Reducing foreign tax credit due to tax treaties

[MichaelLiu]

According to the Form 1116 instructions: "You can't take a credit for the following foreign taxes. 1. Taxes paid to a foreign country that you don't legally owe, including amounts eligible for refund by the foreign country. [...] Example. Country X withholds $25 of tax from a payment made to you. Under the income tax treaty between the United States and Country X, you owe only $15 and can claim a refund from Country X for the other $10. Only $15 is eligible for the foreign tax credit (whether or not you apply for a refund)."

And according to the Form 1040 instructions for Schedule 3, Line 1: "You don’t have to complete Form 1116 to take this credit if all of the following apply. [...] 5. All of your foreign taxes were: a. Legally owed and not eligible for a refund or reduced tax rate under a tax treaty."

Question: When computing the foreign tax credit, does TurboTax support excluding the portion of foreign tax paid that is eligible for a refund or reduced tax rate under a tax treaty?

In my case, I own Ferrari stock, and I received a dividend (less than $300) of which 26% was withheld for foreign tax. Due to a tax treaty between the United States and Italy, I believe I'm only entitled to a foreign tax credit of 15% of the dividend amount. However, TurboTax didn't ask me about the country that withheld the tax, and it is claiming a foreign tax credit for the full amount of taxes paid.

[tagteam]

I'll page Champ @pk

[pk]

@MichaelLiu , i need to read through your post a  little bit more in  detail to be sure my position is correct in the  tax law.  However, you also have to note that  if you are a US citizen / GreenCard) you generally cannot  assert  Tax treaty benefits  i.e. benefit position based on  treaty assertions  like a  foreign country  citizen living in the USA ( the person was a resident of that country prior to coming to the USA -- even if a Resident for Tax purposes )

Does that make sense  -- ?   I will come back   and really would be grateful if you have any more facts and circumstances to share .

pk

[MichaelLiu]

I'm a US citizen residing in the US, and I'm not trying to assert tax treaty benefits. Instead, my concern is that TurboTax may be improperly claiming a larger foreign tax credit than I am entitled to. I think my situation is basically identical to the example given in the Form 1116 instructions:

"Country X [in my case, Italy] withholds $25 [in my case, 26% of the dividend amount] of tax from a payment [dividend from Ferrari stock held in a taxable brokerage account] made to you. Under the income tax treaty between the United States and Country X [Italy], you owe only $15 [in my case, 15% of the dividend amount] and can claim a refund from Country X for the other $10 [in my case, 11% of the dividend amount]. Only $15 [15% of the dividend amount] is eligible for the foreign tax credit (whether or not you apply for a refund)."

But TurboTax is computing a foreign tax credit (Form 1040 Schedule 3, Line 1) equal to the entire "foreign tax paid" reported on my Form 1099-DIV (which equals 26% of the dividend amount), and I can't figure out how to tell TurboTax to reduce the foreign tax credit to 15% of the dividend amount. In short, I believe I owe more to the IRS than what TurboTax is calculating.

[pk]

@MichaelLiu , i think I understand your consternation in that  (a) TurboTax is not making / allowing for  treaty based  taxation  ( generally this is done by changing the asset value as an adjustment on form 1116 -- see instruction s for 1116  and (b) you may be getting more of a foreign Tax Credit than you are entitled to. -- YES ?

Recognizing that the purpose of the foreign tax credit is to reduce the eliminate / ameliorate the burden of double taxation.   Thus if you paid 26% to Italy and you pay another 20% to the USA, the Foreign Tax Credit should be 26% because  you will still pay the 20% to the USA plus State Tax ( where there is NO Foreign Tax Credit).

The other and  harder way is to go back to Italy, show them the treaty ( most rates are bilateral )  condition  tax @ 15% , and  because that is what you pay to Italy, you  claim the  15% as Foreign Tax Credit.

Does this make sense  or am I in the left field ( sometimes  I do get lost ).

pk

[MichaelLiu]

Right. Without the foreign tax credit, I'd pay both the ordinary income tax levied by the US (the dividend I received is not qualified) as well as Italy's 26% withholding tax. The foreign tax credit allows me to get a refund for the latter, but (assuming I'm reading the IRS instructions correctly) only to the extent I actually owe the tax. And it appears the US and Italy have a tax treaty that says US residents only owe 15%, not 26%. Since I can theoretically get Italy to refund the 11% difference, the IRS only allows me to claim 15% for the foreign tax credit, not the full 26%. But I can't figure out how to inform TurboTax about this.

[SusanY1 · Accepted solution]

To reduce the amount of the credit, list the tax paid to equal the lower tax that you should have paid.  You'll just enter the actual tax due rather than the tax withheld.