Important Reminders

Exemption from foreign tax credit limit.   If your only foreign income is passive income and the total of all your foreign taxes shown on Forms 1099-DIV, Dividends and Distributions, 1099-INT, Interest Income, and similar statements is not more than $300 ($600 if married filing jointly), you can make an election not to be subject to the foreign tax credit limit. If you make this election, you can claim a foreign tax credit without filing Form 1116, Foreign Tax Credit (Individual, Estate, Trust, or Nonresident Alien Individual). See How To Figure the Credit.

Change of address.   If your address changes from the address shown on your last return, use Form 8822, Change of Address, to notify the Internal Revenue Service.

Photographs of missing children.   The Internal Revenue Service is a proud partner with the National Center for Missing and Exploited Children. Photographs of missing children selected by the Center may appear in this publication on pages that would otherwise be blank. You can help bring these children home by looking at the photographs and calling 1-800-THE-LOST (1-800-843- 5678) if you recognize a child.

Introduction

If you paid or accrued foreign taxes to a foreign country on foreign source income and are subject to U.S. tax on the same income, you may be able to take either a credit or an itemized deduction for those taxes. Taken as a deduction, foreign income taxes reduce your U.S. taxable income. Taken as a credit, foreign income taxes reduce your U.S. tax liability.

In most cases, it is to your advantage to take foreign income taxes as a tax credit. The major scope of this publication is the foreign tax credit.

The publication discusses:

• How to choose to take the credit or the deduction,
• Who can take the credit,
• What foreign taxes qualify for the credit,
• How to figure the credit, and
• How to carry over unused foreign taxes to other tax years.

Unless you choose not to be subject to the foreign tax credit limit, you claim the credit by filing Form 1116 with your U.S. income tax return. Two examples with filled-in Forms 1116 are provided at the end of this publication.

Comments and suggestions.   We welcome your comments about this publication and your suggestions for future editions.

You can e-mail us while visiting our web site at www.irs.gov.

You can write to us at the following address:

Internal Revenue Service
Tax Forms and Publications
W:CAR:MP:T
1111 Constitution Ave. NW
Washington, DC 20224

We respond to many letters by telephone. Therefore, it would be helpful if you would include your daytime phone number, including the area code, in your correspondence.

Useful Items

You may want to see:

Publication

• 54   Tax Guide for U.S. Citizens and Resident Aliens Abroad
• 519   U.S. Tax Guide for Aliens
• 570   Tax Guide for Individuals With Income From U.S. Possessions

Form (and Instruction)

• 1116   Foreign Tax Credit

See How To Get Tax Help near the end of this publication for information about getting these publications and this form.

Choosing To Take
Credit or Deduction

You can choose each tax year to take the amount of any qualified foreign taxes paid or accrued during the year as a foreign tax credit or as an itemized deduction. You can change your choice for each year's taxes.

To choose the foreign tax credit, you generally must complete Form 1116 and attach it to your U.S. tax return. However, you may qualify for the exception that allows you to claim the foreign tax credit without using Form 1116. See How To Figure the Credit, later. To choose to claim the taxes as an itemized deduction, use Schedule A (Form 1040), Itemized Deductions.

Figure your tax both ways - claiming the credit and claiming the deduction. Then fill out your return the way that benefits you most. See Why Choose the Credit, later.

Choice Applies to All
Qualified Foreign Taxes

As a general rule, you must choose to take either a credit or a deduction for all qualified foreign taxes.

If you choose to take a credit for qualified foreign taxes, you must take the credit for all of them. You cannot deduct any of them. Conversely, if you choose to deduct qualified foreign taxes, you must deduct all of them. You cannot take a credit for any of them.

See What Foreign Taxes Qualify for the Credit, later, for the meaning of qualified foreign taxes.

There are exceptions to this general rule, which are described next.

Exceptions for foreign taxes not allowed as a credit.   Even if you claim a credit for other foreign taxes, you can deduct any foreign tax that is not allowed as a credit if:

1. You paid the tax to a country for which a credit is not allowed because it provides support for acts of international terrorism, or because the United States does not have diplomatic relations with it or recognize its government,
2. You paid withholding tax on dividends from foreign corporations whose stock you did not hold for the required period of time,
3. You participated in or cooperated with an international boycott, or
4. You paid taxes in connection with the purchase or sale of oil or gas.

For more information on these items, see the discussion later under Foreign Taxes for Which You Cannot Take a Credit.

Foreign taxes that are not income taxes.   Generally, only foreign income taxes qualify for the foreign tax credit. Other taxes, such as foreign real and personal property taxes, do not qualify. But you may be able to deduct these other taxes even if you claim the foreign tax credit for foreign income taxes.

