Foreign Tax Credit: Introduction to Avoiding Double Taxation

What Is the Foreign Tax Credit?

The Foreign Tax Credit (FTC) is the IRS's mechanism for preventing double taxation on income earned overseas. If you earn income in a foreign country and pay income tax to that country's government, the FTC provides a dollar-for-dollar credit against your U.S. tax liability for those foreign taxes paid.

The credit is reported on Form 1116 and is calculated for each category of income (general, passive, etc.) separately. The rules have remained largely unchanged for decades, making this a relatively stable area of tax law.

How the FTC Works

The FTC is calculated using a limitation formula that ensures you only receive a credit up to the amount of U.S. tax attributable to your foreign-source income. You cannot use foreign taxes paid to offset U.S. tax on U.S.-source income.

If you paid more in foreign taxes than the FTC limitation allows, the excess carries forward for up to 10 years (and can carry back 1 year). If you paid less in foreign taxes than the limitation, you can credit the full amount and still owe some U.S. tax on the foreign income.

FTC vs. Foreign Tax Deduction

Instead of claiming a credit, you can choose to deduct foreign taxes paid as an itemized deduction. However, a credit is almost always more beneficial because it reduces your tax dollar-for-dollar, while a deduction only reduces your taxable income. In most cases, the FTC provides greater tax savings.