How Foreign Tax Credits Work

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].

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].

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