How to Calculate Your Foreign Tax Credits & Carryover (With Examples!)
The US is one of the only countries in the world that imposes citizenship-based taxation. It means that US expats, regardless of where they live or if they’re green card holders, must file a US tax return to report their worldwide income.
It might not be fun to go through all the extra paperwork on top of the taxes you must also file in your new home country. However, thanks to tools like the Foreign Tax Credit, the good news is that there are ways to avoid double taxation on your income.
This article gives you a brief overview of the Foreign Tax Credit (FTC) and carryover with some example calculations illustrating how many tax credits you can claim.
Quick overview: What’s the Foreign Tax Credit (FTC)?
The Foreign Tax Credit (FTC) allows US expats to reduce their tax liability based on what they already paid in foreign taxes on a dollar-for-dollar basis. You can claim foreign tax credits by filing IRS Form 1116 (directly available for download here) as part of your annual tax return to the IRS.
For example, let’s say you owe the US government $1500. At the same, you’ve already paid $1000 in Portugal taxes. With the FTC, you can use the $1000 you paid in Portugal taxes to reduce your US tax liability to $500. (Though the calculation in real life isn’t quite as simple).
One of the goals of the FTC is to help US taxpayers who earn foreign source income avoid double taxation. So if you live in a country with a higher tax rate than the US, like Japan or Finland, you may end up owing nothing in US taxes by using the FTC.
The maximum amount of tax credits you can claim depends on several factors, including how much foreign tax you’ve already paid and how much of your income is considered foreign sourced.
What are the rules for the Foreign Tax Credit (FTC)?
You must follow specific rules to benefit from the IRS’ Foreign Tax Credit (FTC). Here are the requirements that you must meet to be able to offset your taxes with the FTC:
The foreign tax must be an income tax.
Below, is a comprehensive list of foreign taxes that the IRS does not qualify as income tax:
- – Foreign taxes on mineral income
- – Social security taxes paid to a country with a totalization agreement with the US
- – Taxes paid to a country that the US deems to finance terrorism
- – Foreign taxes that are refundable
- – Taxes that US expats can only take an itemized deduction from
- – Taxes related to a foreign tax splitting event
Your country of residence must impose the tax on you.
For a foreign tax to qualify for the FTC, it must be a compulsory tax imposed on your pay. For example, France automatically deducts taxes from the employee’s monthly paycheck, which qualifies the tax as credits.
The foreign tax must be legal and an actual foreign tax liability
You must be required to pay the foreign tax for it to qualify for the FTC. For example, many US expats live as digital nomads with no official “base” where they have to pay foreign taxes. These type of expats won’t be able to take advantage of the foreign tax credit.
Let’s say that you’re an American digital nomad that has no established residency anywhere, but spent 5 months in Mexico. In this case, while maybe you spent almost half a year in Mexico, you did not spend enough time in the country or build enough social ties to become a Mexican tax resident. As a result, you can’t claim the FTC.
Instead, the Foreign Earned Income Exclusion may be a better tool to reduce US taxes for digital nomads. You can read these blog posts to learn more:
- – Claiming the Foreign Tax Credit vs. the Foreign Earned Income Exclusion
- – Digital Nomad Taxes: A Complete Guide
What is the Foreign Tax Credit (FTC) carryover?
Something that expats should know about the FTC is the potential to carry forward and carryback credits. If you don’t use all of your foreign tax credits in one year, you can carry that amount forward to the next year or back to the year before to lower your tax bill related to foreign income.
The IRS allows you to use unused foreign taxes for up to 10 years. If you’re short on tax credits the year before, you can also carry the excess back just one tax year to cover them, which may require you to amend a previous year’s return.
