Taxpayers who are subject to foreign income taxes may qualify to take a foreign tax credit against their U.S. tax liability. In most cases, these foreign income taxes are levied on individuals who have partial-year residency in a foreign country or who receive income from foreign-based business activities. The IRS has created the foreign tax credit to help taxpayers offset these additional charges. 

Qualifying for the Foreign Tax Credit

The IRS only allows taxpayers to use the Foreign Tax Credit for certain taxes. These taxes must meet the following tests:

1. The tax must be a legal tax that actually appears in the foreign country's tax code.
2. The taxpayer must have either paid the tax or accrued it in order to claim it.
3. The foreign country's tax authority must have imposed the tax on the individual. (Estimates of tax liability do not qualify for the credit.)
4. The tax must either be an income tax or a tax that is imposed in place of an income tax. (In some cases, war profits and excess profits taxes meet this standard.)

Meeting the IRS Regulations for Foreign Tax Credit

There are many stipulations for claiming the Foreign Tax Credit and taxpayers must comply with them all. A few of these regulations include the following:

1. If a taxpayer earns interest, he must divide the income between his U.S. taxes and his foreign country taxes. All kinds of interest fall under this requirement, including home mortgage tax interest, investment interest, and business interest.
2. The Foreign Tax Credit is affected by tax treaties between the U.S. and selected foreign countries. In this case, a taxpayer can only claim a credit based on the amount of the reduced tax rate, not the full amount that has been withheld.
3. A taxpayer cannot use charitable contributions to reduce the taxes due on foreign based taxes.
4. If the foreign country reassesses the amount of foreign income tax due after the taxpayer has claimed the Foreign Tax Credit, the taxpayer must amend his U.S. return using Form 1040X to reflect the updated foreign tax balance. Failure to do this may result in an IRS tax penalty.

Claiming the Foreign Tax Credit

The IRS provides two forms for claiming the Foreign Tax Credit. Form 1116 "Foreign Tax Credit" is for individuals, estates, or trusts, while Form 1118 "Foreign Tax Credit - Corporations" is used for corporate foreign taxes. In both cases, taxpayers must file a separate form for each kind of income that is subject to the foreign tax. For example, if an individual has accrued foreign taxes on both general and investment income, he would need to file two copies of Form 1116: one for his general income and another for his passive income.

If you qualify to claim the Foreign Tax Credit, it can save you a considerable amount on your U.S. income tax return. However, you must familiarize yourself with the IRS regulations to make sure that you claim the credit properly. A qualified tax professional can provide tax information that can help you determine your own Foreign Tax Credit.