Foreign tax credit

What is the foreign tax credit?
The foreign tax credit is intended to reduce the double tax burden that would otherwise arise when foreign income is taxed by both the United States and the foreign country from which the income is derived.

Generally, income taxes paid or accrued to a foreign country or a U.S. possession, or taxes paid or accrued to a foreign country or U.S. possession in lieu of an income tax, will qualify for the foreign tax credit.

For mutual fund shareholders, you may be able to claim the credit based on your share of foreign income taxes paid by the fund if it chooses to pass the credit on to its shareholders. You should receive from the mutual fund a Form 1099-DIV, or similar statement, showing the foreign country or U.S. possession, your share of the foreign income, and your share of the foreign taxes paid. Form 1099-DIV Box 6 reports foreign tax paid, and this amount is included in Box 1a, even though it represents dividends you don't actually receive.

You can choose to take the amount of any qualified foreign taxes paid or accrued during the year as a foreign tax credit or as an itemized deduction. To choose the deduction, you must itemize deductions on Form 1040, Schedule A. To choose the foreign tax credit you generally must complete Form 1116 and attach it to your Form 1040.


 * Exception: you do not have to complete Form 1116 to take the credit if all five of the following apply:


 * 1) All of your gross foreign source income was from interest and dividends and all of that income and the foreign tax paid on it were reported to you on Form 1099-INT, Form 1099-DIV, or Schedule K-1.
 * 2) If you had dividend income from shares of stock, you held those shares for at least 16 days.
 * 3) You are not filing Form 4563 (Exclusion of income for bona fide residents of American Samoa) or excluding income from sources within Puerto Rico.
 * 4) The total of your foreign taxes was not more than $300, or $600 if married filing jointly (amounts current as of April 15, 2008).
 * 5) All of your foreign taxes were:
 * 6) *Legally owed and not eligible for a refund, and
 * 7) *Paid to countries that are recognized by the United States and do not support terrorism.

Note that only taxable investors can claim the deduction or credit. You cannot claim the deduction or credit for foreign tax paid by mutual funds held in a tax-advantaged account such as an IRA, 401(k), variable annuity, etc.

Choosing To Take the Credit or a Deduction
You can choose each tax year to take the amount of any qualified foreign taxes paid or accrued during the year as a foreign tax credit or as an itemized deduction. You can change your choice for each year's taxes.

To choose the foreign tax credit, you generally must complete Form 1116, as mentioned above. To choose to claim the taxes as an itemized deduction, use Form 1040, Schedule A (Itemized Deductions).

Although no one rule covers all situations, it is generally better to take a credit for qualified foreign taxes than to deduct them as an itemized deduction on Form 1040, Schedule A. This is because:


 * 1) A credit reduces your actual U.S. income tax on a dollar-for-dollar basis, while a deduction reduces only your income subject to tax
 * 2) You can choose to take the foreign tax credit even if you do not itemize your deductions. You then are allowed the standard deduction in addition to the credit, and
 * 3) If you choose to take the foreign tax credit, and the taxes paid or accrued exceed the credit limit for the tax year, you may be able to carry over or carry back the excess to another tax year

Not all Vanguard funds eligible
Not all of Vanguard's international funds are eligible for the foreign tax credit. The IRS does not allow taking the credit for mutual funds that hold other mutual funds rather than individual securities (so-called Funds of funds). Since Vanguard Developed Markets Index Fund (VDMIX) is a fund of funds, it is not eligible for the foreign tax credit. However, Vanguard Total International Stock Index Fund (VGTSX) directly holds stocks and funds. Sharesholders of the fund are eligible for the credit for the portion directly invested in stocks.

Balanced funds-of-funds such as Vanguard STAR Fund, Vanguard LifeStrategy Funds, and Vanguard Target Retirement Funds are not eligible for the credit on their foreign fund holdings.

Note that taxable shareholders of these funds do receive an implicit deduction for foreign taxes paid. Form 1099-DIV Box 6 is $0, but the lost foreign taxes are not included in Box 1a.

Links

 * Foreign Tax Paid at Fairmark.com
 * Vanguard International Index Fund Tax Attributes (PDF)
 * 2007 Instructions for Form 1116 (PDF)