Foreign Tax Credit 101: What It Is, Who Qualifies & How to Use It
Imagine earning money in another country, only to find yourself taxed twice—once by the foreign government and again by the U.S. That’s the frustrating reality of double taxation, which can eat into your earnings fast. The Foreign Tax Credit (FTC) exists to prevent this financial drain. Instead of paying full taxes to both countries, you can offset your U.S. tax bill by claiming credit for taxes already paid abroad. But the FTC comes with rules, limits, and filing requirements. Who qualifies? How much can you claim? And how do you avoid mistakes? This guide breaks it all down in simple terms.
What is Foreign Tax Credit?
The Foreign Tax Credit (FTC) is a U.S. tax benefit designed to reduce or eliminate double taxation on income earned outside the country. If you pay taxes to a foreign government, you can claim a credit to lower your U.S. tax bill. The goal is to prevent taxpayers from being taxed twice on the same income.
FTC applies to both individuals and businesses. If you’re a U.S. citizen or resident earning income from foreign wages, self-employment, or investments, you may be eligible. Businesses that operate in multiple countries and pay foreign taxes can also use FTC to reduce their tax burden.
However, not all foreign taxes qualify. The tax must be an income tax or a tax in place of income tax. That means sales tax, value-added tax (VAT), or property tax don’t count. Also, FTC can only offset U.S. income tax—not other types of U.S. taxes like self-employment tax.
While the credit can significantly lower your U.S. taxes, it’s not always a dollar-for-dollar reduction. The IRS limits how much FTC you can claim based on how much of your total income comes from foreign sources. This means some taxpayers may not be able to use the full credit immediately.
How the Foreign Tax Credit Works
Who Can Claim FTC?
FTC is available to U.S. citizens, resident aliens, and domestic corporations that pay foreign taxes. If you have wages, self-employment income, rental earnings, or investments in another country, you may qualify.
Businesses that operate overseas or have foreign subsidiaries can also claim FTC, but the rules are more complex. A U.S. company that owns a foreign corporation may be eligible for a deemed paid credit, which allows it to claim credit for taxes paid by its foreign subsidiary.
Non-residents and dual-status taxpayers have special rules. If you’re a non-resident for tax purposes, you typically can’t claim FTC unless you elect to be treated as a U.S. resident for tax reasons.
Qualifying Foreign Taxes
Not every tax paid to a foreign country qualifies for FTC. The tax must be an income tax or a tax imposed in place of an income tax. This includes:
- Taxes on wages and self-employment income.
- Withholding taxes on foreign dividends, interest, and royalties.
- Foreign taxes on rental income.
Taxes that don’t qualify include:
- Sales tax, property tax, and value-added tax (VAT).
- Social security taxes paid to another country.
- Taxes refunded by the foreign government.
How FTC Is Calculated
FTC isn’t always a dollar-for-dollar reduction of your U.S. taxes. The IRS limits how much you can claim based on the percentage of your total taxable income that comes from foreign sources.
For example, if 30% of your total income is foreign-earned, then FTC can only offset 30% of your total U.S. tax bill. If your foreign tax is higher than that limit, you may not be able to use the full credit this year—but you can carry it forward for up to ten years or back for one year.
To calculate your FTC, you typically need IRS Form 1116 (for individuals) or Form 1118 (for corporations). These forms help determine how much credit you can use in a given tax year.
Foreign Tax Credit vs. Foreign Earned Income Exclusion
FTC isn’t the only way to avoid double taxation. Another option is the Foreign Earned Income Exclusion (FEIE), which lets U.S. taxpayers exclude a certain amount of foreign-earned income from their taxable income altogether. But there’s a big difference between the two.
FTC reduces your U.S. tax liability, meaning you still report all your income but get a credit for foreign taxes paid. FEIE, on the other hand, excludes a portion of your income from U.S. taxation entirely.
For 2024, FEIE allows individuals to exclude up to $126,500 of foreign-earned income. However, it only applies to wages or self-employment income—not passive income like dividends, interest, or rental income.
Which one is better? It depends. FTC is often the better choice if you pay high foreign taxes, since it can offset most (or all) of your U.S. tax liability. FEIE, however, works best if your foreign income is relatively low, and you want to simplify your tax return.
