Hidden Traps in the Foreign Tax Credit

The Foreign Tax credit is important to keep in mind for any individual who pays or accrues foreign tax on foreign income which is also subject to U.S. tax.

Not all foreign taxes qualify for the credit however. To qualify, the tax must be imposed on you, you must have paid or accrued the tax, the tax must be the legal and actual foreign tax liability and the tax must be an income tax (or a tax in lieu of an income tax).  Treaties between the United States and other countries are in place to prevent double taxation.  If you claim the credit under a treaty provision you must report it on Form 8833 or might otherwise be subject to a $1,000 penalty.

The most common trap an individual can fall into is the requirement that the tax must be imposed on you.  If you pay a foreign tax you are not otherwise required to pay, you cannot claim the Foreign Tax credit.  For example, Ireland’s Depository Interest Retention Tax is only required to be paid by Irish residents, but will be applied on interest income from a deposit account without proof of non-residency.

Another common trap is not being aware of treaty provisions between the United States and the foreign government you paid tax to.  If you were not required to pay a foreign tax due to a treaty provision but you paid it anyways, you cannot now claim the Foreign Tax credit because the tax paid was not your actual foreign tax liability.