27 Jun Foreign Tax Credit (FTC) A Drill Down into IRS Form 1116
Foreign Tax Credit (FTC) A Drill Down into IRS Form 1116. With all the political rhetoric about borders and boundaries circulating these days by ‘news media’ outlets the fact of the matter is US Taxpayers are increasingly working and living abroad everyday.
With that taxpayers and tax practitioners alike find it difficult navigating the shoals of Foreign Earned Income Exclusions (FEIE) reported on Form 2555 and Foreign Tax Credits (FTC) reported on Form 1116 causing all sorts of brain damage along the way. Today’s post dives into Foreign Tax Credit (FTC).
Generally, the following four tests must be met for any foreign tax to qualify for the US foreign tax credit
- The foreign income tax in question must be a compulsory tax imposed on you
- You must have paid or accrued the tax,
- The tax must be the legal and actual foreign tax liability, and
- The tax must be an income tax or a tax imposed in lieu of an income tax.
If you are still with me the 6 most salient points to glean include
- Foreign Tax Credit (FTC) may only be claimed if you paid or accrued foreign taxes to a foreign country or U.S. possession and are subject to U.S. tax on the same income.
- In this circumstance you may be able to take either a credit or an itemized deduction for those income taxes paid to a foreign government.
- The intent of the governing regulation is to relieve a double tax burden when foreign source income is taxed by both the United States and the foreign country.
- If for example the foreign tax rate is higher than the U.S. rate, there will be no U.S. tax on the foreign income.
- If the foreign tax rate is lower than the U.S. rate, U.S. tax on the foreign income will be limited to the difference between the rates.
- The most common question asked with regards to US Foreign Tax Credit (FTC) is whether to claim the actual credit or claim the amount of foreign taxes paid as an itemized deduction on Schedule A. The answer of course all depends on your specific situation.
- The most common mistake seen is US taxpayers attempting to claim the credit for interest and penalties owed to foreign taxing authorities for incurred delinquencies.
- You cannot claim a credit for tax penalties and interest paid to foreign governments.
- The second most common mistake seen is taxpayers claiming both the foreign tax credit AND the foreign earned income exclusion.
- You can NOT take a credit or a deduction for foreign taxes paid on income you exclude under the foreign earned income exclusion or the foreign housing exclusion.
- Considering that foreign tax credits can only reduce U.S. taxes on foreign source income and does not reduce U.S. taxes on U.S. source income, in some instances you might find yourself best served deducting the foreign taxes on your US income tax return as opposed to claiming the credit.
- Here is where a licensed tax professional is worth their salt, providing an analysis of your tax liability when asserting either the foreign tax credit (FTC) vs. the foreign earned income exclusion (FEIE).
Top 10 Lessons relevant to IRS Form 1116 – learned in the trenches
- For you DIY-ers the best place to research foreign tax credits is with the IRS Form 1116 instruction set & IRS Publication 514, even though neither are deemed ‘substantial authority’ Internal Revenue Sections 901 & 904 are and I would strongly advise reading those next if you can tolerate the brain damage.
- Although no one rule covers all situations, in most case files running across my desk it is better to take a credit for qualified foreign taxes than to deduct the taxes on Schedule A mostly because the credit reduces actual U.S. income tax on a real dollar for dollar basis, while the deduction merely reduces income subject to taxation and needs to be multiplied by your effective tax rate to arrive at a real dollar tax savings.
- You can choose to take the foreign tax credit even if you do not itemize your deductions allowing for the standard deduction in addition to the credit.
- If you choose to take the foreign tax credit, and the taxes paid or accrued exceed the credit limit for the tax year, you may be able to carry over or carry back the excess to another tax year.
- When deciding whether to take the credit or the deduction in the current tax year, you will need to consider whether you can benefit from a carry back or carryover of that unused foreign tax. This is one of several areas where a licensed tax practitioner with experience is worth their salt.
