Taxes of Foreign Countries & U.S. Possessions

You can take either a credit or a deduction for income taxes imposed on you by a foreign country or a U.S. possession. Taken as a deduction, foreign income taxes reduce your taxable income. Taken as a credit, foreign income taxes reduce your tax liability. You must treat all foreign income taxes in the same way. You generally cannot deduct some foreign income taxes and take a credit for others. However, regardless of whether you take a credit for foreign income taxes, you may be able to deduct other foreign taxes. See Deduction for Other Foreign Taxes, later.

There is no rule to determine whether it is to your advantage to take a deduction or a credit for foreign income taxes. In most cases, it is to your advantage to take foreign income taxes as a tax credit, which you subtract directly from your U.S. tax liability, rather than as a deduction in figuring taxable income. However, if foreign income taxes were imposed at a high rate, and the proportion of foreign income to U.S. income is small, a lower final tax may result from taking the foreign income tax deduction. In any event, you should figure your tax liability both ways and then use the one that is better for you.

You can make or change your choice within 10 years from the due date for filing your U.S. tax return for the tax year for which you make the claim.

The terms "foreign country" and "foreign taxes" include possessions of the United States and the income taxes imposed by these possessions. See Foreign Country, in chapter 4.

Foreign income taxes. These are generally income taxes you pay to any foreign country.

The foreign income tax you can claim is the amount of foreign income tax that is the legal and actual tax liability you pay or accrue during the year. The amount you claim is not necessarily the amount of tax withheld by the foreign country. You cannot take a foreign tax credit or deduction for income tax you paid to a foreign country that would be refunded by the foreign country if you made a claim for refund.

Subsidies. If a foreign country returns your foreign tax payments to you in the form of a subsidy, you cannot claim these payments as taxes qualified for the foreign tax credit. This rule applies to a subsidy provided by any means that is determined, directly or indirectly, by reference to the amount of tax, or to the base used to figure the tax.

Some ways of providing a subsidy are refunds, credits, deductions, payments, or discharges of obligations. The credit is also not allowed if the subsidy is given to a person related to you, or persons who participated in a transaction or a related transaction with you.

Foreign income taxes on U.S. return. Foreign income taxes can only be taken as a credit on Form 1040, line 43, or as an itemized deduction on Schedule A. These amounts cannot be included as withheld income taxes on Form 1040, line 58.

Foreign taxes paid on excluded income. You cannot take a credit or deduction for foreign income taxes paid on income that is exempt from tax under the foreign earned income exclusion, the foreign housing exclusion, or the possession exclusion. If your wages are completely excluded, you cannot deduct or take a credit for any of the foreign taxes paid on these wages.

If only part of your wages is excluded, you cannot deduct or take a credit for the foreign income taxes allocable to the excluded part. You find the taxes allocable to your excluded wages by applying a fraction to the foreign taxes paid on foreign earned income received during the tax year. The numerator (top number) of the fraction is your excluded foreign earned income received during the tax year minus deductible expenses allocable to that income (not including the foreign housing deduction). The denominator (bottom number) of the fraction is your total foreign earned income received during the tax year minus all deductible expenses allocable to that income (including the foreign housing deduction).

If foreign law taxes both earned income and some other amount (for example, unearned income, earned income from U.S. sources, or a type of income not subject to U.S. tax), and the taxes on the other amount cannot be segregated, the denominator of the fraction is the total amount of income subject to foreign tax minus deductible expenses allocable to that income.

If you take a foreign tax credit for tax on income you could have excluded under your choice to exclude foreign earned income or your choice to exclude foreign housing costs, one or both of the choices may be considered revoked.

At the time this publication was being prepared for print, Congress was considering legislation that would replace the foreign sales corporation (FSC) provisions with an extraterritorial income exclusion. If the pending legislation is enacted, foreign taxes paid on excluded extraterritorial income will not qualify for the foreign tax credit or the deduction for foreign taxes. For more information about this and other important tax changes, see Publication 553, Highlights of 2000 Tax Changes.

Credit for Foreign Income Taxes

If you take the foreign tax credit, you may have to file Form 1116 with Form 1040. Use Form 1116 to figure the amount of foreign tax paid or accrued that you can claim as a foreign tax credit. Do not include the amount of foreign tax paid or accrued as withheld federal income taxes on Form 1040, line 58.