Categories of Income on the Form 1116
When preparing Form 1116, you will need to report different categories of income and the foreign tax paid related to them, on different copies of the form. This is because you can only apply foreign tax paid to income in the same category. Let’s say you live in Singapore and pay income tax on your wages, but your capital gains are tax-free in Singapore. On the US tax return, you can use the foreign tax related to your wages to offset your (general category) income tax but not your capital gains tax (passive category)
Here are the different types of income you can report on Form 1116:
- – Section 951A category income: Income under Section 951A refers to any intangible low-taxed income (GILTI) included by U.S. shareholders of certain CFCs.
- – Foreign branch category income: Any income that consists of profits made by a US person in one or more qualified business units (QBUs) in one or more foreign countries (and doesn’t include passive income).
- – Passive category income: This covers any passive income via sources such as rental properties, wages, and annuities.
- – General category income: This includes any wages you collect or income you generate from your business.
- – Section 901(j) countries: You use this category to report any income you earn from a country accused of supporting international terrorism, that doesn’t have a diplomatic relationship with the US or that the US government doesn’t recognize.
- – Resourced by treaty: You must use this category to complete Form 1116 if the country where you reside has a tax treaty with the US that classifies all the income you earn as income from the treaty country.
- – Lump-sum distributions: This category refers to any income you earn from a foreign-sourced pension plan.
Calculating your Foreign Tax Credit (FTC) and carryover
Here’s the formula you should use to calculate the maximum foreign tax credits you can use:
Foreign sourced income / total taxable income * US tax liability = Maximum FTC you are allowed to take
If the foreign tax you paid is less than this then FTC = Foreign tax paid
If the foreign tax you paid is more than this then FTC = Maximum FTC you are allowed to take
To calculate your carryover amount:
Foreign taxes paid – FTC taken = FTC carryover
We have outlined some examples to give you a better idea how this formula actually works:
Example #1: John, Web Developer in Zurich, Switzerland
John is a US expat from Illinois. He works as a web developer in Zurich, Switzerland. His salary is $150,000 annually, and John paid over $40,000 in taxes to the Swiss government. He also has rental income from property he owns back in Chicago, earning $30,000, bringing him to a total of $180,000 for the year. John’s US tax liability is $25,000.
Here’s how we calculate his total FTC based on the elements above:
$150,000 (his foreign income) / $180,000 (his total income) * $25,000 (his US tax bill) = $20,833 is the maximum amount of his US tax bill he can offset with foreign taxes
John can claim up to $20,833 in tax credits. But he must have paid at least that much in Swiss taxes to fully take advantage of the credit.
Let’s say he paid more, and John paid $30,000 in Swiss tax. He can still only take $20,833 of credit, but the leftover tax can be brought forward to future years, and here’s how we calculate his carry-over amount:
$30,000 (total amount of Swiss paid) – $20,833 (FTC credits) = $9,167
So in total, John has an FTC carryover amount of $9,167.
Example #2: Sarah, Psychologist in Costa Rica
Sarah is a California native working as a psychologist in Costa Rica. She has a yearly salary of $100,000 and paid $13,000 in taxes to the Costa Rican government.
She also has income from a trust fund in the US that provides an extra $20,000 per year. With this in mind, her US tax liability is $20,000.
Here’s how we calculate the maximum tax credit Sarah can claim:
$100,000 / $120,000 * $20,000 = $16,666
The total amount she could claim is $16,666, but since she only paid $13,000 to Costa Rica, her credit is only $13,000.
If Sarah has any excess foreign tax credits next year, she’ll be able to go back and amend her tax return and carry back up to an additional $3,666 ($16,666 maximum -$13,000 taken).
What is the deadline for claiming the Foreign Tax Credits (FTC)?
You must file Form 1116 on the same day as your US tax return: April 15th. That being said, US expats benefit from an extension until June 15th and can also request an additional extension to October 15th.
Need assistance with your FTC? Bright!Tax is here to help!
The Foreign Tax Credit can be a difficult matter to navigate for American expats. If you still have questions about the FTC and whether you qualify, our tax team at Bright!Tax is here to help and offer guidance. Contact us today and one of our CPAs will reply right away with answers about your US expat tax situation.