In Hong Kong many of our clients commonly claim the foreign tax credit benefit while living abroad. The foreign tax credit prevents the dreaded double taxation by allowing taxpayers a dollar for dollar tax credit for foreign taxes paid. For many taxpayers, claiming a tax credit is more beneficial than claiming a tax deduction. However, this is not always the case, or taxpayers may combine a deduction and a credit. Or use a deduction first, then claim a foreign tax credit for the remaining eligible amounts. The foreign tax credit is claimed on IRS Form 1116. The following explains a few rules regarding the foreign tax credit:
What taxes qualify for the Foreign Tax Credit?
- The Tax Must Be Imposed on you by a foreign country or US possession.
- You Must Have Paid or Accrued the Tax to the foreign jurisdiction
- The Tax Must Be the Legal and Actual Foreign Tax Liability you paid or accrued during the year, less any refunds you may have received.
- The Tax Must Be an Income Tax (or a Tax In Lieu of an Income Tax). Foreign taxes on wages, dividends, interest, and royalties generally qualify for the credit.
Foreign Taxes for Which You Cannot Take a Credit
The following are some foreign taxes for which you cannot take a foreign tax credit:
- Taxes on excluded income (such as the foreign earned income exclusion),
- Taxes for which you can only take an itemized deduction,
- Taxes on foreign mineral income,
- Taxes from international boycott operations,
- A portion of taxes on combined foreign oil and gas income,
- Taxes of U.S. persons controlling foreign corporations and partnerships who fail to file required information returns,
- Taxes related to a foreign tax splitting event, and
- Social security taxes paid or accrued to a foreign country with which the United States has a social security agreement.
What is the maximum credit I can receive?
Taxpayers can reduce their US tax liability using the foreign tax credit, but the credit cannot be more than the amount of US taxes due. For example, if a taxpayer’s US tax liability is $1,500 US in 2020, the foreign tax credit can only be up to $1,500 US for that year.
The foreign tax credit is calculated by taking total foreign source taxable income and then dividing this amount by worldwide taxable income. Take this ratio and multiply it by US income tax before foreign tax credit. The remainder will be the foreign tax credit limitation.
The following is a basic illustration of how the foreign tax credit is calculated, specially with regards to the maximum credit the taxpayer can claim.
John has foreign sourced taxable income of $50,000. Assuming a foreign tax rate of 25%, his foreign tax liability is $12,500. His worldwide taxable income (i.e non-foreign and foreign) is $250,000. His total US tax liability is $58,500 (without regard to the foreign tax credit).
FTC Limitation = 50,000 X 58,500 = $11,700 250,000.
Regardless of the $12,500 of foreign income taxes that John has paid (or should pay) to the foreign jurisdiction in the current year, he cannot claim more than the $11,700 foreign tax credit for that year due to the limitation.
One additional limitation to keep in mind is that the foreign tax credit cannot be taken for the portion of foreign income that is excluded. For taxpayers claiming the foreign earned income exclusion (excluding $105,900 on Form 2555 in 2019), the foreign tax credit is not allowable for this portion of excluded income. To the extent the filer’s income exceed the $107,600 limitation, only the excess portion is eligible for claiming a foreign tax credit. The foreign tax credit basically is a credit given to the taxpayer for all foreign taxes paid on foreign sourced income that that is not excluded.
Jane has foreign source actively earned income of $150,000. Her total worldwide income is $250,000. Assuming a foreign tax rate of 25%, her foreign tax liability would be $37,500. Her total US tax liability is $58,500 (without regard to the foreign tax credit). Her foreign income exceeds the $105,900 limitation amount by $44,100 (150,000 – 105,900).
FTC Limitation = 44,100 X 58,500 = $10,500 250,000.
Even though Jane paid $37,500 of foreign income taxes, her foreign tax benefit cannot exceed $10,500 for the current year.
Baskets of Income
Taxpayers claim separate tax credits for each type of income category, or basket. Examples of the types of baskets that are provided for in the Form 1116:
- General category income – Residual basket, and includes financial services income earned by a person predominantly engaged in active banking, insurance, financing or similar business.
- Passive category income – Generally income that would be FPHCI under Section 954(c). This is basically interest, dividends, rents, or any type of passive income
- Amounts includible in income by U.S. shareholder under Section 951A (i.e., GILTI inclusions) – this applies to income from a controlled foreign corporation subject to the special GILTI reduced tax
Carryover or Carryback of Foreign Tax Credit
For tax years where there is excess foreign tax credit, taxpayers may be able to carry the credit back one year or carry it forward to a future year (up to 10 years). This carryback and carryover allows taxpayers to utilize the credit in another year there is tax liability to prevent losing the tax credit. One of the requirements of carrying back or carrying forward the credit is that taxpayers must file Form 1116. It may also be important to keep records of AMT or Alternative Minimum Tax credit carryovers on separate Form 1116s for each category of income.
Received Foreign Interest and Dividend Income While in the U.S.
The foreign tax credit is available for US taxpayers even when living in the US. For investors investing in foreign securities and investments, they will usually receive a 1099 DIV or 1099 INT. The form will report the total income received during the year and the foreign taxes paid. These taxpayers can also claim the foreign tax credit for foreign taxes paid on interest and dividend income.
Please contact us today if you have additional questions and would like to talk to a qualified CPA about the foreign tax credit.
The above is for general and informational purposes only and should not be used as legal or other tax advice. Calculating the foreign tax credit can be very complex and this is only a brief summary. Please consult your own professional CPA or lawyer for clarification.