We discuss the rules and regulations of claiming the foreign tax credit for US expats. Form 1116 is used to calculate the taxpayer’s allowable foreign taxes paid. The IRS follows specified rules for calculating the allowable foreign taxes paid. Filing taxes, especially when foreign income is involved, is a bit of an ordeal. With our guidance and preparation, you can make this headache disappear for good.
What is IRS Form 1116?
Form 1116 is a US expat tax form that is used to calculate the taxes owed on income from foreign sources. This tax form is for Americans living and working abroad. This includes interest, dividends, rents, royalties, and pensions. As an expat, when you work in a foreign country and get paid for it, you owe taxes to your new host country. In contrast, a certain amount of tax is also owed to the US government as a citizen. The US government introduced credits, exclusions, and deductions to ease the financial stress on the foreign earner. As you file your annual tax return, you need to provide information about your foreign income sources and the amount of taxes you paid in the new host country.
How do you qualify for the Foreign Tax Credit
The taxpayer can only claim the credit if they have paid taxes in a foreign country. To qualify for the foreign tax credit, these specific requirements must be met:
- Tax legislation has imposed a tax on you as an individual
- You must have paid or accounted for the tax
- Your tax owed must be legal and form a foreign tax liability for you
- Tax owed should be related to your income earned from foreign sources
Taxes that do not qualify for Form 1116:
- Any taxes that were not included in your US gross income. In case you commit your foreign income and do not include it as part of your US gross income, the same may not be claimed as a credit under Form 1116
- If your new host country is part of the sanctioned list
- Form 1116 only includes taxes on income. It does not include taxes paid in the form of Value Added Tax (VAT), Sales Tax, Luxury Tax, or Real Estate Tax that you paid in a foreign country
- Taxes paid or accrued on foreign oil, gas, and mineral incomes
- Taxes paid or accrued on operations involving international boycotts
- Taxes paid or accrued in an event where foreign tax splitting takes place
How is Foreign Tax Credit calculated in Form 1116?
As an individual, your foreign tax credit calculation will involve your foreign taxable income divided by your total taxable income before exemptions. The amount thus calculated is multiplied by your total US tax obligation, and you get your foreign tax credit.
When you need to avail the foreign tax credit, you have to complete Form 1116. However, you may elect not to file Form 1116 yet claim foreign tax credit if all of the following conditions apply:
- Your foreign income is only a passive income, i.e. not employment-linked.
- Your total creditable foreign taxes do not exceed US$300 or US$600 (in case of a joint return)
- All the income and any foreign taxes paid on it were reported on a qualified payee statement (such as Form 1099-DIV, Form 1099-INT, or Schedule K-1)
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Guide towards filling your Form 1116
Step One: Ascertain that your case qualifies for the Foreign Tax Credit
The following conditions need to be met to qualify:
- There should be a foreign tax liability, either paid or accrued
- Tax is being assessed on your annual income
- Tax must be calculated in your individual capacity
- A foreign country should have generated your foreign tax liability
Step Two: Knowing the proper tax provisions
You can claim your foreign taxes with the following options:
- Claim the taxes that you already pay up in your new host country as deduction.
- File Form 1116 to claim them as credit so that you can reduce your taxes owed in the US dollar-for-dollar.
Note: You can carry over your excess credit amount if your liability for the current year is less than tax credits. You can go on carrying over the amount up to the next 10 years. You could attach a schedule of foreign tax carryover amounts for each year to your annual tax return.
Step Three: Convert your foreign taxes to US dollars
Being a citizen of the US, you file your US tax return in US dollars. Hence it is required to convert your foreign taxes to US dollars. You could refer to foreign exchange rates listed on the IRS website.
Step Four: Know your maximum tax credit eligibility
When filing to receive tax credits, you cannot exceed your US tax amount. Any excess amount needs to be carried over to the following years. Use the calculation:
Foreign taxable income divided by overall taxable income for the tax year before exemptions. The resulting amount is to be multiplied by the total US tax amount.
Once you complete the steps above, you may file your Form 1116 with the IRS to claim your foreign tax credit.
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