- The FTC limitation provides that the total amount of the claimed credit may not exceed the total U.S. Income tax liability determined without regard to the credit and attributable to foreign source income.
- The Maximum FTC equals you Foreign Source Taxable Income (Form 1116 Line 17) X U.S. Tax Liability (Form 1116 Line 20)
- The amount of foreign tax that qualifies is not necessarily the amount of tax withheld by the foreign country.
- Only the legal and actual foreign tax liability that you paid or accrued during the year qualifies for the credit.
- A FTC cannot be taken for income taxes paid to a foreign country if the amounts would be refunded, credited, abated, rebated, or forgiven if a claim was made.
Top 7 Situations where good intending US taxpayers are getting tripped up claiming the credit
- Taxes are paid to a foreign country that you do not legally owe, including amounts eligible for refund by the foreign country. If you do not exercise your available remedies to reduce the amount of foreign tax to what you legally owe, a credit for the excess amount is not allowed. The amount of tax actually withheld by a foreign country is not necessarily 100% creditable as per Regulations section 1.901-2(e)(2)(i).
- Taxes imposed by and paid to certain foreign countries that repeatedly provide support for acts of international terrorism, countries with which the United States does not have or does not conduct diplomatic relations, or countries whose governments are not recognized by the United States. Be careful to check here!
- Foreign taxes withheld on a dividend from a corporation, if you have not held the stock for at least 16 days within the 31-day period that begins 15 days before the ex-dividend date. This required holding period is greater for preferred-stock dividends attributable to periods totaling more than 366 days as per IRC Section 901(k)(3). Yes this happened to one of my clients!
- Foreign taxes withheld on a dividend, income or gain to the extent that you have to make related payments on positions in substantially similar or related property.
- Payments of foreign tax that are returned to you in the form of a subsidy.
- Foreign taxes paid or accrued on income for which you are claiming an exclusion on Form 8873, Extraterritorial Income Exclusion.
- The disqualified portion of any foreign tax paid or accrued in connection with a covered asset acquisition including certain acquisitions that result in a stepped-up basis for U.S. tax purposes under IRC 901(m).
Foreign Source Income Categories
Use a separate Form 1116 to figure the credit for each category of foreign source income listed in Part I of Form 1116. For more information, see IRS Publication 514 Foreign Tax Credit for Individuals & Internal Revenue Code section 904. Income categories include:
- Passive Category Income – Generally passive income is NOT gain from the sale of inventory or property held primarily for sale to customers; gain from commodities hedging transactions; OR active business gains or losses of producers, processors, merchants, or handlers of commodities. It also (generally) excludes dividends, interest, rents, or royalties received from a controlled foreign corporation (CFC) in which you are a U.S. shareholder who owns 10% or more of the total voting power of all classes of the corporation’s stock as well as export financing interest, active business rents and royalties. Capital gains not related to the active conduct of a trade or business are however generally considered passive income.
- General Category Income – Includes income that is not passive category income such as wages, salaries, and overseas allowances of an individual as an employee. It also includes income earned in the active conduct of a trade or business; gains from the sale of inventory or depreciated property used in a trade or business; as well as financial services income.
- Section 901(j) Income – No credit is allowed for foreign taxes imposed by and paid or accrued to certain sanctioned countries. However, income derived from each sanctioned country is subject to a separate foreign tax credit limitation. You must use a separate Form 1116 for income derived from each sanctioned country. Sanctioned countries are those designated by the Secretary of State as countries that repeatedly provide support for acts of international terrorism, countries with which the United States does not have or does not conduct diplomatic relations, or countries whose governments are not recognized by the United States.
- Certain Income -Sourced by Treaty – If a sourcing rule in an applicable income tax treaty considers U.S. source income as foreign source, and you elect to apply the treaty provision, the income will be treated as foreign source. You may be required to file Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b), for the re-sourced income.
