Definition of foreign tax credit


What is the foreign tax credit?

The foreign tax credit is a non-refundable tax credit for income taxes paid to a foreign government as a result of foreign income tax withholdings. The foreign tax credit is available to anyone who works in a foreign country or has investment income from a foreign source.

Tax deductions vs. Tax credits

Key takeaways

  • The foreign tax credit is a tax relief provided by the government to reduce the tax liability of certain taxpayers.
  • The foreign tax credit applies to taxpayers who pay taxes on their foreign investment income to a foreign government.
  • While some or all of foreign earned income may be excluded from federal income tax, a taxpayer cannot claim both foreign earned income and foreign tax credit exclusions on the same income.

Understanding the foreign tax credit

The foreign tax credit is a tax relief provided by the government to reduce the tax liability of certain taxpayers. A tax credit is applied to the amount of tax owed by the taxpayer after all deductions from their taxable income are made, and it reduces the total tax bill from one dollar to one dollar. If a person owes $ 3,000 to the government and is eligible for a $ 1,100 tax credit, they will only have to pay $ 1,900 after the credit is applied. A tax credit can be refundable or non-refundable. A refundable tax credit generally results in a refund check if the tax credit is greater than the person’s tax bill. A taxpayer who applies a $ 3,400 tax credit to his $ 3,000 tax bill will see his bill reduced to zero, and the remaining portion of the credit, that is, $ 400, will be refunded.

On the other hand, a non-refundable tax credit does not result in a refund to the taxpayer as it will only reduce the tax owed to zero. Following the example above, if the $ 3,400 tax credit was non-refundable, the person will owe nothing to the government, but will also lose the amount of $ 400 that remains after the credit is applied. The most commonly claimed tax credits are non-refundable, one of which is the foreign tax credit.

The foreign tax credit applies to taxpayers who pay taxes on their foreign investment income to a foreign government. Generally, only taxes on income, war profits, and excess profits qualify for the credit. The credit can be used by individuals, estates, or trusts to reduce your income tax liability. Additionally, taxpayers can carry over unused amounts to future tax years, up to ten years.

Not all taxes paid to a foreign government can be claimed as a credit against US federal income tax. A taxpayer is not Eligible for a foreign tax credit if they did not pay or accrue the tax, the tax was not imposed on the taxpayer, the tax is not a legal and actual foreign tax liability, or the tax is not based on income. Therefore, a US taxpayer who has a legal and real property tax imposed by the UK government will not be able to claim this tax as a foreign tax credit because it is not an income tax.

The foreign tax credit is claimed on Form 1116, unless the taxpayer qualifies for the de minimis exception, in which case, they can claim the tax credit for the full amount of foreign taxes paid directly on Form 1040. The credit can only be claimed on income that is also subject to national taxes. For example, if part of the taxpayer’s foreign income is taxable and part of the income is exempt, then the taxpayer should be able to itemize taxes paid on foreign income only and only claim the credit for taxes paid on that foreign income. . .

While some or all of foreign earned income may be excluded from federal income tax, a taxpayer cannot claim both foreign earned income and foreign tax credit exclusions on the same income. If the taxpayer chooses to exclude foreign earned income or foreign housing costs, they cannot take a foreign tax credit for the income taxes they can exclude. If they take the credit, the Internal Revenue Service (IRS) may consider one or both options revoked.

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Mark Holland

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