You generally can deduct these other taxes only if they are expenses incurred in a trade or business or in the production of income. However, you can deduct foreign real property taxes that are not trade or business expenses as an itemized deduction on Schedule A (Form 1040).

Carrybacks and carryovers.   There is a limit on the credit you can claim in a tax year. If your qualified foreign taxes exceed the credit limit, you may be able to carry over or carry back the excess to another tax year. If you deduct qualified foreign taxes in a tax year, you cannot use a carryback or carryover in that year. That is because you cannot take both a deduction and a credit for qualified foreign taxes in the same tax year.

For more information on the limit, see How To Figure the Credit, later. For more information on carrybacks and carryovers, see Carryback and Carryover, later.

Making or Changing
Your Choice

You can make or change your choice to claim a deduction or credit at any time during the period within 10 years from the due date for filing the return for the tax year for which you make the claim. You make or change your choice on your tax return (or on an amended return) for the year your choice is to be effective.

Example.   You paid foreign taxes for the last 13 years and chose to deduct them on your U.S. income tax returns. You were timely in both filing your returns and paying your U.S. tax liability. In February 2002, you file an amended return for tax year 1991 choosing to take a credit for your 1991 foreign taxes because you now realize that the credit is more advantageous than the deduction for that year. Because your return for 1991 was not due until April 15, 1992, this choice is timely (within 10 years).

Because there is a limit on the credit for your 1991 foreign tax, you have unused 1991 foreign taxes. Ordinarily, you first carry back unused foreign taxes and claim them as a credit in the 2 preceding tax years. If you are unable to claim all of them in those 2 years, you carry them forward to the 5 years following the year in which they arose.

Because you originally chose to deduct your foreign taxes and the 10-year period for changing the choice for 1989 and 1990 has passed, you cannot carry the unused 1991 foreign taxes back to tax years 1989 and 1990.

Because the 10-year periods have not passed for your 1992 through 1996 income tax returns, you can still choose to carry forward any unused 1991 foreign taxes. However, you must reduce the unused 1991 foreign taxes that you carry forward by the amount that would have been allowed as a carryback if you had timely carried back the foreign tax to tax years 1989 and 1990.

You cannot take a credit or a deduction for foreign taxes paid on income you exclude under the foreign earned income exclusion or the foreign housing exclusion.

Why Choose the Credit?

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:

1. 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,
2. 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
3. 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, later.)

Example 1.   For 2002, 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 $3,000 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 $64,000 and your tax is $11,083.

If you take the credit instead, your itemized deductions are only $8,000. Your taxable income then is $66,000 and your tax before the credit is $11,623. After the credit, however, your tax is only $9,623. Therefore, your tax is $1,460 lower ($11,083 - $9,623) by taking the credit.

Example 2.   In 2002, 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 $3,000 exemption, and have other itemized deductions of $5,400. If you deduct the foreign tax on your U.S. return, your taxable income is $49,100 ($5,000 + $56,000 - $3,000 - $5,400 - $3,500) and your tax is $9,610.

If you take the credit instead, your taxable income is $52,600 ($5,000 + $56,000 - $3,000 - $5,400) and your tax before the credit is $10,555. You can take a credit of only $865 because of limits discussed later. Your tax after the credit is $9,690 ($10,555 - $865), which is $80 ($10,156 - $9,690) more than if you deduct the foreign tax.

If you choose the credit, you will have unused foreign taxes of $2,635 ($3,500 - $865). 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 it 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 filed.

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 Tax Redetermination.

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 amount claimed.

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 take credit in the year taxes accrue.   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 take the credit when foreign taxes accrue 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 when accrued.

If you make the choice to take the credit when foreign taxes accrue 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 year.

Example.   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 accrued.

Foreign Currency and
Exchange Rates

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 country.

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 States.
• You choose to or are required to use the dollar as your functional currency.
• 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 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.

Exception.   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.

1. 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.
2. 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:

1. $10,000, or
2. 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:

1. The accrued taxes when paid differ from the amount you claimed as a credit,
2. The accrued taxes you claimed as a credit in one tax year are not paid within 2 years after the end of that tax year, or
3. 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 Exchange Rates.

Notice to the Internal Revenue Service (IRS) 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.

Failure-to-notify penalty.   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 penalty.

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 foreign tax credit taken for the original foreign tax, reduce the amount of the refund by the foreign tax paid on the refund.

Example.   You paid a foreign income tax of $3,000 in 2000, and received a foreign tax refund of $500 in 2002 on which a foreign tax of $100 was imposed. When you refigure your credit for 2000, 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:

1. Fixing math errors in figuring qualified foreign taxes,
2. Reporting qualified foreign taxes not originally reported on the return, or
3. 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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