2

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?

-------------Update --------------

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.

2

(This is what I've been able to understand from doing this tax form for several years. Not tax advice ....)

In the calculation in your Update:

(foreign_income / total_taxable_income) x (tax+18984.50)=(10,000/197600) x (44247+18,984.50)=3199.97

you are essentially saying Person Y would like their credit to be:

foreign_income * 32%

where 32% is the marginal tax rate; which is to say, they want to assume that Person Y's foreign income is taxed at the marginal tax rate. Unfortunately, that isn't how Form 1116 works.

Instead, as you demonstrated, the calculation in this form computes the credit based on their effective tax rate. Specifically, observe that another way of writing the computation in Form 1116 is:

credit = effective_tax_rate * foreign_income

= (gross_tax / total_taxable_income) * (total_taxable_income - taxable_domestic_income)

= (1 - taxable_domestic_income / total_taxable_income) * gross_tax

Put another way, the credit prorates Person Y's gross_tax by the fraction taxable_domestic_income / total_taxable_income. Concretely, for Person Y, this fraction is 94.94%, and applied to Person Y's gross_tax yields their net_tax of $42008, which accords with your computation.

Person Y might feel better if this credit were explained as "getting a discount on their tax in proportion to their foreign income, capped at the amount of foreign tax they had already paid".

  1. Person Y can carry over the unused foreign taxes paid back for one year and forward for ten years.
  2. Person Y would prorate their standard deduction over their foreign income using Line 3a, which slightly decreases Line 17 and further decreases their credit.
  3. (unrelated rant) Form 1116 handles qualified dividends in a way that is actually unfair, by "adjusting" them with a discount as though they had been taxed at the top marginal tax rate, causing the credit to plummet.
4
  • thank you for your response. From what I understood, person Y is in a bad position: not only does person Y have to pay the 5k foreign tax, on top of that, person Y still has to pay the 961$ to the US! (seems totally unfair to me...). – Joris Kinable 2 days ago
  • I'm not sure I understand your 2nd suggestion. When I prorate the standard deduction using Line 3a, this indeed slightly decreases Line 17 but in turn decreases the credit. Using the earlier example, if the 10k foreign income gets decreased to say 9500, then the credit computation becomes (9,500/197600) x 44247= 2127$ which is less than the earlier 2239$ credit. How do you compensate for this reduction in credit? – Joris Kinable 2 days ago
  • (1) Well, that's because the US taxes all foreign income, but at a lower rate. Compare Person Y's position to that of Person Z, who made $210k all domestic. Person Z has to pay $3200 more. So Person Y's US marginal rate on their foreign $10k this year was 9.61%, whereas Person Z's US marginal rate was the full 32%. Whether that's still not fair is up for debate ... it's just how it is. (2) Sorry, I did indeed mean that the credit "decreases"! Thank you for catching my error. I edited my answer. – user106227 yesterday
  • More pithily: since 94.94% of Person Y's income is domestic, Person Y should pay at least 94.94% of their (US) gross tax liability. This proportional discount is fairer than your proposal, which would essentially deduct all foreign income from taxable income; if many countries (with progressive tax systems) did this, people would want to distribute income across as many countries as they could. – user106227 yesterday
2

It is true that foreign income can cause a net increase in US tax liability even when the maximum foreign tax credit is applied. This is because the limit on the credit ("US tax liability on foreign income") is defined using the effective US tax rate, which in our progressive system is lower than the marginal US tax rate. The latter determines the actual effect on tax liability from incremental income.

The "preventing double taxation" feature is more operative when foreign tax rates are lower than US tax rates, in which case the foreign tax can be fully offset. This might be more typical in an example like yours, where Person Y has a fairly small amount of foreign income, since the foreign country may also have progressive tax rates (with a low rate on small amounts of income, unlikely to be 50%).

2

There is nothing unreasonable about your result. Person Y has a higher global income than person X, so should have a higher US effective tax rate, since the US has progressive tax brackets. In this case, since the foreign tax is higher, the foreign tax credit effectively reduces the income that is taxed by the US to the US income, but for Person Y it is still taxed at the higher effective tax rate determined by Person Y's higher global income, and therefore, Person Y's US tax is higher.

