What Is the Foreign Tax Credit? The foreign tax credit is intended to relieve U.S. taxpayers of thedouble tax burden when their foreign source income is taxed by boththe United States and the foreign country from which the income comes.Generally, if the foreign tax rate is higher than the U.S. rate, therewill be no U.S. tax on the foreign income. If the foreign tax rate islower than the U.S. rate, U.S. tax on the foreign income will belimited to the difference between the rates. Because the foreign taxcredit applies only with respect to foreign source income, it cannotreduce U.S. taxes on U.S. source income. Choice To TakeCredit or Deduction discount hotels in YorkYou can choose each tax year to take the amount of any qualifiedforeign taxes paid or accrued during the year as a foreign tax creditor as an itemized deduction. You can change your choice for eachyear's taxes. To choose the foreign tax credit, you generally must complete Form1116 and attach it to your U.S. tax return. However, you may qualifyfor an exception that allows you to claim the foreign tax creditwithout 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. TaxTip: Figure your tax both ways--claiming the credit and claimingthe deduction. Then fill out your return the way that benefits youmost. See Why Choose the Credit, later. Choice Applies to AllQualified Foreign Taxes As a general rule, you must choose to take either a credit or adeduction for all qualified foreign taxes. If you choose to take a credit for qualified foreign taxes, youmust take the credit for all of them. You cannot deduct any of them.Conversely, if you choose to deduct qualified foreign taxes, you mustdeduct 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 describedunder Foreign taxes not allowed as a credit. Caution: You cannot take a credit or a deduction for foreign taxes paid onincome you exclude under the foreign earned income exclusion or theforeign housing exclusion. Foreign taxes not allowed as a credit.Even if you claim a credit for other foreign taxes, you can deductany foreign tax that is not allowed as a credit if: You participated in or cooperated with an internationalboycott (discussed later under Taxes From International BoycottOperations), You paid the tax to one of certain countries for which acredit is not allowed because these countries provide support for actsof international terrorism, or because the United States does not havediplomatic relations with them or recognize their governments, or You paid withholding tax on dividends from foreigncorporations whose stock you did not hold for the required period oftime. For more information on items (2) and (3), see the discussion laterunder 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 taxcredit. Other taxes, such as foreign real and personal property taxes,do not qualify. But you may be able to deduct these other taxes evenif you claim the foreign tax credit for foreign income taxes. You generally can deduct these other taxes only if they areexpenses incurred in a trade or business or in the production ofincome. However, you can deduct foreign real property taxes that arenot 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 yourqualified foreign taxes exceed the credit limit, you can carry over orcarry back the excess to another tax year. If you deduct qualifiedforeign taxes in a tax year, you cannot use a carryback or carryoverin that year. That is because you cannot take both a deduction and acredit for qualified foreign taxes in the same tax year. For more information on the limit, see How To Figure theCredit, later. For more information on carrybacks andcarryovers, see Carryback and Carryover, later. Making or Changing Your Choice You can make or change your choice to claim a deduction or creditat any time during the period within 10 years from the duedate for filing the return for the tax year for which you make theclaim. You make or change your choice on your tax return (or on anamended return) for the year your choice is to be effective. Example.You paid foreign taxes for the last 13 years and chose to deductthem on your U.S. income tax returns. You were timely in both filingyour returns and paying your U.S. tax liability. In February 1999 youfile an amended return for tax year 1988 choosing to take a credit foryour 1988 foreign taxes because you now realize that the credit ismore advantageous than the deduction for that year. Because yourreturn for 1988 was not due until April 17, 1989, this choice istimely (within 10 years). Because there is a limit on the credit for your 1988 foreign tax,you have unused 1988 foreign taxes. Ordinarily, you first carry backunused foreign taxes and claim them as a credit in the 2 preceding taxyears. If you are unable to claim all of them in those 2 years, youcarry them forward to the 5 years following the year in which theyarose. Because you originally did not choose to take a credit for yourforeign taxes and the 10-year period for changing the choice for 1986and 1987 has passed, you cannot carry the unused 1988 foreign taxesback to tax years 1986 and 1987. Because the 10-year periods have not passed for your 1989 through1993 income tax returns, you can still choose to carry forward any unused 1988 foreign taxes. However, you must reduce the unused1988 foreign taxes that you carry forward by the amount that wouldhave been allowed as a carryback if you had timely carried back theforeign tax to tax years 1986 and 1987. Why Choose the Credit Although no one rule covers