foreign taxes paid. practical questions about tradeoffs of credit vs deduction

[tuxedorose]

Im an everyday US citizen who has a few mutual funds and etfs  in a garden variety retirement plan with the popular  big box brokers.  Im flabbergasted how much effort it is to deal with a few hundred dollars of foreign taxes paid that are reported on my 1099s.  it is taking me hours to research how to answer all the Q's that TT is asking me about this.

Practical Question: 

taking a credit seems to be better than a deduction...but I notice that TT is telling me im only allowed to take a credit for about 1/3 of the foreign tax paid . this seems to happen every year and I now have accumulated (over 7 years) about 6x more than what im allowed to take as credit in a given year

-if i take a deduction rather than a credit, will that allow me to use up more of the accumulated amt?

-after 10 years, do i start losing some of the accumulated amt?

-what if anything can i do to be able to use more in a given year?

thanks!

[pk · Accepted solution]

@tuxedorose , you appear  to have two posts around the same subject.  My comments on the situation is as follows :

(a)  Generally  Foreign Tax Credit ( FTC )  is more efficient in reducing Federal tax liability   ( exact facts and circumstances  will dictate actual benefit )

(b)  Deduction is limited by SALT   --  Itemized deduction under  State And Local Taxes 

(c)   Safe harbor  amount  ( US300 per filer  i.e. US$600 for a joint return  ) often  is more efficient then using form 1116.

(d) Form 1116  while recognizing the  foreign taxes paid ( dollar for dollar ) , limits the  allowable  FTC to lesser of actual amount paid  and US tax on the same doubly taxed income.  Note that what it is trying to do is to reduce double taxation by giving you zero US tax  on the doubly taxed income.  A corollary / side-effect  of this is often while your  accumulated  FTC plus current  FTC may get higher and higher,  your allowable  FTC is limited to  US tax on the  foreign income.  It is an asymptotic situation.

(e) A great reading material on un-used FTC or unused deduction is   below, especially  1.904.2.(c).3

-->  26 CFR § 1.904-2 - Carryback and carryover of unused foreign tax. | Electronic Code of Federal Regul...

Note that  this  FTC/ Deduction is ONLY  available  if , and  only if , US and that foreign country has a tax treaty in effect and  also the double taxation clause in effect.

Is there more i can do for you ?

[tuxedorose]

@pk thanks for the excellent explanation! that is very helpful

a couple of followups to clarify my remaining confusion..

1. you mention safeharbor ($300 credit for single filer) if often more efficient than dreaded form 1116

do you mean easier ?   for example if I have $800 of foreign tax this year and i take safe harbor. does that mean i forfeit any carry forward of the remaining $500 but at least i don't have to deal with all the byzentine calculations?

2. regarding the accumulated carry fwd. will it eventually 'expire/drop off the 10 year look back' ?  is it one of those situations where, in theory i can use it in the future, but the  rules are such that, from a practical perspective, I will never get to use. 

i will read the article you linked to as well. thx!

[pk · Accepted solution]

@tuxedorose 

Response to Q-1 --- in order to be able to use the safe harbor ( and keep 1116 out )  you would have to claim/ recognize ONLY the safe harbor amount.   While  you must recognize any and all foreign income, there is no such requirement for the foreign taxes paid.    The form 1116 is not only complicated  but  its limitations  often will result in less FTC for the year.   My personal view is that  because this area of statute is driven by treaty requirement of "ameliorating" the effects of double taxation it advertises " we recognize dollar for dollar " foreign taxes paid, the actual effect on the taxpayer is far less. So I always suggest ( especially  when FT is  not too far above the  safe harbor ), try it both ways and see which is more beneficial to you.

Response to Q-2 ---- You are correct in your understanding.

Is there more I can do for you ?

[tuxedorose]

@pk   thanks for all your help !... just to summarize some dummy proof  bullet points 🙂 ( maybe to help  others). are my following statements correct.

if I am willing to go thru the aggravation of completing form 1116 and I see the foreign tax credit calculates to be   more than $300 (for single TP ) than its a no brainer to use it an d NOT elect the safe harbor method

if you use the safe harbor method (ie , you forfeit any of the EXCESS foreign tax you paid for this tax year  (ie you can not add it to the carry fwd amount that you may have been accumulating from prior years?

you should always compare taking the deduction vs the credit because your foreign tax for a given year may in some circumstances be high enough that the deduction is better than the credit because the credit is limited by several factors calculated in form 1116

taking  foreign tax as a deduction only applies to the tax paid in this tax year (ie. there is no using the carry fwd tax from prior years to create a deduction for this year.