This post was originally published in December, 2011 but has been updated as of October 30, 2017.
Many foreign countries require residents to remit taxes to the host government, regardless of the citizen’s nationality. For this reason, many US expats have an opportunity to claim the Foreign Tax Credit on their US expat taxes. The Foreign Tax Credit is claimed on US expat taxes by completing Form 1116 and attaching it to an individual US tax return, Form 1040. The credit reduces the liability on US tax due on expat income dollar for dollar. The credit cannot be taken against income which has already been excluded by the Foreign Earned Income Exclusion, nor can it exceed the US tax liability relating to foreign earned income (that is, you cannot receive a refund of foreign taxes paid through your US tax return).
US Expat Taxes – The Foreign Tax Credit
Before completing Form 1116 to claim the Foreign Tax Credit on your US expat taxes, you must meet four criteria:
- You must have a foreign tax liability that was either paid or has accrued during the current tax year,
- The tax must be assessed on income,
- The tax must be imposed on you as an individual, and
- The tax must have originated legally in a foreign country.
Taxes that are due to be refunded to you are not included in the amount of foreign taxes paid. Before completing Form 1116, all of the foreign taxes paid will need to be converted to US dollars. The IRS prefers that each transaction be converted at the foreign exchange rate at the date of each transaction. These historical exchange rates can be obtained from oanda.com. If the numbers of transactions are excessive or the exchange rate not readily available, they will accept the annual average foreign exchange rate. To support the preparation of your US expat taxes, the IRS provides average annual exchange rates on their website. If the taxes have been assessed but have not yet been paid, you should use the exchange rate on the last day of the year for which the taxes were assessed.
Calculating Foreign Tax Credit
The Foreign Tax Credit claimed on your US expat taxes cannot exceed the amount of US tax that you pay on foreign sourced income. To determine the amount of the limitation, you can use the following formula:
Foreign Tax Credit Limitations
There are certain foreign taxes that are not eligible to be claimed as foreign tax credits on your US tax return. These include taxes paid to certain countries that the Secretary of State has designated as supporting international terrorism, such as Cuba, Iraq and North Korea. Other taxes that cannot be claimed on your US expat taxes include taxes associated with financial services income, dividends from each 10 to 50 percent-owned foreign corporation, shipping and aircraft income, “domestic international sales corporation” dividends, dividends from foreign sales corporations, foreign trade income of foreign sales corporations, and foreign oil and gas extraction income.
Even though these taxes can’t be claimed for the purposes of the Foreign Tax Credit, they can be claimed as an itemized deduction on Schedule A.
Carryovers on US Expat Taxes
With US citizens who have lived abroad for long periods of time, carrybacks and carryforwards of foreign tax credits can be very important. If you are eligible for a foreign tax credit larger than your US expat income tax liability, the credit can be carried back to the tax year immediately preceding the current, or carried forward for the next ten years. This means that you can use the excess credit to try to obtain a refund from the prior year where you did not have enough credits to offset your US tax liability, or choose to offset your future years’ tax liability. Most taxpayers will retain a schedule attached to their annual US tax return that includes all of the foreign tax carryovers for which they are eligible.
Example: Blake and Lauren Expat
Earlier in our US Expat Taxes Explained series, you were introduced to Blake & Lauren Expat: Montana natives who moved abroad to become professional samba dancers. In 2016, Blake & Lauren had income of $65,000, and paid taxes to the Brazilian government in the amount of $15,000. They had a $3,000 carryover from 2014, and a $4,000 carryover from 2015. Normally, all of this income would be excluded because of the Foreign Earned Income Exclusion, and Blake & Lauren would not have a US expat tax liability. However, for the purposes of this example, we will assume that Blake & Lauren have not yet claimed the Foreign Earned Income Exclusion and will only be claiming the foreign tax credit. Additionally, you may remember from our article regarding the completion of Schedule A, Blake & Lauren had $17,129 in itemized deductions, $10,550 of which were due to home mortgage interest.
When claiming the foreign tax credit on Form 1116, taxpayers are required to categorize the income earned by the taxpayer. A separate Form 1116 will need to be completed for each category of income. Luckily, Blake & Lauren only have income attributable to the General Income category (basic wage, salary & business income). For information regarding the other categories, please contact one of our US expat tax experts. The information portion of Blake & Lauren’s Form 1116 will be completed as follows:
Next, Blake & Lauren will complete Part I. This information asks the taxpayer to explain all of the income from sources outside the US. Blake & Lauren only had income from Brazil, in the amount of US$65,000. As US citizens, Blake & Lauren are required to report and pay taxes on this income to the US. However, they are still eligible for itemized or standard deductions, which they have used to offset their income. Before calculating their foreign tax credit, these amounts will need to be considered on their Form 1116. Part I will be completed as follows:
Part II of Form 1116 asks the taxpayer to report the amount of taxes that were actually paid (or accrued) by the taxpayer in the current tax year. Please note that this section also asks for foreign taxes paid to be reported in the foreign currency amount, as well as the US dollar amount. In Brazilian real, the amount of foreign taxes that Blake & Lauren paid were 8,161 R$. When reporting this information, the IRS also requests that the taxpayer add a statement to the tax return that includes the foreign currency conversion rate.
Part III of Form 1116 actually computes the amount of credit eligible to be claimed on the taxpayers US tax return. With earned income of $65,000, and claiming itemized deductions of $17,129, Blake & Lauren had a US tax liability of $5,039. Each line of Part III is essentially math calculations, and the instructions associated with each line on the form will walk the taxpayer through its completion. The foreign tax credit for which Blake & Lauren are eligible will completely wipe out their US expat tax liability, and they never even had to complete the much more complex Form 2555! Nor did they have to tap into their prior year’s foreign tax credit carryovers.
Blake & Lauren paid $15,000 in total foreign taxes during 2016. However, because their US tax liability was only $5,039 after their exemptions and itemized deductions, they could only use $5,039 of the total $15,000. Thus, they will be eligible to carry $9,961 of the 2016 foreign tax credit over into future tax years!
The last portion of Form 1116 simply asks the taxpayer to summarize the foreign tax credits claimed on other Forms 1116 for the current tax year. Because Blake & Lauren only had income from the “General” category, they will only need to include this one form, and Part IV of Form 1116 will be completed as follows:
Questions About The Foreign Tax Credit?
Although the IRS does require US citizens and Green Card-holders to report and pay taxes on their worldwide come, there are many ways to reduce double taxation, including the Foreign Tax Credit. See our series about how to reduce your tax liability as a US citizen for other examples of credits and deductions. Although this article offers a simple example of how to file Form 1116 for the Foreign Tax Credit, it may be too complicated for expatriates who need to file US expat taxes. If you need any assistance with your Form 1116, or if you would like to know more about our expat tax services, please contact us for expert help.