The Foreign Tax Credit: An Ultimate Guide for U.S. Expats

The United States taxes its citizens and residents on their worldwide income, regardless of where they live. This means that even if you’re living abroad, you might still owe U.S. taxes on income earned in another country. For many expats, this comes as a surprise. This may also provoke anxiety, as many expats are also paying taxes to their new country of residence. In these cases, expats worry about paying taxes twice on the same income. Fortunately, the Foreign Tax Credit (FTC) provides a solution. This credit allows individuals and corporations to offset income taxes paid to a foreign country against their U.S. tax liability.

However, not everyone is eligible to claim the credit. To benefit, you must meet specific IRS requirements. You must also comply with the IRS’ rules with regard to timely tax return filing and income tax payment. 

Here, we’ll discuss the basics of the Foreign Tax Credit, including eligibility criteria, how to claim it, and strategies for maximizing its benefits.

What is the Foreign Tax Credit?

It’s a provision in the U.S. tax code designed to reduce the double taxation burden for U.S. taxpayers with foreign-source income. If you paid or accrued foreign taxes on foreign source income and are subject to U.S. tax on the same income, you may take either a credit or an itemized deduction for those taxes. Unlike the foreign earned income exclusion, you do not need to live or work in a foreign country to claim this benefit.

The FTC is generally limited to your U.S. tax liability on foreign-source income, ensuring it only offsets taxes on foreign income, not U.S. income. The calculation involves multiplying your total U.S. tax liability by the ratio of foreign-source income to total taxable income.

What is Double Taxation

Double taxation occurs when taxpayers must pay taxes on the same income to two countries. This can lead to a significant financial loss. Fortunately, a U.S. taxpayer overseas may reduce U.S. taxable income and double taxation by claiming the foreign tax credit on Form 1116.

Foreign income not fully offset by the foreign earned income exclusion, housing exclusion, or housing deduction can use the foreign tax credit paid or accrued as a deduction or credit on the U.S. tax return. 

If the foreign tax rate is higher than the U.S., there’ll be no U.S. tax on foreign income. If the foreign tax rate is lower than the U.S. rate, U.S. tax on foreign income is generally limited to the difference between the rates.

TIP: Review the tax treaties between the U.S. and the country where you earned your income. These treaties can often provide additional relief from double taxation and might offer benefits that are not immediately obvious.

Credit vs. Deduction

The IRS allows taxpayers to claim qualifying taxes as an itemized deduction instead of the foreign tax credit. Before deciding which options will be best, you need to understand the difference between a credit and a deduction.

Tax Credit

A tax credit directly reduces the amount of tax you owe, dollar-for-dollar. For example, if your income tax liability is $5,000 and you have a $1,000 tax credit, you will pay only $4,000 in taxes. Tax credits are generally more valuable than deductions because they directly reduce the tax owed rather than just reducing the amount of taxable income. 

Note that foreign tax credit is non-refundable. It can reduce your tax liability to zero but will not result in a refund.

Tax Deduction

A tax deduction, on the other hand, reduces your taxable income by the deduction amount. For example, if your gross income for the year is $50,000 and you have a $5,000 tax deduction, your taxable income would be $45,000. Deductions can lower the amount of income that is subject to tax, which can reduce your overall tax liability. However, this generally provides the least tax benefit compared to a credit, as it only reduces the taxable amount, not the tax owed.

Why Choose the Foreign Tax Credit?

In most cases, claiming foreign income taxes as a credit rather than a deduction is more beneficial. This is because:

• A credit reduces your actual U.S. income tax on a dollar-for-dollar basis, while a deduction reduces only your income subject to tax,
• You can take the foreign tax credit even if you do not itemize your deductions. You then are allowed the standard deduction in addition to the credit and
• If you choose to take the foreign tax credit, and the taxes paid or accrued exceed the credit limit for the tax year, you may be able to carry over or back the excess to another tax year.

If you can’t claim the Foreign Tax Credit, deducting foreign taxes is an alternative. To claim this deduction, you must itemize your deductions on Schedule A. You can’t split your foreign taxes between a deduction and a credit. If you choose to deduct, you must do so for all foreign taxes paid or accrued during the year.

Who Can Claim the Credit?

To qualify for the Foreign Tax Credit, you must meet the following criteria:

• The tax must be imposed on you by a foreign country.
• You must have paid or accrued the tax.
• The tax must be your legal and actual foreign tax liability.
• The tax must be an income tax.

