Understanding Foreign Tax Credit
What is Tax Credit?
A tax credit is an amount of money that is deducted from the total tax amount to be paid by a taxpayer which leads to a reduction in the amount of the overall tax liability that the taxpayer owes to the government. The value of the tax credits usually determines the amount of reduction that the tax-paying entity will be able to get from the total amount of money owed as tax to the government.
Foreign Tax Credit
A foreign tax credit is a tax credit given to taxpayers that pay tax to a foreign government on income derived from jobs, businesses, or investments in that foreign country. For example; the foreign tax credit can be claimed by a resident or citizen of the US on the Federal income tax. Such an individual already pays an income tax on foreign income to the government of that foreign country. This helps prevent being taxed twice on the same income as a single taxpayer. However, if tax has not been paid on the income in the foreign country where the income was earned, it is expected of the tax payer to remit the tax in the federal income tax to the IRS.
This foreign tax credit however is non-refundable, that is, even if the value of the tax credit allowed is above the required tax amount, the tax amount can be reduced to Zero, but no refunds can be given. This means that if an individual owes a tax of $400 to a foreign country and is qualified for a tax credit of $1000, the tax amount owed by the individual will be reduced to Zero and the individual will not be required to pay any amount. However, the outstanding amount of $600 on the tax credit will not be refunded to the taxpayer but can be carried over to future years, of up to 10years, to reduce future tax liabilities. The monetary value of your tax credit will therefore determine the amount to subtract from your tax debt directly when filing your federal income tax return.
Foreign tax credits can be applied to income from businesses, wages, or investment profits in a foreign country; however, they cannot be claimed on non-income tax liabilities like property tax.
Eligibility for a foreign tax credit
There are certain requirements that qualify a taxpayer for a foreign tax credit. These are certain requirements that the Internal Revenue Service will check and confirm before you can be eligible to claim a foreign tax credit on your income.
- The tax paid on the foreign income or investment profits must have been imposed by the foreign government. If that tax is not imposed and the taxpayer paid it in the foreign country as a voluntary tax, the IRS will deny the taxpayer of a foreign tax credit. It is only foreign tax imposed on the taxpayer on any income earned in a foreign country that can be eligible for a foreign tax credit.
- A taxpayer can be eligible for a foreign tax credit if the tax on income earned or investment profits in that foreign country was actually paid. If the tax was not paid on the income to the foreign government by the taxpayer, the taxpayer will not be eligible for a foreign tax credit.
- A taxpayer is eligible for a foreign tax credit if the tax paid on income or profit to a foreign government is a legal and actual foreign tax liability. The tax paid to the foreign government must have been required by law and the taxable income must be earned in that foreign country.
- A taxpayer that pays tax to a foreign government can be eligible for a foreign tax credit if the tax paid to the foreign government is an income tax or tax paid on investment profits. Tax paid to a foreign government for property owned in the said foreign country is not qualified for a foreign tax credit.
Claiming a foreign tax credit
Your foreign tax credit can be claimed while filing your tax returns. The taxpayer ( individual, estate, or trust) will be required to file an IRS form 1116 and calculate according to given specifications, the amount of tax credits that they are eligible for. For Corporations claiming foreign tax credits, they will be required to file Form 1118 with the Internal Revenue Service (IRS).
A foreign tax credit is necessary to reduce the financial strain of being doubly taxed by two governments from a taxpayer. It will be unfair for a taxpayer to pay income tax on income earned in a foreign country to the said foreign government and still be taxed on the same income in their country of residence. Therefore, to avoid this occurrence, a provision was made for taxpayers to be able to obtain a foreign tax credit.
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