The foreign tax credit is intended to relieve you of the double tax burden when your foreign source income is taxed by both the United States and the foreign country. Generally, if the foreign tax rate is higher than the U.S. rate, there will be no U.S. tax on the foreign income. If the foreign tax rate is lower than the U.S. rate, U.S. tax on the foreign income will be limited to the difference between the rates. The foreign tax credit can only reduce U.S. taxes on foreign source income; it cannot reduce U.S. taxes on U.S. source income.
Although no one rule covers all situations, it is generally better to take a credit for qualified foreign taxes than to deduct them as an itemized deduction. This is because:
- A credit reduces your actual U.S. income tax on a dollar-for-dollar basis, while a deduction reduces only your income subject to tax,
- You can choose to take the foreign tax credit even if you do not itemize your deductions. You then are allowed the standard deduction in addition to the credit, and
- If you choose to take the foreign tax credit, and the taxes paid or accrued exceed the credit limit for the tax year, you may be able to carry over or carry back the excess to another tax year. (See Limit on the Credit under How To Figure the Credit, later.)
For 2008, you and your spouse have adjusted gross income of $80,000, including $20,000 of dividend income from foreign sources. None of the dividends are qualified dividends. You file a joint return and can claim two $3,500 exemptions. You had to pay $2,000 in foreign income taxes on the dividend income. If you take the foreign taxes as an itemized deduction, your total itemized deductions are $15,000. Your taxable income then is $58,000 and your tax is $7,901.
If you take the credit instead, your itemized deductions are only $13,000. Your taxable income then is $60,000 and your tax before the credit is $8,201. After the credit, however, your tax is only $6,201. Therefore, your tax is $1,700 lower ($7,901 − $6,201) by taking the credit.taxmap/pubs/p514-001.htm#en_us_publink10001451
In 2008, you receive investment income of $5,000 from a foreign country, which imposes a tax of $3,500 on that income. You report on your U.S. return this income as well as $56,000 of income from U.S. sources. You are single, entitled to one $3,500 exemption, and have other itemized deductions of $7,100. If you deduct the foreign tax on your U.S. return, your taxable income is $46,900 ($5,000 + $56,000 − $3,500 − $7,100 − $3,500) and your tax is $8,075.
If you take the credit instead, your taxable income is $50,500 ($5,000 + $56,000 − $3,500 − $7,100) and your tax before the credit is $8,950. You can take a credit of only $734 because of limits discussed later. Your tax after the credit is $8,216 ($8,950 − $734), which is $141 ($8,216 − $8,075) more than if you deduct the foreign tax.
If you choose the credit, you will have unused foreign taxes of $2,766 ($3,500 − $734). When deciding whether to take the credit or the deduction this year, you will need to consider whether you can benefit from a carryback or carryover of that unused foreign tax.taxmap/pubs/p514-001.htm#en_us_publink10001452
You can claim the credit for a qualified foreign tax in the tax year in which you pay it or accrue it, depending on your method of accounting. "Tax year" refers to the tax year for which your U.S. return is filed, not the tax year for which your foreign return is filed.taxmap/pubs/p514-001.htm#en_us_publink10001453
If you use an accrual method of accounting, you can claim the credit only in the year in which you accrue the tax. You are using an accrual method of accounting if you report income when you earn it, rather than when you receive it, and you deduct your expenses when you incur them, rather than when you pay them.
Foreign taxes generally accrue when all the events have taken place that fix the amount of the tax and your liability to pay it. taxmap/pubs/p514-001.htm#en_us_publink10001454
If you are contesting your foreign tax liability, you cannot accrue it and take a credit until the amount of foreign tax due is finally determined. However, if you choose to pay the tax liability you are contesting, you can take a credit for the amount you pay before a final determination of foreign tax liability is made. Once your liability is determined, the foreign tax credit is allowable for the year to which the foreign tax relates. If the amount of foreign taxes taken as a credit differs from the final foreign tax liability, you may have to adjust the credit, as discussed later under Foreign Tax Redetermination. taxmap/pubs/p514-001.htm#en_us_publink10001455
If you claim a credit for taxes accrued but not paid, you may have to post an income tax bond to guarantee your payment of any tax due in the event the amount of foreign tax paid differs from the amount claimed.
