The use of foreign tax credits eliminates double taxation when more than one country uses the same income for tax purposes. The United States Internal Revenue Service (IRS) gives a foreign tax credit to an American taxpayer if that taxpayer paid tax on income produced in another country. In the U.S., an income tax includes a withholding tax paid on foreign-sourced income. A gross income tax, however, is not included in the classification of income tax and so would not be subject to a foreign tax credit.
The foreign tax credit allows businesses to grow beyond their own countries. Without the tax credit, countries could tax a business twice for income generated beyond their own borders. The tax credit allows open competition between businesses despite their nationality. There are also cases in which you do not need to work or live in a foreign country in order to claim this benefit. For example, you can claim the deduction or credit if a mutual fund pays foreign taxes on your behalf. Your foreign tax credit cannot exceed your U.S. tax liability multiplied by a percentage. This percentage is your total foreign-source income divided by your total worldwide income. For more information on this subject, see www.jhcohn.com/International/International-Tax-Outbound/Foreign-Tax-Credit-Planning.aspx.
U.S. citizens or resident aliens who pay income tax to a foreign country or U.S. possession have a choice of taking this amount as a deduction or credit. If they choose the deduction, this lowers their taxable income. A credit lowers their tax liability. For most people, taking the tax credit is a better solution than taking the deduction.
Some foreign taxes do not count toward the credit, so in those cases the deduction would be the better option. If you choose to take a deduction, bear in mind that you must take a deduction for all the foreign taxes you paid. You must itemize your deductions on schedule A of form 1040. To take the credit, you need to file a Form 1116. This form is available on the IRS web site at www.irs.gov/pub/irs-pdf/f1116.pdf.