Your idea that Persons X and Y should pay the same US tax, basically means that you think that the US effective tax rate should only be calculated on the US income, and so the two people should have the same US effective tax rates because they have the same incomes, but that is unfair in the progressive tax bracket system.

Imagine another scenario, where two people, Person A and Person B both earn $400k. Person A earns it all in the US, while Person B earns $200k in the US and the other $200k in a foreign country with the exact same tax structure as the US. Person B is a US citizen or resident and nonresident in the other country, and is eligible to claim the Foreign Tax Credit. If we follow your idea that the effective tax rate should only be calculated on the US income, then the person should pay US tax equivalent to someone with only $200k income, all from the US. So then Person B would pay twice the tax of someone with $200k income, whereas Person A would pay the tax of someone with $400k income. The tax of someone with $400k income is much more than twice the tax of someone with $200k income, because of progressive tax brackets. So it is fundamentally unfair for the US effective tax rate to be calculated only from the US income, because it allows someone to lower their tax rate by spreading the same income over more countries.

3
  • I do not dispute that someone with a higher income should pay more tax. There are 2 scenarios: (1) tax in foreign country is <= tax in the US or (2) the reverse. If the US tax rate is 20%, then A pays 80k tax in your example. For B to pay the same as A, he should pay 40k over his US share and 40k over his foreign share. If B paid only 20k tax abroad, then he should pay 40+max(0,40-20)=60k to the US. However, if B paid 50k abroad, B should (in theory) pay 40+max(0,40-50)=40k to the US. If, in the latter case, the US would ask for more than 40k then the US would take more than its fair share. – Joris Kinable yesterday
  • (continued) Unfortunately, in the example I gave with persons X and Y, Y pays $961 *more* to the US government than X, and this is in addition to the $5k that Y already paid to the foreign government. The 10k that Y earned more than X, resulted in a net tax increase of 44247-41047=3200$. This increase is a direct consequence of Y's earnings abroad. Since Y already paid 5k tax abroad, I would argue that Y should pay max(0,3200-5000)=0$ US tax over his foreign share instead of 961$. Hence it seems to me that the US takes more than its fair share. – Joris Kinable yesterday
  • @JorisKinable: No, because your example has a flat tax rate, i.e. where the effective tax rate is the same regardless of income. In your system, someone with twice the income would have twice the tax, but that is NOT the tax system in the US. The US has a progressive tax rate. Each additional dollar of income increases the effective tax rate. Twice the income results in more than twice the tax. That is the part you are missing. – user102008 yesterday
0

I think you misinterpreted the concept. Person Y has a 10k higher global income, so he has to pay more taxes (everything else being equal). The foreign tax credit will be considered as 'tax already paid', but it doesn't reduce the total tax due.

So person Y has a 936 $ higher total tax (trusting yojr calculation), minus 5000 $ already paid, which means that the net amount he pays to the US government is 4064$ lower, but the over tax amount (including the 5000 paid already) is higher - as it should be.

The direct foreign tax credit ('deduction') has also an upper limit (which I don't know by heart), so it will probably not work with the full 5000$. If you build your example with 500 $ foreign tax already paid, it will work as described above.

There is a second option for foreign tax credit, which works for larger amounts, but it is generally less favorable - as you calculated. In the end, the US government's logic is that they want their money, and if you pay a lot of taxes in other countries, too bad for you.

2
  • 1
    Your answer focuses on small amounts of the foreign tax credit. You refer to the upper limit to claim the entire foreign tax paid as a credit without filing Form 1116, namely $300 on only passive income. However, the question asks specifically about larger amounts of foreign tax paid, and why Form 1116 computes the foreign tax credit to be less than the foreign tax paid. – user106227 2 days ago
  • 1
    I think this misunderstands the calculation. Y pays ~$900 more to the US government than X, and this is in addition to the $5,000 that Y pays to the foreign government. – nanoman 2 days ago

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.