The IRS can request this bond at any time without regard to the Time Limit on Tax Assessment, discussed later under Carryback and Carryover. taxmap/pubs/p514-001.htm#en_us_publink10001456
If you use the cash method of accounting, you can choose to take the credit either in the year you pay the tax or in the year you accrue it. You are using the cash method of accounting if you report income in the year you actually or constructively receive it, and deduct expenses in the year you pay them. taxmap/pubs/p514-001.htm#en_us_publink10001457
Even if you use the cash method of accounting, you can choose to take a credit for foreign taxes in the year they accrue. You make the choice by checking the box in Part II of Form 1116. Once you make that choice, you must follow it in all later years and take a credit for foreign taxes in the year they accrue.
In addition, the choice to take the credit when foreign taxes accrue applies to all foreign taxes qualifying for the credit. You cannot take a credit for some foreign taxes when paid and take a credit for others when accrued.
If you make the choice to take the credit when foreign taxes accrue and pay them in a later year, you cannot claim a deduction for any part of the previously accrued taxes. taxmap/pubs/p514-001.htm#en_us_publink10001458
If, in earlier years, you took the credit based on taxes paid, and this year you choose to take the credit based on taxes accrued, you may be able to take the credit this year for taxes from more than one year. taxmap/pubs/p514-001.htm#en_us_publink10001459
Last year you took the credit based on taxes paid. This year you chose to take the credit based on taxes accrued. During the year you paid foreign income taxes owed for last year. You also accrued foreign income taxes for this year that you did not pay by the end of the year. You can base the credit on your return for this year on both last year's taxes that you paid and this year's taxes that you accrued.taxmap/pubs/p514-001.htm#en_us_publink10001460
U.S. income tax is imposed on income expressed in U.S. dollars, while the foreign tax is imposed on income expressed in foreign currency. Therefore, fluctuations in the value of the foreign currency relative to the U.S. dollar will affect the foreign tax credit. taxmap/pubs/p514-001.htm#en_us_publink10001461
If you receive all or part of your income or pay some or all of your expenses in foreign currency, you must translate the foreign currency into U.S. dollars. How you do this depends on your functional currency. Your functional currency generally is the U.S. dollar unless you are required to use the currency of a foreign country.
You must make all federal income tax determinations in your functional currency. The U.S. dollar is the functional currency for all taxpayers except some qualified business units. A qualified business unit is a separate and clearly identified unit of a trade or business that maintains separate books and records. Unless you are self-employed, your functional currency is the U.S. dollar.
Even if you are self-employed and have a qualified business unit, your functional currency is the U.S. dollar if any of the following apply.
- You conduct the business primarily in dollars.
- The principal place of business is located in the United States.
- You choose to or are required to use the dollar as your functional currency.
- The business books and records are not kept in the currency of the economic environment in which a significant part of the business activities is conducted.
If your functional currency is the U.S. dollar, you must immediately translate into dollars all items of income, expense, etc., that you receive, pay, or accrue in a foreign currency and that will affect computation of your income tax. If there is more than one exchange rate, use the one that most properly reflects your income. You can generally get exchange rates from banks and U.S. Embassies.
If your functional currency is not the U.S. dollar, make all income tax determinations in your functional currency. At the end of the year, translate the results, such as income or loss, into U.S. dollars to report on your income tax return.
For more information, write to:
Internal Revenue Service
P.O. Box 920
Bensalem, PA 19020-8518.
Use the rate of exchange in effect on the date you paid the foreign taxes to the foreign country unless you meet the exception discussed next. If your tax was withheld in foreign currency, you use the rate of exchange in effect for the date on which the tax was withheld. If you make foreign estimated tax payments, you use the rate of exchange in effect for the date on which you made the estimated tax payment. taxmap/pubs/p514-001.htm#en_us_publink10001464
If you claim the credit for foreign taxes on an accrual basis, you must generally use the average exchange rate for the tax year to which the taxes relate. This rule applies to accrued taxes relating to tax years beginning after 1997 and only under the following conditions.
- The foreign taxes are paid on or after the first day of the tax year to which they relate.
- The foreign taxes are paid not later than 2 years after the close of the tax year to which they relate.
- The foreign tax liability is not denominated in an inflationary currency. (This condition applies to taxes paid or accrued in tax years beginning after November 6, 2007.)
