Foreign Tax Credits (FTCs) in Real Life
Foreign tax credits are used to avoid double taxation when the USA taxes foreign income that has already been taxed by another country. This happens with some frequency to US taxpayers because the US taxes its residents on their worldwide income, and worldwide income includes by definition foreign income that foreign countries where the income is from will tax. The US taxes its citizens and permanent legal residents as US tax residents, even when they live abroad where they are earning foreign income that is taxed by their country of physical residence. The foreign tax credit, in theory, works like this:
You earn $100 in a foreign country. You pay $25 in income tax to the foreign country. The USA also taxes this foreign income. Let’s say that the US tax is also $25. You offset the $25 in US tax with the $25 of tax paid to the foreign country.
Magically, this foreign tax credit makes your US tax disappear.
You pay nothing to the USA. Double taxation is avoided. All is good.
That’s the theory.
In practice, it’s a bit more complicated than our example.
There are many reasons why it is more complicated.
For starters, there are sourcing rules that limit the applicability of the foreign tax credit. There are also rules about what constitutes a creditable foreign tax and what doesn’t. Not every tax can be credited, it must be a foreign income tax. Foreign wealth taxes, which are usually calculated in foreign income tax returns, are one example of a foreign tax that cannot be taken as a credit to offset US income tax.
But the main reason it’s complicated is what it’s referred to as Foreign Income Baskets.
Foreign Tax Credit Category Baskets
What is a foreign income basket?
A foreign income basket is simply another word for foreign income category. The Internal Revenue Code classifies income into different categories and calls these categories, baskets.
|What category baskets are there?
You can find the different foreign tax credit baskets at the top of Form 1116, which is the form used by individuals to calculate their foreign tax credits (FTCs):
|As you can see, there are seven different foreign tax credit baskets. They are the following:
Section 951A basket
Foreign Branch basket
Section 901(j) basket
Certain Income Resourced by treaty basket, and
Lump-sum distributions basket
Section 951 basket:
This basket made its debut at the end of 2017 when the Tax Cuts and Jobs Act (TCJA) was signed into law. Section 951 is a new section of the Internal Revenue Code (IRC) known as Global Intangible Low Taxed Income or GILTI.
GILTI is one of the most complex provisions of the IRC, and I explain it in several other articles on my blog at www.mooresrowland.tax
|Foreign Branch Basket:
This FTC basket is another TCJA of 2017 gift. Unfortunately, as opposed to the GILTI basket, this basket impacts Americans living overseas who work independently.
When an American works independently, they are considered self-employed. Self-employed means, as the term implies, being an employee of oneself. When an American is self-employed abroad, they are a foreign employee of themselves. Since they are American, they are a US employer. Since they live abroad, they are also a foreign located employee. This combination of US employer with a foreign situs employee creates a “foreign branch” of the US expat in their country of residency.
Before 2018, self-employed income earned overseas fell into the General Limitation basket. From 2018 on, it’s Foreign Branch basket. This is NOT a good change because adding FTC baskets makes it more difficult to efficiently use FTCs to offset US income tax.
Passive income is one of the traditional income baskets that pre-exists the TCJA of 2017. In general, passive income is income derived from passive investments: interest, dividends, royalties and rents. For an individual taxpayer examples include the interest paid on savings accounts, dividends earned in investment accounts, royalties received from acquired intellectual property rights (royalties from self-developed are General Limitation) and rental income reported on Schedule E.
Section 901(j) basket:
This basket applies to income from countries with which the USA has severed diplomatic relations, it doesn’t recognize, or has sanctioned in some way. Examples include Iran, North Korea, Syria and Cuba.
I don’t expect any of our readers to have income from these countries, but if you do, understand that any tax paid to those countries is not eligible for the FTC. Such a tax is segregated for the purpose of denying the credit in this separate basket.
If you do have income from these countries, you should be aware that in addition to missing on the FTC, you may also get a visit from the Department of State…..
