Foreign Tax Deductions
Individuals and corporations earning income from abroad face the possibility of double taxation when their home countries and foreign governments assert tax jurisdiction over their income. Double taxation on income earned from abroad typically can be avoid in two ways: the foreign tax credit and the foreign earned-income exclusion.
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The Foreign Tax Credit: Eligibility
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To claim the foreign tax credit, an individual or a corporation must have actually paid the foreign taxes claimed, or the taxes must have been actually assessed and due for the tax year in question --- future and contingent liabilities cannot be claimed. The tax must be mandatory rather than voluntary. It must be legal --- a company that has been a victim of extortion by public authorities, for example, must pursue remedies other than a U.S. tax credit. In most cases, the taxpayer is allowed to credit an amount less than 100 percent of its total foreign taxes paid or due, and total credits may never exceed the taxpayer's total U.S. tax obligation. The foreign taxes credited must be income tax, excess profits tax or war profits tax.
Exclusions
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If an exclusion to the general foreign tax credit rules applies, the taxpayer may credit 100 percent of foreign taxes paid or due. Taxes imposed on passive income earned from overseas investments come within the exclusion, as do certain other taxes such as export financing by corporations. Additional exclusions may be available under bilateral tax treaties. If all of the foreign taxes paid fall within an exclusion, the taxpayer need not file separate forms for the foreign tax credit --- individuals simply file Form 1040, while corporations file Form 1120.
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Expatriates
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Employees who are physically located abroad while earning the income falling under the jurisdiction of U.S. and foreign tax authorities have two alternatives to the foreign tax credit --- the foreign earned income exclusion and the housing deduction. Individuals may exclude up to $92,900 from their taxable income (for the 2011 tax year) and may also exclude costs incident to employer-provided housing abroad. These two exclusions can be used in partial conjunction with each other --- they cannot simply be summed. They cannot be used together with the foreign tax credit, unless the taxpayer earned some, but not all of the foreign-taxed income while physically present in the United States.
Paperwork
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Unless an exclusion applies, individuals must file forms 1116 and 1040 to claim the foreign tax credit, while corporations must file forms 1118 and 1120. The foreign tax credit is subtracted directly from total tax due rather than from taxable income. There is also a foreign tax deduction available that allows taxpayers to subtract foreign taxes paid from taxable income; however, the IRS recommends using the foreign tax credit instead, because it almost always results in a lower tax burden.
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References
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