For all other foreign taxes, you should use the exchange rate in effect on the date you paid them. taxmap/pubs/p514-001.htm#en_us_publink10001465
If you have accrued foreign taxes that you are otherwise required to convert using the average exchange rate, you may elect to use the exchange rate in effect on the date the foreign taxes are paid if the taxes are denominated in a foreign currency. If any of the accrued taxes are unpaid, you must translate them into U.S. dollars using the exchange rate on the last day of the U.S. tax year to which those taxes relate. You may make the election for all nonfunctional currency foreign income taxes or only those nonfunctional currency foreign income taxes that are attributable to qualified business units with a U.S. dollar functional currency. Once made, the election applies to the tax year for which made and all subsequent tax years unless revoked with the consent of the IRS. The election is available for tax years beginning after 2004. It must be made by the due date (including extensions) for filing the tax return for the first tax year to which the election applies. Make the election by attaching a statement to the applicable tax return. The statement must identify whether the election is made for all foreign taxes or only for foreign taxes attributable to qualified business units with a U.S. dollar functional currency.taxmap/pubs/p514-001.htm#en_us_publink10001466
A foreign tax redetermination is any change in your foreign tax liability that may affect your U.S. foreign tax credit claimed.
The time of the credit remains the year to which the foreign taxes paid or accrued relate, even if the change in foreign tax liability occurs in a later year.
If a foreign tax redetermination occurs, a redetermination of your U.S. tax liability is required if any of the following conditions apply.
- The accrued taxes when paid differ from the amounts claimed as a credit.
- The accrued taxes you claimed as a credit in one tax year are not paid within 2 years after the end of that tax year.If this applies to you, you must reduce the credit previously claimed by the amount of the unpaid taxes. You will not be allowed a credit for the unpaid taxes until you pay them. When you pay the accrued taxes, you must translate them into U.S. dollars using the exchange rate as of the date they were paid. The foreign tax credit is allowed for the year to which the foreign tax relates. See Rate of exchange for foreign taxes paid, earlier, under Foreign Currency and Exchange Rates.
- The foreign taxes you paid are refunded in whole or in part.
- For taxes taken into account when accrued but translated into dollars on the date of payment, the dollar value of the accrued tax differs from the dollar value of the tax paid because of fluctuations in the exchange rate between the date of accrual and the date of payment. However, no redetermination is required if the change in foreign tax liability for each foreign country is less than the smaller of:
- $10,000, or
- 2% of the total dollar amount of the foreign tax initially accrued for that foreign country for the U.S. tax year.
In this case, you must adjust your U.S. tax in the tax year in which the accrued foreign taxes are paid.
The notification requirements discussed here apply to foreign tax redeterminations occurring in:
- 2008 and later tax years.
- 2005, 2006, and 2007 if:
- The redetermination reduced the amount of foreign taxes you paid or accrued for any tax year, and
- As of November 7, 2007, you had not notified the IRS of the redetermination.
If you are required to notify the IRS about a redetermination of your U.S. tax liability for each tax year affected by the redetermination, you generally must file Form 1040X, Amended U.S. Individual Income Tax Return, with a revised Form 1116 and a statement that contains information sufficient for the IRS to redetermine your U.S. tax liability for the year or years affected. See Contents of statement later.
You are not required to attach Form 1116 for a tax year affected by a redetermination if:
- The amount of your creditable taxes paid or accrued during the tax year is not more than $300 ($600 if married filing a joint return) as a result of the foreign tax redetermination, and
- You meet the requirements listed under Exemption from foreign tax credit limit under How To Figure the Credit, later.
There are other exceptions to this requirement. They are discussed later under Due date of notification to IRS.taxmap/pubs/p514-001.htm#en_us_publink10001471
The statement must include all of the following.
- Your name, address, and taxpayer identification number.
- The tax year or years that are affected by the foreign tax redetermination.
- The date or dates the foreign taxes were accrued, if applicable.
- The date or dates the foreign taxes were paid.
- The amount of foreign taxes paid or accrued on each date (in foreign currency) and the exchange rate used to translate each amount.
- Information sufficient to determine any interest due from or owing to you, including the amount of any interest paid to you by the foreign government and the dates received.
In the case of any foreign taxes that were not paid before the date two years after the close of the tax year to which those taxes relate, you must provide the amount of those taxes in foreign currency and the exchange rate that was used to translate that amount when originally claimed as a credit.