Eligible claimants include individuals, estates, or trusts that have paid qualifying taxes to a U.S. possession or foreign country. Nonresident aliens can’t generally claim this credit except in limited circumstances.

What Income Counts for the Foreign Tax Credit?

Your foreign taxes will count for the purposes of the foreign tax credit if they were paid on allowable income. According to the IRS, qualifying foreign taxes may have been paid on a variety of different types of foreign income, such as:

• Compensation for services performed outside the United States
• Interest income from a payer located outside the United States
• Dividends from a corporation incorporated outside the United States
• Gain on the sale of non-depreciable personal property you sold while maintaining a tax home outside the United States; if you paid a tax of at least 10% of the gain to a foreign country.

Which Taxes Count for the Foreign Tax Credit?

Foreign income taxes are income tax payments to any foreign country. However, not every tax or fee you pay to another country is considered a “qualifying tax”. To be a qualifying tax, the tax must pass four separate tests.

1. The foreign tax liability must be “legal and actual”. Legal and actual taxes are taxes you actually owe and pay. You cannot claim the foreign tax credit for taxes you don’t owe or could have remedied. Under IRS law, you are responsible for taking advantage of all available remedies to reduce the tax you owe. If you fail to do so, the excess amount won’t be a qualifying tax. Likewise, you cannot count toward this credit any taxes for which you received a refund or could receive a refund.
2. The tax must be imposed on you. Qualifying taxes are tax assessments specifically on you. They cannot be tax payments on behalf of another party.
3. You must have paid or accrued the tax. To count a foreign tax toward the income tax credit, you must show that you paid the tax or will have to pay the taxes in question as a result of your earning activities in the country.
4. The tax must be an income tax. The IRS requires you to use only income taxes or taxes imposed in lieu of an income tax for the foreign tax credit. You cannot include other taxes imposed by foreign taxing authorities, such as property taxes, for this credit.

How to Claim the Foreign Tax Credit

You must usually file Form 1116 to claim the foreign tax credit. If you meet specific requirements established by the IRS, you may be able to claim the FTC without this form. To elect to claim the foreign tax credit without Form 1116:

• You must not be filing on behalf of a trust or an estate.
• Your qualifying foreign taxes must not exceed the limit for your filing status, as listed in Form 1040 instructions.
• You must have only passive foreign source income, such as dividends and interest.
• All your foreign income taxes and foreign source income must appear on a qualified payee statement, such as Schedule K-1, Form 1099-DIV, or Form 1099-INT.

Remember that claiming the foreign tax credit without filing Form 1116 will prevent you from carrying back or carrying forward any unused foreign taxes.

TIP: Even if you qualify to claim the FTC without Form 1116, it’s wise to file it to preserve your ability to use carrybacks and carryovers for future tax years.

Completing Form 1116

Form 1116 requires you to supply basic information about yourself and your income, such as your name, identifying number, and country of residence. You will also need to indicate the category of income you receive. If you receive more than one type of foreign income, you must complete a separate Form 1116 for each income category.

In Part I and Part II of the form, you will input more specific information about the income you earned and the taxes you paid. If you received income and/or paid income taxes to more than one country, you should input this information country-by-country. You will also list certain deductions and expenses on this form.

TIP: After completing Form 1116, attach it to your annual income tax return (IRS Form 1040) and file them both simultaneously. This ensures your Foreign Tax Credit is properly claimed and processed by the IRS.

Calculating the FTC

When using Form 1116 to compute the FTC, the total credit will be the smaller of the U.S. tax applicable to your foreign source income or the total amount of foreign tax you accrued or paid. The form includes detailed line-by-line instructions to help you calculate the specific credit you can claim. However, many taxpayers find these instructions confusing and complicated. If you struggle to calculate the proper foreign tax credit, consider contacting an expat tax professional for assistance.

Maximum Foreign Tax Credit

Your foreign tax credit cannot exceed your U.S. tax liability multiplied by a percentage. The percentage is your total foreign-source income divided by your total worldwide income. You must figure out the allowable amount by various categories of income. Examples of income categories include general income, such as wages, and passive income, such as interest or investment income.