The IRS doesn’t let you double dip—you can’t exclude income with FEIE and then claim FTC on the same income. However, you can use FTC on foreign income that exceeds the FEIE limit, which can provide additional tax savings. Understanding when to use each can make a huge difference in how much tax you owe.
The Limitations and Restrictions of FTC
FTC Limitation Formula
The Foreign Tax Credit (FTC) is not unlimited. The IRS caps the amount of credit you can claim based on the percentage of your total taxable income that comes from foreign sources. This prevents U.S. taxpayers from using FTC to completely erase their U.S. tax liability.
The formula for determining your maximum FTC is:
(Foreign taxable income ÷ total taxable income) × U.S. tax before credits
For example, if your total taxable income is $100,000 and $30,000 of it comes from foreign sources, you can only use FTC to offset up to 30% of your U.S. tax bill. If your foreign tax credit exceeds this amount, you may not be able to claim the full amount right away.
Per-Country vs. Overall Limitation
FTC can be calculated in two ways:
- Per-country limitation – Each country is treated separately, and FTC is limited based on the tax paid to that specific country.
- Overall limitation – All foreign income is combined, and FTC is limited based on the total foreign tax paid.
In most cases, the overall limitation method applies, but it’s important to ensure that foreign tax payments are properly categorized.
Carryback and Carryforward Provisions
If you can’t use all of your FTC in the current tax year due to the limitation rules, the IRS allows you to carry back the excess credit one year or carry it forward for up to ten years. This means that if you have a lower U.S. tax bill one year but a higher one in the future, you can still benefit from unused FTC credits.
How to Claim the Foreign Tax Credit
IRS Forms and Documentation
To claim FTC, individuals must file IRS Form 1116, while corporations use Form 1118. These forms calculate how much credit can be claimed and ensure compliance with the FTC limitation rules.
You’ll also need:
- Proof of foreign taxes paid (such as tax receipts or official statements).
- Foreign income details (wage statements, investment reports, etc.).
Step-by-Step Filing Process
- Determine if you qualify – Verify that your foreign tax was an income tax or a substitute for an income tax.
- Separate foreign income – Identify how much of your total income comes from foreign sources.
- Calculate your FTC limit – Use the IRS formula to determine the maximum credit you can claim.
- File Form 1116 (or Form 1118 for businesses) – Complete the form, attach supporting documents, and include it with your tax return.
- Claim the credit or deduction – Decide whether to use the credit or the deduction (you cannot use both for the same income).
Refunds and Adjustments
If a foreign government refunds part of your taxes after you’ve already claimed FTC, you may have to amend your U.S. tax return. The same applies if additional foreign taxes are assessed later. The IRS requires taxpayers to report changes and adjust their FTC accordingly.
Special Rules for Businesses
Deemed Paid FTC for Corporations
Unlike individuals, U.S. corporations with foreign subsidiaries may qualify for a deemed paid credit. This means that a U.S. parent company can claim credit for foreign income taxes paid by its subsidiary, even if those taxes were not directly paid by the U.S. entity.
This rule helps multinational corporations avoid double taxation on foreign earnings when profits are repatriated to the U.S. However, it comes with complex regulations that require tracking foreign earnings and tax payments carefully.
FTC on Foreign Stock Dividends
If a U.S. investor owns stock in a foreign company and receives dividends, the foreign government may withhold taxes on those payments. In such cases, FTC allows investors to claim a credit for the withholding tax to avoid being taxed twice on the same income.
Corporations with foreign investments can also claim FTC on dividends from foreign subsidiaries, but they must meet ownership requirements to qualify for deemed paid credits. The rules around foreign stock dividends and FTC are strict, so careful record-keeping is essential.
Sourcing Rules and Deduction Allocation
Determining Foreign Source Income
FTC is based on foreign source income, but how do you determine whether income is foreign or U.S.-sourced? The IRS has specific sourcing rules:
- Wages & self-employment income – Generally sourced to the country where the work is performed.
- Interest income – Sourced based on the location of the payer.
- Dividends – Sourced based on where the company paying the dividend is incorporated.
- Rental income – Sourced based on where the property is located.
- Sales of inventory – Sourced based on where the product is produced and sold.
Expense Allocation and FTC Impact
FTC rules also require that certain deductions be allocated to foreign or U.S. income before calculating the credit. Expenses such as interest, R&D costs, and general business expenses must be properly allocated, as they can impact the total taxable amount used to determine the FTC limit.