Certain Income Resourced by Treaty:
This is a category of potential great importance for our readers, if you are US expats and live in countries with which the USA has an income tax treaty.
As we explained earlier, the US taxes its citizens and long term permanent residents (green card holders) on their worldwide income. It taxes them on their worldwide income even when they live overseas. Most countries also tax their residents on their worldwide income. The USA is not unique in this regard.
When you have a US expat living in a country that also taxes them on their worldwide income, you have two countries taxing the same person on their worldwide income and potentially leading to double taxation.
Let’s assume that a US expat owned their home before moving overseas. Unsure if they would want to return to their US home, the US expat converts it into a rental property and rents it during their expat assignment. This rental activity generates rental income. This rental income is US source income because the rental property is located in the USA.
Clear so far, right?
The USA will tax this rental income because it is US source income and because the beneficial owner is a US citizen.
Now let’s assume that this US expat lives in a country that taxes them on their worldwide income too. The US rental activity is also taxed by the foreign country. The rental income is double taxed.
Can this taxpayer use the foreign tax credit to offset the tax on the US side?
The short answer is NO.
Foreign tax credits can only be used to offset tax on foreign source income. Income from a US rental property is NOT foreign source income. It is US income taxed by a foreign country. Those are two very different things.
If the foreign country doesn’t have their own foreign tax credit rule, the rental income will be double taxed .
A tax treaty comes to the rescue. How does a tax treaty solve this double taxation problem?
By allowing the US expat to pretend that the US rental income is earned in the foreign country where they live. It is deemed to be “foreign” source income, even though it is US source income.
The tax treaty provision converts (resources) US source income into foreign source, thus allowing the use of foreign tax credits to offset the US income tax imposed on it.
Curious about the most common situation in which US expats use this treaty benefit?
The answer is: interest and dividend income from US financial accounts and investments.
It is very common for foreign countries to tax US US dividends and interest if the beneficial owner lives in that country. If the tax treaty didn’t allow the US expat to pretend that the interest and dividends are foreign, the US expat would end up paying tax twice.
Lump-sum distribution basket:
A lump-sum distribution takes place when a large amount of money is distributed all at once, instead of being broken down into installments or smaller size payments. Lump-sum distributions are common with pension fund or retirement account distributions, when the entire account is distributed at once.
This FTC basket allowed for preferential treatment of lump-sum distribution income until the tax reform of 1986. Now, it is only available to taxpayers who were born before 1936 and who are participants in foreign retirement plans eligible for this special 20% lump-sum distribution rate on contributions made before 1974.
General limitation basket:
Why is this the best basket? Because it’s the catch-all basket.
Any income that does not fit into another category previously described, is General Limitation income.
Want some examples of general limitation income?
Retirement account distributions
Social security income
Taxable employee benefits (paid in cash or in kind)
If you work abroad for a foreign employer, the greater part of your foreign income will fall under the General Limitation basket.
If you live in the USA, your foreign income is most likely to be investment income, and thus fall under the Passive basket (interest, dividends, royalties, rents, capital gains, etc.)
Topic No. 856 Foreign Tax Credit
The foreign tax credit intends to reduce the double tax burden that would otherwise arise when foreign source income is taxed by both the United States and the foreign country from which the income is derived.
Qualifying Tests for the Credit
The tax must meet four tests to qualify for the credit:
- The tax must be a legal and actual foreign tax liability
- The tax must be imposed on you
- You must have paid or accrued the tax, and
- The tax must be an income tax (or a tax in lieu of an income tax)
Generally, only income taxes paid or accrued to a foreign country or a U.S. possession (also referred to as a U.S. territory), or taxes paid or accrued to a foreign country or U.S. possession in lieu of an income tax, will qualify for the foreign tax credit.
Foreign Taxes That Don’t Qualify:
- Taxes refundable to you.
- Taxes returned to you in the form of a subsidy to you or someone related to you.
- Taxes not required by law, because you could have avoided paying the taxes to the foreign country.
