“The foreign tax credit is intended to reduce the double tax burden that would otherwise arise when foreign source income is taxed by both the United States and the foreign country from which the income is derived.”
IRS, Topic 856 – Foreign Tax Credit

The US has a worldwide tax regime.  Therefore, US persons are required to pay taxes on their worldwide income. The intent of foreign tax credit is to reduce or eliminate the burden of double taxation.

If foreign source income reported by a US person has been subject to taxes by a foreign country, and the same income is subject to US tax then this individual may be able to take a credit or deduction.

X, a US person, earned foreign interest income of $500 on which he paid foreign taxes of $150 to a foreign country.  X has $150 foreign taxes paid to calculate his foreign tax credit.

Foreign taxes paid may be taken as an itemized deduction and result in a reduction of US taxable income.  Alternatively, if foreign taxes paid are taken as a tax credit then it directly reduces the individual’s US tax liability.  Usually it’s more advantageous to take a credit for foreign income taxes paid.

If foreign source income has been excluded from US income taxes, then foreign income tax credit cannot be taken even if foreign income taxes have been paid on such income.  A common example of income that has been excluded from US income taxes is income for which foreign earned income exclusion has been taken.

Z, a US person, worked overseas during 2012 and earned income of $50,000.  Z paid foreign income taxes of $10,000 on his earnings to a foreign country.  Z had no other foreign income subject to foreign income taxes. On his 2012 US income tax return, Z reported total income of $100,000 and took a foreign earned income exclusion of $50,000.  Even though Z had foreign income taxes paid of $10,000 he cannot take a foreign tax credit as all foreign income subject to foreign taxes was excluded for US income taxes.

The amount of foreign tax credit can be lower than the actual foreign taxes paid depending on the individual’s foreign tax credit limit.  Proper computation of foreign tax credit is valuable to individuals, for besides reducing current tax liability, subject to certain provisions, unused foreign tax credits have one year carryback and ten year carryover.

Disclaimer: Every individual’s tax situation is different and tax situations change over time. This article is intended to give general information to enable the reader to discuss their situation with a tax adviser.  It is not intended to be tax or legal advice and should not be construed as such.

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