The foreign tax credit is intended to relieve you of a double tax burden when your foreign source income is taxed by both the United States and the foreign country. The IRS limits the foreign tax credit you can claim to the lesser of the amount of foreign taxes paid or the U.S. tax liability on the foreign income.
While looking into foreign tax credit, it seems that this does not really avoid double taxation. I wonder whether I misunderstood something. Please see below a small numerical example based on fictional data where one person gets taxed more than the other despite a foreign tax credit reduction.
Person X, who's single, earned 200,000$ in 2020. This person has a standard deduction of $12,400. His taxable income (line 15 on 1040) is: 200,000-12,400=187600$. Since this amount is over 100k$, the tax owed (line 16 on 1040) is computed using the Tax computation worksheet (page 77 of the 2020 1040 instruction) as: taxable_income x .32 - 18984.50. Applied to this example we get: 187600 x .32 - 18984.50 = 41047.5$. In summary, person X must pay 41047.5$ tax.
Person Y, who's single, earned 210,000$ in 2020: 200k$ in the US, and 10k$ abroad. Over the 10k$, person Y payed 5k$ tax to a foreign country (note: a 50% tax rate is higher than any U.S. tax liability). This person has a standard deduction of $12,400. His taxable income (line 15 on 1040) is: 210,000-12,400=197600$. This person's tax (line 16 on 1040): 197600 x .32 - 18984.50 = 44247.5$.
Person Y can claim foreign tax credit to avoid double taxation. Foreign tax credit is calculated via Form 1116, where foreign_income (line 17)=10k$, total_taxable_income(line 18)=197600, line 19=10,000/197600=0.0506, tax(line 20)=44247. The foreign tax credit is calculated as: (foreign_income / total_taxable_income) x tax=(10,000/197600) x 44247=2239$. Since 2239$ is less than the 5k$ taxes payed in the foreign country, person Y can claim 2239$ tax credit. In summary, person Y ends up paying 44247.5-2239=42008.5$ tax.
Now here's my misunderstanding: Person Y ends up paying 42008.5-41047.5=961$ more tax than person X! I would have expected that person X and person Y would pay an equal amount of US tax (41047.5$) since person Y already payed an amount of tax over the 10k$ extra income to the foreign country that exceeded person Y's US tax liability.
Does anyone know how to get this problem fixed on Form 1116?
The problem I try to illustrate here, is caused by the 18,984.50$ adjustment in the tax calculation. Had the foreign tax credit been calculated as: (foreign_income / total_taxable_income) x (tax+18984.50)=(10,000/197600) x (44247+18,984.50)=3199.97, then person Y would have payed 44247.5-3200=41047.5$ which indeed is the same as person X. I still don't know how to represent this correctly on Form 1116.