Foreign Tax Credit and Completing Form 1116

By | March 3, 2015

US citizens and residents determine their US tax considering the income from all sources around the world. This sometimes results in US citizens end up paying double tax on the same income: the government of the foreign country where it originated income and also the US government.


Why does the Foreign Tax Credit Exist?

The foreign tax credit was created to help taxpayers avoid this double tax. If you are living outside of the United States or have income outside of the United States, it is very important to become familiar with the foreign tax credit Form 1116. Properly claiming foreign tax credits can significantly reduce the amount of taxes owed the the U.S. Government.


What is the Foreign Tax Credit (FTC)?

The foreign tax credit allows taxpayers a credit for taxes paid to the government of the foreign country where the income originated and is subject to US tax. For residents of Puerto Rico, the foreign tax credit reduces the liability fully or partially taxpayer so paid or accrued during the year to Puerto Rico. The foreign tax credit is completed for Form 1116 for individual taxpayers. In certain circumstances, it might be best for an individual taxpayer to claim the foreign earned income exclusion instead of using foreign tax credits.


Who Can Take the Foreign Tax Credit (FTC)?

US citizens living in Puerto Rico compute both taxes, the US and in Puerto Rico based on their income from all sources. These taxpayers can take the foreign tax credit to reduce your tax liability US.

To determine when the taxpayer can take the foreign tax credit, you must know if the taxpayer is cash basis or accrual basis:

  • A cash basis taxpayer reports income when currently receives, and report expenses when they are paid. Most people who file a tax return are cash basis.
  • Accrual basis taxpayer when computing the income that they earn now. Its deductions are computed when the debts are incurred, but not necessarily paid.

Most individual taxpayers are cash basis taxpayers. Cash basis taxpayers can elect to use the accrual method for determining the foreign tax credit. However, once taken this option, the taxpayer must use the equity for foreign tax credit on all future tax returns method.

Cash basis taxpayers can choose to take the foreign tax credit for taxes in Puerto Rico in the year in which these taxes were paid or accrued.

  • If you take credit for the taxes on income in the year they were paid, then they can claim payments and withholdings as a foreign tax credit. Additional taxes paid by other government contributions to Puerto Rico for that year are not included.
  • If you take the foreign tax credit the year in which the taxes were accrued, then they can claim all your tax liability of Puerto Rico to December 31 for foreign tax credit, regardless of whether or not they have paid taxes.

Most employees of the US government living in Puerto Rico used to determine the cumulative foreign tax credit method. Because Puerto Rico taxes accumulate in December 31 and paid after year end.


Completing Form 1116 for Foreign Tax Credit

At the top of Form 1116, Foreign Tax Credit (Individual, State, or Managed), taxpayers indicate the type of foreign income they received. The most common categories of income that you will find are:

  • Passive income including dividends, interest, royalties, rents, and annuities
  • General category income includes wages, salaries and compensations outside of an individual as an employee

To calculate the maximum amount of foreign tax credit a taxpayer can claim you should compare your foreign income that was taxed by the US his total taxable income US.


Calculating Foreign Tax Credits on Form 1116

Some taxpayers are compensated for services performed partly within and partly outside the US When you can not segregate their compensation, you spread the income timebase. Determine how much income should be regarded as originating from abroad multiplying it by the fraction:

  # Days worked outside the US this entry

  Total compensation X = foreign income
  Total of days worked by this income


Taxpayers who receive pension income by working part conducted in the US and partly in Puerto Rico or another foreign country, foreign income should be calculated using the formula:

# Years in a foreign country

  X = Number of annual pension abroad
 Total years in service for pension


When calculating the income subject to tax originating abroad for foreign tax credit, subtract expenses related to foreign income, losses, etc., foreign income.