- Lump-Sum Distributions – You can take a foreign tax credit for taxes you paid or accrued on a foreign source lump-sum distribution from a pension plan. Special formulas may be used to figure a separate tax on a qualified lump-sum distribution for the year in which the distribution is received. If you elect to figure your U.S. tax on a lump-sum distribution using IRS Form 4972, Tax on Lump-Sum Distributions, a separate limitation applies.
You may be able to claim the foreign tax credit without filing Form 1116
By making this election, the foreign tax credit limitation (lines 15 through 21 of the form) will not apply to you. This election is available only if:
- All of your foreign source gross income was “passive”
- All the income and any foreign taxes paid on it were reported to you on a qualified payee statement. (1099-DIV, Form 1099-INT, Schedule K-1)
- Your total creditable foreign taxes are not more than $300 ($600 if married filing a joint return)
This election is not available for estates or trusts. Also if you are a nonresident alien, you generally cannot take the credit unless you pay or accrue tax to a foreign country or U.S. possession on income from foreign sources that is effectively connected with a trade or business in the United States. Special rules apply for people spending the entire tax year in Puerto Rico.
- Thank you for making it this far into the post.
- As a general rule, you must choose to take either a credit or a deduction for all qualified foreign taxes.
- If you choose to take a credit for qualified foreign taxes, you must take the credit for all of them. You cannot deduct any of them.
- Conversely, if you choose to deduct qualified foreign taxes, you must deduct all of them. You cannot take a credit for any of them.
- In most cases, only foreign income taxes qualify for the foreign tax credit.
- Other taxes, such as foreign real and personal property taxes, do not qualify.
- But you may be able to deduct these other taxes even if you claim the foreign tax credit for foreign income taxes.
- In most cases, you can deduct these other taxes only if they are expenses incurred in a trade or business or in the production of income.
- However, you can deduct foreign real property taxes that are not trade or business expenses as an itemized deductions on Schedule A.
Recent Treasury Updates
The IRS has issued final regulations effective March 5th 2022 relating to the foreign tax credit including clarifications of Foreign Derived Intangible Income, including:
- the disallowance of a credit or deduction for foreign income taxes with respect to dividends eligible for a dividends-received deduction
- the allocation and apportionment of interest expense, foreign income tax expense, and certain deductions of life insurance companies
- the definition of a foreign income tax and a tax in lieu of an income tax
- the definition of foreign branch category income
- the time at which foreign taxes accrue and can be claimed as a credit.
The final regulations also clarify rules relating to foreign-derived intangible income (FDII). More specifically, the final regulations address the following:
- The determination of foreign income taxes subject to the credit and deduction disallowance provisions of Code Sec. 245A(d);
- The determination of oil and gas extraction income from domestic and foreign sources and of electronically supplied services under Code Sec. 250 regs;
- The impact of the repeal of Code Sec. 902 on certain regs issued under Code Sec. 367(b);
- The sourcing of inclusions under Code Sec. 951, Code Sec. 951A, and Code Sec. 1293;
- The allocation and apportionment of interest deductions of certain regulated utilities;
- A revision to the controlled foreign corporation (“CFC”) netting rule;
- The allocation and apportionment of Code Sec. 818(f)(1) items of life insurance companies that are members of consolidated groups;
- The allocation and apportionment of foreign income taxes, including taxes imposed with respect to disregarded payments;
- The definitions of a foreign income tax and a tax in lieu of an income tax, including changes to the net gain requirement, the replacement of the jurisdictional nexus rule with an attribution rule contained in the net gain requirement, the treatment of certain tax credits, the treatment of foreign tax law elections for purposes of the noncompulsory payment rules, and the substitution requirement under Code Sec. 903;
- The allocation of the liability for foreign income taxes in connection with certain mid-year transfers or reorganizations;
- The foreign branch category rules in Reg §1.904-4(f); and
- The time at which credits for foreign income taxes can be claimed pursuant to Code Sec. 901(a) and Code Sec. 905(a)
For more on Foreign Tax Credit (FTC) A Drill Down into IRS Form 1116, contact me today.