Another reason why your Foreign Tax Credit may be calculated as zero (Form 1116): Foreign Tax Carryover but no current year foreign income

[HardRightEdge99]

This is an FYI-only about a circumstance I recently discovered, a pretty simple one.

I have no foreign source income (and thereby no foreign tax paid) for the current year's return, the 2023 return at this writing.  However, I have a meaningful amount of foreign tax credit carryovers, all from stock dividends and reported on 1099s, accumulated in dribs and drabs over the last 10 years.  Yet I'm getting a calculation of zero foreign tax credit on my 2023 Fed return despite having a meaningful amount of tax due to offset.  I discovered this is not a mistake or miscalculation by TurboTax.

What I discovered in manually working through the Form 1116 calculations is that if there is no foreign source income for the current tax year certain factors in the calculations get set to zero which end up resulting in a zero bottom line for the credit.  There is no way around it.  I did not look at anything related to income other than dividends--whether that's different I can't say.

It would be too exhausting to explain, but there is an internal logic to these calculations.  But one can't help but think there could be a better way.  Maybe this is one reason why the IRS offers the deduction vs. credit option as a way to derive some benefit in circumstances like this but that ain't no help if you don't itemize.  As it stands, without anticipating buying foreign dividend paying stocks in the future, my carryovers will continue to expire bit by bit.  I'm beginning to think "good riddance".

[ThomasM125]

You can only deduct foreign taxes to the extent that you paid US tax on foreign income. For instance, if you earned $10,000 in foreign income and your US tax on the income is $1,500, you can't deduct $2,000 of foreign taxes paid on your tax return. The purpose of the credit is to allow you to avoid being double taxed on the same income. So, your foreign tax credits represent taxes paid on foreign income that has not yet been taxed domestically. Consequently, you are not losing a tax credit or deduction when you have foreign tax credit carryovers, you are just not able to use it yet to avoid double taxation.  

[HardRightEdge99]

@ThomasM I'm not sure how what you posted clarifies the situation I described:  foreign tax carryover never translates to a credit in a year where there happens to be no foreign source income.  It's just something I discovered that I thought was interesting (and disappointing).

It should seem odd that how a prior year's foreign tax carried over translates to a credit (or not) in the current year is a function of whether you happen to have current year foreign income.  The double taxation (or lack thereof) as relates to carried over tax has nothing to do with the foreign income (or lack thereof) in the current year.

But I'm just repeating myself, my federal taxes are done, so I'll leave it at that.

[ThomasM125]

The foreign tax is carried over because you didn't have enough domestic tax on foreign income in the year it arose to allow all of it to be used. It can only be used in a year that you have foreign income because the foreign tax can only be used to offset US tax on foreign income. So, if you have no foreign income in a given year, you will have no US tax on foreign income that year. So, there would be no US tax on foreign income available to offset the foreign taxes carried over.

The double taxation issue comes in to play because you have foreign tax. The foreign income was taxed in the foreign country and then the same income is taxed again on your US tax return. So, you get a credit against your US tax equal to the foreign tax paid on the same income, otherwise you would be double taxed.

[HardRightEdge99]

@ThomasM125  There's more to it than that.  I'll take one more shot with some examples:

1)  If you have no foreign source income in the current tax year, Form 1116 formulas dictate that no foreign tax carryover can be converted to a credit.  On this we agree.  But it's not about double taxation per se--it's about the fact that Form 1116, line 3f is set to zero when 2023 foreign income is zero. 

2)  As a second example, I added a test entry to my completed 2023 Fed return which happens to have about $2,600 in available foreign tax carryover for 2023 and about a $5,600 Fed tax liability available for foreign tax credit offset.  The entry is a simple $100 foreign stock divided with a $15 foreign tax from box 7 on the 1099 with no other variables.  What then happens is Form 1116, line 3f is now calculated by TurboTax as a very small factor that ends up resulting in a $6 foreign tax credit with the remaining $9 of the 2023 foreign tax added to carryover to 2024.

So far so good, I guess.  It matches what a manual calculation of line 3f would yield.

3) I ran another test replacing the dividend entry in 2) above with a simple foreign stock dividend of $100,000 with a box 7 foreign tax paid of only $1.  This large amount of foreign source income relative to total income results in a much, much larger factor in line 3f than in example 2).

The end result is all of the $2600 in foreign tax carryover to 2023 plus the $1 in foreign tax from the test entry were calculated as a foreign tax credit flowing through to 1040, Line 20 and thereby reducing the 2023 tax liability by the self-same $2601.

So riddle me this:  How does adding $1 in foreign tax payments reported in the current return, and by extension $1 in the aggregate across the previous 11 years including the carryover foreign tax, suddenly result in a $2,601 recognition of "double taxation"?   The answer is that it doesn't.  The maximum change to  double taxation is $1.  The results of this example are a peculiar artifact of the internal logic of Form 1116.  The rationale behind this logic could be articulated perhaps in English but we'd have to ask whoever drafted the relevant tax code.

While example 3) is an extreme case, less extreme examples yield less extreme results demonstrating the same point.  Again, this is not a TurboTax problem.  It's a peculiarity of the tax code that is not entirely explainable with boilerplate language about double taxation.