Foreign Tax Credit
The Foreign Tax Credit (FTC) is a nonrefundable U.S. federal tax credit that allows taxpayers to offset income taxes paid or accrued to foreign governments against their U.S. tax liability, preventing double taxation on the same income from foreign sources. It is claimed on Form 1116 for individuals and Schedule K for pass-through entities.
U.S. citizens and resident aliens are subject to U.S. federal income tax on their worldwide income, regardless of where it is earned. When income from foreign sources is also subject to tax in the foreign country, the taxpayer faces the risk of paying tax twice on the same dollars. The Foreign Tax Credit exists to mitigate this double taxation by crediting qualifying foreign taxes against the U.S. tax that would otherwise be owed on that foreign-source income.
The FTC is most commonly encountered by investors who hold foreign stocks, international mutual funds, or American Depositary Receipts (ADRs). Foreign corporations often withhold taxes from dividends before remitting them to U.S. shareholders. The withheld amount — typically 15% to 30%, depending on the applicable tax treaty between the U.S. and the foreign country — is reported on Form 1099-DIV in Box 7 (foreign tax paid) and Box 8 (foreign country or U.S. possession). Investors who hold these securities in taxable brokerage accounts can generally claim the FTC.
For investors with $300 or less ($600 for married filing jointly) of foreign taxes paid — all from passive-category income such as dividends reported on Form 1099 — a simplified reporting method exists that does not require filing Form 1116. In these cases, the credit is entered directly on Form 1040 Schedule 3.
Beyond that threshold, Form 1116 must be completed. The form calculates the foreign tax credit limitation, which generally caps the credit at the amount of U.S. tax attributable to foreign-source income. The limitation is computed separately for different income baskets (passive income, general income, etc.). Excess foreign tax credits that cannot be used in the current year may be carried back one year or carried forward up to ten years.
Investors who hold foreign securities in tax-advantaged accounts such as IRAs or 401(k)s cannot claim the FTC on foreign taxes withheld within those accounts, because income in those accounts is not currently taxable. This is a reason some investors prefer to hold international funds in taxable accounts where the FTC is available.
The FTC does not apply to foreign taxes on income that is excluded from U.S. tax under the Foreign Earned Income Exclusion. It also does not apply to taxes on income that is not legal under U.S. tax law, or taxes paid to countries subject to U.S. sanctions.