The Foreign Tax Credit: A Guide for U.S. Taxpayers with Foreign Income

The Foreign Tax Credit is a provision in the U.S. tax code that lets taxpayers claim a credit for foreign income taxes paid or accrued during the tax year. This credit is designed to ensure that U.S. taxpayers are not unfairly taxed twice on the same income—once by the foreign country and again by the U.S.

To qualify for the Foreign Tax Credit, the following requirements must be met:

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1. The Tax Must Be an Income Tax:

   • The tax must be a foreign income tax or a tax imposed in lieu of an income tax.

   • Non-income taxes such as sales tax or value-added taxes (VAT) do not qualify.

2. Actual Payment or Accrual:

   • The tax must be legally owed and either paid or accrued. It cannot be voluntary.

3. Foreign-Source Income:

   • The income on which the foreign tax is imposed must be derived from foreign sources.

If these conditions are met, the taxpayer can proceed to calculate the amount of credit that can be claimed.

The FTC is subject to a credit limit, which ensures that the credit does not exceed the portion of U.S. tax liability attributable to foreign-source income. The calculation involves the following steps:

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1. Determine Foreign-Source Taxable Income:

   • Calculate the portion of your taxable income that is earned in foreign countries.

2. Calculate Total U.S. Tax Liability:

   • Determine the total U.S. tax owed on all income.

3. Apply the FTC Limit:

   • Use the formula:

FTC Limit= (Foreign− Source Taxable Income/ Total Taxable Income)×Total U.S. Tax Liability FTC Limit = (Foreign-Source Taxable Income / Total Taxable Income) \times Total U.S. Tax Liability

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If your foreign taxes paid exceed the FTC limit, the unused portion can be carried back to the previous tax year or carried forward for up to 10 years, maximizing the benefit of the credit.

To claim the Foreign Tax Credit, taxpayers must file IRS Form 1116, “Foreign Tax Credit,” along with their U.S. tax return. This form requires details such as:

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• Foreign income earned

• Foreign taxes paid or accrued

• Calculation of the credit limit

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Simplified Rules: If the foreign taxes paid are $300 or less ($600 for married couples filing jointly), and other eligibility requirements are met, you can claim the credit directly on your tax return without filing Form 1116.

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Foreign Tax Credit vs. Foreign Earned Income Exclusion

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Taxpayers earning foreign income have an additional option—the Foreign Earned Income Exclusion (FEIE). For 2024, the FEIE allows qualifying taxpayers to exclude up to $126,500 of foreign-earned income from U.S. taxation.

Key Point: You cannot claim the Foreign Tax Credit on income excluded under the FEIE. Therefore, taxpayers must evaluate whether the FTC or FEIE provides the greater tax benefit based on their income and foreign taxes paid.