5

Foreign Tax Credits

Your income is at risk, two or more countries may want to tax you on the same income. You could be subject to tax in two countries in a number of scenarios, but they all boil down to one basic idea. When you live in a country that imposes taxes on worldwide income, such as the US or Canada, and you pay taxes in another (foreign) country because of income you earned in that foreign country, you can potentially be subject to double tax. If everyone wants a piece of your hard-earned money, how do you avoid paying taxes more than once? The good news is that you have two options. The first option is discussed in Chapter 3 (The Treaty), which provides specifics about which country gets to tax what income. The primary goal of the Treaty is to prevent double taxation. The second option to avoid double taxation is through foreign tax credits, which is the topic of this chapter.

Note: Some retail tax software packages do not handle foreign tax credits properly. Of course, since you are not an expert on foreign tax credits, you have no way of knowing whether your software handles them correctly or not. To make matters worse, there are other cross-border issues a retail software package may not address or may handle improperly.

As we mentioned in the introduction, we have been preparing complex tax returns for more 20 years and we are still amazed at the number of people who tell us that they have a simple situation. We want to let you in on a secret, if you are reading this book, you do not have a simple situation. We recommend that you seek a professional that is experienced with cross-border taxes. The professional will have the experience, know-how, and resources (professional software) to do the job properly.

1. What Are Foreign Tax Credits?

The definition of a tax credit is an item that reduces your actual tax. It differs from a tax deduction that reduces only your taxable income. A foreign tax credit is defined as a subtraction against federal income tax for a taxpayer who has paid taxes to another country on income that was also taxed in his or her home country. The foreign tax credit is calculated on IRS Form 1116 (Foreign Tax Credit) and flows through to page two (line 47 of the 2011 Form 1040 — US Individual Tax Return) of your personal tax return. Though we will not discuss the topic in this book, the foreign tax credit form for a corporation is Form 1118 (Foreign Tax Credits - Corporations).

There are two types of tax credits in the US, refundable and nonrefundable. A refundable credit is defined as a tax credit that is not limited by tha amount of an individual’s tax liability, meaning that you could receive a refund even when no tax has been paid. A refundable credit can turn your tax negative, meaning that you could receive a refund even when no tax is owed. However, most credits are nonrefundable, which means that the credit can only reduce the tax liability to zero. Foreign tax credits are nonrefundable.

The first thing to know about foreign tax credits is that you have to have income that is actually taxed (paid or accrued) in two or more countries. Unfortunately, not all types of taxes qualify for a foreign tax credit. To be a creditable tax, the tax has to be —

• imposed on you or, if filing jointly, your spouse, and not on someone else such as your children;

• paid or if it is not paid, it must be a legitimate liability that you will pay for that tax year (accrued); for example, if you had foreign income which had no withholding during the year (2012). The tax that you pay when you file your foreign tax return in 2013 still counts as a credit in 2012;

• an income tax or a tax similar to an income tax; and/or

• not imposed by a sanctioned country such as Iran, North Korea, or Syria.

Some taxes are not income taxes and will therefore not qualify for a tax credit. These include social security tax, sales tax, value added tax (VAT), and customs tax. An example of a tax that is similar to an income tax is a withholding tax.

You have two choices when foreign taxes are paid (or accrued). You can take the tax paid as a credit or as a deduction. The deduction is taken on Schedule A as an itemized deduction. (Chapter 8, Common Deductions, explains in more detail what an itemized deduction is and which expenses can be deducted.) A deduction reduces your income that is subject to tax and is not a direct subtraction on your tax. The benefit of a deduction is based on the highest tax bracket to which you are subject to; this is known as your marginal tax rate. For example, if you are in the 25 percent marginal tax bracket, you will reduce your tax $1 for every $4 of tax deducted. However, a credit is a dollar-for-dollar offset of your tax, so for every $1 of credit, you will reduce your tax by $1. The catch is that you may not get to use every dollar of foreign tax paid as a credit because of various limitations that we will explain shortly.

