Foreign tax credits (“FTCs”) can potentially make an enormous difference on the amount of tax owed on a U.S. tax return. It is important to take a step back and cultivate an understanding of the mechanics of claiming foreign tax credits in the U.S. as there are some significant pitfalls that can prevent you from claiming these credits.
When we are determining if any particular income items are able to create foreign tax credits, the first set of questions regard the specific facts surrounding the income earned and the tax paid on that income:
What type or types (wages, interest, dividends etc.) of income gave rise to the foreign taxes you paid?
Did you pay any foreign taxes on that income?
When were or when will those foreign taxes be paid?
Were the taxes directly withheld from the income and can you confirm that the reported income amount hasn’t already been reduced by the taxes paid?
Were any of those taxes refunded or do you have reason to believe that any of those amounts will be refunded in the future?
Were any of the tax amounts paid for you by a third party or an employer?
We always start with the facts and circumstances, particularly regarding the actual payment of the taxes and the timing of those payments. Once we’ve gathered the data on the taxes that were paid or accrued, we move on to some of the more technical legal questions:
Were the foreign taxes paid considered income taxes?
Is there a tax treaty between the U.S. and the country to whom the taxes were paid?
Is the foreign country ineligible for the generation of foreign tax credits?
What was the category of income on which the foreign taxes were paid?
Was any of the income for which the foreign taxes were paid excluded or otherwise removed from taxability on your return?
Now let’s review why these questions matter and the impact some of these answers have on your ability to claim foreign tax credits.
You can only claim the FTC for taxes that meet the following requirements:
1. Taxes that are classified as income taxes(or taxes in lieu of income taxes). This means you cannot claim the FTC for payments for excise taxes, levies, gross receipts taxes, value added taxes (VATs), sales taxes, property taxes, wealth taxes, and inheritance taxes.
2. The taxes must be imposed on you by a foreign country. You cannot claim the FTC for taxes that you pay for anyone else and people cannot shift the responsibility to pay taxes by contract. If your foreign employer pays your foreign taxes for you, those amounts will need to be included in your income on your U.S. filings, and you will still be eligible to claim the FTC.
3. The foreign taxes must have been paid or accrued (accumulating to be be paid at a fixed time in the future). For any amount of tax to be FTC-able, the taxes have to actually be paid or accrued to be paid. You can’t claim a credit for amounts that you anticipate you will never be required to pay. If you live and work in a foreign country and have your foreign taxes withheld directly from your paycheck, but are able to file a tax return in that country to have those foreign taxes fully refunded to you, then you are not eligible for the foreign tax credit on those taxes. It is also worth noting that interest and penalty amounts, even when associated with foreign taxes paid, are not creditable on your U.S. tax filings either.
4. Taxes that the foreign country correctly and legally imposed upon you. This means you can only include tax amounts that will actually be legally required by the foreign country. Foreign taxes that are removed or reduced via the U.S. tax treaty with the foreign country will only be creditable to the extent that the tax is owed to the foreign country after application of the tax treaty. If you live in the U.S. and mistakenly include your U.S. earnings on your foreign tax return, when you weren’t required to include those earnings on that return, you will not be able to claim a tax credit on your U.S. return. This analysis is largely based on the tax obligations legally imposed on you, as a U.S. person, by the foreign country. For individuals residing within the U.S., these creditable amounts are generally limited to the foreign source income (future blog article on income sourcing coming soon).
Above we’ve established the requirements for your foreign taxes to be included on your return, but there is a significant difference between foreign taxes appearing on Form 1116 on your U.S. tax return and those taxes actually generating a foreign tax credit through Form 1116.
The first legal question that needs to be asked in relation to any foreign taxes is - of which country were you a tax resident for the tax year being reviewed? If you were a U.S. tax resident, you will only be able to claim a credit for taxes associated with items of income that were foreign source. If you were a foreign resident, you may be able to claim a credit for all of the taxes paid to your country of residence.
The next step is to determine the source country for every item of income that you have. You will notice that each country from which you have income is listed separately on line 1a of Form 1116. The amount of income sourced to a particular country serves as a direct limit to the amount of the foreign tax credit that you will be able to claim for a particular year. The amount of the credit is capped by the amount of tax that the U.S. would have applied to that item of income. This means if you have $100 of foreign interest and your tax bracket would result in U.S. tax of $30 on that interest, but you paid $40 of tax to a foreign country, you will only be able to claim $30 of foreign tax credits for that year.
The third legal question is - was any of the foreign source income excluded from your return for any reason? If it was, those amounts will not be eligible for the FTC either. This means that individuals claiming the foreign earned income exclusion (FEIE) will not be able to claim FTCs for the amounts that were excluded. For example, if you earned $207,600 in foreign wages for 2020, you paid $83,040 in taxes to the foreign country, and you claim the full amount of the FEIE for 2020 ($107,600) then you will have your claimable foreign tax credit proportionally reduced by the exclusion amount (this will happen on Part III line 12 of the 1116).
This isn’t an exhaustive list of the potential issues that can arise to limit the amount of foreign tax credits that you will be able to claim, but it should serve to give you a strong understanding of what types of taxes will be creditable and of the most common circumstances that will further limit your ability to claim those credits. Unfortunately, the Form 1116 is a deceptively complicated form, and it is also a form that has an elevated audit risk when the credits being claimed are substantial. If you have 1116 issues or questions, you can always follow up with us using the ‘ask us’ button on the right side of each blog post.