To qualify for the foreign tax credit, a tax must satisfy four key conditions:
The tax must be directly imposed on you.
You must have either paid or accrued the tax.
The tax must be a legitimate and actual foreign tax liability.
The tax must be classified as an income tax or a substitute for an income tax.
Generally, only income taxes paid or accrued to a foreign nation or a U.S. territory qualify for the foreign tax credit. However, some foreign taxes do not qualify, even if they meet the four conditions.
Foreign Taxes That Do Not Qualify
Certain foreign taxes are not eligible for the credit, including:
Taxes paid to a foreign country that you do not legally owe, including those eligible for refunds.
Taxes that have been offset or reduced by another foreign tax credit.
Taxes imposed solely because you qualify for a foreign tax credit against U.S. taxes.
Taxes paid to countries identified by the U.S. Secretary of State as supporting terrorism, lacking diplomatic relations with the U.S., or restricted from purchasing defense articles.
Foreign taxes withheld on dividends if you did not hold the stock for a specified period.
Taxes withheld on dividends when required to make offsetting payments.
Taxes on non-dividend income if you did not meet the holding period requirement.
Taxes on non-dividend income when required to make offsetting payments.
Foreign taxes that effectively subsidize you or a related party.
Taxes paid on oil or gas income if you lack an economic interest or the price is inconsistent with market value.
Taxes paid on income excluded under the extraterritorial income exclusion.
Foreign mineral income taxes.
Taxes related to covered asset acquisitions resulting in basis adjustments for U.S. tax purposes.
Foreign taxes disallowed under section 965(g).
Interest and penalties associated with foreign taxes.
Choosing Between a Credit and a Deduction
Instead of claiming the foreign tax credit, taxpayers may opt to deduct foreign income taxes on Schedule A of Form 1040. To claim the credit, complete Form 1116 and attach it to your tax return. You must choose between the credit or deduction for all foreign taxes paid within a given year, and this decision must be made annually. Even if you choose the credit, you may still deduct certain taxes, including those:
Disallowed due to boycott provisions.
Paid to countries where credits are restricted.
On income that does not meet the holding period requirement.
Associated with related payments on similar property.
Connected to oil or gas transactions where market value discrepancies exist.
Incurred through covered asset acquisitions.
Paid in prior years if you had elected to deduct instead of credit them.
Special Rules for Cash vs. Accrual Basis Taxpayers
Cash basis taxpayers can only claim the foreign tax credit in the year they pay the taxes unless they elect to claim the credit in the year taxes are accrued. This choice, once made, must be applied consistently to all future returns.
Foreign Earned Income and Housing Exclusions
You cannot claim a credit or deduction for the portion of foreign taxes paid on income excluded under the foreign earned income exclusion or housing exclusion, as this income is not subject to U.S. taxation.
Calculating the Credit Using Form 1116
The foreign tax credit is generally limited to the lower of the foreign tax paid or the U.S. tax attributable to foreign income. When using Form 1116, separate limits must be calculated for different types of income, including passive income, resourced income under treaties, sanctioned country income, foreign branch income, and general category income.
Carryback and Carryover of Unused Credits
If you cannot claim the full amount of your foreign tax credit in a given year, you may carry back the unused credit to the previous year or carry it forward for up to ten years. However, this does not apply to foreign taxes on income included under section 951A.
Claiming the Credit Without Filing Form 1116
Taxpayers may elect to claim the foreign tax credit without filing Form 1116 if:
All foreign-source gross income is passive income, such as interest or dividends.
The foreign income and taxes are reported on a qualified payee statement, such as Form 1099-INT, 1099-DIV, or Schedule K-1.
The total foreign taxes do not exceed the threshold in the Form 1040 instructions.
This option is not available to estates or trusts. Additionally, unused foreign taxes cannot be carried back or forward when electing this simplified approach.
Amending a Return to Claim the Credit
If you previously claimed a deduction for foreign taxes but later determine that claiming the credit would be more beneficial, you can file an amended return (Form 1040-X) within ten years from the original due date. This time limit also applies to correcting previously claimed foreign tax credits.
If foreign taxes previously credited are later refunded or reduced, an amended return must be filed by the due date (with extensions) for the year in which the refund or reduction occurred.