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Why Choose the Credit?
The foreign tax credit is intended to relieve you of the double tax burden when your foreign source income is taxed by both the United States and the foreign country. Generally, if the foreign tax rate is higher than the U.S. rate, there will be no U.S. tax on the foreign income. If the foreign tax rate is lower than the U.S. rate, U.S. tax on the foreign income will be limited to the difference between the rates. The foreign tax credit can only reduce U.S. taxes on foreign source income; it cannot reduce U.S. taxes on U.S. source income.
Although no one rule covers all situations, it is generally better to take a credit for qualified foreign taxes than to deduct them as an itemized deduction. This is because:
Example 1. For 2001, you and your spouse have adjusted gross income of $80,000, including $20,000 of dividend income from foreign sources. You file a joint return and can claim two $2,900 exemptions. You had to pay $2,000 in foreign income taxes on the dividend income. If you take the foreign taxes as an itemized deduction, your total itemized deductions are $10,000. Your taxable income then is $64,200 and your tax is $12,012.
If you take the credit instead, your itemized deductions are only $8,000. Your taxable income then is $66,200 and your tax before the credit is $12,562. After the credit, however, your tax is only $10,562. Therefore, your tax is $1,450 lower ($12,012 - $10,562) by taking the credit.
Example 2. In 2001 you receive investment income of $5,000 from a foreign country, which imposes a tax of $3,500 on that income. You report on your U.S. return this income as well as $56,000 of income from U.S. sources. You are single, entitled to one $2,900 exemption, and have other itemized deductions of $5,400. If you deduct the foreign tax on your U.S. return, your taxable income is $49,200 ($5,000 + $56,000 - $2,900 - $5,400 - $3,500) and your tax is $10,156.
If you take the credit instead, your taxable income is $52,700 ($5,000 + $56,000 - $2,900 - $5,400) and your tax before the credit is $11,118. You can take a credit of only $912 because of limits discussed later. Your tax after the credit is $10,206 ($11,118 - $912), which is $50 ($10,206 - $10,156) more than if you deduct the foreign tax.
If you choose the credit, you will have unused foreign taxes of $2,588 ($3,500 - $912). When deciding whether to take the credit or the deduction this year, you will need to consider whether you can benefit from a carryback or carryover of that unused foreign tax.
Credit for Taxes Paid or Accrued
You can claim the credit for a qualified foreign tax in the tax year in which you pay it or accrue it depending on your method of accounting. "Tax year" refers to the tax year for which your U.S. return is filed, not the tax year for which your foreign return is filed.
Accrual method of accounting. If you use an accrual method of accounting, you can claim the credit only in the year in which you accrue the tax. You are using an accrual method of accounting if you report income when you earn it, rather than when you receive it, and you deduct your expenses when you incur them, rather than when you pay them.
Foreign taxes generally accrue when all the events have taken place that fix the amount of the tax and your liability to pay it. If you are contesting your foreign tax liability, you cannot accrue it and take a credit until the amount of foreign tax due is finally determined. However, if you choose to pay the tax liability you are contesting, you can take a credit for the amount you pay before a final determination of foreign tax liability is made. Once your liability is determined, the foreign tax credit is allowable for the year to which the foreign tax relates. If the amount of foreign taxes taken as a credit differs from the final foreign tax liability, you may have to adjust the credit, as discussed later under Foreign Tax Redetermination.
You may have to post a bond. If you claim a credit for taxes accrued but not paid, you may have to post an income tax bond to guarantee your payment of any tax due in the event the amount of foreign tax paid differs from the amount claimed.
The IRS can request this bond at any time without regard to the Time Limit on Tax Assessment, discussed later under Carryback and Carryover.
Cash method of accounting. If you use the cash method of accounting, you can choose to take the credit either in the year you pay the tax or in the year you accrue it. You are using the cash method of accounting if you report income in the year you actually or constructively receive it, and deduct expenses in the year you pay them.
Choosing to accrue taxes. Even if you use the cash method of accounting, you can choose to take a credit for foreign taxes in the year they accrue. You make the choice by checking the box in Part II of Form 1116. Once you make that choice, you must follow it in all later years and take a credit for foreign taxes in the year they accrue.
In addition, the choice to accrue foreign taxes applies to all foreign taxes qualified for the credit. You cannot take a credit for some foreign taxes when paid and take a credit for others when accrued.
If you make the choice to accrue foreign taxes and pay them in a later year, you cannot claim a deduction for any part of the previously accrued taxes.
Credit based on taxes paid in earlier year. If, in earlier years, you took the credit based on taxes paid, and this year you choose to take the credit based on taxes accrued, you may be able to take the credit this year for taxes from more than one year.
Example. Last year you took the credit based on taxes paid. This year you chose to take the credit based on taxes accrued. During the year you paid foreign income taxes owed for last year. You also accrued foreign income taxes for this year that you did not pay by the end of the year. You can base the credit on your return for this year on both last year's taxes that you paid and this year's taxes that you accrued.
Foreign Currency and Exchange Rates
U.S. income tax is imposed on income expressed in U.S. dollars, while the foreign tax is imposed on income expressed in foreign currency. Therefore, the tax credit is affected when the foreign currency depreciates or appreciates in value in terms of U.S. dollars.
Translating foreign currency into U.S. dollars. If you receive all or part of your income or pay some or all of your expenses in foreign currency, you must translate the foreign currency into U.S. dollars. How you do this depends on your functional currency. Your functional currency generally is the U.S. dollar unless you are required to use the currency of a foreign country.