If a deduction only provides a partial benefit for the foreign tax you pay and a credit is a dollar-for-dollar reduction in tax, why would anyone ever take the tax as a deduction? We hope the following examples will help to explain why in some circumstances, taking the deduction may be the best choice.

Credit Example

Let’s say you have $10,000 of foreign (Canadian) income, which results in $1,500 (15 percent) of US tax before credits. You also have $1,000 of taxes paid to Canada (foreign tax). The $1,000 paid to Canada becomes a foreign tax credit. If you choose the credit for the foreign tax paid (assuming you were able to use all $1,000 of the credit), your net US tax would be $500 ($1,500 minus the credit of $1,000). Note that you may not be able to use all of the $1,000 foreign tax paid in the year paid.

Deduction Example

Now take the same scenario and run it through the deduction model. Your income would be reduced to $9,000, from $10,000 because of the $1,000 of foreign tax you paid. Your tax would now be $1,350 ($9,000 x 15 percent). In other words, the benefit you receive from taking the deduction is only $150. Thought of a different way, you take the foreign tax of $1,000, times the 15 percent tax rate to get $150.

If the net tax is $500 for a credit and $1,350 for a deduction, why would anyone choose to take the deduction? In nearly every case you would chose the credit, but there are times why it is better to take the deduction. For instance, you might choose to take the deduction instead of the credit if you are unable to use all of your foreign tax paid, as a credit, in its entirety. This happens when the two countries tax income differently or at substantially different rates.

An example would be if you sold assets in Canada that were taxed differently in the US, resulting in a much larger gain in Canada than in the US. This can happen in a number of ways, such as different depreciation (capital cost allowance) amounts taken, or a portion of the gain is excluded in one country or another, or due to a change in currency.

For example, you withdrew $100,000 from your Registered Retirement Savings Plan (RRSP) and paid $25,000 in Canadian withholding tax. Furthermore, the US cost basis is $90,000 and your US tax is $1,500 on the $10,000 that is taxable in the US. Since the tax credit cannot exceed the US tax (remember it is a nonrefundable tax), the maximum credit is $1,500. In this case, you will have to carry $23,500 of credits forward for up to ten years; this is called a “credit carry forward.” You may or may not be able to use this credit in future years. However, if you took the deduction of $25,000, you would have reduced your taxes by $3,750 ($25,000 x 15 percent), a benefit that exceeds the credit by $2,250.

Even in this case, it is not clear what the best option is. You might be able to use some or all of the $23,500 foreign tax credit carry forward during the next ten years. To do this you would have to generate significant foreign income over those years because you can only use the foreign tax credit to the extent that you have foreign income.

As a rule, you would typically choose the deduction over the credit when the scenario is similar to the one above and where you would be using the money from the RRSP (e.g., to buy a house) and therefore the money would not be available to produce foreign income going forward.

Note: If you think that Form 1116 (Foreign Tax Credit) looks dizzyingly complex, don’t feel bad, it is. If you are completing this form yourself, please read the instructions and Publication 514 very carefully.

2. Types of Foreign Income

As you will see at the top of IRS Foreign Tax Credit (Form 1116), there are five different foreign income categories, but only two of them are used on a regular basis — passive category income and general category income. The segregation is to prevent a taxpayer from manipulating investments and averaging foreign tax credits on operating income, which generally have relatively high foreign tax rates imposed, with foreign tax credits on passive types of income. These latter types of income can often be invested in a way that allows for a low foreign tax. By segregating passive foreign source income and active foreign income into separate baskets in applying the foreign tax credit limitation, the tax law prevents cross-crediting of foreign taxes between operating and investment income.

“General limitation income” is anything that does not fall into one of the other categories. The most common types of general limitation income are wages, self-employment income, company pensions, and even income that would normally be passive.

