Foreign Tax Credits – A Primer
For those that have moved abroad permanently or just earned income in a different country, the foreign tax credit can be a crucial tool for reducing their income taxes. The foreign tax credit prevents Americans from paying a double-tax on income that is earned, and already taxed, in a different country. If you think you may benefit from foreign tax credits, you should speak with an international tax attorney to ensure that everything is in order.
How does the foreign tax credit work?
First, it’s important to note that Americans are taxed by the federal government for all income, regardless of where it was earned. However, the foreign tax credit can prevent the taxpayer from paying tax on the same income to both the country where the money was earned and the American government.
To accomplish this goal, the foreign tax credit functions, unsurprisingly, as a tax credit. This means that for every dollar paid in taxes on a foreign investment or foreign income, the taxpayer may reduce his or her own tax liability by a dollar.
Therefore, if a person’s tax liability in America is higher than the taxes paid to the foreign government, he or she will still be liable for paying taxes to the American government for the difference.
Which foreign taxes can be used to receive a foreign tax credit?
In simplest terms, the foreign tax credit can be used for “income taxes.” While countries may not use the term “income tax,” if it acts in the same functional capacity, then it should qualify a foreign tax credit deduction.
This exempts all other forms of taxation. A taxpayer may not claim sales taxes, value-added taxes, or property taxes. For some countries, these forms of taxation, especially the value-added tax, are the primary source of taxation. Unfortunately for Americans living and working in those countries, the foreign tax credit may not be as helpful in offsetting their tax burden.
Other taxes that, for political or other reasons, do not qualify for the tax credit: taxes on “excludable income” as defined by the IRS, taxes on income derived from either oil, natural gas, or mineral extractions, and taxes paid towards five countries suspected of supporting terrorism.
What can prevent someone from using the foreign tax credit?
There are two important regulations that can prevent someone from taking advantage of the foreign tax credit.
First, individuals utilizing the standard deduction are not able to take advantage of the foreign tax credit. Like always, the taxpayer will be required to choose between a standard deduction or itemized deductions, although depending on the amount of income this could make the itemized deduction option much more attractive.
Second, the foreign tax credit cannot absolve a taxpayer from paying the alternative minimum tax. The foreign tax credit does not function as a way for a taxpayer to pay less to the American government than he would otherwise owe. Similar to the way a person will still owe the American government money if his or her tax liability is higher on the income than the foreign government where the income was earned, the alternative minimum tax will impose the same obligation.
If you have questions about foreign tax credits, contact us today to schedule a consultation.
Posted in: International Tax