This step is important because improper allocation of deductions can reduce FTC eligibility, leaving taxpayers with a higher U.S. tax bill than expected.
Tax Sparing and International Treaties
Some countries have tax sparing agreements with the U.S. to encourage foreign investment. These agreements allow FTC to be claimed even when a foreign government grants tax breaks or incentives, preventing U.S. taxpayers from being penalized for benefiting from lower foreign taxes.
International tax treaties also play a key role in FTC eligibility. Many tax treaties contain provisions that:
- Reduce or eliminate foreign withholding taxes on dividends, interest, and royalties.
- Clarify which country has taxing rights over specific types of income.
- Prevent abusive tax planning strategies that exploit FTC rules.
Because tax treaties vary by country, understanding them can be crucial in maximizing FTC benefits. Businesses and individuals with significant foreign income should always check whether a tax treaty applies to their situation.
Real-World Examples of Foreign Tax Credit
Effect of FTC on Global Tax Burden
A U.S. company with operations in Canada earns $1 million and pays $250,000 in Canadian income tax. Without FTC, it would also owe full U.S. corporate tax on this income. But by claiming FTC, the company offsets its U.S. tax bill, reducing its overall global tax liability.
Impact of Expense Allocation on FTC
A self-employed U.S. consultant working abroad earns $100,000 in foreign income and pays $20,000 in foreign tax. However, after deducting business expenses, only $70,000 is taxable. Since the FTC limit is based on taxable income, the consultant may not be able to claim the full $20,000 credit immediately.
FTC for Individuals vs. Businesses
An expat living in Germany earns $80,000 in wages and pays $15,000 in German taxes. Without FTC, they’d pay full U.S. income tax on this amount. By claiming FTC, they significantly reduce their U.S. tax liability. A multinational corporation, on the other hand, deals with more complex FTC rules involving foreign subsidiaries, deemed paid credits, and multiple jurisdictions.
Final Thoughts
The Foreign Tax Credit (FTC) is a valuable tool for taxpayers earning income abroad, but it comes with strict rules, limitations, and filing requirements. By reducing or eliminating double taxation, FTC can lead to significant tax savings—especially for those in high-tax foreign countries.
However, it’s important to calculate the credit correctly, allocate deductions properly, and keep up with IRS documentation requirements. Mistakes can lead to audits, penalties, or missed tax-saving opportunities.
For individuals, choosing between FTC and the Foreign Earned Income Exclusion (FEIE) can make a big difference in overall tax liability. Businesses with global operations must navigate more complex FTC rules, including deemed paid credits and tax treaty benefits.
Ultimately, consulting a tax professional or using expert tax software can help ensure you maximize your FTC benefits while staying compliant with U.S. tax laws.
FAQs
Can I claim both the Foreign Tax Credit (FTC) and the Foreign Earned Income Exclusion (FEIE)?
Yes, you can claim both, but not on the same income. The FEIE allows you to exclude a certain amount of foreign-earned income from U.S. taxation, while the FTC provides a credit for foreign taxes paid on income not excluded. Careful planning is essential to maximize benefits and comply with IRS rules.
Do I need to file Form 1116 to claim the Foreign Tax Credit?
Generally, yes. Form 1116 is used to calculate the amount of FTC you can claim. However, if your only foreign income is from passive sources, your total foreign taxes are below $300 ($600 if married filing jointly), and other specific conditions are met, you might be able to claim the credit without filing Form 1116.
What happens to unused Foreign Tax Credits?
If you can’t use all your FTC in the current tax year due to limitations, you can carry it back one year or forward up to ten years. This means you can apply the unused credit to past or future tax returns, potentially reducing your U.S. tax liability in those years.
Are foreign property taxes eligible for the Foreign Tax Credit?
No, foreign property taxes do not qualify for the FTC. The credit is generally limited to foreign income taxes. However, you may be able to deduct foreign property taxes as an itemized deduction on Schedule A of your tax return, subject to certain limitations.
How does the Foreign Tax Credit affect my state taxes?
The FTC applies to federal income tax, but its impact on state taxes varies. Some states allow a credit or deduction for foreign taxes paid, while others do not. It’s important to check your state’s tax laws or consult a tax professional to understand how foreign taxes influence your state tax obligations.
