Making the Choice
You can choose each tax year to take the amount of any qualified foreign taxes paid or accrued during the year as a foreign tax credit or as an itemized deduction. You can change your choice for each year's taxes.
To choose the foreign tax credit, you generally must complete Form 1116, Foreign Tax Credit and attach it to your U.S. tax return. However, you may qualify for an exception that allows you to claim the foreign tax credit without using Form 1116. Refer to How To Figure the Credit. To choose to claim the taxes as an itemized deduction, use Schedule A (Form 1040), Itemized Deductions.
Note: Figure your tax both ways-claiming the credit and claiming the deduction. Then fill out your return the way that benefits you most. See Why Choose the Credit below.
Choice Applies to All Qualified Foreign Taxes
As a general rule, you must choose to take either a credit or a deduction for all qualified foreign taxes.
If you choose to take a credit for qualified foreign taxes, you must take the credit for all of them. You cannot deduct any of them. Conversely, if you choose to deduct qualified foreign taxes, you must deduct all of them. You cannot take a credit for any of them.
Why Choose the Credit?
The foreign tax credit is intended to relieve you of the double tax burden when your foreign source income is taxed by both the United States and the foreign country.
The foreign tax credit can only reduce U.S. taxes on foreign source income; it cannot reduce U.S. taxes on U.S. source income.
It is generally better to take a credit for qualified foreign taxes than to deduct them as an itemized deduction. 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 choose to 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 carry back the excess to another tax year.
Credit for Taxes Paid or Accrued
You can claim the credit for a qualified foreign tax in the tax year in which you pay or accrue it, depending on your method of accounting. "Tax year" refers to the tax year for which your U.S. return is filed, not the tax year for which your foreign return is filed.
Accrual Method of Accounting
If you use an accrual method of accounting, you can claim the credit only in the year in which you accrue the tax. Foreign taxes generally accrue when all the events have taken place that fix the amount of the tax and your liability to pay it. If you are contesting your foreign tax liability, you cannot accrue it and take a credit until the amount of foreign tax due is finally determined.
Cash Method of Accounting
If you use the cash method of accounting, you can choose to take the credit either in the year you pay the tax or in the year you accrue it. You are using the cash method of accounting if you report income in the year you actually or constructively receive it, and deduct expenses in the year you pay them.
Choosing to Accrue Taxes
Even if you use the cash method of accounting, you can choose to take a credit for foreign taxes in the year they accrue. You make the choice by checking the box in Part II of Form 1116. Once you make that choice, you must follow it in all later years and take a credit for foreign taxes in the year they accrue. In addition, the choice to accrue foreign taxes applies to all foreign taxes qualified for the credit. You cannot take a credit for some foreign taxes when paid and take a credit for others when accrued.
If you make the choice to accrue foreign taxes and pay them in a later year, you cannot claim a deduction for any part of the previously accrued taxes.
You must express the amounts you report on your U.S. tax return in U.S. dollars. If you receive all or part of your income or pay some or all of your expenses in foreign currency, you must translate the foreign currency into U.S. dollars. For information about converting foreign currencies to U.S. dollars refer to Foreign Currency and Currency Exchange Rates.
However on Part II of Form 1116, you must enter the amount of foreign taxes in both the foreign currency denomination(s) and as converted into U.S. dollars. See the Form 1116 Instructions for more information.