If any foreign tax was refunded in whole or in part, you must provide the date and amount (in foreign currency) of each refund, the exchange rate that was used to translate each amount when originally claimed as a credit, and the exchange rate for the date the refund was received (for purposes of computing foreign currency gain or loss under Internal Revenue Code section 988).taxmap/pubs/p514-001.htm#en_us_publink10001472
If you pay less foreign tax than you originally claimed a credit for, you must file a notification by the due date (with extensions) of your original return for your tax year in which the foreign tax redetermination occurred. There is no limit on the time the IRS has to redetermine and assess the correct U.S. tax due. If you pay more foreign tax than you originally claimed a credit for, you have 10 years to file a claim for refund of U.S. taxes. See Time Limit on Refund Claims, later.
Exceptions to this due date are explained in the next three paragraphs.taxmap/pubs/p514-001.htm#en_us_publink10001473
If the redetermination occurred in 2005, 2006, or 2007, you must file the notification by the due date (including extensions) of your 2009 Form 1040 or Form 1040NR.taxmap/pubs/p514-001.htm#en_us_publink10001474
Where more than one foreign tax redetermination requires a redetermination of U.S. tax liability for the same tax year and those redeterminations occur in the same tax year or within two consecutive tax years, you can file for that tax year one notification (Form 1040X with a Form 1116 and the required statement) that reflects all those tax redeterminations. If you choose to file one notification, the due date for that notification is the due date of the original return (with extensions) for the year in which the first foreign tax redetermination that reduced your foreign tax liability occurred. However, foreign tax redeterminations with respect to the tax year for which a redetermination of U.S. tax liability is required may occur after the due date for providing that notification. In this situation, you may have to file more than one Form 1040X for that tax year.taxmap/pubs/p514-001.htm#en_us_publink10001475
If a foreign tax redetermination requires a redetermination of U.S. tax liability that would otherwise result in an additional amount of U.S. tax due, but the additional tax is eliminated by a carryback or carryover of an unused foreign tax, you do not have to amend your tax return for the year affected by the redetermination. Instead, you can notify the IRS by attaching a statement to the original return for the tax year in which the foreign tax redetermination occurred. You must file the statement by the due date (with extensions) of that return. The statement must show the amount of the unused foreign taxes paid or accrued and a detailed schedule showing the computation of the carryback or carryover (including the amounts carried back or over to the year for which a redetermination on U.S. tax liability is required).taxmap/pubs/p514-001.htm#en_us_publink10001476
If you fail to notify the IRS of a foreign tax redetermination and cannot show reasonable cause for the failure, you may have to pay a penalty.
For each month, or part of a month, that the failure continues, you pay a penalty of 5% of the tax due resulting from a redetermination of your U.S. tax. This penalty cannot be more than 25% of the tax due. taxmap/pubs/p514-001.htm#en_us_publink10001477
If you receive a foreign tax refund without interest from the foreign government, you will not have to pay interest on the amount of tax due resulting from the adjustment to your U.S. tax for the time before the date of the refund.
However, if you receive a foreign tax refund with interest, you must pay interest to the IRS up to the amount of the interest paid to you by the foreign government. The interest you must pay cannot be more than the interest you would have had to pay on taxes that were unpaid for any other reason for the same period. Interest also is owed from the time you receive a refund until you pay the additional tax due.taxmap/pubs/p514-001.htm#en_us_publink10001478
If your foreign tax refund is taxed by the foreign country, you cannot take a separate credit or deduction for this additional foreign tax. However, when you refigure the foreign tax credit taken for the original foreign tax, reduce the amount of the refund by the foreign tax paid on the refund. taxmap/pubs/p514-001.htm#en_us_publink10001479
You paid a foreign income tax of $3,000 in 2006, and received a foreign tax refund of $500 in 2008 on which a foreign tax of $100 was imposed. When you refigure your credit for 2006, you must reduce the $3,000 you paid by $400.taxmap/pubs/p514-001.htm#en_us_publink10001480
You have 10 years to file a claim for refund of U.S. tax if you find that you paid or accrued a larger foreign tax than you claimed a credit for. The 10-year period begins the day after the regular due date for filing the return for the year in which the taxes were actually paid or accrued.
You have 10 years to file your claim regardless of whether you claim the credit for taxes paid or taxes accrued. The 10-year period applies to claims for refund or credit based on:
- Fixing math errors in figuring qualified foreign taxes,
- Reporting qualified foreign taxes not originally reported on the return, or
- Any other change in the size of the credit (including one caused by correcting the foreign tax credit limit).
The special 10-year period also applies to making or changing your choice of whether to claim a deduction or credit for foreign taxes. See Making or Changing Your Choice discussed earlier under Choosing To Take Credit or Deduction.