Foreign Tax Credit
If you paid or accrued foreign taxes to a foreign country on foreign source income and are subject to U.S. tax on the same income, you may be able to take either a credit or an itemized deduction for those taxes. Taken as a deduction, foreign income taxes reduce your U.S. taxable income. Taken as a credit, foreign income taxes reduce your U.S. tax liability. In most cases, it is to your advantage to take foreign income taxes as a tax credit.
Once you choose to exclude either foreign earned income or foreign housing costs, you cannot take a foreign tax credit for taxes on income you can exclude. If you do take the credit, one or both of the choices may be considered revoked.
The foreign tax credit laws are complex. Link to Foreign Tax Credit Compliance Tips for help in understanding some of the more complex areas of the law. Below are some of the 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 must 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 that qualifies is not necessarily the amount of tax withheld by the foreign country. 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.
- If a foreign tax redetermination occurs, a redetermination of your US tax liability is required in most situations. You must file a Form 1040X or Form 1120X. Failure to notify the IRS of a foreign tax redetermination can result in a failure to notify penalty.
- A foreign tax credit may not be claimed for taxes on excluded income.