Foreign Tax Credit

The foreign tax credit is the credit allowed under Internal Revenue Code section 901 for income, war profits and excess profits taxes paid or accrued to a foreign country or a US possession. Because the United States taxes its citizens and residents on worldwide income, the same dollar of foreign earnings, dividends or interest can be taxed twice, and the credit is the main mechanism for preventing that. It is subtracted from US tax dollar for dollar, subject to a limitation in section 904 that caps it at the portion of US tax attributable to foreign-source income. The alternative treatment is a deduction for the same tax under section 164(a)(3), which reduces taxable income instead. The two cannot be combined for the same year: section 275(a)(4) denies the deduction for any year in which the taxpayer chooses the credit "to any extent."

Why the credit almost always beats the deduction. A credit removes a dollar of tax; a deduction removes a dollar of taxable income, which is worth the dollar multiplied by your marginal rate. At any positive tax rate below 100 percent the credit wins on that comparison alone, and it wins twice over for a taxpayer who takes the standard deduction, since the foreign tax deduction is an itemized deduction and is available only to someone itemizing at all. One narrow point in the deduction's favor is worth knowing: the last sentence of section 164(b)(6) excludes foreign taxes described in section 164(a)(3) from the cap on state and local tax deductions, so the deduction is not competing with property and state income taxes for room under that limit. The case for deducting instead of crediting is essentially confined to a year when the section 904 limitation would leave most of the credit unusable and the carryover looks unlikely to be absorbed.

The section 904 limitation, and the shape of the problem it creates. Section 904(a) limits the credit to the same proportion of US tax as foreign-source taxable income bears to entire taxable income. The purpose is that the credit relieves double taxation without letting a foreign government reach the US tax on US income. The consequence is that a taxpayer paying a foreign rate higher than their US effective rate on the same income generates more credit than the limitation allows. That excess is not lost immediately: section 904(c) treats it as paid in the first preceding taxable year and then in any of the first ten succeeding years, in that order. The limitation is also applied separately to categories of income under section 904(d), so credits are tracked basket by basket and an excess in one cannot be used against the limitation in another. Form 1116 is completed once per category for this reason.

The de minimis election that removes all of it. Section 904(j) lets an individual elect out of the limitation entirely, which in practice means claiming the credit without filing Form 1116, if two conditions hold: the taxpayer's entire foreign-source gross income for the year consists of qualified passive income shown on a payee statement, and creditable foreign taxes for the year are no more than $300, or $600 on a joint return. This is the provision that covers the very common case of a small amount of foreign withholding reported in a box on a brokerage statement. It comes with a real cost: under section 904(j)(1)(B) and (C) no carryback or carryforward runs to or from an election year, so credits that would otherwise have carried are simply gone. Section 904 contains no inflation clause anywhere, so the $300 and $600 figures have not moved and will not without legislation.

Only a compulsory payment is creditable, which is where treaties bite. Treasury Regulation 1.901-2(e)(5)(i) provides that an amount remitted to a foreign country is not a compulsory payment, and so is not creditable, to the extent it exceeds the taxpayer's liability under foreign tax law "including applicable tax treaties," and it requires the taxpayer to exhaust all effective and practical remedies to reduce that liability. If a treaty caps withholding on dividends at 15 percent and a payer withholds 30 percent, the extra 15 points is not a creditable tax. The remedy is a refund claim in that country, usually by giving the payer the treaty documentation before payment. The regulation does allow one practical concession: a taxpayer is not required to pursue a reduction where the reasonably expected arm's length cost of getting it would exceed the amount recovered.

The exclusion interaction, stated plainly because it catches people. Section 911(d)(6) denies any credit or deduction allocable to income excluded under the foreign earned income exclusion. An American abroad who excludes part of their salary cannot also credit the foreign tax paid on the excluded part; only the tax attributable to the income that remained in gross income is creditable. Deciding between excluding and crediting is therefore a real calculation rather than a formality, and in a high-tax country the credit alone often produces the better answer.

The mechanics run in a fixed order.

1. Separate foreign-source from US-source income, and identify the foreign income taxes paid or accrued on the foreign part.
2. Check whether the payment was compulsory, meaning it did not exceed what the foreign country could actually charge under its own law and any treaty.
3. Choose credit or deduction for the year. Electing the credit for any part of the foreign tax rules out deducting any of it.
4. Apply the section 904 limitation within each category of income.
5. Carry the excess back one year, then forward up to ten, or claim the section 904(j) election if the year qualifies.
6. File Form 1116, Foreign Tax Credit (Individual, Estate, or Trust), unless the de minimis election applies.

A hypothetical example. Elena is a single US citizen living in the United States. She has $120,000 of US wages and $10,000 of dividends from foreign companies, on which foreign countries withheld $1,500 at treaty rates. After her deductions her taxable income is $110,000, of which $10,000 is foreign-source, and her US tax before credits is $19,000.

The section 904 limitation is $19,000 multiplied by $10,000 divided by $110,000, which is about $1,727. Her creditable foreign tax of $1,500 is below that, so all of it is used and her US tax falls to $17,500.

Change one input. If the foreign withholding had been $2,500 rather than $1,500, the limitation would still be about $1,727. She would credit $1,727 this year and carry the remaining $773, first back to the preceding year and then forward for up to ten years within the same category.

The comparison with deducting makes the choice obvious in her case. Deducting the original $1,500 at her 24 percent marginal rate would have saved her $360 rather than $1,500, and only if she itemized at all. Her foreign taxes exceed $600, so she cannot use the section 904(j) election; a taxpayer with, say, $250 of foreign withholding shown on a brokerage statement and no other foreign income could, and would skip Form 1116 altogether.

Pros

• Dollar-for-dollar relief, which is worth several times what deducting the same tax would be worth at any normal marginal rate.
• Available whether or not you itemize, unlike the deduction.
• Unused amounts carry back one year and forward ten, so a single bad year for the limitation is not necessarily a loss.
• A small-investor election lets most people with foreign dividends claim the credit without touching Form 1116.

Cons

• The section 904 limitation means a high-tax country can generate credit you cannot use, sometimes for years.
• Category-by-category tracking makes Form 1116 one of the harder individual forms, and errors compound across carryover years.
• Excess withholding above a treaty rate is not creditable at all, and recovering it means dealing with a foreign tax authority.
• Electing the de minimis rule silently forfeits carryovers into and out of that year.
• No credit is allowed for tax on income excluded under the foreign earned income exclusion, so the two reliefs cannot be stacked on the same dollar.