Foreign Tax Credit: How to Avoid Double Taxation

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The Foreign Tax Credit (FTC) is a dollar-for-dollar reduction in your U.S. tax liability for taxes paid to a foreign government. Unlike tax deductions, which reduce your taxable income, a tax credit lowers your overall tax bill.

The point of this tax credit is to cut down on the double taxation American citizens and resident aliens must pay on income earned while living and working abroad. Depending on your situation, you can either itemize your deductions when filing income taxes or claim the credit. Both options will reduce your tax bill.

How Does the Foreign Tax Credit Work?

However, it’s worth noting that the Foreign Tax Credit doesn’t necessarily reduce the amount of income tax the foreign country withholds. Limitations and other restrictions also apply.

As per the IRS website, “If you are entitled to a reduced rate of foreign tax based on an income tax treaty between the United States and a foreign country, only that reduced tax qualifies for the credit.”

Know that the U.S. has tax treaties with certain foreign countries meant to prevent double taxation on the same income. Some of these treaties allow you as a U.S. citizen to claim an additional tax credit for some of the tax imposed by your host country. This treaty is both separate and in addition to the standard Foreign Tax Credit.

Countries that have this tax treaty with the U.S. include:

• Australia
• Austria
• Bangladesh
• Belgium
• Bulgaria
• Canada
• Czech Republic
• Denmark
• Finland
• France
• Germany
• Iceland
• Ireland
• Israel
• Italy
• Japan
• Luxembourg
• Malta
• Mexico
• The Netherlands
• New Zealand
• Portugal
• Slovak Republic
• Slovenia
• South Africa
• Spain
• Sweden
• Switzerland
• The U.K.

Who Qualifies for the Foreign Tax Credit?

According to the IRS, you can claim a credit only for foreign taxes imposed on you by a foreign country or U.S. possession. U.S. possessions include:

• Puerto Rico
• The U.S. Virgin Islands
• Guam
• The Northern Mariana Islands
• American Samoa

What Income and Taxes Qualify?

 Qualifying income types include:

• Wages and salaries
• Dividends and interest
• Capital gains
• Royalties and rental income
• Annuities, pensions, and alimony
• Business income and bonuses

What Taxes Don’t Qualify for the Credit?

Taxes that do NOT qualify:

• Value-added tax (VAT)
• Real estate tax
• Sales tax
• Social Security taxes (if covered by treaty)
• Refundable or voluntary taxes
• Taxes on income you excluded under the Foreign Earned Income Exclusion

Any income that qualifies for either the foreign earned income exclusion or the foreign tax credit or the deduction is tax-free.

How to Calculate the Foreign Tax Credit

 To qualify for the Foreign Tax Credit, all of the following must apply:

• The tax must be imposed on you
• You must have paid or accrued the tax
• The tax must be a legal and actual foreign income tax
• The tax must be on qualifying foreign income (not already excluded or refunded)
• You must file Form 1116 if your foreign taxes exceed $300 (single) or $600 (joint)

How to Claim the Credit (Form 1116 Instructions)

Here’s how to file Form 1116.

1. Calculate your foreign income and taxes by country
2. Convert all values to U.S. dollars
3. Fill out Form 1116 to figure your allowable credit
4. Attach Form 1116 to your Form 1040 or 1040-SR
5. Use carryover rules if your foreign tax credit exceeds your U.S. tax owed

Should You Take the Credit or a Deduction?

If you’re trying to decide between claiming the Foreign Tax Credit or taking a deduction for foreign taxes, know that the credit will usually save you more money. However, some exceptions exist. Speak with a professional tax preparer who’s well-versed in foreign income tax and can help you choose the option that reduces your tax bill the most.

Tips for Maximizing the Foreign Tax Credit

International tax law is complicated, but here are a few ways to maximize your foreign tax credit and avoid double taxation:

• Keep track of any and all foreign tax payments. Not all taxes qualify for the FTC, but keeping records of any you’ve made just in case is wise.
• Understand carryovers and carrybacks. If your tax credit is more significant than your U.S. tax liability, the IRS allows you to apply that excess amount to the previous year’s taxes. Alternatively, you can carry it forward for up to 10 years.
• Consider taking a tax deduction. The Foreign Tax Credit lowers your U.S. tax bill on a dollar-for-dollar basis. But there are times when excluding your taxable income through the Foreign Earned Income Exclusion might be better. Consult with a tax professional about your options.

What to Know About the Foreign Tax Credit

• Prevents double taxation on foreign income
• Credit usually saves more than a deduction
• You must file Form 1116 for most claims
• Foreign earned income exclusions may limit eligibility
• Credit amounts over your U.S. tax liability can be carried forward 10 years or back 1 year

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