Carryback and Carryover

Sometimes, the qualifying foreign taxes you pay may exceed the limit imposed on your foreign tax credit. If you are in this situation, you may be able to carry back the unused foreign income tax to a previous tax year or carry over the unused foreign income tax to a future tax year. The IRS allows a one-year carryback only, but you can carry unused taxes forward for up to 10 years. Remember that you can’t use carrybacks or carryovers if you do not file Form 1116. If you think you may have any excess tax credit, it is best to file this form.

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Compliance Issues of the Foreign Tax Credit

The foreign tax credit laws are complex. Below are some of the foreign tax credit compliance issues:

• Foreign-sourced qualified dividends and/or capital gains (including long-term capital gains, collectible gains, unrecaptured section 1250 gains, and section 1231 gains) that are taxed in the U.S. at a reduced tax rate may need to be adjusted in determining foreign source income on Form 1116, line 1a.
• Interest expense must be apportioned between U.S. and foreign source income.
• Charitable contributions are not apportioned against foreign source income.
• The amount of foreign tax qualifies is not necessarily the amount withheld by the foreign country. If you are due a refund of taxes withheld or 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.
• If a foreign tax redetermination occurs, a redetermination of your US tax liability is required in most situations. You must file an amended tax return to adjust the foreign tax credit claim. Failure to notify the IRS of a foreign tax redetermination can result in a failure to notify the penalty.
• A foreign tax credit may not be claimed for taxes on excluded income.

Amending Your Tax Return for the Foreign Tax Credit

If you claimed an itemized deduction instead of a Foreign Tax Credit (FTC) for a previous year, which would have resulted in a refund, you can fix this by amending your return. To do this, you must file Form 1040X within ten years of the original return’s due date to receive a refund related to an amended return. This differs from the three-year restriction on amended tax returns that usually applies. You can also amend your previous return using this method if you need to make corrections.

You must file an amended return if you ultimately receive a refund or reduction of the foreign taxes you used to calculate the credit. This type of amendment typically requires you to pay more taxes to the United States, and it applies even after ten years have passed.

TIP: If you realize you could have benefited from the FTC in a prior year, don’t hesitate to file an amended return. This can help you recover missed credits and potentially reduce your tax liability retrospectively.

The Foreign Tax Credit and the Foreign Earned Income Exclusion

The foreign tax credit is one of many tax benefits available to people who earn income in a foreign country. The IRS also allows taxpayers to exclude income they earn in a foreign country from their U.S. taxable income, known as the “foreign earned income exclusion.” In many cases, the foreign-earned income exclusion will be more beneficial than the foreign tax credit.

The IRS will not allow you to claim both for the same income. The reason for this restriction lies in the fact that if you can exclude your income from your U.S. tax return, there is no double taxation. Thus, you do not need the tax credit.

When choosing what to do, it is easy to use the exclusion if there were no foreign tax payments. However, if you work in a country where the tax rate is the same or higher than the U.S., it may be more advantageous to claim the credit only. Further, depending on your income and the tax rate in your resident country, it may make more sense to use a combination of the exclusion and credit; then again, it may not. Either way, a proper analysis and comparison is a must to determine what is optimal based on the individual situation.

Claiming Both the Exclusion and the Credit

In some cases, even after choosing the foreign-earned income exclusion, a taxpayer may have earned more total income than he or she could exclude with this method. In this case, the taxpayer may claim a partial tax credit for any tax attribution to the excess income.

Situations involving tax credits and foreign earned income exclusion are complex. For this reason, expats should consult a professional tax preparer for guidance and assistance.

Foreign Tax Credit and Foreign Housing Exclusion

The foreign housing exclusion or deduction is another popular tax benefit. It is available to taxpayers who live and work overseas. If you paid for qualifying housing expenses with employer-provided funds, you may be able to exclude a portion of these amounts from your taxable income for U.S. purposes. If you paid for qualifying housing expenses with self-employment income, you can claim a deduction for a portion of these amounts on your U.S. tax return.

You cannot use the foreign tax credit for taxes based on income you excluded under the foreign earned income exclusion. You cannot claim the credit for any taxes based on income excluded under the foreign housing exclusion or deduction.

Common Mistakes to Avoid with the FTC

Dealing with the Foreign Tax Credit can be tricky, and mistakes can lead to unnecessary financial loss or IRS penalties. Here are some of the most common errors to watch out for:

1. Missing Out Completely

Many taxpayers aren’t aware of the FTC and miss out on its benefits, paying more tax than necessary. If you’ve overlooked the credit, you can amend your tax return. Some expats even fail to file their returns because they don’t know about the FTC and other expat benefits. Not filing a required tax return can lead to penalties and additional taxes once the IRS catches up. It’s always better to file if you meet the filing threshold.

