A Comprehensive Guide to Foreign Tax Credit (FTC) with Form 1116

For U.S. citizens residing abroad, IRS Form 1116 can be beneficial to avoid double taxation on income that you earn in a foreign country. It allows you to claim the Foreign Tax Credit (FTC) and reduces your tax liability in the US by the amount of foreign income taxes you have paid. Filing Form 1116 will help you ensure that you are not being taxed twice in two different nations.

It means once by the U.S. and again by the foreign country from where you acquired the income. You may have to take actions based on the foreign income type that you have earned and the amount of foreign tax you have paid to claim the credit.

Keep reading our guide to learn more about Form 1116 and determine whether you are eligible to claim this tax credit.

What is the Foreign Tax Credit?

The foreign tax credit is a U.S. tax credit designed to offset income tax paid abroad. Resident aliens and U.S. citizens can claim the credit if they pay income taxes enforced by a foreign country or a U.S. possession. Claiming the credit can help you lower your U.S. tax liability as well as ensure that you are not being taxed twice on the same income.

Claiming Foreign Income on Your Tax Return

The IRS wants U.S. citizens and U.S. resident aliens to report and pay taxes on their worldwide income. It includes both those who hold a U.S. green card and those who fulfill the significant presence test. However, the taxpayers must be aware of some implications that are involved.

What are the Options to Avoid Double Taxation?

The IRS offers several options to Americans staying abroad to help them avoid double taxation, which are as follows:

• Utilize Form 1116 to claim the Foreign Tax Credit (FTC) and deduct the amount of taxes they paid in another country from whatever they are liable to pay to the IRS.
• Subtract their foreign taxes on Schedule A, similar to other common deductions.
• Completing Form 2555 to claim the Foreign Earned-Income Exclusion (FEIE) that permits qualifying individuals to avoid some or all of their foreign-earned income from their U.S. taxes.

Claiming the FTC will help you lower your U.S. tax liability significantly in most situations.

Foreign Tax Credit Eligibility

Not all the taxes you pay to a foreign government can be claimed as a credit against the U.S. federal income tax. The taxes paid in another country will qualify for the FTC when you:

• were obligated legally to pay the tax
• have already paid or accrued the tax
• did not receive any gain from paying tax, and
• You paid the tax on your income to either a local or a provincial government

Apart From These, Some Taxes do not Qualify to be Included in the FTC:

• taxes paid to a restricted country
• taxes paid for a foreign tax splitting event
• taxes from international boycott operations
• taxes on foreign mineral, oil, and gas income
• taxes paid to a foreign government, including sales tax, value-added tax, real estate taxes, or luxury taxes
• Social Security taxes paid or accrued to a foreign country that has a Social Security Agreement with the U.S.
• Taxes on income that was not included in your U.S. gross income (you are not allowed to claim a credit for foreign taxes for those wages earned in another country, and you didn't include it as a part of your U.S. income).

Form 1116 Overview

If you have only a single foreign income type, you are required to fill out only Form 1116. Additionally, all those filing Form 1116 must choose how they view their income, which can be either on an accrual basis or a cash basis.

• You use the accrual method if you record income when it is earned, rather than when it is received.
• Conversely, for the cash basis, if you record your income when you receive it, you can use this method. Also, it is the most used method. 

Remember, you need to convert every amount to U.S. dollars that you report on Form 1116, unless otherwise stated. You must use the conversion rate that is in effect on the day you paid your foreign taxes or the date they were withheld. In case you select the accrual method, you can use the average exchange rate in effect during that specific tax year.

If you read the instructions for Form 1116, you can understand each line item, and it also includes worksheets. The form has four sections, using which you provide detailed information:

• Part 1: used to calculate taxable income from one to three countries
• Part 2: lists the taxes paid in both foreign currency and their U.S. dollar equivalent
• Part 3: Figures out the FTC for the income category
• Part 4: to aggregate all credits from each income category.

In case your credit is more than your U.S. tax obligation, utilize the extra amount to reduce your taxes in the future. Moreover, remember that if a foreign tax redetermination (recalculation to your benefit) takes place, you need to file a Form 1040-X to inform the IRS about the changes. Failing to notify could lead to fines.

