Foreign Tax Credit

What is the Foreign Tax Credit?

The U.S. taxes its citizens and resident aliens on worldwide income, but if you pay taxes in a foreign country, you may be able to use the Foreign Tax Credit to avoid double taxation. In general, if your tax rate is higher in the foreign country, the credit will fully offset your U.S. tax liability. Conversely, if your income is earned in a country with a low tax rate, you could end up paying tax in both countries.

Which foreign taxes qualify for the credit?

Not all foreign taxes qualify. They must be taxes paid on income or profit (with some exclusions, see below). This means that foreign real estate, social security, and property taxes do not qualify for the credit, because they are not a tax that is imposed on income. Additionally, to be deductible the tax must meet four tests.

From the IRS: Generally, the following four tests must be met for any foreign tax to qualify for the credit:

1. The tax must be imposed on you.
2. You must have paid or accrued the tax.
3. The tax must be the legal and actual foreign tax liability.
4. The tax must be an income tax (or a tax in lieu of an income tax).

Which income taxes do not qualify for the credit?

There are a few specific situations in which foreign taxes paid on income do not qualify for the credit. Some of the most common are:

1. Taxes you paid that are not legally owed, or are eligible to be refunded. Regardless of whether you take the steps necessary to have them refunded, they only qualify if they are a legal obligation.
2. Taxes paid to a foreign government designated as a state sponsor of terrorism, not recognized by the U.S. Government, or countries with which the U.S. does not have a diplomatic relationship.
3. Certain foreign tax withholding for dividends paid by a foreign corporation for which you are a short-term holder (less than 15 days) of the security.

Does the U.S. need to have a tax treaty with the foreign country for me to receive a credit?

No, you can qualify for the Foreign Tax Credit even if the U.S. does not maintain a current tax treaty with the country in which you paid income taxes.

How does the Foreign Earned Income Exclusion and Foreign Housing Exclusion affect the Foreign Tax Credit?

Tax paid on income that is excluded from taxation under the Foreign Earned Income Exclusion or Foreign Housing Exclusion doesn’t qualify for the credit. Basically, you can’t have your cake and eat it too. The tax code does not allow you to exclude your income and then also take a credit for taxes paid on said excluded income.

This doesn’t necessarily mean you can’t use both the Foreign Earned Income Exclusion and Foreign Tax Credit in the same year. If you have excess income that is subject to taxation after applying the Foreign Earned Income Exclusion, the foreign taxes paid on that non-excluded income may qualify for the Foreign Tax Credit.

Let’s look at an example: You are living in Bulgaria, making $150,000 per year, and paying taxes at a 10% local rate ($15,000). On your U.S. return, you qualify for the Foreign Earned Income Exclusion and exclude $120,000 (2023 figure) of that income from U.S. taxation. Since you can’t receive a Foreign Tax Credit for taxes paid on excluded income, you’ll only be entitled to a partial Foreign Tax Credit of $3,000 ($150,000 – $120,000 = $30,000 X 10% = $3,000).

What is the difference between the Foreign Tax Credit and Foreign Tax Deduction?

You can elect to benefit from foreign taxes you’ve paid by taking a credit or a deduction; it’s your choice. However, in the grand majority of cases, a tax credit is much more beneficial than a tax deduction.

Here’s why: A credit is a dollar-for-dollar reduction in the amount of tax owed, while a deduction is a dollar-for-dollar reduction in taxable income. It is much more beneficial to reduce your taxes by a dollar than to reduce your income by a dollar. Further, the Foreign Tax Deduction is an itemized deduction, and is therefore subject to phaseouts and must exceed the standard deduction, in aggregate, before generating a tax benefit.

Additionally, if you qualify for a Foreign Tax Credit in excess of the amount you can deduct during the year, you may be able to carry the credit forward or backward to other tax years and still receive a benefit. The Foreign Tax Deduction has no such carryover benefit.

Can I carry over unused credits to another year?

If your Foreign Tax Credit is greater than the deductible limit for the year, you may be able to carry the credit back one year and then forward up to 10 years to reduce your tax liability. The excess credit must be applied to the prior-year first, if possible, before being carried forward to future years.

Is the Foreign Tax Credit refundable?

The Foreign Tax Credit is not a refundable credit. It is limited by your total U.S. tax liability multiplied by the percent of your total income that is foreign sourced for the year. In other words, it can only be used to reduce your U.S. tax liability that is generated by foreign income. If you have U.S. income as well, the credit will not do anything to reduce your tax liability from your domestic income.

Do You Have Questions About the Foreign Tax Credit? Leave them in the Comments Below!

Resources and Tax Forms:

IRS Summary: Foreign Tax Credit

IRS Form 1116: Foreign Tax Credit

IRS Form 1116: Instructions

IRS Publication 514: Foreign Tax Credit for Individuals

IRS Foreign Tax Credit Compliance Tips

Tax Guide for U.S. Citizens and Resident Aliens Abroad