2. Double Dipping

Attempting to use the same income for both the Foreign Earned Income Exclusion (FEIE) and the FTC can cause issues with the IRS. This mistake requires an amendment to your tax return to correct.

3. Choosing the Wrong Tax Benefit

If you qualify for both the FEIE and the FTC, you must decide which to claim for most of your income. Choosing incorrectly can lead to significant financial losses. While the FEIE used to be the go-to choice, the FTC often provides more benefits now. Consulting a tax professional can help you make the best decision.

4. Overlooking Other Tax Benefits

Improper use of the FEIE over the FTC can affect your eligibility for other benefits, like the Child Tax Credit or Roth IRA contributions. For example, using the FEIE to exclude all your income means you won’t have after-tax dollars to contribute to a Roth IRA. Similarly, utilizing the FEIE rather than FTC could make you miss out on the refundable Child Tax Credit.

5. Incorrect Calculations

Calculating the FTC involves complex computations. Mistakes can result in paying too much or too little in taxes, leading to unintended consequences. Even though the forms come with instructions, many taxpayers make errors. Double-check your calculations or seek professional help to avoid issues.

Foreign Tax Credit Frequently Asked Questions

1. Can I use a portion of foreign taxes paid as a deduction and the other as a credit?

Taxpayers can deduct foreign taxes paid on Schedule A or claim a credit on Form 1116. The taxpayer must choose the itemized deduction or credit for any given year. While every taxpayer’s situation is different, it is generally preferred to claim a credit for foreign income taxes paid.

2. I’ve previously taken credit for foreign taxes accrued on Form 1116. Can I instead take a credit for taxes paid in the current year?

If you’re a cash-based taxpayer, you can only take the foreign tax credit in the year you pay the qualified foreign tax unless you claim the foreign tax credit in the year the taxes are accrued. Once you make this election, you can’t switch back to claiming the taxes in the year paid in later years.

3. Can I take credit for taxes paid on foreign income excluded under the Foreign Earned Income Exclusion?

You may not take a credit or a deduction for taxes paid or accrued on the income you exclude under the foreign earned income or housing exclusion. The excluded income is not subject to double taxation or available for credit.

4. Can I carry back or carry over any unused Foreign Tax Credit?

If you can’t claim a credit for the total amount of qualified foreign income taxes you paid or accrued in that particular year, you can carry back and/or carry over the unused foreign income tax. You can carry back the unused foreign tax for one year and then forward it for ten years.

5. What Foreign Taxes Do Not Qualify for the Foreign Tax Credit?

Not all foreign taxes are eligible for the Foreign Tax Credit (FTC). According to the IRS, the following types of taxes do not qualify:

1. Refundable Taxes: Taxes eligible for a refund, even if the refund is not claimed, do not qualify for the FTC.
2. Subsidized Taxes: Taxes subsidizing you or a relative cannot be claimed.
3. Avoidable Taxes: Taxes you could have legally avoided paying do not qualify. The IRS requires you to take all available measures to reduce your tax liability.
4. Taxes to Unrecognized Governments: Taxes paid to governments not recognized by the United States, or those with which the U.S. has severed diplomatic relations, do not qualify. This includes:

• Countries designated by the Secretary of State as supporters of international terrorism.
• Countries with which the U.S. does not conduct diplomatic relations.
• Governments not recognized by the U.S., unless eligible to purchase defense articles or services under the Arms Export Control Act.

Getting Help

Like many topics related to expat taxes, the foreign tax credit is very complex. There are many rules applicable to this credit as well as many decisions you must make when you qualify for it. For example, if you are eligible for the foreign earned income exclusion and the tax credit, you must decide which benefit to rely on. In some cases, you may even be better off using a combination of these benefits. Sometimes, you may need to decide whether to carry back or forward excess credits. You may also need to determine if you will claim the credit by completing Form 1116 or elect to claim it without filing this form.

These decisions can considerably impact your tax liability and/or your ability to qualify for other tax benefits. To make the best decisions, you must look at all possible options while considering the intricate details of your unique tax situation. For this reason, consulting an expat tax professional is a key recommendation for anyone who may qualify for the foreign tax credit.

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