Foreign tax credits are crucial in avoiding double taxation of income earned abroad, so helping clients claim them properly is vital for adhering to tax regulations and remaining compliant.

Contrary to tax deductions, which only reduce taxable income, an FTC offers a direct reduction of your actual taxes owed – providing dollar-for-dollar relief on those amounts owing. However, certain conditions must be fulfilled to qualify for this credit.

Benefits

The Foreign Tax Credit (FTC) is a non-refundable credit that can reduce a client’s US federal income tax liability dollar-for-dollar, making it often the more beneficial choice than Foreign Earned Income Exclusion for those residing in countries with higher foreign taxes than American rates.

For the Foreign Tax Credit to apply, your client’s foreign taxes must have been paid or accrued on income sourced from a foreign country or U.S. possession – passive foreign income such as dividends, interest and royalties typically does not qualify.

Foreign tax credits cannot be claimed directly as deductions on Form 1040; rather, they must be computed and declared on Form 1116. Claiming them can help eliminate itemized deductions on Schedule A as well as double taxation risk, making the foreign tax credit an invaluable asset for multinationals with employees abroad.

Risks

Understanding the difference between credits and deductions is essential when planning for international taxes. A credit reduces a taxpayer’s total tax liability while deductions reduce how much income is subject to taxes.

For a foreign tax credit to apply, a taxpayer must be legally required to pay the foreign tax in question on income earned abroad and not simply as an alternative tax burden imposed as part of an ordinary income tax liability.

Expats face the risk of double taxation when living abroad. Thankfully, the Foreign Tax Credit can provide relief by offsetting their US tax liability against taxes paid overseas – but there are limitations as to its use so an understanding of tax treaties and FTC is key for effective implementation.

Limits

Assistanceing clients in maximizing their foreign tax credits requires an in-depth knowledge of both the four tests for eligibility as well as carrying back or forward credits. Credits carried back can be applied against past taxes paid while those carried forward provide long-term planning opportunities that could save thousands in U.S. taxes.

To qualify for the foreign tax credit, a tax must have been levied against you by a foreign country or its possession. This includes income taxes, war profits taxes and excess profit taxes levied by foreign governments – though local property taxes don’t count; additionally, this credit cannot be used to offset itemized deductions on federal returns.

As a result, taxpayers who use foreign tax credits as part of arrangements that generate significant foreign tax savings are ineligible for this credit. This is particularly the case when those arrangements shift income or expenses between entities (for instance through buy-sell/swap arrangements that shift tax liabilities between entities).

Exhaustion of Remedies

Treasury and the Service are currently working on regulations designed to combat abusive arrangements involving high withholding taxes. These regulations will generally prohibit foreign tax credits generated through structures or transactions which exploit discrepancies between U.S. and foreign tax laws to lower a taxpayer’s residual liability for income taxes.

These rules also restrict how many foreign tax credits may be applied against taxable profits. To qualify as creditable foreign taxes, the underlying taxes must be levied directly against income, war profits, excess profits or revenue taxes and cannot include deductions, rebates, payments or discharge of obligations.

Also, these regulations will prohibit creditable foreign taxes that result from abusive arrangements that employ hedging devices to shield from U.S. income, such as rules that allocate interest expense non-traceably – such a move is in direct contradiction to the intent and structure of foreign tax credit provisions.