The Foreign Tax Credit Definition Explained
Under the United States tax system, a US person is taxed on their worldwide income. This is different than most foreign country tax systems — in which only permanent residents of the country (or other residents who the foreign country’s residence requirement) are subject to worldwide income tax by the foreign country. The United States is different in that it follows a worldwide income model — which means as long as a person is considered a US person for income tax purposes, they are subject to US tax on all of their income, whether it is sourced within the United States or outside of the United States — and whether they reside within the United States or abroad. When a US person has already paid foreign taxes on their foreign income, they may qualify for a foreign tax credit on Form 1116. Foreign tax credits are not always full credits, and are oftentimes impacted by whether or not it is:
Passive or general foreign income;
If the Taxpayer claimed the Foreign Earned Income Exclusion (FEIE);
The foreign country’s tax rate, and
Whether they have sufficient tax credits to cover all of their US income tax for the same foreign income
Let’s review the basics of the foreign tax credit —
Example of the Foreign Tax Credit
Matthew is a US person who resides overseas. Matthew earned $170,000 of earned income from employment abroad and paid a 28% tax on the income. He also earned $7,000 of foreign interest income, of which he paid 20% tax.
How the Foreign Tax Credit is Applied
Let’s take a look at how the foreign tax credit works:
Different Buckets of Foreign Tax Credit
The foreign tax credit goes into different buckets. For example, income earned from employment is considered general income and income earned from investments is considered passive income. The two buckets remain separate when it comes to applying the credit (subject to some exceptions such as HTKO), so that a foreign tax credit for employment can be applied in the employment bucket — and the same goes for the passive income foreign tax credit.
Full Foreign Tax Credit
If the Taxpayer qualifies for a full foreign tax credit, then he would not owe any tax liability in the United States on the income — because there would be sufficient foreign tax credits to reduce the US tax liability on that same income to zero.
Carry-Forward Foreign Tax Credit
If the Taxpayer had more foreign tax credit available than income he could apply it to in the current year, he can carry that credit forward in future years. It does not allow him to take a refund in the United States for the additional foreign credits.
Insufficient Foreign Tax Credit
If the Taxpayer does not have sufficient foreign tax credits to completely offset his US tax liability on the foreign income, then he would owe the difference in the United States.
Foreign Earned Income Exclusion
When a US person has earned foreign employment or other types of working income (not passive income), they may be able to claim the Foreign Earned Income Exclusion — and eliminate up to about $108,000 of annual income from their US tax liability, as well as some housing exclusion as well. If they earned more income than allowed under the FEIE, then they may be able to apply a portion of the foreign tax credit (presuming they have sufficient credits beyond what is eliminated through FEIE) to the additional foreign earned income above the FEIE amount — no double-dipping is allowed.
HTKO High-Tax Kick Out
The High-Tax Kick Out refers to foreign income that was taxed at too high a tax rate sufficient to apply to offset US tax on that same foreign passive income on their US tax Return. Therefore, the passive income gets kicked over to the general income category. You can learn more about that in a separate article we authored on the topic of HTKO.
What does the IRS Say?
The IRS provides its own summary of the foreign tax credit below:
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.
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