What is the Foreign Tax Credit?

By Dean Alexander

Foreign-currency

You have a choice to take the foreign tax paid as either credit or as a deduction.

Before we answer the question fully let us ask what a credit is. A credit is best defined by contrast to a deduction. At the outset let us just say that a credit is much more important than a deduction. This will be apparent as we explain the difference. Let us start by explaining what a tax deduction is. Suppose that Taxpayer has income of two hundred thousand dollars.

Tax Credit Is Superior to Tax Deduction

Suppose that Taxpayer has a deduction of one hundred thousand dollars. Taxpayer net income then is the one hundred thousand dollars left after deduction. Suppose that Taxpayer is in thirty per cent tax bracket. Then his tax bill will be thirty thousand dollars. If he were to pay income tax on the full amount of income without deduction Taxpayer would have to pay sixty thousand dollars… So one hundred thousand dollars of deductions produced a savings of sixty thousand dollars of tax.

Suppose that the IRS allowed us to take a credit of thirty thousand dollars. That credit will immediately erase the tax bill of the thirty thousand dollars. Every dollar of credit will go against a dollar of tax. To summarize, it took a hundred thousand dollars to give us a benefit of thirty thousand dollar taxes while a thirty thousand dollar credit wiped out the whole thirty thousand dollars of taxes. The easy way to remember the difference is to remember that the credit is a dollar for dollar benefit against the final income tax number.

What is a Tax Credit?

After this rather lengthy discussion now it is time to define what foreign income tax credit is. From our discussion above it has to be just that: a tax credit against any foreign taxes we paid. So if you paid thirty thousand dollars credit against foreign income that credit will be deducted against your tax bill. It is not a deduction. So foreign tax credit is good. It is good because it is a benefit and it is good because the benefit is credit not a deduction.

An example will make the point clearer. In your business transaction in 2011, you earned one hundred thousand in Canada on which you paid fifteen thousand dollars tax and two hundred thousand in the USA. Your income worldwide is three hundred thousand dollars. Let us say that your tax on that income is sixty thousand dollars.

If you take the fifteen thousand dollars that you paid to Canada as a deduction it will barely make a dent in your tax liability. It may save you four thousand dollars but if you take it as a credit it will reduce the sixty thousand liability by fifteen thousand. Thus you will pay forty five thousand dollars of US income tax.

You Can Take Tax Deduction Instead of Tax Credit

I must say that you have the choice to take the foreign tax paid as either credit or as a deduction if the situation arises to better benefit from them as deduction rather than credit. In this instance you claim the credit as an itemized deduction on schedule A. Here are some situations when you can take the deduction if you cannot take the credit.

If there is a boycott that does not allow the credit you still can take the deduction on schedule A. Also you can use the deduction If the credit is denied as ineligible foreign credit, you do not meet the holding period for the credit to be taken, tax is accrued on account on a foreign oil sale, and finally the credit is denied if it is related to what they call covered assets which are assets that acquire a step up in basis.  Form 1116 is the one that is usually used to claim the credit.

Dean Alexander is the CEO of NFA Tax Help and has been helping clients with tax issues for over 35 years. More information is available at www.resolvemytaxes.com.

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