A deep dive into the workings of the Foreign Tax Credit, Form 1116, and avoiding double taxation.
Taxpayers who earn income from foreign sources may find themselves facing double taxation – that is, taxation by both the United States and the foreign country. To alleviate this burden, the U.S. offers the Foreign Tax Credit (FTC), a tax relief mechanism designed to mitigate or if possible – eliminate double taxation on income. This article will provide an overview of the FTC, discuss its limitations, and explore some key concepts related to Form 1116, which is used to claim the credit. We will also touch on the new Schedules B and C introduced for 2021 tax returns.
Foreign Tax Credit Basics
The U.S. tax policy is based on the principle that U.S. taxpayers should be taxed on their worldwide taxable income (WWTI), including citizens, residents, and domestic corporations. Double taxation occurs when income is taxed both by the U.S. and a foreign country. The FTC, primarily governed by code sections 901 through 909, aims to mitigate or eliminate double taxation by allowing taxpayers to reduce their U.S. tax liability on foreign source income by all or part of the foreign taxes paid or accrued during the year. However, the FTC does not reduce U.S. tax on income unrelated to foreign taxes paid.
Qualifying for the Foreign Tax Credit
To qualify for the FTC, taxpayers must meet the following four requirements:
- The tax must be imposed or paid or accrued by the taxpayer.
- It must be imposed on the taxpayer by a foreign country or possession of the U.S.
- It must be compulsory, meaning it’s the legal and actual liability.
- It must be an income tax or a tax levied in lieu of an income tax.
The Foreign Tax Credit Limitation
The FTC limitation is in place to prevent foreign taxes from offsetting U.S. tax on U.S. income, ensuring that the U.S. does not subsidize the levies of foreign countries. The allowable FTC is limited annually to the amount of U.S. tax on Foreign Source Taxable Income (FSTI) as computed under U.S. tax principles. The allowable credit is the lesser of the foreign taxes paid or accrued or the overall limitation on the FTC.
Calculating the Allowable Foreign Tax Credit
The maximum FTC allowed can be calculated using the following formula: (FSTI / WWTI) * pre-credit U.S. tax liability. The pre-credit U.S. tax liability refers to the U.S. tax liability on worldwide income before taking the FTC into account. If a taxpayer’s creditable foreign taxes paid or accrued exceed the FTC limitation, the taxpayer cannot take credit for the excess. However, unused credits are carried back one year and carried forward up to ten years, after which they expire.
Form 1116 and Associated Schedules
Starting with 2021 tax returns, Schedules B and C have been introduced to provide additional information related to the FTC. Taxpayers must carefully complete Form 1116 and associated schedules to ensure they do not overstate their FTC and inadvertently reduce their U.S. tax on U.S. source income.
Form 1116 is used to determine the FTC allowed for each of the seven separate income categories (Box a-g). These categories address the requirements laid out in Section 904(d) of the tax code, which mandates that taxpayers compute a separate FTC limitation for each distinct category or “basket” of income. This prevents taxpayers from blending high and low foreign tax rates to artificially reduce their overall foreign tax rate.
The Seven Income Categories:
- Section 951A category income (Box a) – This category is related to Global Intangible Low Taxed Income (GILTI) and was introduced in 2018 by the Tax Cuts and Jobs Act (TCJA). U.S. shareholders of Controlled Foreign Corporations (CFCs) are required to include certain income received under Section 951A.
- Foreign branch category income (Box b) – This category includes business profits of a U.S. person that are not attributable to one or more Qualified Business Units (QBUs) in one or more foreign countries. It excludes passive category income.
- Passive category income (Box c) – This common category includes dividends, interest, rents, royalties, annuities, and net gains from sales of non-income producing investment property or property that generates passive income, among other sources.
- General category income (Box d) – Income from sources outside the U.S. that do not fall into any other separate limitation categories. It generally includes active business income, wages, and salaries of individuals who work overseas as employees, as well as high taxed income that would otherwise be passive.
- Section 901(j) income (Box e) – Income earned from activities conducted in sanctioned countries. Each year, Pub 514 FTC for Individuals lists these countries.
