The Meaning of Foreign Tax Credit
This is a non-repayable tax credit that is paid to the government of a foreign country due to foreign income tax withholdings. Foreign income tax credit is only obtainable by people who did work in a foreign nation or have their investment income flowing from a foreign source.
The FTC is claimed on the Form 1116, except the taxpayer is qualified for the de minimis exclusion. Foreign Tax Credit will only be claimed if the income is liable to domestic taxation. The taxpayer can only claim credit on taxes paid on foreign income.
Your exclusions may be revoked if you exclude the foreign housing costs or foreign earned income and still proceed to obtain a foreign tax credit on same income excluded
Importance of Foreign Tax Credit
Foreign tax credit is very important to reduce the possibility of double taxation. It helps to check for the systems that tax residents on their income which probably have been taxed in another country. The credit applied mainly to the taxes that are similar in nature to the tax that is being lessened by the credit. It is though limited to the tax amount that is linked to the foreign income source.
When appropriated as a deduction, Foreign Tax Credits mitigates your U.S. taxable earning. The itemized tax deduction is made on Schedule A (Form 1040).
When appropriated as a credit, Foreign Tax Credit mitigates your U.S. tax obligation. It is advisable in most cases to take your foreign income taxes as a credit.
Know when Foreign Tax Credit is Used
Foreign tax credit can be used depending on:
- The description of the foreign levy i.e. whether it is an optional levy, has a discretionary as its rate, compulsory, for payment of services, etc.
- If the foreign country has the system for similar credit
- Whether there is a tax treaty between the two countries involved
- The characteristics of the base for which the levy is given i.e. whether it is for property, deemed profits, gross receipts, etc.
- The method of making the payments i.e. is it through payments in kind? By check or through withholdings.
- The services or nature of the property offered by the levying body or people related in the tax.
- The stipulations enforced by the levying body on the taxpayers
- The considerations of the political systems of the taxing country like tax boycotts etc.
Some systems try to limit foreign income tax in some way. Such limitations mostly come on the domestic income tax that is created by the source of the foreign income.