- Taxes that are paid or accrued to a country if the income giving rise to the tax is for a period (the sanction period) during which:
- The Secretary of State has designated the country as one that repeatedly provides support for acts of international terrorism,
- The United States has severed or doesn’t conduct diplomatic relations with the country, or
- The United States doesn’t recognize the country’s government, unless that government is eligible to purchase defense articles or services under the Arms Export Control Act.
- Withheld foreign taxes on dividends for foreign stocks that don’t meet required minimum holding periods.
- Withheld foreign taxes on gains and income from other foreign properties that don’t meet required minimum holding periods.
Note: These taxes may be claimed as an itemized deduction even if you claim foreign tax credits for qualifying taxes.
Choosing a Credit or a Deduction
You can choose to take the amount of any qualified foreign taxes paid during the year as a credit or as a deduction. To choose the deduction, you must itemize deductions on Schedule A (Form 1040). To choose the foreign tax credit, you generally must complete Form 1116 and attach it to your Form 1040, Form 1040-SR or Form 1040-NR. You must choose either the foreign tax credit or itemized deduction for all foreign taxes paid or accrued during the year. This is an annual choice.
If you’re a cash basis taxpayer, you can only take the foreign tax credit in the year you pay the qualified foreign tax unless you elect to claim the foreign tax credit in the year the taxes are accrued. Once you make this election, you can’t switch back to claiming the taxes in the year paid in later years.
Foreign Earned Income and Housing Exclusions
You may not take either a credit or a deduction for taxes paid or accrued on income you exclude under the foreign earned income exclusion or the foreign housing exclusion. There’s no double taxation in this situation because that income isn’t subject to U.S. income tax.
Computing the Credit When Filing Form 1116
If you use Form 1116 to figure the credit, your foreign tax credit will be the smaller of the amount of foreign tax paid or accrued, or the amount of U.S. tax attributable to your foreign source income. Compute the limit separately for passive income, income resourced under a tax treaty, section 901(j) income derived from sanctioned countries, income included under section 951A, foreign branch income, and all other income.
Carryback and Carryover of Unused Credit
If you can’t claim a credit for the full amount of qualified foreign income taxes you paid or accrued in the year, you’re allowed a carryback and/or carryover of the unused foreign income tax, except that no carryback or carryover is allowed for foreign tax on income included under section 951A. You can carry back for one year and then carry forward for 10 years the unused foreign tax. For more information on this topic, see Publication 514, Foreign Tax Credit for Individuals.
Claiming Without Filing Form 1116
You can elect to claim the credit for qualified foreign taxes without filing Form 1116 if you meet all of the following requirements:
- All of your foreign source income is passive income, such as interest and dividends,
- All of your foreign source income and the foreign income taxes are reported to you on a qualified payee statement, such as Form 1099-INT, Form 1099-DIV, or Schedule K-1 from a partnership, S corporation, estate or trust, and,
- The total of your qualified foreign taxes isn’t more than the limit given in the Instructions for Form 1040 and Form 1040-SR PDF for the filing status you’re using, or in the Instructions for Form 1040-NR PDF (if filing Form 1040-NR).
If you claim the credit without filing Form 1116, you can’t carry back or carry forward any unused foreign tax to or from this year.
This election isn’t available to estates or trusts.
Amending Your Return to Claim the Tax Credit
If you claimed an itemized deduction for a given year for qualified foreign taxes, you can choose instead to claim a foreign tax credit that’ll result in a refund for that year by filing an amended return on Form 1040-X within 10 years from the original due date of your return. The 10-year period also applies to calculation corrections of your previously claimed foreign tax credit.
If the foreign income taxes you claimed as a credit are refunded to you or otherwise reduced, you must file an amended return on Form 1040-X reporting the reduced foreign tax credit no later than the due date (with extensions) of your return for the year in which the foreign taxes were refunded or reduced.
- Instructions for Form 1116
- Foreign Tax Credit
- Am I Eligible to Claim the Foreign Tax Credit?