- Certain income re-sourced by treaty (Box f) – This category encompasses income that is treated as foreign sourced under a tax treaty, even though it is U.S. sourced under general rules.
- Lump-sum distributions (Box g) – This category applies to income received from a foreign lump sum distribution retirement plan.
Key Components of Form 1116, Part I
- Line (i) – Listing countries: Each country where the taxpayer has foreign income should be listed in Line i. If there are more than three countries, an additional Form 1116 should be attached for that category. The separate forms ensure that taxpayers accurately report their foreign income and tax credits associated with each specific country.
- Line 1a – Income in the selected category: Line 1a includes income in the category checked in Box (a) – (g) that is taxable by the U.S. from sources within the country listed in Part I Line (i). Common adjustments under Part I Line 1a include earned income excluded on Form 2555 Foreign Earned Income (FEI) and passive category income adjustments for foreign sourced qualified dividends or capital gains. These adjustments ensure that only taxable income is included in the foreign tax credit calculation.
- Line 1b – Alternative basis for foreign source income: Line 1b is not very common but requires checking the box if the foreign source income earned as an employee is $250,000 or more, and an alternative basis is used. The alternative basis may be employed when the taxpayer’s income is divided between U.S. and foreign sources and a reasonable allocation method is applied. This ensures that the appropriate portion of income is attributed to each respective source.
Deductions and Losses in Part I
- Line 2 – Expenses definitely related to the income on line 1a: This line contains allocated expenses that are related to the foreign income, such as foreign rental expenses or foreign business expenses. It is essential to allocate the appropriate overhead and shared expenses against the foreign source gross income reported on Line 1a, as leaving this section blank or understating the expenses can increase the percentage of foreign source income to the total worldwide income.
- Line 3a and 3b – Pro rata share of other deductions not definitely related: These lines include a ratable share of other deductions that do not definitely relate to the taxpayer’s foreign source or U.S. source income. Line 3a includes itemized deductions other than interest expense or the standard deduction, while Line 3b may include deductions for alimony paid. These deductions help reduce the taxpayer’s overall taxable income.
- Line 4 – Pro rata share of interest expense: Interest expense must be apportioned between U.S. and foreign source income, with Line 4a for mortgage interest and Line 4b for other interests like investment interest. This apportionment ensures that the interest expense is allocated fairly between the two sources of income.
- Line 5 – Losses from foreign sources: This line deals with capital losses from foreign sources, which can be used to offset foreign capital gains. By accounting for these losses, taxpayers can reduce their overall taxable income, ensuring a more accurate reflection of their financial situation.
Foreign Taxes Paid or Accrued: Form 1116, Part II
Part II of Form 1116 focuses on the foreign taxes paid or accrued by the taxpayer, which is crucial for determining the foreign tax credit. This section addresses the election between the cash basis (Paid method) and the accrual basis for claiming the credit.
Cash Basis vs. Accrual Basis
- Cash Basis (Paid method) Most taxpayers use the cash basis method, which recognizes foreign income taxes when they are paid. This method is generally more straightforward and allows taxpayers to claim the foreign tax credit based on the actual amount of foreign taxes paid during the tax year.
- Accrual Basis Accrual-basis taxpayers recognize foreign income taxes on the last day of the foreign jurisdiction’s tax year. This method is typically chosen to avoid mismatches between taxes and related foreign source income. However, once the Accrual method election is made, it is binding on all future years, and taxpayers cannot switch back to the cash basis without filing an amended return.
Making the Election between Cash Basis and Accrual Basis
Taxpayers can elect to claim the foreign tax credit on either a cash basis (Paid method) or an accrual basis by checking either Box (j) or (k) on Form 1116. It is essential to make the appropriate election based on the taxpayer’s specific financial situation and tax strategy.
Limited Exception under Reg section 1.905-1(e)(2)
A limited exception exists under Reg section 1.905-1(e)(2) that permits taxpayers to make an election on an amended return if certain conditions are met. To qualify for this exception, the taxpayer must not have claimed FTCs in any prior year returns or on a timely filed original return.
