An individual can have income from foreign sources. Taxation on that foreign earned income is governed by the taxation laws of that country, and usually, a person or organization is to pay the taxes to that country on the income earned there. Foreign Tax Credit (FTC) comes into play when a person pays taxes to a foreign government, possibly because a person works internationally or earns an investment income from another country. Since such a person has already paid taxes on that income to that country, he may be liable to receive a foreign tax credit in their own country. Therefore, in essence, FTC is a non-refundable tax credit advantage to a person in his own country for the taxes already paid by him to a foreign country. And this is on account of foreign income tax withholdings.
Purpose of FTC
The primary goal of giving a foreign tax credit is to ensure that taxpayers do not pay taxes twice on the same income. Double taxation occurs when taxpayers pay taxes on the same income abroad and in their home country. The FTC helps to reduce the tax burden on taxpayers for the taxes already paid, albeit to a foreign country.
Usually, income, war gains, and excess profits are eligible for such a credit. Only an individual, estate, or trust can claim the FTC. The FTC benefit is not generally applicable or meant for foreigners residing abroad. Of course, there are a few exceptions.
What Qualifies for Foreign Tax Credit
FTC benefit is not a blanket one and thus not applicable to all the taxes paid to the foreign government by the taxpayer. To be eligible to enjoy the FTC, the person needs to fulfill certain conditions, and they are:
- There is no credit eligibility if the taxpayer does not pay or accrue the tax.
- When the tax is not levied, there would be no credit.
- There is no credit if the tax is not a real or legal foreign tax liability. For example, if a foreign government imposes a legal property tax, it is not eligible for a foreign tax credit.
- There is no credit if the tax is not based on income.
- The credit is only available for income that is also taxable in the home country. The income which is not taxable in the home country, there will be no tax credit. Hence, if only partial foreign income is taxable, then FTC will also be for that part only.
- If a taxpayer decides to exclude foreign income from federal income tax, then they will not be able to claim any credit for it. Currently, the IRS allows taxpayers to exclude up to $107,600 of their foreign income for tax purposes in the United States. (the capping is dynamic and changes anytime).
- As we discussed earlier, it is a non-refundable tax credit. Hence, if the tax is refundable, no FTC benefit will be available to you. Similarly, if you or another family member has received the tax back as a subsidy, then FTC will not be given to you.
- If the taxes you pay in the foreign government are not according to the law, you will not get the credit in this situation.
- When the tax you pay on dividends, profits, or income that does not meet the minimum holding periods. Again FTC will not be available to you.
- If the US does not recognize a foreign government, then the taxes you pay to such a government do not qualify for the FTC.
- If a foreign government supports terrorism, then taxes are not eligible for the FTC either.
Choosing Between Credit and Deduction
If you are in the US, you have the option of either applying for a deduction or the FTC. Hence, for a US Citizen, it is extremely important to understand and appreciate the difference between the two terms very clearly. To apply the proper process and take advantage thereof.
A deduction means you can deduct the allowable foreign tax from taxable income in the US. This would reduce your taxable income and your tax liability. For example, your taxable income in the US was $20,000, and your foreign tax was $3,000. Your taxable income in the US will now be $17,000. So in this scenario, your taxable income stands reduced to the extent of deductions. This deduction may make your taxable income either non-taxable or may land up in a lower tax slab.
However, a tax credit is much more advantageous. Because in such a case, your tax liability directly stands reduced to the extent of FTC instead of taxable income. For instance, your tax in the U.S. is $5,000, and you have a tax credit of $1,500. Now, your net tax liability is $3,500. A tax credit can either be refundable or non-refundable. A refundable credit means that the government returns the excess amount after adjusting your tax liability. A non-excrefundable credit means that the government forfeits the excess credit. The foreign tax credit is non-refundable in nature. If your net liability is less than the tax credit, the same stands forfeited. That means no benefits would be passed on to the extent of the excess.
Is There a Limit on FTC?
In general, there is not capping or limit on the FTC amount that can be claimed in the home country. However, the credit is limited within one year to the amount of tax due in the home country on the foreign taxable income. This means that if a person pays more taxes to the foreign country than the tax due on the same foreign income in the home country, then the credit is limited to the tax liability in the home country.
For example, a taxpayer applies for a $2,000 tax credit on his total tax liability of $1,500. In such a case, his net tax liability is zero. The government will forfeit the balance of the $500 credit as the FTC is non-refundable. However, the IRS may allow you to carry forward the balance FTC when you file Form 1116.
How to Claim Foreign Tax Credit?
To claim such a credit in the United States, an individual must submit Form 1116. An estate or trust also submits the same form to claim the credit. The corporation will have to file Form 1118 to claim this credit. If a taxpayer qualifies for the de minimis exception (if an investment advisor has less than 5 clients), then they can claim the credit on the entire amount of foreign taxes through Form 1040. The De minimis exception is basically to continue without regular registration in certain specific situations.
Frequently Asked Questions (FAQs)
IRS Form 1116
1. Credit will not be allowed if tax is not levied.
2. If the tax is refundable in nature.
3. If the foreign government supports terrorism.
In the above three cases, FTC can not be claimed.