Foreign Tax Credit
Under normal circumstances claiming a foreign tax credit or deduction was a simple thing to do on a 1040, with three possible options described below. The choice of options takes on a whole new meaning with the addition of Schedules K-2 and K-3 to Partnership and Sub S Corporation returns as discussed in Chapter 3.36.
Options
File Form 1116 to Compute and Claim Foreign Tax Credit - If a taxpayer does not qualify to claim the foreign tax credit without filing Form 1116 (see below) or chooses not to claim the foreign tax as an itemized deduction (also see below), they will have to file Form 1116 with their 1040 return to get a tax benefit for foreign income taxes they paid or had withheld.
Claim the Foreign Taxes Paid as an Itemized Deduction - As an alternative to claiming a credit for foreign income taxes, an individual may claim them on Schedule A as “other taxes” (line 6). Taxes entered on line 6 are not subject to the $10,000 SALT limitation. Foreign real property taxes are not eligible to be deducted on Schedule A for federal purposes.
Election to Claim the Foreign Tax Credit Without Filing Form 1116 - When certain conditions are met, the foreign tax credit can be claimed without Form 1116. By making this election, the foreign tax credit limitation (lines 15 through 23 of the form) do not apply. This election is available only if the taxpayer (does not apply to estates and trusts) meets all the following conditions:
1. The creditable foreign taxes don’t exceed $300 ($600 if married filing a joint return).
Example – Creditable Foreign Taxes: Country X withholds $25 of tax from a dividend payment made to the taxpayer. Under the income tax treaty between the U.S. and Country X, the taxpayer only owes $15 and can claim a refund from Country X for the other $10. Only $15 is eligible for the foreign tax credit (whether or not the taxpayer applies for a refund).
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Foreign taxes withheld on a dividend from a corporation are not eligible for the credit if the taxpayer hadn’t held the stock for at least 16 days within the 31-day period that begins 15 days before the ex-dividend date. This required holding period is greater for preferred-stock dividends. Similarly, foreign taxes withheld on income or gain (other than dividends) from property if the taxpayer hadn’t held the property for at least 16 days within the 31-day period that begins 15 days before the date on which the right to receive the payment arises.
See the instructions to Form 1116 for other situations when foreign taxes aren’t creditable.
2. All the foreign source gross income on which the foreign tax was assessed was passive category income which includes most interest and dividends. However, passive category income can include other sources of income rarely encountered by individuals and small businesses. See the Form 1116 instructions for additional information.
3. All the income and any foreign taxes paid on it were reported to the taxpayer on a qualified payee statement. Qualified payee statements include Form 1099-DIV, Form 1099-INT, Schedule K-1 (Form 1041), Schedule K-3 (Form 1065), Schedule K-3 (Form 1120-S), or similar substitute statements.
If this election is made certain restrictions apply:
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Unlike when using Form 1116, the taxpayer can't carry over to or from any other year any foreign taxes paid or accrued in a tax year to which the election applies (but carryovers to and from other years are unaffected).
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The taxpayer is still required to take into account the general rules for determining whether a tax is creditable.
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Taxes paid on earned income excluded using Form 2555 cannot be included when figuring the credit.
To make the election, enter on the foreign tax credit line of the tax return (Schedule 3 (Form 1040)), Part I, line 1) the smaller of (a) the total foreign tax credit, or (b) the regular tax.
K2/K3 Filing Exceptions
See Chapter 3.36.
California Differences
California has no equivalent credit and does not allow an itemized deduction for foreign income taxes paid but does permit an itemized deduction for foreign real property taxes.