Optimizing Tax Efficiency: Ins and Outs of Foreign Tax Credits
Foreign Tax Credits reduce International Double Taxation
The United States taxes its citizens, residents, and domestic corporations on their worldwide income. The U.S. relieves international double taxation by granting a foreign tax credit for foreign taxes imposed on U.S. taxpayers for foreign-source income.
In lieu of the credit, U.S. taxpayers may claim a tax deduction to avoid double taxation.
Qualifying Foreign Taxes
Foreign income taxes must satisfy the following four tests to qualify for the foreign tax credit:
Foreign countries (or U.S. possessions) must impose the tax on the taxpayer
The foreign tax credit is available only for foreign taxes that are imposed on the taxpayer by a foreign country or U.S. possession. A foreign country includes any foreign state and its political subdivisions, such as a foreign city and province. U.S. possessions include Puerto Rico, the U.S. Virgin Islands, Guam, the Northern Mariana Islands, and American Samoa.
Credits are not available for taxes paid to countries that support international terrorism. Taxes paid to countries with no diplomatic relations with the United States are not eligible for foreign tax credits.
The taxpayer must have paid or accrued the tax
If a taxpayer paid or accrued any foreign tax, then the taxpayer can claim a foreign tax credit.
The tax must be the legal and actual foreign tax liability
The foreign tax must be the legal and actual foreign tax liability that the taxpayer paid or accrued to a foreign government during the taxable year. The amount of foreign tax that qualifies is not necessarily the amount of tax withheld by the foreign country. For example, if the taxpayer is entitled to a reduced rate of foreign tax under an income tax treaty, only the reduced amount qualifies for the foreign tax credit.
The tax must be an income tax
The foreign tax credit is available for only income tax, war profits tax, or excess profits tax (collectively, income taxes). Thus, a property tax or sales tax does not qualify. The foreign income tax must be a foreign levy that is not payment for a specific economic benefit. Also, the foreign income tax must not be a soak-up tax, which refers to a foreign tax that is assessed only if a foreign tax credit is available to the taxpayer.
The foreign income tax imposed can be both earned and unearned income.
Foreign Tax Credits vs. Deductions
The choice between the foreign tax credit and deduction
Taxpayers have the option to either claim a tax credit or take an itemized deduction for foreign taxes paid or accrued during the tax year. Taxpayers can change this selection every year. The choice generally applies to all qualified foreign taxes, and thus taxpayers cannot mix and match.
Claiming the foreign tax credit or deduction
To choose the foreign tax credit, individual taxpayers must complete IRS Form 1116 (Foreign Tax Credit) and attach it to their U.S. income tax return. Corporations file IRS Form 1118 (Foreign Tax Credit – Corporations) instead.
To claim a deduction for the foreign taxes paid, individual taxpayers use IRS Schedule A (Form 1040) (Itemized Deductions). Corporations use Line 17 (Taxes and Licenses) on their U.S. income tax return (Form 1120).
Advantages of credit over deduction
It is generally better to claim a foreign tax credit than a tax deduction because the credits reduce the actual U.S. tax liability on a dollar-for-dollar basis while tax deductions reduce only the income subject to tax.
In addition, individual taxpayers who choose to take the foreign tax credit can choose between the itemized deduction and the standard deduction while individual taxpayers who choose to deduct foreign taxes must itemize deductions.
Foreign Earned Income Exclusions
The Foreign Earned Income Exclusion
Individual taxpayers who are U.S. citizens or U.S. residents and live abroad may qualify to exclude income earned abroad when they calculate their U.S. income tax liability. Taxpayers can choose the foreign earned income exclusion by completing IRS Form 2555 (Foreign Earned Income). In addition, taxpayers may exclude or deduct certain foreign housing expenses.
Excludable amount
The excludable amount is adjusted annually for inflation. The excludable amount for 2024 is USD 126,500 (USD 120,000 for 2023 and USD 112,000 for 2022).
What if the Foreign Earned Income Exclusion cannot offset all income?
Taxpayers must calculate U.S. tax liability on the non-excluded income using the tax rate that would have applied to it had they not claimed the foreign earned income exclusion.
Qualifying individuals for the Foreign Earned Income Exclusion
To claim the foreign earned income exclusion, taxpayers must have their “tax home” in a foreign country, and the taxpayers who pay foreign taxes must meet one of the following tests:
Bona Fide Residence Test: U.S. citizens who lived in a foreign country - continuous - for an entire tax year);
Physical Presence Test: U.S. citizens or U.S. residents who spent at least 330 full days in a foreign country - consecutively - for a 12 month period);
Income Tax Treaty Test: U.S. resident and citizen or national of a country with U.S. income tax treaty, living continuously in one or more foreign countries for a period that includes an entire tax year).
