Foreign Income Taxes – Credit or Deduction
Generally, a taxpayer can either take a deduction or a credit for income taxes imposed by a foreign country or a U.S. possession. However, no deduction or credit is allowed for foreign income taxes paid on income that is exempt from U.S. tax under the foreign earned income exclusion or foreign housing exclusion. Generally, the foreign tax on dividends is 15% and after making all the adjustments on Form 1116, the actual tax credit will be less, typically around 12%.
Practice Tip
Tax treaties with most countries set the rates at 15%. When there is a foreign tax withheld but the gross amount of the dividends or interest is not stated, the gross foreign income can be estimated by dividing the tax by 0.15.
Strategy
Which is better, tax credit or tax deduction? If used as a deduction, the benefit would only be, assuming 37% tax bracket, 5.55% (.37 x .15) as compared to about 12% when used as a credit. Therefore, it is generally better to take the tax credit.
Foreign Tax Optional Treatment
See the guide Foreign Tax for alternative treatments of foreign taxes.
Caution K-2/K-3 Issue
Beginning for 2021, Schedules K-2 and K-3 must be included with a domestic partnership’s Form 1065 or S corporation’s Form 1120-S when these entities have items of international tax relevance. These two 19- and 20page schedules replaced a couple of lines on pre-2021 Schedules K and K-1 and were designed to provide greater clarity for partners and shareholders to compute their U.S. tax liability. Unexpectedly the IRS noted in the forms’ instructions that if a partner or shareholder paid foreign taxes and filed Form 1116 on their 1040, that would trigger the requirement for Schedules K-2 and K-3 to be included by the entity, even when the entity had no international income, expenses, etc. One of the potential workarounds for a partner or shareholder to avoid filing a Form 1116 is to qualify to claim the credit without filing a Form 1116 or deducting the tax on Schedule A. Consult chapter 9.18 – Foreign Taxes for further details.