For example, in Year 1, a U.S. taxpayer has foreign source income and pays foreign taxes but doesn’t claim FTCs in prior returns or on the originally filed return. In Year 2, the taxpayer learns about the benefits of claiming FTCs using the accrual method, amends their Year 1 return, and claims FTCs accordingly. Under this regulation, the taxpayer’s election on the amended return is permitted, as it is the first time the taxpayer chooses the accrual method to claim FTCs.
Part II – Item (I) – Date paid or accrued
In this section, enter the dates when foreign taxes were paid or accrued.
Part II – columns (m) through (u)
In columns (m) through (t), enter the creditable foreign taxes paid in foreign currency and then in U.S. dollars. Taxpayers should consider whether all available remedies have been exhausted to reduce foreign taxes, such as treaty rates that result in lower foreign taxes. If a treaty rate results in lower foreign taxes, only the lower amount should be listed in columns (m) through (u). The total of columns (q) through (t) should be added and entered in Item (u).
Part III – Figuring the Credit
Some items in Part III are self-explanatory, such as Line 9, which carries over the amount from Part II Line 8. Other items, like Line 12 (Reduction in foreign taxes) and Line 13 (Taxes reclassified under high tax kickout), require more careful attention.
Line 12 deals with situations that require taxpayers to reduce foreign taxes paid or accrued. For example, if a taxpayer excludes a certain amount of foreign source income from U.S. taxation, the related foreign tax must also be excluded. This ensures that taxpayers cannot claim FTCs on income excluded from U.S. taxation.
Line 13 addresses foreign taxes paid or accrued on high tax passive income that has been backed out of the passive category Form 1116 and subsequently added to the general category Form 1116. This adjustment is necessary because FTCs cannot be used to reduce U.S. tax on U.S. income.
Part III Line 16 – Adjustments to line 15
Line 16 is among the most challenging aspects of completing Form 1116. It deals with negative or positive adjustments to foreign source income, including the recapture of losses allocated in one year when income is derived from that category in the following year. The recapture process is complex but aims to prevent FTCs from being used disproportionately and ensure fairness when trading losses and recapture in later years.
For example, consider a taxpayer named John Doe who operates as a sole proprietor abroad and whose foreign source income falls into the general category. In 2021, John had $10,000 in U.S. source income and $10,000 in foreign source losses, resulting in zero worldwide income. In 2021, John paid no foreign or U.S. taxes.
In 2022, John had $10,000 in U.S. source income and $10,000 in foreign taxable income, resulting in $20,000 in worldwide income. If John is in the 10% tax bracket, this results in $1,000 of foreign income tax and $2,000 of U.S. tax before FTCs.
Without recapture rules, John would pay $1,000 in U.S. tax in 2022 ($2,000 U.S. tax minus $1,000 creditable foreign tax). However, the recapture rules ensure that the United States collects the full U.S. tax on $20,000 of U.S. taxable income. In 2022, John must recapture $10,000 of foreign source income as U.S. source income, leaving zero in the numerator of the FTC limitation formula. Consequently, John’s 2022 FTC equals zero, and the 2022 U.S. tax is $2,000. Over the two years, the United States collects $2,000 U.S. tax on $20,000 of U.S. taxable income. The recapture rules prevent John from avoiding U.S. tax on $10,000 of U.S. source income.
Part IV – Summary of Credits from Separate Parts III
Once all sections of Form 1116 are completed, the total FTC is transferred to Schedule 3 of Form 1040 Line 1, as indicated on Line 35 of Form 1116. This section summarizes all allowable FTCs from different income categories. If multiple Forms 1116 have been completed, only one form should be used for this summary, typically the one with the largest allowable FTC.
Schedule B: Foreign Tax Carryover Reconciliation Schedule
From tax year 2021, Schedule B is added to Form 1116 to standardize the reporting of foreign tax carryovers and carrybacks on Form 1116 Part III Line 10. Section 904(c) stipulates a mandatory one-year carryback, and a 10-year carryforward for unused FTCs, with the exception of the Global Intangible Low-Taxed Income (GILTI) under section 951A, which is ineligible for carrybacks or carryovers.
