Foreign Tax Credit
The purpose of the foreign tax credits is to allow U.S. taxpayers to avoid double taxation on income that is taxed both by the United States and a foreign government. Note that any foreign taxes you paid can be deducted on your income tax return. But in most cases it is to your advantage to take the foreign tax credit instead.
The type of foreign taxes that qualify are any taxes imposed on you by a foreign country or U.S. possession. In addition, the tax must have been actually paid or accrued by you. The type of foreign tax must be an income tax (or a tax in lieu of an income tax).
To claim the credit you must file Form 1116 on your individual, estate or trust return. Corporations use Form 1118.
There are a number of complex issues relating to the foreign tax credit. For instance:
- Foreign sources of dividends and capital gains that are taxed at a reduced rate in the U.S. must be adjusted to take into account that reduced rate when computing the foreign source income.
- You have to divide interest expense between the U.S. and foreign source income.
- There are special provisions with regard to how charitable contributions are used in computing the foreign source income.
- The amount of foreign tax that qualifies for the tax credit is not necessarily equal to the amount of tax withheld by the foreign country. There are tax treaties that may entitle you to a reduced tax rate. If that tax treaty applies, the amount of foreign tax that applies to the credit is equal to the reduced rate under the tax treaty and not the higher amount that was withheld.
- If the foreign tax authority re-determines the tax you paid to them, then you are required to notify the IRS of this redetermination and file an amended return adjusting your foreign tax credit. You may receive a failure to notify penalty if you do not do this.
- Finally, a foreign tax credit may not be claimed for taxes on foreign income that was excluded for U.S. income tax purposes.
If you have foreign source income that is also subject to U.S. income taxation, and need to determine if you might be entitled to a foreign tax credit then schedule your free consultation by calling (480) 888-7111 or submit a web request here.