Don’t Put All Your Foreign Tax Credits into One Basket: A Brief Overview of Foreign Tax Credit Rules

November 14, 2011

Ashley Erwin, CPA

Whether you’ve received earned income from foreign sources, or have investment portfolios with international assets, the foreign tax credit exists in order to prevent the burden of double taxation.  Many resident aliens of the U.S. could potentially benefit from the foreign tax credit, depending on their situation.  Additionally, because more funds are investing in global assets, many U.S. citizens have foreign tax paid or accrued included on their Forms 1099.    

It should be noted that taxpayers are allowed either a foreign tax credit or deduction, but the scope of this article is limited to the foreign tax credit.  

Creditable taxes:

A taxpayer is allowed a credit against U.S. income and alternative minimum tax liability for any income, war profits, and excess profits taxes imposed by, and paid or accrued to, any foreign country or U.S. possession.  You may not claim a credit for foreign tax paid on foreign income excluded from U.S. gross income. 

Limitations:

  1. Overall limitation: The credit may not exceed a taxpayer’s U.S. income tax liability prorated for the percentage of foreign taxable income to taxable income from all sources worldwide.
  2. Limitation by income category or basket: Limitations must be calculated separately for certain categories or “baskets,” as referred to by the IRS, of foreign source income.
    1. Passive Category Income: This category includes investment income such as dividends, interest, rents and royalties as well as income from a qualified electing fund.  It does not include rents or royalties from the active conduct of a trade or business.
    2. General Category Income: This category includes all income which is not considered passive category income.

These limitations generally mean that a taxpayer needs to determine the ratio of their foreign income compared to their overall taxable income, and must do this separately for each category of income on which foreign tax was paid.  For example, let’s say Joe Global paid foreign taxes on foreign dividend income (passive category) and on wages from a foreign source (general category).  He would first calculate the ratio of foreign taxable passive category income to total taxable income.  Then, he would multiply his U.S. income tax by this ratio in order to come up with the maximum foreign tax credit allowed in the passive income category.  He would then separately run the same calculation on the general category income to find out how much of the foreign taxes he paid on his foreign wages would be allowed as a credit. Any unused credit is available for carryover (see below).  These calculations are completed using IRS Form 1116, which is filed with your U.S. income tax return. 

 

Carryover:

Any unused foreign tax credit may be carried back one year or carried forward 10 years.  The unused credit carries over to the same “basket” of income to the carryover year.  The carryover will not apply if the election, discussed in the next paragraph, is made.

Election to not report:

Certain taxpayers may be eligible to enter their foreign tax credit directly onto Form 1040 without completing Form 1116 and without being subject to the limitations listed above.  No formal election is filed to apply this treatment, the election is assumed if the credit is entered directly in the section for nonrefundable credits on page two.  In order to qualify for this treatment, the following must apply:

  1. All of the foreign source income must be in the passive income category
  2. All of the foreign income and taxes paid must be reported on a qualified payee statement (Form 1099)
  3. The total creditable foreign taxes must be less than $300 ($600 for joint filers)

The limitations listed above do not apply when this election is made.  However, the foreign tax credit is still nonrefundable and is limited to the total amount of U.S. income tax liability.  And, if it is limited in this way, there is no longer the option to carryover any unused credit.  

Whether you fall into the category of filers who must file Form 1116 or those who may enter the credit directly onto page two of the tax return, it is important to be informed of the amount of credit that you could potentially utilize in any given year.  If you would like to discuss this topic in more detail, please contact us.