“Passive income” includes dividends, interest, rents, royalties, annuities, and capital gains. There is, however, an exception called the “high tax kick out.” This exception occurs when the foreign tax is higher than the highest US tax that can be imposed on that income. When this happens, income that would normally be passive will be moved to the general limitation category. To be clear, it is not the US tax that is actually imposed, but instead, it is the tax that theoretically can be imposed. For example, if the foreign tax paid on the foreign income is equal to or greater than 35 percent (in 2012, this is the highest US marginal tax rate), it will be subject to the high tax kick out.

Note: Foreign tax credits are subject to limitations per category. Each category is limited to the foreign income in that category, divided by worldwide income.

If you are taking the foreign taxes paid as a credit on the federal return, you must do the same on the state return as well. Keep in mind that most states do not allow a credit for taxes paid to another country.

3. How to Calculate the Foreign Tax Credit

When taking the credit, you are asked to choose between “paid” or “accrued.” We recommend that you choose accrued. Why? If you choose “paid,” you are choosing the “cash method” of accounting. The cash method of accounting records income when cash is received and expenses when cash is paid out. This means that if you had withholding throughout the year, only those taxes could be taken as a credit for that year, and additional taxes due with the return (the following year) would have to be claimed on next year’s return. If you received a refund, you would have to amend the previous year’s return to reduce the credit taken for that year — too complicated, in our opinion, and therefore should be avoided.

Intuitively, you would think if you paid $100 in foreign tax that you would get $100 in foreign tax credits, but that is not always the case. The reason for this is that you can only take a credit against your foreign income. The maximum foreign tax credit is equal to the total US tax, times total foreign income, divided by your total world income. This ratio is applied separately to each type of foreign income then added together for a total. This can have the effect of reducing the total possible tax credit. Though the actual calculation of the foreign tax credit is more complicated in a number of ways, the following example below is used to illustrate the concept; the actual tax credit might ultimately be less than the example.

• Assume that you have $25,000 of wages (general limitation income) and $10,000 of dividends (passive income) from Canada and you have another $65,000 of US income (type does not matter), for a total income of $100,000. Further, you paid $10,000 of Canadian tax on the wages and $1,500 of Canadian withholding on the dividends, for a total tax paid to Canada of $11,500. Your US tax before credits is $25,000. If you were able to aggregate income and foreign taxes the calculation would be $25,000 X $35,000/$100,000 = $8,750 (FTC) and $2,750 would be carried over.

When you split the amount out into separate buckets as required, you get the following:

• General limitation: $25,000 X $25,000/$100,000 = $6,250 with $3,750 carried over in the general limitation category.

• Passive income: $25,000 X $10,000/$100,000 = $2,500. However, you only paid $1,500 of tax on passive income and are therefore limited to $1,500 of passive foreign tax credit, with $0 carried forward.

Combining the two you get a total foreign tax credit on only $7,750 ($6,250 + $1,500). Because you were required to separate the income and tax into separate buckets, you are limited to $7,750 of foreign tax credit compared to what you would have received if you were able to aggregate, $8,750. The extra $1,000 is carried forward for up to ten years. Instead of having a carryover of $2,750, your carryover is $3,750.

If you are unable to fully use the entire amount of foreign tax paid as a credit in the current year, you are able to carry back the excess one year and forward 10 years, for a total of 12 years (including the current year). If you are amending last year’s return by carrying back the credit, you will need to complete Amended US Individual Income Tax Return (Form 1040X) and attach the revised Form 1116. When applying the tax credit, you must first use all of the current year’s tax, and then use the credits in the order they were incurred (oldest first).

Proper calculation of the foreign tax credit is very complex; do not try to compute the credit by hand. As a matter of fact, some tax software programs do not properly calculate the credit or keep track of carry forwards.

Note: You can choose to take the taxes as either a deduction or a credit, but not both. Think about what should happen if you are going along for three years and always choosing to take the credit and you have had a carry forward each year. In year four, you choose to take the deduction. What should happen with your tax credit carry forwards? Should they simply carry on as if nothing happened? Well, the answer is that you have to calculate the foreign tax credit separately, as if you had chosen the credit and you would lose the benefit of any excess credit you would have otherwise been entitled to. The following is the example from Publication 514.