How to Report Foreign Income With Form 1116?

Once you classify your foreign income according to the category, you need to complete an individual form for each of the seven income types that you may have:

1. Passive Category Income: It includes income received from interest, dividends, royalties, and annuities.
2. Lump-Sum Distributions: Income that you acquire from a foreign-sourced pension plan.
3. Section 951A Category Income: It is a global intangible low-taxed income (GILT) introduced by U.S. shareholders of some controlled foreign corporations, but doesn't include any passive category income.
4. Foreign Branch Category Income: It involves profits in a business made by U.S. persons from one or more qualified business units (QBUs) in more than one foreign country. However, it doesn't include passive category income.
5. General Category Income: It includes your wages, salary, and any highly taxed passive income. Income becomes "highly-taxed" for the IRS's purpose when the tax rate of the foreign country is higher than the tax rate of the U.S.
6. Section 90(j) Countries: Countries that the U.S. authorizes for repeatedly offering support for the acts of international terrorism, countries with which the U.S. does not maintain diplomatic relations, or countries whose governments are not recognized by the U.S. You need to report earnings that you acquire from any of them.
7. Resourced by Treaty: Specific income that is resourced by treaty relates to tax treaties that the U.S. has with other countries. Fill out Form 1116 for this category if the country where you have worked has a special agreement with the U.S. regarding how the country will tax your income as a foreigner. Under this agreement, all your income, including any money you acquire in the U.S., will be considered as income from the treaty country when calculating the taxes you are liable to pay.

How to Claim Foreign Tax Credit Without Form 1116?

There might be situations that might permit you to claim the FTC without filing Form 1116 if the concerned income satisfies the qualifying definition. Let's understand this with an example:

• If your foreign-taxed income was 1099-reported passive income, like interest and dividends, you are not required to complete Form 1116. This applies if any dividends are acquired from the stock that you owned for a minimum of 16 days.
• Single filers who spend $300 or less in foreign taxes, and who are married to a joint filer who paid $600 or less, can avoid filing Form 1116. However, filing the form will help you carry forward any leftover credit balance to future tax years.
• Suppose you acquired the income from a U.S. territory like American Samoa, Puerto Rico, Guam, or the U.S. Virgin Islands. In that case, special rules control how you utilize Form 1116 to claim the Foreign Tax Credit.

What are Refundable and Non-Refundable Tax Credits?

The tax credit can either be refundable or non-refundable. A refundable tax credit provides a refund if the tax credit is more than your tax bill. For example, if you apply for a $5,300 refundable tax credit to a $5,000 tax bill, you will get a refund of $300.

A non-refundable tax credit will not provide a refund, as it only lowers the tax you are responsible for paying to zero. If the $5,300 tax credit were non-refundable, you would owe nothing to the government. However, you will also lose the leftover amount of $400 after the credit is applied.

Many tax credits, including the foreign tax credit, are non-refundable.

What is the Difference Between Tax Credits and Tax Deductions?

Although both tax credits and tax deductions help you save money, there is a difference between the two.

Tax credits reduce the tax that you need to pay dollar-for-dollar; on the other hand, tax deductions will reduce the amount of taxable income. A $1,000 tax credit will reduce your tax bill by $1,000. On the contrary, a $1,000 tax deduction will lower your taxable income. If you are in the 25% tax bracket, a $1,000 tax deduction will save you nearly $250 on your tax bill.

What is the Difference Between The Foreign Tax Credit and the Foreign Earned Income Exclusion?

The foreign tax credit and the foreign earned income exclusion are the two ways that help you avoid double taxation on the income that you earn while staying abroad. The main difference between the two is the income to which each applies. The foreign tax credit is applicable to both earned and unearned income, such as dividends and interest. On the contrary, the foreign earned income exclusion only applies to earned income.

To Conclude

The foreign tax credit is a U.S. tax break that balances income tax paid to other countries. The tax must be enforced on you by a foreign country or U.S. possession, and you must have paid the tax to be eligible to claim the FTC. Generally, taxes on income, wages, dividends, interest, and royalties qualify for the foreign tax credit.

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