As a taxpayer, you may encounter complexities in understanding certain aspects of the tax system. One such area is the Foreign Tax Credit (FTC). This article, based on IRS guidelines as per IRM 21.8.1.4.6 (10-01-2022), seeks to simplify this topic and provide a clear, concise understanding of the FTC.

What is the Foreign Tax Credit?

The FTC is a non-refundable tax credit that individual taxpayers can use to offset income taxes paid or accrued to foreign governments against their U.S. tax liability. This reduces the likelihood of being taxed twice on the same income.

How is the FTC Computed?

When dealing with individual taxpayers, the FTC is calculated separately for seven distinct categories of income:

1. Section 951A category income
2. Foreign branch income
3. Passive category income
4. General Limitation Category Income
5. Section 901(j) Category Income
6. Income Re-sourced by Treaty
7. Lump Sum Distributions

You can find more information on these categories in Publication 514.

To compute the FTC, you use Form 1116 for each category of income. If you paid taxes to more than three countries with the same type of income, you must use additional Forms 1116. It’s important not to combine the same type of income for different countries by writing “various” where the name of the country should be listed. However, there are exceptions to this rule, particularly when income is passed through a mutual fund or other Regulated Investment Company (RIC).

Income from mutual funds or other Regulated Investment Companies (RICs)

Things get a bit easier here. If you have income coming from various countries but it’s all funneled through a mutual fund or RIC, you can aggregate all that income into a single column on Form 1116. Just make sure to write “RIC” on line g of Part I.

Understanding the FTC Limitation

One of the fundamental principles in the computation of the FTC is the limitation rule. This rule states that the credit on each category of income cannot exceed the proportionate amount of U.S. tax paid on that category of income. Consequently, the FTC is limited to the lower of the FTC limitation or the foreign tax paid or accrued attributable to that category of income.

Reductions to the FTC

The FTC is subject to a ‘scale down’ if it’s attributable to excluded or exempt income, such as income from sources within American Samoa (IRC 931(a)) or Puerto Rico (IRC 933(a)). This means the amount of foreign income taxes claimed as a credit must be reduced to account for the income on which no U.S. tax is paid.

How the amount allocable to excludable income is determined.

The amount allocable to excludable income is determined by multiplying the foreign tax paid or accrued by a fraction of the excluded foreign earned income (minus apportioned deductible expenses) divided by the total foreign earned income (minus allocable deductible expenses).

Accounting for qualified dividends and capital gains and losses when calculating the Foreign Tax Credit

If a taxpayer has qualified dividends and/or capital gains and losses, adjustments to the amounts reported on line 1a (gains), line 5 (losses) and/or line 18 (taxable income before subtracting exemptions) of Form 1116 may be required.

What About Treaty Countries?

Certain treaty countries allow U.S. citizens who are residents in these countries to claim an additional credit for some taxes paid to the treaty country on U.S. source income. This effectively re-sources a portion of U.S. income as foreign income, increasing the taxpayer’s FTC limitation. This special credit is provided by the treaties of the following countries:

• Australia
• Austria
• Bangladesh
• Belgium
• Bulgaria
• Canada
• Czech Republic
• Denmark
• Finland
• France
• Germany
• Iceland
• Ireland
• Israel
• Italy
• Japan
• Luxembourg
• Malta
• Mexico
• The Netherlands
• New Zealand
• Portugal
• Slovak Republic
• Slovenia
• South Africa
• Spain
• Sweden
• Switzerland
• The United Kingdom

Treaty countries allowable for an additional credit calculation using the worksheet in Publication 514

The countries that allow for additional credit calculation using the worksheet in Publication 514 include:

• Australia
• Austria
• Bangladesh
• Belgium
• Bulgaria
• Canada
• Czech Republic
• Denmark
• Finland
• France
• Germany
• Iceland
• Ireland
• Israel
• Italy
• Japan
• Luxembourg
• Malta
• Mexico
• The Netherlands
• New Zealand
• Portugal
• Slovak Republic
• Slovenia
• South Africa
• Spain
• Sweden
• Switzerland
• The United Kingdom

Exceptions to using the worksheet in Publication 514 for calculating additional credit?

Do not use the worksheet in Publication 514 to figure the additional credit for Australia and New Zealand. If a statement is attached to the return, claiming a Foreign Tax Credit from these countries, the IRS will process the claim as if it is calculated on Form 1116.

IRC 901(j)

IRC 901(j) is a provision in U.S. tax law that denies the Foreign Tax Credit for taxes paid to certain countries due to nonrecognition of the foreign government (in most instances), the severance or lack of diplomatic relations, or the classification of the foreign country as one supporting terrorism.

Countries where the Foreign Tax Credit is not available.

The Foreign Tax Credit is not available for taxes paid to Iran, North Korea, Sudan, and Syria. However, a deduction for taxes paid to these countries is permitted.

When a taxpayer participates in a boycott with certain countries

If a taxpayer participates in a boycott with certain countries, the foreign tax credit is not available for foreign income taxes paid to those countries. These countries include Iraq, Kuwait, Lebanon, Libya, Qatar, Saudi Arabia, Syria, and Yemen.

In conclusion, understanding the FTC is essential to ensure you’re leveraging this credit to offset your U.S. tax liabilities effectively. As always, consult with a tax professional if you have any questions or need assistance with your personal tax situation.