Foreign tax credit

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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. The credit is the amount you paid to the foreign country, but it is usually limited up to the fraction of your U.S. income tax corresponding to taxable income attributed to the foreign country; for example, if 5% of your taxable income was subject to foreign tax, you cannot take a credit for more than 5% of your U.S. tax. Details are in IRS Form 1116 and Form 1116 Instructions.

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.

Tax forms
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.

Example of how it affects your taxes
Say that you hold an international stock fund. The stocks in the fund earn $1000 in dividends, but foreign countries withhold tax of $70 of those dividends. Therefore, the fund only pays you $930 in dividends; this is what you will receive if you hold the fund in a tax-advantaged account.

Now say that you hold the fund in a taxable account, you are in a 25% tax bracket, and 70% of the dividends are qualified. Your Form 1099-DIV reports $1000 in dividends, $70 in foreign tax withheld, and $700 in qualified dividends. When you do your taxes, you will owe tax on the full $1000 in dividends; 15% of the $700 qualified dividend and 25% of the $300 non-qualified dividend is $180. However, you can then take a credit for the $70 foreign tax (assuming no limitations apply), so your total tax bill is only $110. You have $820 after tax, just as if you had received the full $1000 and there had been no foreign tax withholding.

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.

How to find information for Vanguard funds
In order to fill out Form 1116, you need to list your total foreign source income. If you hold a Vanguard mutual fund, or hold Vanguard exchange-traded funds (ETFs) in a Vanguard brokerage account, you will receive a Foreign Tax Paid Reporting Information statement which lists the total. If you hold a non-Vanguard fund or ETF in a Vanguard brokerage account, or hold funds or ETFs in a non-Vanguard brokerage account, the brokerage may not list the foreign source income, so you will need to find the correct amount from the ETF provider.

For Vanguard, the necessary information is at Foreign Tax Credit Worksheets. If that link becomes invalid, go to Vanguard's web site for advisors, and select "Tax Center" under "Investment Products"; the foreign tax credit worksheets are listed there.

What is listed is the foreign income percentage, which you multiply by the total income from the fund to find the foreign amount.

State income taxes
Some states allow a credit for foreign income taxes, computed the same way as the credit for taxes paid to other states; combined with the federal credit, this gives a double benefit. Since the state tax rate is usually lower than the foreign tax rate, you will not get a full state credit for the foreign tax, but the foreign income will be effectively tax-free. In these states, it is particularly attractive to hold foreign stocks in a taxable account

According to Individual Income Tax Provisions in the states, the foreign tax credit is available in AL, AZ, HI, IA, MT, NC, and a limited credit in LA.