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How Foreign Tax Credits Work

By: Chris Opfer

Calculating the Credit

Once you determine that you're eligible for the foreign tax credit, the next question is: How much of a credit can you get? Typically, credit seekers are required to file a Form 116. This document is used to calculate both the amount of your credit and the maximum amount of the credit that you can take [source: IRS].

The total amount of the tax credit can't exceed the total of your U.S. tax obligation multiplied by a fraction. The fraction is calculated by taking your taxable income from sources outside of the U.S. and dividing it by your total taxable income from U.S. and other sources. Consider, for example, a person who makes $100,000 in the U.S. and $50,000 in Canada (after accounting for any exclusions) and has a U.S. tax obligation of $10,000. The maximum foreign tax credit that this individual can obtain is $3,300 ($10,000 x 1/3). If the same person earns all $75,000 in Canada and $75,000 in the U.S., his or her maximum credit would be for $5,000 ($10,000 x 1/2) [source: IRS].

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Certain tax filers are exempt from these limits. That includes people whose foreign tax obligation is no more than $300 ($600 for joint filers) and whose only foreign source of income is deemed "passive income." This form of income refers to money derived from dividends, interest rent, royalties, annuities and the like [sources: IRS, IRS].

Finally, a note about being straight with the tax authorities. If you're entitled to a foreign tax credit or exclusion, you may be thinking "Hey, why don't I just make things a little easier and 'forget' to mention some of that foreign income to the IRS. I'm not going to get taxed on it anyway." This, of course, is a bad idea. The consequences of failing to report income or assets can include additional taxes, money penalties and even jail time [source: IRS].

Foreign Tax Credits FAQ

How does the foreign tax credit work?
The foreign tax credit allows individuals to lower the potential tax burden on income earned outside of the U.S. -- it lets taxpayers avoid paying taxes both in the U.S. and the foreign country in which the money was earned. In order to qualify for this credit, you'll need to meet certain IRS requirements.
Are foreign taxes deductible?
Foreign taxes can be deductible. You can opt to use either the IRS's Foreign Tax Credit or a foreign tax deduction depending on your unique situation. If you use the foreign tax deduction, it's an itemized deduction, and you can include any taxes you've already paid to another foreign government.
Can I claim foreign tax credit?
You can claim the IRS Foreign Tax Credit if you have had taxes imposed on you by a foreign government. You will have to make sure that the taxes you're claiming for the credit qualify, and generally only income, war profits, and excess profits taxes will qualify.
Who can claim a foreign tax credit?
If you have accrued or paid taxes to a foreign government, you're eligible to claim the foreign tax credit.
Is foreign tax credit dollar for dollar?
Yes, the foreign tax credit -- like all tax credits -- reduces your taxable income dollar for dollar.

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Sources

  • Internal Revenue Service. "Foreign Earned Income Exclusion." May 29, 2014 (Nov. 24, 2014) http://www.irs.gov/Individuals/International-Taxpayers/Foreign-Earned-Income-Exclusion
  • Internal Revenue Service. "Foreign Tax Credit." Nov. 14, 2014 (Nov. 24, 2014) http://www.irs.gov/Individuals/International-Taxpayers/Foreign-Tax-Credit
  • Internal Revenue Service. "Foreign Tax Credit – How to Figure the Credit." Nov. 14, 2014 (Nov. 24, 2014) http://www.irs.gov/Individuals/International-Taxpayers/Foreign-Tax-Credit---How-to-Figure-the-Credit
  • Internal Revenue Service. "Foreign Tax Credit - Special Issues." May 13, 2014 (Nov. 24, 2014) http://www.irs.gov/Individuals/International-Taxpayers/Foreign-Tax-Credit---Special-Issues
  • Internal Revenue Service. "In 2014, Various Tax Benefits Increase Due to Inflation Adjustments." Oct. 31, 2013 (Nov. 24, 2014)
  • Internal Revenue Service. "Income from Abroad is Taxable." Sept. 24, 2014 (Nov. 24, 2014) http://www.irs.gov/Businesses/Income-from-Abroad-is-Taxable
  • Internal Revenue Service. "Publication 514 – Main Content." (Nov. 24, 2014) http://www.irs.gov/publications/p514/ar02.html
  • Internal Revenue Service. "Topic 856- Foreign Tax Credit." Aug. 28, 2014 (Nov. 24, 2014) http://www.irs.gov/taxtopics/tc856.html
  • Internal Revenue Service. "What Foreign Taxes Qualify For The Foreign Tax Credit?" Jan. 16, 2014 (Nov. 24, 2014) What Foreign Taxes Qualify For The Foreign Tax Credit? http://www.irs.gov/Individuals/International-Taxpayers/What-Foreign-Taxes-Qualify-For-The-Foreign-Tax-Credit%3F