The amount of the foreign tax a taxpayer can use as a credit to offset his or her
tax liability is limited based on the following formula. The
tax liability is regular tax only (i.e., does not include Alternative Minimum Tax or Self Employment tax) reduced by certain nonrefundable personal credits. However, for tax years 2000?2008, there was no reduction for any of the nonrefundable personal credits.
U.S. tax paid X Foreign Source Income / Total Income
As an example, if your income was $200,000 and it included $1,000 of foreign source income from a mutual fund that withheld $200 of foreign tax. The your maximum credit would be (if your
tax were $24,000).
$24,000 X $1,000 / $200,000 = $120
The foreign tax credit may not exceed the portion of
tax attributable to income from foreign sources. The limitation is calculated on Form 1116. If the foreign taxes paid or accrued in the current year exceed the limitation, the excess taxes are first carried back to the preceding year and then forward to the 10 succeeding years. There is no election to forego the carry back period. The excess taxes are considered paid in the year to which they are carried and can be used only when the overall limitation for that year exceeds the foreign taxes actually paid or accrued.
An individual with (1) no more than $300 ($600 for married filing jointly) of creditable foreign taxes, and (2) only qualified passive foreign income, may elect to be exempt from the foreign tax credit limitation. Qualified passive income generally includes investment income such as dividends, interest, rents, royalties, and sale or exchange gains. The election is made by simply claiming the foreign tax credit on the appropriate line of Form 1040 instead of filing Form 1116. Any unused credit cannot be carried back or forward if this election is made.
Making the election should be considered when:
The cost to amend the prior year return (one year carry back) is greater than the lost credits due to the election.
The current year credit is reduced by the formula above by more than the credits lost due to the election.
- The amount of foreign tax lost is so small it does not justify the extra cost of preparing Form 1116.