Foreign tax home
Taxpayers may have a foreign tax home if they are present in another country for work with an expectation that they will continue working in the country for an indefinite, rather than temporary, period of time.
Taxpayers do not have a foreign tax home if their abode (i.e., closer familial, economic, and personal ties) remains in the U.S., unless they work in a presidentially-declared combat zone supporting the U.S. Armed Forces.
Foreign earned income
Foreign-earned income covers wages, salaries, and professional fees for personal services rendered, but excludes corporate distributions misrepresented as compensation.
Additionally, foreign earned self-employment income qualifies as part of a taxpayer's gross foreign income for purposes of the exclusion. The excluded amount will reduce the taxpayer's regular income tax liability but not the self-employment tax.
Disqualifying Income
Foreign earned income does not include the following amounts:
- Pay for services conducted in international waters or airspace (because those are not a foreign country);
- Pay received as a military or civilian employee of the U.S. government or any of its agencies;
- Payments received after the end of the tax year following the year in which the services that earned the income were performed;
- Pay otherwise excludable from income; and
- Unearned income (including dividends, interest, capital gains, alimony, pensions and social security benefits).
Factors to consider before taking the Foreign Earned Income Exclusion
Taxpayers cannot claim the additional child tax credit or earned income credit if they choose the foreign earned income exclusion.
Taxpayers can open and make contributions to an Individual Retirement Arrangement (IRA) if they (or their spouse if they file a joint return) received taxable compensation during the year. Compensation does not include any amounts (other than combat pay) that taxpayers exclude as foreign earned income.
Taxpayers opting for the foreign earned income exclusion cannot claim a foreign tax credit or deduction on excluded income. However, taxpayers can claim a foreign tax credit or deduction for taxes on the amount of foreign income that exceeds the amount excludable under the foreign earned income exclusion.
Foreign tax credit limitation
Under the foreign tax credit rules, the credit cannot exceed the foreign tax credit limitation, which is the taxpayer’s total U.S. tax liability multiplied by a fraction. The numerator of the fraction is the taxable income from foreign sources. The denominator is the total taxable income from both U.S. and foreign sources.
For purposes of calculating the foreign tax credit limitation, taxable income also must be assigned to separate baskets depending on the type of income, and the foreign tax credit limitation is then computed for each basket. There are separate baskets for passive category income, general category income, items of income that are resourced under U.S. tax treaties, foreign branch income, and global intangible low-taxed income (GILTI).
Foreign tax credit carry-over
If taxpayers have foreign income taxes that they cannot use because of the foreign tax credit limitation, the taxpayers may carry accrued foreign taxes back to a previous tax year or forward for use against future income. Any unused foreign tax credits must be, first, carried back one year and, second, carried over 10 years in progressive order.
Foreign tax credits for the GILTI basket, however, may not be carried back or forward.
Individual taxpayers’ exemption from foreign tax credit limitation, and form 1116
Individual taxpayers can elect to claim the foreign tax credit without being subject to the foreign credit limitation and without filing IRS Form 1116 if they meet all of the following conditions:
- All of their foreign source gross income is passive income;
- All the income and the related foreign income axes were reported to them on a qualified payee statement, including IRS Form 1099-DIV, Form 1099-INT, Schedule K-1 (Form 1041), Schedule K-3 (Form 1065), Schedule K-3 (Form 1120-S) or similar substitute statements; and
- Their total creditable foreign income taxes are not more than USD 300 (USD 600 if filing a joint return).
Taxpayers who make this election for a tax year cannot carry back or forward any unused foreign income tax to or from that year.
Deemed-Paid (indirect) foreign tax credit
In addition to a foreign tax credit for the foreign income tax that taxpayers have paid (i.e. a direct foreign tax credit), a corporate taxpayer may claim a deemed-paid (or indirect) foreign tax credit for the foreign income taxes paid by a controlled foreign corporation (CFC) with regard to which the taxpayer is a U.S. shareholder. A deemed-paid foreign tax credit applies to foreign income taxes attributable to Subpart F income or GILTI that is included in the taxpayer’s gross income.
How Foreign Tax Credit works for Foreign Taxpayers
Non-resident foreign individuals and foreign corporations generally cannot claim the foreign tax credit because they are not taxed by the U.S. on their foreign-source income. However, when they are engaged in a trade or business in the US, they are taxed on their effectively connected income (ECI) and may claim an foreign tax credit for foreign income taxes paid with respect to the ECI.
The foreign tax credit is not available if following apply:
- The taxpayer is a citizen or tax resident of, or is domiciled in, the taxing foreign country, and
- The foreign country would not have imposed the tax in the absence of the citizenship, residency or domicile.
Resources and more information
IBFD offers a range of online products, books, and other resources that provide expert discussion and distillation of foreign and local tax laws, credit guidance and regulations:
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