What Is a Foreign Tax Credit?

Companies and individuals that do business outside the United States may be eligible for a foreign tax credit on their federal taxes. This tax credit program is designed to prevent double taxation and to help companies avoid double taxation. Here are a few things to consider about the foreign tax credit and how it is used by companies. 

Foreign Business

Many companies and individuals in the United States do business outside of the country. Depending on what country they are doing business with, they may have to pay some type of foreign taxes. Many countries will impose an income tax on the amount of money that is made in them. A company could have to pay a significant amount of money to a foreign government in order to cover the taxes.

Credit or Deduction

Companies have an option about how they handle foreign taxes in relation to their domestic taxes. Typically, they will be given the choice to take either a tax deduction or a tax credit on their federal taxes. A tax deduction will allow them to deduct the amount of money that they have paid in foreign taxes from their taxable income for the year. Then, their tax liability will be calculated off of that taxable income.

The other option that they have is to utilize a tax credit. A tax credit is a dollar for dollar reduction of tax liability. In most cases, people prefer to get a tax credit because they will be able to save significantly more money than they would with a tax deduction. Tax deductions reduce only by percentages, while credits reduce by the dollar. 

Requirements

In order to qualify for a foreign tax credit, you have to meet a few qualifications. First of all, the tax must be imposed on you or your business by the foreign government. In addition to that, you have to pay the tax or accrue the tax. The tax also must be the legal and actual foreign tax liability. The tax has to be an income tax or a payment in lieu of income tax. If you meet these qualifications, you may be eligible to file for the foreign tax credit. You do not necessarily have to live in the foreign country or work there in order to file for the foreign tax credit. In order to claim the foreign tax credit, you need to fill out Form 1116 for your tax return.

Figuring Tax Credit

To determine how much of a tax credit you can get, you need to utilize a specific formula. First of all, take the total amount of money that you make from foreign sources and divide that by your total worldwide income. This gives you a percentage. Then you multiply that percentage by your United States tax liability. The foreign tax credit that you receive cannot exceed this amount when you file your taxes.