Foreign Tax Credit and Form 1116 Basics

If you paid income tax to a foreign country, you may be able to reduce your U.S. tax. This is the foreign tax credit. It exists so that the same income is not fully taxed twice. Most individuals claim it on Form 1116, Foreign Tax Credit. IRS: Topic no. 856, Foreign tax credit

Four tests a foreign tax must pass

The tax must meet four tests to qualify for the credit. The tax must be imposed on you. You must have paid or accrued it. It must be a legal and actual foreign tax liability. It must be an income tax, or a tax paid in place of an income tax. IRS: Topic no. 856

Amounts that do not qualify

You cannot take a credit for interest, fines, or penalties paid to a foreign country. Taxes you did not legally owe do not count, including amounts the foreign country could refund to you. Taxes offset by a foreign tax credit do not count. IRS: Topic no. 856

Some withholding on dividends does not count either. For example, if you did not hold the stock for at least 16 days within the 31-day period that starts 15 days before the ex-dividend date, the withholding is not creditable. The IRS lists other holding-period rules too. IRS: Topic no. 856

Credit or deduction

You can choose to claim a credit or a deduction for foreign income taxes. A deduction lowers your taxable income. A credit lowers your tax. You may change the choice within the time limits set by law. IRS: Instructions for Form 1116

When Form 1116 is needed

File Form 1116 to claim the credit if you are an individual, estate, or trust that paid or accrued eligible foreign taxes. Form 1116 figures the credit limit. The limit depends on your foreign source income. The form has separate sections for each category of income, such as passive income. IRS: About Form 1116

The simpler exemption

You may skip Form 1116 if all four basic requirements are met:

Your only foreign source gross income is passive income.
Your qualified foreign taxes are not more than $300, or $600 on a joint return.
All of your foreign income and foreign taxes are reported to you on a payee statement, such as Form 1099-DIV or Form 1099-INT.
You elect this procedure for the tax year.

If you use this rule, you cannot carry unused foreign tax back to another year, or forward from it. IRS: How to figure the credit

Illustration only, with made-up numbers. Dana receives $200 of dividends from a foreign fund. The foreign country withheld $60 of tax. Form 1099-DIV reports both amounts. Dana's only foreign income is passive, and the tax is under $300. Dana may be able to use the simpler rule and skip Form 1116, if Dana makes the election.

Records to keep

Keep the foreign tax receipts or statements that show the amount you paid, the date paid, and the country. Keep your Forms 1099 and any Form 1116 worksheets. Keep copies for the years when you may still need to claim a credit.

Steps to take

List each foreign income tax you paid or accrued, with the date and country.
Remove any amount that does not qualify, such as interest or penalties.
Check whether all of your foreign income is passive, and whether the tax is $300 or less ($600 on a joint return).
If the simpler rule applies and you elect it, you may skip Form 1116.
If it does not apply, complete Form 1116 and carry the credit to your return.

General information, not advice about your return.

Sources: Sources: IRS, Topic no. 856, Foreign tax credit (https://www.irs.gov/taxtopics/tc856); IRS, About Form 1116 (https://www.irs.gov/forms-pubs/about-form-1116); IRS Instructions for Form 1116 (https://www.irs.gov/instructions/i1116); IRS, Publication 514 (https://www.irs.gov/publications/p514); IRS, Foreign tax credit: how to figure the credit (https://www.irs.gov/individuals/international-taxpayers/foreign-tax-credit-how-to-figure-the-credit) This is general information, not advice about your specific return.

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