If you own a range of stocks and/or mutual funds, you may be paid dividends or interest from them each year, which is often taxable income in the eyes of Uncle Sam. But when a portion of that income comes from foreign sources, you may have already been taxed on it in the respective countries. That may sound like double taxation, but it doesn't have to be. The foreign tax credit will essentially give you back the tax you paid to foreign governments.
Credits and deductions
As an initial matter, it's important to distinguish tax credits from their more commonly used cousins, tax deductions. If you're entitled to a $1,000 deduction and you're in the 25% tax bracket, the deduction will reduce your taxable income by $1,000 and thereby reduce your taxes by $250. Alternatively, if you qualify for a $1,000 tax credit, the effect is to reduce your tax load directly by the full $1,000.
Somewhat muddying the water is the fact that you can choose to claim a foreign tax credit or deduction. Why would you choose the latter? While a deduction usually yields a smaller tax benefit, it also requires less paperwork, and you claim it on Schedule A of Form 1040. The IRS recommends running the numbers for both scenarios and choosing the most beneficial. Your accountant or the tax-prep software you use should be able to help in this regard.
Note, too, that the foreign tax credit is nonrefundable. That means, to use a simple example, that if your total tax due is $500 and your foreign tax credit is $600, you don't get to wipe out your tax and collect the difference of $100. If it were a refundable tax credit, as some credits are, then you'd be able to get a tax refund of $100.
Take it to the limit
To claim the foreign tax credit, you'll generally need to file IRS Form 1116.
The total amount of foreign tax you can have refunded has a limit, which you calculate with Form 1116. The IRS explains the limit this way:
Your foreign tax credit cannot be more than your total U.S. tax liability multiplied by a fraction. The numerator of the fraction is your taxable income from sources outside the United States. The denominator is your total taxable income from U.S. and foreign sources.
Skip the form and the limit
You get to bypass Form 1116 and the foreign tax credit limit if you meet all of the following conditions:
- Your only foreign source gross income for the tax year is passive income, such as dividends, interest, and annuity income. Active income, such as that deriving from work you performed in another country, doesn't qualify.
- Your qualified foreign taxes for the tax year are not more than $300 ($600 if filing a joint return).
- All of your gross foreign income and the foreign taxes are reported on a payee statement you receive, such as Form 1099-DIV or 1099-INT.
- You elect this procedure for the tax year. (Note that if you make this election, you can't carry back or carry over any unused foreign tax to or from this tax year.)
If you qualify on the above counts, you can just report your tax paid on Form 1040.
When the foreign tax credit doesn't apply
Fortunately, not all foreign governments will tax you. The United Kingdom and Canada, for example, have tax treaties with the U.S., agreeing to not tax Americans on certain income earned there, or to tax them at a reduced rate.
Many don't, though, leaving investors with some foreign taxes paid -- perhaps just via owning a mutual fund that invested in some foreign companies. The Vanguard Total World Stock Index Fund (VTWSX), for example, has more than $7 billion invested in it, and among its top 10 holdings are Nestle (NASDAQOTH: NSRGY), Novartis (NYSE: NVS), and Roche (NASDAQOTH: RHHBY), all based in Switzerland, where a 15% tax rate recently applied to dividends.
You might also bypass paying foreign taxes by doing a little research. Some companies let investors select from among several classes of shares with different tax domiciles. My colleague Alexander MacLennan explained last year, "Royal Dutch Shell is one example with Royal Dutch Shell Class A Shares (NYSE: RDS-A) being hit with a 15% Dutch dividend withholding tax and Royal Dutch Shell Class B Shares (NYSE: RDS-B) taking advantage of the U.K.'s 0% dividend withholding tax. Thus, if you're going to buy into a foreign stock, it's worth checking to see if there are different classes of stock to choose from.
Note, too, that when it comes to foreign income collected in an IRA, the foreign tax credit does not apply, and you won't get any money back.
There's more to learn about the foreign tax credit, such as how to deal with it when it's on a Schedule K-1 form, how to apportion interest expense, or what to do about taxes related to foreign boycotts. Read and learn more in IRS Publication 514, Foreign Tax Credit for Individuals. IRS Topic 856 offers a briefer review.
Selena Maranjian owns shares of Novartis. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.