519.5.

Option 2: He chooses to take the FTC instead,

• his taxable income would be $55,000 ($50,000 + $3,000 + $2,000) and
• his tax before the credit would be $8,039.5.
• Using the credit limitation calculation (discuss later), his FTC  would be 7,747.16.
• His tax liability after the FTC would be $292.34.

Because the FTC decreases his tax liability on a dollar-to-dollar basis, it benefits Frank $4227.16 ($4519.5 – $292.34) more.

If Frank chooses to take the FTC, he will have unused foreign taxes of $8,252.84 ($16,000 − $7,747.16), which he can choose to carry back or carry over.

How do I deal with the unused FTC?

As mentioned above, the FTC is non-refundable which does not result in refund to the you as it will only reduce the tax owed to zero.  However, you are able to carrybacks (I year) and carryovers (10 years) the extra credit amount.  If you live and pay tax in a highly taxed foreign country for years, you will most likely continue to accumulate the FTC carryovers. If you plan to move back to the United States with these carryover credit, you could not use the credit against your income from United States because the FTC could only be applied to foreign sourced income. This means the only way to use up carryover credit would be to move to a lower taxed country and pay the lower tax.

Can I Claim FTC without using Form 1116?

If you use the Form 1116 to calculate your FTC, there are several limitations. However, you would be able to avoid these limitations by claiming the credit without filing Form 1116 if you meet all the following requirements:

1. All your foreign source gross income is passive category income (mostly interest and dividends, including high-taxed income and export financing interest.).

2. Qualified foreign taxes for the tax year are not more than $300 ($600 for MGJ)

3. All the foreign income and foreign income taxes are reported on a payee statement (such as 1099-DIV, 1099-INT and Schedule K-1)

4. Make this election and agree to not carry back or carry over any unused foreign tax to or from this tax year.