In line 2, enter the deductions that are definitely related to foreign income such as:

  • Business Expenses
  • Moving expenses
  • Contributions to IRA and Keogh
  • Professionals and by union dues

In lines 3a and 3b, type the deductions that are not definitely related to a specific input as:

  • Certain itemized deductions or the standard deduction
  • Other deductions (eg deduction for food pensions paid)

No modification is necessary for personal exemptions.  For taxpayers who do not itemize their deductions, online 3a, writes:

  • Your standard deduction or
  • The allowable portion of your standard deduction (line 2d Publication 1321 worksheet) for taxpayers who received free from income tax under IRC 933

For taxpayers who itemize their deductions, online 3a, scores certain detailed as deductions:

  • Medical Expenses
  • Real Estate Tax

These amounts were taken from lines 4 and 6 of Annex A and have already been modified due to exempt from income tax under IRC 933. In line 3b, list some other deductions that are not definitely related to a specific type of income, such as alimony (Form 1040, line 31a).

For these assignments only, overseas gross income on line 3d and 3e gross income online:

  • Includes exempt and excluded income (such as tax-exempt income Puerto Rico)
  • Do not include COLA

3d online scores overseas gross income for income category labeled at the top of Form 1116. In line 3e, scores gross income from all sources and categories, both US and abroad.

If the taxpayer only has income of Puerto Rico and only this filing Form 1116 for a category, 3d and 3e line will be equal.

Interest expense is subject to a separate amendment in line 4.

Taxpayers who have gross income exempt from tax in Puerto Rico:

  • $ 5,000 or less may assign all your expenses for mortgage interest income US and not have to include it here.
  • More than $ 5,000, divide the deductible on your mortgage interest (including points) using the method of gross income. Use the worksheet in the instructions for Form 1116.

Notice: If an expense or deduction is not related to a specific type of income, should be assessed regardless of when, where, and that income was paid.


Specifics of Completing Form 1116

Use Form 1116, Part II, to establish the number of qualified foreign taxes paid or accrued during the year.

This table has instructions on how to complete each line in Part II.

Column (s) Addresses
Box hyi Indicated in the box if the taxpayer is claimed taxes paid or accrued.
j Report date on which taxes were paid or accrued. For cash basis taxpayers using the accrual method writes the last day of this year.
k to n Ignore these columns to taxpayers who are claiming tax paid only Puerto Rico; these lines are for taxpayers who paid foreign tax in foreign currency.
or until r Write the type of income for which the taxpayer paid foreign tax. R Use column for taxes paid or accrued salaries and pensions.

Some taxpayers, such as those with salary and pension income must complete more than one Form 1116. For those taxpayers, includes only the amount of foreign tax in the form of income for the type of Form 1116 that is used.


Calculate the Foreign Tax Reduction

Use Form 1116, Part III, to implement the comprehensive formula of limitation. This determines the maximum amount in foreign tax credit the taxpayer.

This table has instructions on how to complete each line in Part III.

Line (s) Addresses
9 Enter the amount of foreign tax Part II
10 Overseas tax transferred from other years; Please refer to Publication 514 for more information
12 Report reduction in foreign tax, if applicable; this is discussed later in this topic
14-21 Calculations to determine the maximum amount of credit
22 Reports the Foreign Tax Credit allowed; this is the lesser of:

  • Line 14: foreign tax credit available
  • Line 21: Limiting

On Form 1116, Part II all taxes paid or accrued Puerto Rico in both income exempt and not exempt from tax, can be displayed in calculating the credit. However, taxes paid in tax-exempt income are not allowed as part of the foreign tax credit. Tax-exempt income allocated to Puerto Rico should be included in Part III, line 12, as a reduction in foreign tax.

To find the reduction in foreign tax the taxpayer, use this formula:

Puerto Rico income not subject
to federal taxation under IRC 933
Deductible expenses
assigned to this entry

x Tax paid or accrued to Puerto Rico
Total taxable income
in Puerto Rico
Deductible expenses
assigned to this entry

Summary of Appropriations Separate Parts III

Use Form 1116, Part IV, to summarize the credit.

If the taxpayer claimed:

  • One category of foreign income, write the amount from line 22 on line 28 and then complete line 30
  • More than one category of foreign income and has a multiple Forms 1116, complete Part IV in only one of them; for these taxpayers, complete lines 23 through 30