U.S. Tax Break for Foreign Income Taxes on Investments Overseas
Who Can Claim the Credit?
If you are a U.S. citizen or resident, you are generally subject to U.S. income tax on your worldwide earnings. But foreign income taxes can be taken as either a deduction, reducing your income subject to U.S. tax, or as a credit, directly reducing your U.S. tax burden. The intent of this foreign tax deduction or credit is to reduce or eliminate the double tax burden that would otherwise result when the same income is taxed in both a foreign country and in the United States. The foreign tax credit is generally the lower of the actual foreign income tax paid or accrued, or the amount of U.S. income tax that would apply on that foreign-source income.
Generally, if you were a nonresident alien for U.S. tax purposes, or you were a citizen of a U.S. possession (except for Puerto Rico) but not a U.S. citizen, you are not eligible to claim the foreign tax credit. Bona fide residents of Puerto Rico are subject to the same rules as U.S. citizens and residents, and qualify for the foreign tax deduction or credit. And there is an exception for nonresident aliens of the U.S. who pay tax to a foreign country or U.S. possession on income that is effectively connected with a trade or business in the United States.
In order to qualify for the foreign tax credit, the tax must have been imposed on you, and you must have paid or accrued the tax. But there are instances in which you can claim the credit for foreign taxes that you did not directly pay or accrue yourself.
�· Taxpayers who are married filing jointly can claim the deduction or credit for foreign taxes paid or accrued by either spouse, or by both spouses.
�· Members of a partnership, or shareholders in an S corporation can claim the credit for their proportionate share of foreign income taxes paid or accrued by the partnership or S corporation and passed along to them. These amounts should be reported on Schedule K-1.
�· A beneficiary of a trust or estate can claim the credit based on a proportionate share of the foreign tax on the trust or estate.
�· Mutual fund shareholders can claim a credit for the foreign tax that the fund allocates to its shareholders, as reported on Form 1099-DIV.
Ã?· Shareholders of controlled foreign corporations (CFCs), who choose to be taxed at corporate rates on their income from the corporation can claim a credit for their share of the foreign taxes paid or accrued by the corporation. In this case, the credit would be claimed by filing Form 1118, Foreign Tax Credit – Corporations.
What Foreign Taxes Qualify for the Credit?
The foreign tax deduction or credit for individuals is available only for foreign income taxes, and not other types of foreign taxes such as real and personal property taxes. Foreign income taxes, for this purpose, include war profits and excess profits taxes, and taxes in lieu of income taxes.
Foreign real property taxes may be claimed as an itemized deduction in the Taxes section of Schedule A. Other foreign taxes could be deducted if they are expenses incurred in a trade or business, or for the production of income. In this case, these taxes would be reported on the applicable form, such as Schedule C or E.
If the United States has a treaty with the foreign country to avoid double taxation, and it is reasonably certain that any foreign tax paid will be refunded, or credited, or that a lower treaty rate will apply, the foreign tax credit for U.S. income tax purposes can only be claimed for the amount that will effectively be charged, after any refund or credit, or that will be imposed at the lower treaty tax rate.
Foreign Earned Income
If you have income from personal services you performed in a foreign country, either as an employee or self-employed in your own business, you may be better off to claim the foreign earned income exclusion. This tax break allows you to exclude from your U.S. taxable income up to a certain amount of income earned in a foreign country ($80,000 for 2005). To claim the foreign earned income exclusion, you would need to file Form 2555 or 2555EZ.
If you claim the exclusion, you would not be able to claim a deduction or credit on your U.S. income tax return for the foreign income tax on your earned income.
Foreign Tax on Investments
The foreign tax credit applies to passive income, or investment income such as interest and dividends. For example, if you have diversified your investment portfolio to include investments in other countries, you may have incurred taxable income in one or more foreign countries. The foreign tax that was paid on these dividends or distributions is reported in box 6 of Form 1099-DIV – Dividends and Distributions, that you receive from your investment fund manager, or on Form 1099-INT in the case of interest income.
Holding Period for Stocks
If you directly own stocks on a foreign stock exchange and you have foreign income tax on dividends from those stocks, there is a holding period requirement in order to qualify for the foreign tax credit:
�· For common stock, you must have held the stock for at least 16 days during the 31-day period that begins 15 days before the ex-dividend date.
�· For preferred stock, if the dividends cover a period of 366 days or more, you must have held the stock for at least 46 days during the 91-day period that begins 45 days before the ex-dividend date.
There is an exception to these holding period rules for securities dealers.
Itemized Deduction
As an individual taxpayer, you can claim these foreign taxes as an itemized deduction on Schedule A, along with other taxes you paid, such as real estate taxes and state and local income taxes. You would report the amount of the foreign taxes separately, in the Taxes section of Schedule A, and indicate on the dotted line next to the amount that this deduction is for “Foreign Taxes”, or “Foreign Tax from 1099-DIV”, if applicable.
