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,
For 2000, you and your spouse have adjusted gross income of
$80,000, including $20,000 of dividend income from foreign sources.
You file a joint return and can claim two $2,800 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 $10,000. Your taxable income then is $64,400 and your
tax is $12,339.
If you take the credit instead, your itemized deductions are only
$8,000. Your taxable income then is $66,400 and your tax before the
credit is $12,899. After the credit, however, your tax is only
$10,899. Therefore, your tax is $1,440 lower ($12,339 - $10,899)
by taking the credit.
In 2000 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 $2,800 exemption, and have
other itemized deductions of $5,400. If you deduct the foreign tax on
your U.S. return, your taxable income is $49,300 ($5,000 + $56,000
- $2,800 - $5,400 - $3,500) and your tax is $10,399.
If you take the credit instead, your taxable income is $52,800
($5,000 + $56,000 - $2,800 - $5,400) and your tax before
the credit is $11,379. You can take a credit of only $933 because of
limits discussed later. Your tax after the credit is $10,446 ($11,379
- $933), which is $47 ($10,446 - $10,399) more than if you
deduct the foreign tax.
If you choose the credit, you will have unused foreign taxes of
$2,567 ($3,500 - $933). 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.
Credit for Taxes
Paid or Accrued
You can claim the credit for a qualified foreign tax in the tax
year in which you pay 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
Accrual method of accounting.
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. 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
You may have to post a bond.
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
The IRS can request this bond at any time without regard to the
Time Limit on Tax Assessment, discussed later under
Carryback and Carryover.
Cash method of accounting.
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.
Choosing to accrue taxes.
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 accrue foreign taxes applies to
all foreign taxes qualified for the credit. You cannot take
a credit for some foreign taxes when paid and take a credit for others
If you make the choice to accrue foreign taxes and pay them in a
later year, you cannot claim a deduction for any part of the
previously accrued taxes.
Credit based on taxes paid in earlier year.
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
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
Foreign Currency and
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, the tax credit is affected when the foreign
currency depreciates or appreciates in value in terms of U.S. dollars.
Translating foreign currency into U.S. dollars.
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
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 dollar if any of the following apply.
- You conduct the business in dollars.
- The principal place of business is located in the United
- You choose to or are required to use the dollar as your
- 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
International Returns Section
P.O. Box 920
Bensalem, PA 19020-8518.
Rate of exchange for foreign taxes paid.
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.
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, but not later than 2 years after the
close of that tax year.
- The foreign taxes are not paid in an inflationary currency.
For all other foreign taxes, you should use the exchange rate in
effect on the date you paid them.
Foreign Tax Redetermination
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 in the following situations.
Tax years beginning before 1998.
For tax years beginning before 1998, a redetermination of your
U.S. tax liability is required if:
- You must pay additional foreign taxes,
- You receive a refund of foreign taxes paid, or
- There is a change in the dollar amount of your foreign tax
credit because of differences in the exchange rate at the time the
foreign taxes were accrued and the time they were paid.
See Rate of exchange for foreign taxes paid, earlier
under Foreign Currency and Exchange Rates.
When redetermination of tax is not required.
A redetermination is not required if the change is due solely to an
exchange rate fluctuation and the change in foreign tax liability for
the tax year 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.
In this case, you must adjust your U.S. tax in the tax year in
which the accrued foreign taxes are paid.
Tax years beginning after 1997.
For tax years beginning after 1997, a redetermination of your U.S.
tax liability is required if:
- The accrued taxes when paid differ from the amount you
claimed as a credit. But, see When redetermination of tax is not
- The accrued taxes you claimed as a credit in one tax year
are not paid within two years after the end of that tax year,
- The foreign taxes you paid are refunded in whole or in part
by the foreign taxing authority.
If (2) above applies to you, 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
When redetermination of tax is not required.
If the accrued taxes when paid differ from the amount you claimed
as a credit only because of the fluctuation in the currency exchange
rate, a redetermination is not required if the amount is paid within
two years after the close of the tax year to which the taxes relate.
Notice to the Internal Revenue Service of redetermination.
You must file Form 1040X, Amended U.S. Individual Income Tax
Return, and a revised Form 1116 for the tax year affected by the
redetermination. The IRS will redetermine your U.S. tax liability for
the year or years affected.
If you pay less foreign tax than you originally claimed a credit
for, you must file Form 1040X and a revised Form 1116 within 180 days
after the 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.
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
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.
Foreign tax refund.
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.
Foreign tax imposed on foreign refund.
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 credit taken for the original tax,
reduce the refund by the foreign tax paid on the refund.
You paid a foreign income tax of $3,000 in 1998, and received a
foreign tax refund of $500 in 2000 on which a foreign tax of $100 was
imposed. When you refigure your credit for 1998, you must reduce the
$3,000 you paid by $400.
Time Limit on Refund Claims
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.
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