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What Foreign Taxes Qualify For The Foreign Tax Credit?

posted Jan 31, 2016, 9:36 PM by Zaher Fallahi

The IRS has offered these guidelines:

 

Generally, the following four tests must be met for any foreign tax to qualify for the credit:

The tax must be imposed on you

 

1- You must have actually paid or accrued the tax;

2- The tax must be the legal and actual foreign tax liability (obligation); and,

3- The tax must be an income tax (or a tax in lieu of an income tax). Some foreign countries may have transfer tax on sale of property.

 

Tax Must Be Imposed on You

You can claim a tax credit only for foreign taxes that are imposed on you by a foreign country or U.S. possession, such as taxes that are deducted from your wages.

 

Foreign Country

A foreign country means any foreign state and its political subdivisions. Income, war profits, and excess profits taxes paid or accrued to a foreign city or province qualify for the foreign tax credit.

 

U.S. Possessions

For foreign tax credit purposes, all qualified taxes paid to U.S. possessions are considered foreign taxes.  For this purpose, U.S. possessions include Puerto Rico and American Samoa.

 

Tax Must Be Paid Or Accrued

You can claim a tax credit only if you paid it or accrued the foreign tax to a foreign country or U.S. possession.

 

Joint Return

If you file a joint return, you can claim the tax credit based on the total of any foreign income tax paid or accrued by both you and your spouse.

 

Combined Income

If foreign tax is imposed on the combined income of two or more persons (like, spouses), the tax is allocated among, and considered paid by these persons proportionate with each person's combined income.

 

Mutual Fund Shareholder

If you are a shareholder of a mutual fund, or other regulated investment company (RIC), you may be able to claim the tax credit based on your share of foreign income taxes paid by the mutual fund if it chooses to pass the credit on to its shareholders. You should receive from the mutual fund  form 199-DIV, or similar statement from the brokerage house, showing the foreign country or U.S. possession, your share of the foreign income, and your share of the foreign taxes paid. If you do not receive this information by January 31st, you should contact the mutual fund.

 

Tax Must Be an Income Tax or Tax In Lieu of Income Tax

Generally, only income, war profits, and excess profits taxes (collectively referred to as income taxes) qualify for the foreign tax credit. Foreign taxes on wages, dividends, interest, and royalties generally qualify for the tax credit. The tax must be a levy that is not payment for a specific economic benefit and the predominant character of the tax must be that of an income tax in the U.S. sense.

 

A foreign tax is not an income tax and does not qualify for the foreign tax credit to the extent it is a soak-up tax. A soak-up tax is a foreign tax that is imposed only if a tax credit is available to the taxpayer. This rule only applies if and to the extent the foreign tax would not be imposed if the credit were not available.

 

Foreign taxes on income can qualify even though they are not assessed under an income tax law if the tax is in lieu of an income, war profits, or excess profits tax. The tax must be a foreign levy that is not payment for a specific economic benefit and the tax must be imposed in lieu of, and not in addition to, an income tax otherwise generally assessed. See Publication 54 for additional information. Examples of such taxes in lieu of foreign income taxes may include:

 

1- The gross income tax assessed on nonresidents on income not attributable to a trade or business in the country, where residents with a trade or business are generally taxed on realized net income.

 

2- A tax imposed on gross income, gross receipts or sales, or the number of units produced or exported.

If a foreign country imposes a tax in lieu of an income tax that is a soak-up tax imposed in lieu of an income tax, the amount that does not qualify for the foreign tax credit is the lesser of:  a) the amount of the tax that would not be imposed unless a foreign tax credit would be available; or b) the foreign tax you paid that is more than the amount you would have paid if you had been subject to the generally imposed income tax.

 

 

Foreign Taxes for Which You CANNOT Take a Credit

The following are some foreign taxes for which you cannot take a foreign tax credit:

 

1) Taxes on excluded income, the IRS form 2550 (such as the foreign earned income exclusion),

 

2) Taxes for which you can only take an itemized deductions,

 

3) Taxes on foreign mineral income,

 

4) Taxes from international boycott operations. This may include countries under the US sanctions administered by the US Treasury office of Foreign Assets Control (OFAC),

 

5) A portion of taxes on combined foreign oil and gas income,

 

6) Taxes of U.S. persons controlling foreign corporations and partnerships who fail to file required information returns,

 

7) Taxes related to a foreign tax splitting event, and

 

8) Social security taxes paid or accrued to a foreign country with which the United States has a social security agreement known as Totalization Agreement.

 

Zaher Fallahi, CPA, Esq., assists taxpayers including Americans Living Abroad with their tax preparation, OVDP, FBAR, FATCA, and tax audits.  He has been rated 10 by Avvo  http://www.avvo.com/attorneys/90024-ca-zaher-fallahi-1955056.html  , and named a top tax attorney  http://www.ocbar.org/AllNews/NewsView/tabid/66/ArticleId/1631/Coast-Magazine-Names-OCBA-Members-Top-Attorneys.aspx .  About 1.8% of the US lawyers are also CPAs, and Zaher Fallahi is proudly one of them.  Telephones: (310) 719-1040 (Los Angeles), (714) 546-4272 (Orange County), e-mail taxattorney@zfcpa.com

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