By doing this you are increasing your itemized deductions, reducing your taxable income, and therefore reducing your U.S. tax at your effective tax rate. The net tax benefit would therefore be the amount of the foreign taxes times your effective tax rate, assuming you are not subject to any limitation on the amount of your itemized deductions because of the level of your adjusted gross income.
If you take the standard deduction instead of itemizing, you can claim the foreign tax credit.
Foreign Tax Credit
Claiming a credit rather than a deduction directly reduces your U.S. income tax by the same amount of the foreign taxes you paid. Assuming there are no limitations on the amount of the credit you can claim, you would be able to take advantage of 100% of the foreign taxes to reduce your U.S. taxes. Therefore, claiming a credit rather than a deduction will generally provide you with a greater tax benefit.
Form 1116 and the Exception
To claim a credit for foreign taxes, you would generally have to file Form 1116. But if you meet certain requirements, you may be able to avoid filing this form and report the credit directly on Form 1040. These requirements are:
�· Your only gross taxable income from foreign sources is passive income, such as investment income, including interest, dividends, annuities, rents, and royalties.
�· Your foreign income is reported on a payee statement, such as a 1099-DIV, or 1099-INT.
�· Your total foreign taxes are $300 or less, if you are single, and $600 or less, if you are married filing jointly.
If you meet these requirements, and choose not to file Form 1116, you can report the credit directly on line 44 of your Form 1040. In this case you would have to file Form 1040, and not 1040A or 1040EZ.
If you complete Form 1116, you will need to know the amount of the foreign income corresponding to the foreign income tax, and the country in which the income was earned. If your foreign tax comes from income on investments, such as in a mutual fund, there is a box on Form 1099-DIV to indicate the country (box 7). But the mutual fund may have investments in more than one foreign country. In this case, you would need to refer to the annual report you receive from the mutual fund, or from your broker, to find the corresponding foreign income by country.
If you qualify, and you choose to claim the foreign tax credit directly on Form 1040, rather than filing Form 1116, you will not be able to carry back or carry forward any foreign tax credit that you cannot use in the current year. By filing Form 1116, if you cannot use the full amount of the foreign tax this year, because of the limitation described below, you are to carry back and carry forward any unused portion of the credit. For tax years beginning after October 22, 2004, any unused foreign taxes can be carried back one year and carried forward for 10 years.
Foreign Tax Credit Limitation
Your foreign tax credit is limited to the smaller of the actual foreign tax you paid, or the equivalent U.S. income tax that would apply on the foreign income at your effective U.S. tax rate. This limitation is built into the calculations of the allowable foreign tax credit on Form 1116. The effect of this limitation is that, if the foreign tax rate is higher than your effective U.S. tax rate, there will be no U.S. tax on the related foreign-source income. And, if the foreign tax rate is lower than the U.S. tax rate, you will be subject to U.S. income tax on the foreign income for the difference in the tax rates. But, even if the limitation applies, you will normally get a bigger tax benefit by claiming the foreign tax credit rather than an itemized deduction.
If you qualify, and choose to claim the credit directly on Form 1040, without filing Form 1116, the limitation does not apply. As indicated above, this would only apply if your foreign tax credit is $300 or less if you are single, and $600 or less if you are married filing jointly.
Foreign Tax Refund
If all or part of the foreign taxes are subsequently refunded, you will have to file an amended U.S. income tax return (Form 1040X), and a revised Form 1116, if applicable, for the year in which you originally claimed the deduction or credit.
Choosing the Deduction or the Credit
For each year you have foreign taxes you can choose whether to claim the itemized deduction or the foreign tax credit. You can change your choice from one year to another. But generally, you must claim either the deduction or the credit for all your foreign taxes in a given year – you cannot claim a deduction for part of them and a credit for the rest. If you are in doubt as to which method provides the most tax benefit, you may want to calculate your taxes both ways.
Foreign Currency Conversion
If the foreign tax is paid in a foreign currency, you have to convert it to dollars to determine the amount of your deduction or credit for U.S. income tax purposes. The way you convert the foreign currency depends on your functional currency. Generally this is the U.S. dollar, unless you are required to use a foreign currency. If you are an individual with investments overseas that are generating foreign income and foreign income taxes, your functional currency is the U.S. dollar. Generally, only a separate business entity that maintains its books in a foreign currency would have a functional currency other than the U.S. dollar. If you are reporting foreign income tax from a payee statement, such as Form 1099-DIV or 1099-INT, the amount will be expressed in U.S. dollars.
If you are claiming a deduction or credit for foreign income tax that is not reported on a payee statement, and your functional currency is the U.S. dollar, you would have to translate the foreign currency amounts into U.S. dollars at the time you receive the income and on the date(s) you pay the taxes. If the taxes are withheld from your income, you would use the exchange rate in effect on the withholding date. According to the Internal Revenue Service, if there is more than one exchange rate in effect for that particular currency, you should use the rate that “most properly reflects your income”.
If your functional currency is not the U.S. dollar, you would determine your income and expense in the functional currency, and then at the end of the year, translate the results (net income or loss) into U.S. dollars to report on your tax return.