You must make all federal income tax determinations in your functional currency. The U.S. dollar is the functional currency for all taxpayers except some qualified business units. A qualified business unit is a separate and clearly identified unit of a trade or business that maintains separate books and records. Unless you are self-employed, your functional currency is the U.S. dollar.
Even if you are self-employed and have a qualified business unit, your functional currency is the dollar if any of the following apply.
If your functional currency is the U.S. dollar, you must immediately translate into dollars all items of income, expense, etc., that you receive, pay, or accrue in a foreign currency and that will affect computation of your income tax. If there is more than one exchange rate, use the one that most properly reflects your income. You can generally get exchange rates from banks and U.S. Embassies.
If your functional currency is not the U.S. dollar, make all income tax determinations in your functional currency. At the end of the year, translate the results, such as income or loss, into U.S. dollars to report on your income tax return.
For more information,
Rate of exchange for foreign taxes paid. Use the rate of exchange in effect on the date you paid the foreign taxes to the foreign country unless you meet the exception discussed next. If your tax was withheld in foreign currency, you use the rate of exchange in effect for the date on which the tax was withheld. If you make foreign estimated tax payments, you use the rate of exchange in effect for the date on which you made the estimated tax payment.
Exception. If you claim the credit for foreign taxes on an accrual basis, you must generally use the average exchange rate for the tax year to which the taxes relate. This rule applies to accrued taxes relating to tax years beginning after 1997 and only under the following conditions.
For all other foreign taxes, you should use the exchange rate in effect on the date you paid them.
Foreign Tax Redetermination
A foreign tax redetermination is any change in your foreign tax liability that may affect your U.S. foreign tax credit claimed.
The time of the credit remains the year to which the foreign taxes paid or accrued relate, even if the change in foreign tax liability occurs in a later year.
If a foreign tax redetermination occurs, a redetermination of your U.S. tax liability is required in the following situations.
Tax years beginning before 1998. For tax years beginning before 1998, a redetermination of your U.S. tax liability is required if:
See Rate of exchange for foreign taxes paid, earlier under Foreign Currency and Exchange Rates.
When redetermination of tax is not required. A redetermination is not required if the change is due solely to an exchange rate fluctuation and the change in foreign tax liability for the tax year is less than the smaller of:
In this case, you must adjust your U.S. tax in the tax year in which the accrued foreign taxes are paid.
Tax years beginning after 1997. For tax years beginning after 1997, a redetermination of your U.S. tax liability is required if:
If (2) above applies to you, you will not be allowed a credit for the unpaid taxes until you pay them. When you pay the accrued taxes, you must translate them into U.S. dollars using the exchange rate as of the date they were paid. The foreign tax credit is allowed for the year to which the foreign tax relates. See Rate of exchange for foreign taxes paid, earlier, under Foreign Currency and Exchange Rates.
When redetermination of tax is not required. If the accrued taxes when paid differ from the amount you claimed as a credit only because of the fluctuation in the currency exchange rate, a redetermination is not required if the amount is paid within two years after the close of the tax year to which the taxes relate.
Notice to the Internal Revenue Service of redetermination. You must file Form 1040X, Amended U.S. Individual Income Tax Return, and a revised Form 1116 for the tax year affected by the redetermination. The IRS will redetermine your U.S. tax liability for the year or years affected.
If you pay less foreign tax than you originally claimed a credit for, you must file Form 1040X and a revised Form 1116 within 180 days after the redetermination occurred. There is no limit on the time the IRS has to redetermine and assess the correct U.S. tax due. If you pay more foreign tax than you originally claimed a credit for, you have 10 years to file a claim for refund of U.S. taxes. See Time Limit on Refund Claims, later.
Failure-to-notify penalty. If you fail to notify the IRS of a foreign tax redetermination and cannot show reasonable cause for the failure, you may have to pay a penalty.
For each month, or part of a month, that the failure continues, you pay a penalty of 5% of the tax due resulting from a redetermination of your U.S. tax. This penalty cannot be more than 25% of the tax due.
Foreign tax refund. If you receive a foreign tax refund without interest from the foreign government, you will not have to pay interest on the amount of tax due resulting from the adjustment to your U.S. tax for the time before the date of the refund.
However, if you receive a foreign tax refund with interest, you must pay interest to the IRS up to the amount of the interest paid to you by the foreign government. The interest you must pay cannot be more than the interest you would have had to pay on taxes that were unpaid for any other reason for the same period.
Foreign tax imposed on foreign refund. If your foreign tax refund is taxed by the foreign country, you cannot take a separate credit or deduction for this additional foreign tax. However, when you refigure the foreign tax credit taken for the original foreign tax, reduce the amount of the refund by the foreign tax paid on the refund.
Example. You paid a foreign income tax of $3,000 in 1999, and received a foreign tax refund of $500 in 2001 on which a foreign tax of $100 was imposed. When you refigure your credit for 1999, you must reduce the $3,000 you paid by $400.
Time Limit on Refund Claims
You have 10 years to file a claim for refund of U.S. tax if you find that you paid or accrued a larger foreign tax than you claimed a credit for. The 10-year period begins the day after the regular due date for filing the return for the year in which the taxes were actually paid or accrued.
You have 10 years to file your claim regardless of whether you claim the credit for taxes paid or taxes accrued. The 10-year period applies to claims for refund or credit based on:
The special 10-year period also applies to making or changing your choice of whether to claim a deduction or credit for foreign taxes. See Making or Changing Your Choice discussed earlier under Choosing To Take Credit or Deduction.