- Publication 514, Foreign Tax Credit for Individuals
- U.S. Citizens and Resident Aliens Abroad
Foreign Tax Credit
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, you may be able to take either a credit or an itemized deduction for those taxes.
Qualifying Foreign Taxes
You can claim a credit only for foreign taxes that are imposed on you by a foreign country or U.S. possession. Generally, only income, war profits and excess profits taxes qualify for the credit. See Foreign Taxes that Qualify For The Foreign Tax Credit for more information.
Taken as a deduction, foreign income taxes reduce your U.S. taxable income. Deduct foreign taxes on Schedule A (Form 1040), Itemized Deductions
Taken as a credit, foreign income taxes reduce your U.S. tax liability. In most cases, it is to your advantage to take foreign income taxes as a tax credit.
If you elect to exclude either foreign earned income or foreign housing costs under IRC §911, you cannot take a foreign tax credit for taxes on income you exclude. If you do take the credit, one or both of the elections may be considered revoked.
How to Claim the Foreign Tax Credit
File Form 1116, Foreign Tax Credit, to claim the foreign tax credit if you are an individual, estate or trust, and you paid or accrued certain foreign taxes to a foreign country or U.S. possession.
Corporations file Form 1118, Foreign Tax Credit—Corporations, to claim a foreign tax credit.
French Contribution Sociale Generalisee (CSG) and Contribution au Remboursement de la Dette Sociale (CRDS)
In 2019, the United States and the French Republic memorialized through diplomatic communications an understanding that the French Contribution Sociale Generalisee (CSG) and Contribution au Remboursement de la Dette Sociale(CRDS) taxes are not social taxes covered by the Agreement on Social Security between the two countries. Accordingly, the IRS will not challenge foreign tax credits for CSG and CRDS payments on the basis that the Agreement on Social Security applies to those taxes.
The IRS’s change in policy means individual taxpayers, who paid or accrued these taxes but did not claim them, can file amended returns to claim a foreign tax credit.
Generally individual taxpayers have ten (10) years to file a claim for refund of U.S. income taxes paid if they find they paid or accrued more creditable foreign taxes than what they previously claimed. The 10-year period begins the day after the regular due date for filing the return (without extensions) for the year in which the foreign taxes were paid or accrued.
Individual taxpayers should write “French CSG/CRDS Taxes” in red at the top of Forms 1040-X, file them with accompanying Forms 1116 in accordance with the instructions for these forms. U.S. employers may not file for refunds claiming a foreign tax credit for CSG/CRDS withheld or otherwise paid on behalf of their employees.
The foreign tax credit laws are complex. Refer to Foreign Tax Credit Compliance Tips for help in understanding some of the more complex areas of the law. Below are some of the compliance issues:
- Foreign sourced qualified dividends and/or capital gains (including long-term capital gains, collectible gains, unrecaptured section 1250 gains, and section 1231 gains) that are taxed in the United States at a reduced tax rate must be adjusted in determining foreign source income on Form 1116, Foreign Tax Credit, line 1a.
- Interest expense must be apportioned between U.S. and foreign source income.
- Charitable contributions are usually not apportioned against foreign source income; however, contributions to charities organized in Mexico, Canada, and Israel must be apportioned against foreign source income.
- The amount of foreign tax that qualifies as a foreign tax credit is not necessarily the amount of tax withheld by the foreign country. If you are entitled to a reduced rate of foreign tax based on an income tax treaty between the United States and a foreign country, only that reduced tax qualifies for the credit. It is up to you whether you want to file with the foreign country for a refund of the difference (excess) for which a foreign tax credit is not allowed.
- If a foreign tax redetermination occurs, a redetermination of your U.S. tax liability is required in most situations. You must file a Form 1040-X or Form 1120-X. Failure to notify the IRS of a foreign tax redetermination can result in a failure to notify penalty.
- A foreign tax credit may not be claimed for taxes on income that you exclude from U.S. gross income.