all situations, it is generally betterto take a credit for qualified foreign taxes than to deduct them as anitemized deduction. This is because: A credit reduces your actual U.S. income tax on adollar-for-dollar basis, while a deduction reduces only your incomesubject to tax, You can choose to take the foreign tax credit even if you donot itemize your deductions. You then are allowed the standarddeduction in addition to the credit, and If you choose to take a credit for the foreign taxes paid,and the taxes paid exceed the credit limit for the tax year, you cancarry over or carry back the excess to another tax year. (SeeLimit on the Credit, discussed later under How ToFigure the Credit.) Example 1.For 1999, you and your spouse have adjusted gross income of$50,000, including $20,000 of dividend income from foreign sources.You file a joint return and can claim two $2,750 exemptions. You hadto pay $2,000 in foreign income taxes on the dividend income. If youtake the foreign taxes as an itemized deduction, your total itemizeddeductions are $10,000. Your taxable income then is $34,500 and yourtax is $5,179. If you take the credit instead, your itemized deductions are only$8,000. Your taxable income then is $36,500, and your tax before thecredit is $5,479. After the credit, however, your tax is only $3,479.Therefore, your tax is $1,700 lower ($5,179 - $3,479) by takingthe credit. Example 2.In 1999 you receive investment income of $5,000 from a foreigncountry, which imposes a tax of $3,500 on that income. You report onyour U.S. return this income as well as $34,000 of income from U.S.sources. You are single, entitled to one $2,750 exemption, and haveother itemized deductions of $4,400. If you deduct the foreign tax onyour U.S. return, your taxable income is $28,350 ($5,000 + $34,000- $2,750 - $4,400 - $3,500) and your tax is $4,598. If you take the credit instead your taxable income is $31,850($5,000 + $34,000 - $2,750 - $4,400) and your tax beforethe credit is $5,578. You can take a credit of only $723 because oflimits discussed later. Your tax after the credit is $4,855 ($5,578- $723), which is $257 ($4,855 - $4,598) more than if youdeduct the foreign tax. If you choose the credit, you will have unused foreign taxes of$2,777 ($3,500 - $723). When deciding whether to take the creditor the deduction this year, you will need to consider whether you canbenefit from a carryback or carryover of that unused foreign tax. Credit for TaxesPaid or Accrued You can claim the credit for a qualified foreign tax in the taxyear in which you pay or accrue it depending on your method ofaccounting. The tax year referred to is the tax year for which yourU.S. return is filed. Accrual method of accounting.If you use an accrual method of accounting, you can claim thecredit only in the year in which you accrue the tax. You are using anaccrual method of accounting if you report income when you earn it,rather than when you receive it, and you deduct your expenses when youincur them, rather than when you pay them. Foreign taxes generally accrue when all the events have taken placethat fix the amount of the tax and your liability to pay it. If youare contesting your foreign tax liability, you cannot accrue it andtake a credit until the amount of foreign tax due is finallydetermined. However, if you choose to pay the tax liability you arecontesting, you can take a credit for the amount you pay before afinal determination of foreign tax liability is made. Once yourliability is determined, the foreign tax credit is allowable for theyear to which the foreign tax relates. If the amount of foreign taxestaken as a credit differs from the final foreign tax liability, youmust make an adjustment to the credit, as discussed later underForeign Tax Redetermination. You may have to post a bond.If you claim a credit for taxes accrued but not paid, you may haveto post an income tax bond to guarantee your payment ofany tax due in the event the amount of foreign tax paid differs fromthe amount claimed. The IRS can request this bond at any time without regard to theTime Limit on Tax Assessment, discussed later. Cash method of accounting.If you use the cash method of accounting, you can choose to takethe credit either in the year you pay the tax or in the year youaccrue it. You are using the cash method of accounting if you reportincome in the year you actually or constructively receive it, anddeduct expenses in the year you pay them. Choosing to accrue taxes.Even if you use the cash method of accounting, you can choose totake a credit for foreign taxes in the year they accrue. You make thechoice by checking the box in Part II of Form 1116. Once you make thatchoice, you must follow it in all later years and take a credit forforeign taxes in the year they accrue. In addition, the choice to accrue foreign taxes applies toall foreign taxes qualified for the credit. You cannot takea credit for some foreign taxes when paid and take a credit for otherswhen accrued. If you make the choice to accrue foreign taxes and pay them in alater year, you cannot claim a deduction for any part of thepreviously accrued taxes. Credit based on taxes paid in earlier year.If, in earlier years, you took the credit based on taxes paid, andthis year you choose to take the credit based on taxes accrued, youmay be able to take the credit this year for taxes from more than oneyear. Example.Last year you used the cash method of crediting foreign taxes. Thisyear you chose to use the accrual method. During the year you paidforeign income taxes owed for last year. You also accrued foreignincome taxes for this year that you did not pay by the end of theyear. You can base the credit on your return for this year on bothlast year's taxes that you paid and this year's taxes that youaccrued. Foreign Tax Redetermination A foreign tax redetermination is any change in your foreign taxliability that may affect your U.S. foreign tax credit claimed. The time of the credit remains the year to which the foreign taxespaid or accrued relate, even if the change in foreign tax liabilityoccurs in a later year. If a foreign tax redetermination occurs, a redetermination of yourU.S. tax liability is required in the following situations. Tax years beginning before 1998.For tax years beginning before 1998, a redetermination of yourU.