Foreign Tax Credit (Form 1116)

The United States taxes residents on worldwide income, so income already taxed abroad would be taxed twice without relief. The foreign tax credit under section 901 is that relief: income taxes paid or accrued to a foreign country reduce U.S. tax on the same income. It is a credit, not a deduction, and almost always the better choice; the alternative of deducting foreign tax on Schedule A is rarely used.

The limitation is where the arithmetic lives. Form 1116 is completed separately for each category of income (the passive basket for interest, dividends, rent, and capital gains; the general basket for wages and business income), and the credit in each basket cannot exceed the U.S. tax on the foreign income in that basket. Foreign tax above the limit carries back one year and forward ten. Indian TDS at 30% on NRO interest, for example, often exceeds the U.S. tax on that interest in the current year and creates a carryforward rather than a refund. Below $300 of passive foreign tax ($600 joint), the credit can be claimed without Form 1116, at the cost of carryovers.

The creditable amount is the tax finally owed, not the tax withheld. If the home-country return later produces a refund of some of the withholding, the credit must be reduced. Where you rely on a treaty to change the U.S. result rather than simply credit foreign tax, the position is disclosed on Form 8833. The 3.8% net investment income tax cannot be offset by the foreign tax credit, and most states, including California, give no credit for foreign tax at all.