• In 2008, you paid foreign taxes of $600 on general limitation income. You have a foreign tax credit carryover of $200 from the same category from 2010. For 2011, your foreign tax credit limit is $700.

If you choose to claim a credit for your foreign taxes in 2011, you would be allowed a credit of $700, consisting of $600 paid in 2011 and $100 carried over from 2010. You will have a credit carryover to 2012 of $100, which is your unused 2010 foreign tax credit carryover.

If you choose to deduct your foreign taxes in 2008, your deduction will be limited to $600, which is the amount of taxes paid in 2008. You are not allowed a deduction for any part of the carryover from 2007. However, you must treat $100 of the credit carryover as used in 2008, because you have an unused credit limit of $100 ($700 limit minus $600 of foreign taxes paid in 2008). This reduces your carryover to later years.

While the IRS does adequately explain how this whole thing works; no one would ever choose to take the deduction in this scenario. In real life, this would not be much of a concern because the only time you would choose to take the deduction is when you have a foreign tax that you have no hope of utilizing before it expires. So, while there might be an exception that we can’t think of, in general you would choose to deduct only when you were not able to take all of the credit, let alone use up carryovers.

There is a de minimis exception to calculating the limits on each foreign income category. If your creditable foreign taxes are $300 ($600 married filing joint) or less and if you meet the following conditions, you can claim the taxes directly on page two (line 47 of the 2011 Form 1040) of your tax return without completing Form 1116:

• All foreign income qualifies as “passive” income

• All the income and any foreign taxes paid are reported to you on a qualified payee statement such as Form 1099 (Miscellaneous Income) or Form K-1 (Partner’s Share of Income, Deductions, Credits, etc.). (Note: Canadian T slips and NR slips do not count as qualified payee statements.)

An election must be made to take advantage of this benefit. If you make the election, you cannot carryover any other credits to the year the election was made. You are required to reduce the taxes available for credit by any amount you would have entered on line 12 of Form 1116.

The foreign tax credit can be further limited if your foreign earned income is excluded from income using the “foreign earned income exclusion.” The foreign income exclusion allows US taxpayers working in a foreign country to exclude up to $95,100 (in 2012) of foreign earned income. Earned income can be either wages or self-employment income and even some housing expenses. Even though this is foreign income and you did pay foreign tax, a foreign tax credit cannot be taken on this income if you choose to exclude the income. This makes sense since because by excluding the income, you are not paying US tax on the income and you therefore do not have a double-tax situation. (The foreign earned income exclusion is talked about in more detail in Chapter 2.)

4. Alternative Minimum Tax (AMT)

The US has an Alternative Minimum Tax (AMT) similar to the one in Canada. As part of computing your AMT in the US, you must complete a second Form 1116 to determine the amount of credit and carry forwards for AMT purposes. The American Jobs Act also allows for the foreign tax credit calculated under AMT to offset up to 100 percent of the foreign taxes. Previously, foreign tax credit under AMT was limited to 90 percent.

Although the AMT foreign tax credit can now be 100 percent, you will almost always have different amounts to carryover for AMT purposes than you will have for regular tax purposes. For this reason, and for many other reasons, preparing a tax return by hand is foolish, both in terms of the time it would take and that there are so many circular calculations to be made.

Note: The effect of “Foreign Earned Income” on the foreign tax credit can be further limited if your foreign earned income is excluded from income using the “foreign earned income exclusion.” The foreign income exclusion allows US taxpayers working in a foreign country to “exclude” up to $95,100 of foreign earned income in 2012. Earned income can be either wages or self-employment income. Even though this is foreign income and you did pay foreign tax, a foreign tax credit cannot be taken on this income if you choose to exclude the income. This makes sense since by excluding the income, you are not paying US tax on the income and therefore do not have double-tax situation.