If you’ve earned income from your investments, you should receive a 1099-DIV for dividends or distributions, or a 1099-INT for interest income at the end of the year. Box 6 on both forms will indicate foreign taxes paid.
If the foreign countries are withholding tax, you don’t have much to worry about right? Wrong. If you have any interest, dividends or capital gains, you may be subject to U.S. tax as well. Double taxation — that’s harsh. Fortunately, the U.S. tax code provides a tax credit for foreign taxes paid by completing Form 1116 with your U.S. income tax return. However, you can claim the credit without filing the form if it is all passive income reported on a qualified statement, like a 1099, and the foreign taxes are less than $300 ($600 for joint filers).
You could choose to take the amount you paid in foreign taxes as an itemized deduction; however, it is often less beneficial to do so. Tax credits reduce your U.S. income tax liability dollar for dollar; therefore, a $300 tax credit offsets $300 in your tax liability. A tax deduction only reduces your liability by your marginal tax rate. You cannot take both the credit and an itemized deduction, but you can change your choice from year to year, depending on which method results in a lower tax liability.
You’re generally eligible to take the foreign tax credit if you are a citizen of the United States, a resident alien of the United States or a legal resident of Puerto Rico. Additionally, the foreign tax paid must be imposed on you; you must have paid or accrued the tax; the tax must be the legal and an actual foreign tax liability, and the tax must be an income tax or a tax in lieu of an income tax.
The foreign tax credit is nonrefundable, so it is limited to your liability. Generally, if the amount you paid in foreign taxes is lower than your U.S. tax liability, you can claim the entire amount as your foreign tax credit. Likewise, if the taxes paid are higher than what you’d pay the IRS for those earnings, your credit is limited to the U.S. tax amount, but you should be able to carry the remaining credit back to the previous tax year or forward up to 10 years. You can figure your credit by following the instructions on Form 1116. However, you may want to consult a CPA or tax professional to ensure you are computing your credit correctly.