Limit

The foreign tax credit is limited to the part of your total U.S. tax that is in proportion to your taxable income from sources outside the United States compared to your total taxable income. The allowable foreign tax credit cannot be more than your actual foreign tax liability.

Exemption from limit. You will not be subject to this limit and will not have to file Form 1116 if you meet all three of the following requirements.

1. Your only foreign source income for the tax year is passive income (dividends, interest, royalties, etc.) that is reported to you on a payee statement (such as a Form 1099-DIV or 1099-INT).
2. Your foreign taxes for the tax year that qualify for the credit are not more than $300 ($600 if filing a joint return) and are reported on a payee statement.
3. You elect this procedure for the tax year.

If you make this election, you cannot carry back or carry over any unused foreign tax to or from this tax year.

Separate limit. You must figure the limit on a separate basis with regard to each of the following categories of foreign source income (see the instructions for Form 1116).

• Passive income.
• High withholding tax interest.
• Financial services income.
• Shipping income.
• Certain dividends from a domestic international sales corporation (DISC) or former DISC.
• Certain distributions from a foreign sales corporation (FSC) or former FSC.
• Any lump-sum distributions from employer benefit plans for which a special averaging treatment is used to determine your tax.
• Section 901(j) income.
• Income resourced by treaty.
• All other income not included above (general limitation income).

Figuring the limit. In figuring taxable income in each category, you take into account only the amount that you must include in income on your federal tax return. Do not take any excluded amount into account.

To determine your taxable income in each category, deduct expenses and losses that are definitely related to that income.

Other expenses (such as itemized deductions or the standard deduction) not definitely related to specific items of income must be apportioned to the foreign income in each category by multiplying them by a fraction. The numerator (top number) of the fraction is your gross foreign income in the separate limit category. The denominator (bottom number) of the fraction is your gross income from all sources. For this purpose, gross income includes amounts that are otherwise exempt or excluded. You must use special rules for deducting interest expenses. For more information on allocating and apportioning your deductions, see Publication 514.

Exemptions. Do not take the deduction for exemptions for yourself, your spouse, or your dependents in figuring taxable income for purposes of the limit.

Recapture of foreign losses. If you have an overall foreign loss and the loss reduces your U.S. source income (resulting in a reduction of your U.S. tax liability), you must recapture the loss in later years when you have taxable income from foreign sources. This is done by treating a part of your taxable income from foreign sources in later years as U.S. source income. This reduces the numerator of the limiting fraction and the resulting foreign tax credit limit.

Foreign tax credit carryback and carryover. The amount of foreign income tax not allowed as a credit because of the limit can be carried back 2 years and carried forward 5 years.

More information on figuring the foreign tax credit can be found in Publication 514.

Deduction for Foreign Income Taxes

Instead of taking the foreign tax credit, you can deduct foreign income taxes as an itemized deduction on Schedule A (Form 1040).

You can claim a deduction only for those foreign income taxes paid on income that is subject to U.S. tax. You cannot claim a deduction for foreign taxes paid on income you exclude under the foreign earned income or housing exclusions.

Example. You are a U.S. citizen and qualify to exclude your foreign earned income. Your excluded wages in Country X are $70,000 on which you paid income tax of $10,000. You received dividends from Country X of $2,000 on which you paid income tax of $600.

You can claim a deduction for the $600 tax payment because the dividends relating to it are subject to U.S. tax. Because the wages are exempt from U.S. tax, you cannot claim a deduction for the income tax of $10,000.

If only a part of your earnings are excluded, see the earlier discussion under Foreign taxes paid on excluded income.

Deduction for Other Foreign Taxes

You can deduct real property taxes you pay that are imposed on you by a foreign country. You take this deduction on Schedule A (Form 1040). You cannot deduct other foreign taxes, such as personal property taxes, unless you incurred the expenses in a trade or business or in the production of income.

On the other hand, you generally can deduct personal property taxes when you pay them to U.S. possessions. But if you claim the possession exclusion, see Publication 570.

The deduction for foreign taxes other than foreign income taxes is not related to the foreign tax credit. You can take deductions for these miscellaneous foreign taxes and also claim the foreign tax credit for income taxes imposed by a foreign country.

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