Can I Deduct Foreign Taxes Paid?

January, 12 2024 by Steve Banner, EA, MBA

This is a question that comes up often when U.S. taxpayers preparing their annual tax return may be surprised to find that they have paid foreign taxes on the earnings in their investment accounts. Thanks to the internet and our increasingly interconnected world, over the past 30 years, banks and financial firms have significantly expanded the number and type of investment funds they offer to their clients. Investors are now able to choose from a broad range of funds in different categories. Some individual funds might be broad in focus, such as “American Large Caps,” or more specialized, like “International Copper Mining.” The result has been that each year, more and more Americans find themselves paying foreign taxes in addition to U.S. taxes.

But no matter how diversified or narrow the focus of any given investment vehicle, if you paid or accrued foreign tax on your income from that fund, you may be able to get relief for those taxes on your U.S. tax return. Although U.S. taxpayers are taxed on their worldwide income, the tax code contains provisions to help you avoid being taxed twice on the same income. You can choose from two different methods to achieve this goal. You can either claim a foreign tax credit using Form 1116, Foreign Tax Credit, or a foreign tax deduction using Schedule A, Itemized Deductions. You can generally only use one of the two methods each year for all of your foreign taxes, but you are free to choose the other method the following year if you desire.

Let’s look at these two different methods, followed by an example.

 

Foreign Tax Credit

This method allows you to claim a credit against your U.S. taxes to offset the amount you paid in foreign taxes. Form 1116, Foreign Tax Credit is normally required to calculate the amount of the credit but, in certain cases, you may be able to claim the foreign tax credit without filing Form 1116.
 

Foreign Tax Deduction

In this method, your foreign taxes are deducted as a line item on Schedule A, Itemized Deductions. The benefit you receive is that your adjusted gross income (AGI) for tax purposes is reduced by the amount of foreign taxes you have paid. However, this method can only be used by taxpayers eligible to itemize their deductions – all other taxpayers must use the foreign tax credit method instead. As a reminder, you can only file Schedule A if the total of your expenses for the year for state, local, and foreign taxes, mortgage interest, charitable contributions, and medical expenses above 7.5% of your AGI exceeds $20,800 if you are filing as Head of Household (HOH) for 2023, or $27,700 if you are using the status of Married Filing Jointly (MFJ) for 2023.

Example

In addition to her income from her work as a teacher last year, Anne received $2,000 in dividends from her investments in a gold mine in South America. The foreign government withheld $400 in tax on those dividends. Anne is eligible to itemize her deductions, but she is unsure how to handle the foreign taxes she paid. Anne falls into the 22% marginal tax bracket in the U.S. and, thus, her tax liability for the overseas dividends would be $440 ($2,000 x 0.22). If she can claim a foreign tax credit for the tax she paid, her net tax on the dividends would be $40 ($440 - $400). On the other hand, if she claims the foreign tax deduction instead, her taxable dividend income will be reduced to $1,600 ($2,000 - $400), and her tax liability on the dividend income will be $352 ($1,600 x 0.22).

Just to recap the results of these calculations:

• If Anne claims the foreign tax credit, her U.S. tax liability for the dividend income would be $40.
• If Anne claims the foreign tax deduction, her U.S. tax liability for the dividend income would be $352.

As we can see from these figures, Anne’s best course of action in her case would be to claim the foreign tax credit.

To summarize our answer to this question, you can use the US tax code to reduce the impact of foreign taxes you have paid or incurred. But we must also bear in mind that each individual case is different, depending on the country or countries involved. When in doubt, you are well advised to seek the help of an experienced tax professional.