The Foreign Tax Credit is designed to relieve US taxpayers of double taxation if their foreign source income is taxed by both the US and the foreign country. Unlike the Foreign Earned Income Exclusion, you do not have to live overseas to qualify for the Foreign Tax Credit.
Source of Income
Generally speaking, you can take a Foreign Tax Credit for tax paid on income from a source outside the US. This could include such items as payment for services performed outside the US (foreign earned income), interest from a payor located outside the US, dividends paid by a foreign corporation, and gain on the sale of non-depreciable personal property if you live outside the US.
Creditable Foreign Tax
Not all foreign tax qualifies for the credit. The credit is allowed against income tax or a tax in lieu of an income tax, paid or accrued during the tax year. Normally, foreign tax paid or accrued on wages, dividends, interest, royalties, etc. qualify for the foreign tax credit. The tax must be paid to a foreign country or US possession including Puerto Rico, the US Virgin Islands, Guam, the Northern Mariana Islands and American Samoa.
Taxes that do not qualify for the credit Foreign sales taxes and transaction taxes are not available for the credit – such as VAT and GST. Also, taxes based on the value of assets, such as real estate taxes, do not qualify.
Taxes paid to certain foreign countries with which the US does not conduct diplomatic relations or which are designated as supporting acts of international terrorism do not qualify for the credit. These countries include Cuba, Iran, North Korea, Sudan and Syria. You can deduct these taxes as an itemized deduction, but you cannot take the Foreign Tax Credit.
Foreign Tax Credit or Deduction?
Generally it is more advantageous to take the Foreign Tax Credit than a deduction for foreign taxes paid, here’s why:
· The credit reduces US tax on a $1 for $1 basis while the deduction only reduces the amount of income subject to tax. This means that, depending on your tax bracket, the deduction only saves you about $0.30 on the $1.00, while the credit saves you $1.00 on the $1.00.
· Even if you don’t itemize deduction, you can take the foreign tax credit. This means you can take advantage of the standard deduction and take the foreign tax credit. In the case of the foreign tax deduction, it would become part of your overall itemized deductions.
· If you are in AMT (Alternative Minimum Tax), you will lose the deduction for all taxes paid.
· Even if you can’t use all the foreign tax credit you have available in any given year, it is possible to carry over or carry back the excess to other years.