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 taxcredit because of differences in the exchange rate at the time theforeign taxes were accrued and the time they were paid. See Rate of exchange for foreign taxes paid laterunder Foreign Currency and Exchange Rates. When redetermination of tax is not required.A redetermination is not required if the change is due solely to anexchange rate fluctuation and the change in foreign tax liability forthe tax year is less than the smaller of: $10,000, or 2% of the total dollar amount of the foreign tax initiallyaccrued for that foreign country. In this case, you must adjust your U.S. tax in the tax year inwhich 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: The accrued taxes when paid differ from the amount youclaimed as a credit. But, see When redetermination of tax is notrequired, later, The accrued taxes you claimed as a credit in one tax yearare not paid within two years after the end of that tax year,or The foreign taxes you paid are refunded in whole or in partby the foreign taxing authority. If (2) above applies to you, you will not be allowed a credit forthe unpaid taxes until you pay them. When you pay the accrued taxes,you must translate them into U.S. dollars using the exchange rate asof the date they were paid. The foreign tax credit is allowed for theyear to which the foreign tax relates. See Rate of exchange forforeign taxes paid, later, under Foreign Currency andExchange Rates. When redetermination of tax is not required.If the accrued taxes when paid differ from the amount you claimedas a credit only because of the fluctuation in the currency exchangerate, a redetermination is not required if the amount is paid withintwo years after the close of the tax year to which the taxes relate. Notice to the Internal Revenue Service of redetermination.You must file Form 1040X, Amended U.S. Individual Income TaxReturn, and a revised Form 1116 for the tax year affected by theredetermination. The IRS will redetermine your U.S. tax liability forthe year or years affected. If you pay less tax than you originally claimed a credit for, youmust file Form 1040X and a revised Form 1116 within 180 days after theredetermination occurred. There is no limit on the time the IRS has toredetermine and assess the correct U.S. tax due. If you pay more taxthan you originally claimed a credit for, you have 10 years to file aclaim 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 andcannot show reasonable cause for the failure, you may have to pay apenalty. For each month, or part of a month, that the failure continues, youpay a penalty of 5% of the tax due resulting from a redetermination ofyour 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 theforeign government, you will not have to pay interest onthe amount of tax due resulting from the adjustment to your U.S. taxfor 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 theinterest paid to you by the foreign government. The interest you mustpay cannot be more than the interest you would have had to pay ontaxes that were unpaid for any other reason for the same period. Foreign tax imposed on foreign refund.If you receive a foreign tax refund that is taxed by the foreigncountry, you cannot take a separate credit or deduction for thisadditional foreign tax. However, when you refigure the credit takenfor the original tax, reduce the refund by the foreign tax paid on therefund. Example.You paid a foreign income tax of $3,000 in 1997, and received aforeign tax refund of $500 in 1999 on which a foreign tax of $100 wasimposed. Because you can reduce your refund by the foreign tax imposedon it, you must make an adjustment of only $400 to the credit you tookagainst your 1997 U.S. income tax. Time Limit on Refund Claims You have 10 years to file a claim for refund of U.S. tax if youfind that you paid or accrued a larger foreign tax than you claimed acredit for. The 10-year period begins the day after the regular duedate for filing the return for the year in which the taxes wereactually paid or accrued. You have 10 years to file your claim regardless of whether youclaim the credit for taxes paid or taxes accrued. The 10-year periodapplies to claims for refund or credit based on: Fixing math errors in figuring qualified foreign taxes, Reporting qualified foreign taxes not originally reported onthe return, or Any other change in the size of the credit (including onecaused by correcting the foreign tax credit limit). The special 10-year period also applies to making or changing yourchoice of whether to claim a deduction or credit for foreign taxes.See Making or Changing Your Choice discussed earlier underChoice To Take Credit or Deduction.