Even though the US taxes its citizens on their worldwide income, taxes paid to foreign countries on income can be claimed as a “foreign tax credit” to eliminate double taxation, so that the US taxpayer does not pay double (foreign and US) tax on the same income. Foreign taxes paid or accrued on foreign source income can be used to offset US taxes on the same income.
The foreign tax credit allows a taxpayer to subtract income taxes paid to other countries from the tentative tax owed to the US government. Foreign taxes other than income taxes (such as property taxes, excise taxes, payroll taxes, or value added taxes) can be deducted from foreign source taxable income, but cannot be credited against US tax. All foreign income taxes can be credited against US tax, including taxes levied by governments below the national level.
The following four tests must be met to claim a foreign tax credit:
The tax must be a legal and actual foreign tax liability;
The tax must be imposed on the taxpayer;
The taxpayer 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, receiving a tax credit is more beneficial to a taxpayer than a deduction from income taxes. A tax credit provides a dollar for dollar reduction in current income tax liability. For example, a tax credit of $100 will reduce a taxpayer’s tax liability by $100. In contrast, a tax deduction lowers the amount of income that is taxable, and the benefit would be measured by the taxpayer’s marginal income tax bracket. For example, a taxpayer in the 25% marginal tax bracket who receives a tax deduction of $100 would have tax savings of $25, not $100 as the case would be if it was a tax credit.
If a taxpayer excludes amounts from his or her earned income under the foreign earned income exclusion, then the taxpayer cannot receive a foreign tax credit or deduction for taxes on the income that were excluded under the foreign earned income exclusion. It will be important for the taxpayer to determine whether he or she is in a better position receiving the foreign earned income exclusion or receiving the foreign tax credit applicable to the foreign earned income.
Generally, taxpayers who reside in countries with tax rates higher than the US will minimize their US tax exposure by only using the foreign tax credit; and taxpayers who reside in countries with tax rates lower than the US will minimize their US tax exposure by using the foreign earned income exclusion. Other factors will impact these general statements, such as marginal tax brackets and exclusions and deductions from income taxes.
The maximum foreign tax credit that can be claimed by a US taxpayer is limited to the lesser of foreign income tax paid (or deemed paid) or the foreign tax credit limitation. The foreign tax credit limitation is in place to prevent taxpayers from claiming more tax credits than the amounts of US income tax effectively imposed on foreign source income.
Credits for foreign taxes are divided into two categories: general income and passive income. Foreign tax paid on employment income falls into the general income category. Foreign tax paid on interest, rents, pensions, royalties, annuities, and capital gains fall into the passive category. Foreign taxes paid on income that falls into one category cannot be credited against foreign income that falls into the other category. Thus, a taxpayer with excess foreign tax credits in the general income category cannot apply them to offset insufficient foreign tax credits in the passive income category. That taxpayer will end up paying some US tax on his or her foreign passive income. The excess foreign tax credits in the general category can be carried back one year or forward ten years to offset US tax on foreign general category income.