When you pay foreign income tax, and you include that foreign income on your U.S. tax return, you can claim a tax credit or a deduction. To make the figuring process much easier when trying to determine how much of your foreign income tax can be claimed as a foreign tax credit, a Form 1116 is used. The information is then transferred to your 1040 so that you can continue to figure the remainder of your income tax. The amount that is shown becomes entirely different than line 62 on your 1040 because the amount withheld is not always going to be the same as the amount you can claim. This is a little trick that you need to look out for.
You will find that the amount of foreign income tax that you can claim a credit on. For example, you are not able to apply for a credit on income tax you paid to a foreign country if you can get a refund from that country. Even if you don’t request a refund from that country, you do have the option to do so. Because you have that option, you cannot claim that amount for credit. It is the amount that would not be refunded that you can apply for a credit on.
If your foreign income tax refund is given to you in the form of a subsidy, you will not be able to claim a credit on that tax amount. Under no circumstances are you able to claim the credit. There are no exceptions to this particular rule.
Even if the subsidy is given is given to a relative, you are still unable to claim credit. Again, there are no loopholes or exceptions to this rule.
One of the simplest rules regarding foreign income tax credits is that your tax credit cannot exceed the amount you contributed in foreign income tax, hence the purpose of line 62 on your 1040. It shows how much you paid, but it is your Form 1116 that determines how much of credit you are entitled to.
There is, however, an exemption from this limit. You will not even have to file the form 1116. This happens when your income is only passive. This means it was not earned through wages, and if your foreign taxes are not more than $300. If you elect to take this exception, then you cannot carry forward or carry back any unused foreign tax to any other tax returns.
To figure your limit, all you have to do is not include any excluded income. If income has been excluded from your tax return, then you have to exclude the taxes that are associated with it. You must also not include any tax that you could get a refund for.
If you have any losses that reduce your U.S. taxable income, you do have to make up that loss in future from further foreign income that is earned. And if there is ever a time that you are restricted by limits, you can carry the tax paid to a foreign country over to your next tax return and claim the credit then as well.