Structure and Flow
Despite its numerous columns, rows, and lines, Schedule B follows a logical sequence, making it easier to navigate. The schedule comprises two pages:
- Page 1: Covers carryovers from the 10th to the 5th preceding tax year. The total from these years is transferred to Line 1 on Page 2.
- Page 2: Continues from the 4th to the 1st preceding tax year. It also includes adjustments such as section 905(c) for foreign tax redeterminations.
Schedule B is modeled after Schedule K of Form 1118 (Foreign Tax Credit for Corporations), which has been in use for an extended period.
To carry forward unused foreign taxes from one year to the next, transfer the numbers from Line 8 of Schedule B for the current year to Line 1 of Schedule B for the following year.
Schedule C: Foreign Tax Redeterminations
Schedule C is designed to identify and track foreign tax redeterminations (FTRs) in the current year, which relate to prior years. An FTR arises when foreign taxes change due to a foreign audit or a refund from a foreign government. In most instances, taxpayers must file an amended return (Form 1040X) with an amended Form 1116 to rectify the original claim.
Categories and Parts
Schedule C is divided into two main parts:
- Part I: Increase in Amount of Foreign Taxes Accrued—Applicable to taxpayers who follow the accrual method and have increased foreign taxes paid during the current year, which relate back to a prior year or years.
- Part II: Decrease in Amount of Foreign Taxes Paid or Accrued—Required when there is a decrease in foreign taxes and a refund is issued by a foreign government. The taxpayer must relate the decrease back to a prior year, irrespective of the chosen method (paid or accrued).
Reference ID Numbers and the Two-Year Rule
In Column 13 of Schedule C, taxpayers must supply the Employer Identification Number (EIN) or a unique alphanumeric Reference ID Number (RefID) for foreign entities without an EIN. Taxpayers can create their RefID as long as it is alphanumeric.
The two-year rule (Code Section 905(c)(2)) mandates accrual-method taxpayers to make foreign tax payments within two years from the end of the tax year of accrual. If the payment is not made within this timeframe, an FTR occurs, and the taxpayer must amend the original FTC claim. Subsequently, if the tax is paid after the two-year period, another FTR arises, and the paid tax must relate back to the year it was initially accrued.
Navigating Schedule B and Schedule C: Practical Examples
To further illustrate the concepts discussed, let’s consider two hypothetical scenarios.
Example 1: Carryovers and Carrybacks
Suppose a taxpayer, John, has $10,000 in foreign taxes paid in 2022 but only utilized $6,000 as FTC due to limitations. In 2023, he has an excess FTC carryover of $4,000. John would record this carryover on Schedule B of his 2023 Form 1116. If John had excess FTC in the preceding years as well, he would include these amounts in the respective columns on Schedule B, accounting for any adjustments such as foreign tax redeterminations.
Example 2: Foreign Tax Redeterminations
In 2021, Jane, a taxpayer using the accrual method, accrued $5,000 in foreign taxes. In 2023, she receives a refund of $1,000 from the foreign government. Jane must complete Schedule C of her 2023 Form 1116 to account for the $1,000 decrease in her foreign taxes. She must also file an amended 2021 tax return (Form 1040X) with an amended Form 1116 to correct her original FTC claim.
Navigating the complexities of foreign tax credits can be challenging for taxpayers who are not well-versed in tax laws and regulations. Properly managing foreign tax credits can help you avoid overpaying taxes and ensure compliance with both domestic and international tax obligations.
If you have foreign source income and are unsure whether the foreign tax credit is applicable or beneficial for your situation, seeking professional assistance is highly recommended. As a knowledgeable and experienced CPA, I am well-equipped to help you understand and optimize your foreign tax credit claims.
Don’t hesitate to take advantage of my expertise in international taxation and U.S. tax policies. By scheduling a paid appointment with me, you’ll receive personalized guidance and advice tailored to your unique financial situation. My goal is to help you make informed decisions and navigate the intricacies of the tax system with confidence.
***Disclaimer: This communication is not intended as tax advice, and no tax accountant -client relationship results**