The foreign tax credit: getting back what other countries withheld

When a foreign country withholds tax from your dividend, you are not necessarily paying twice. The U.S. foreign tax credit lets you subtract qualifying foreign tax from your U.S. tax bill. For a typical investor with a handful of ADRs in a taxable account, claiming it can take one line on Schedule 3. For a larger portfolio it takes Form 1116, and the limits start to matter.

Credit vs. deduction

You can treat foreign income taxes in one of two ways each year:

• Credit. Reduces your U.S. tax dollar for dollar. $50 of qualifying foreign tax cuts your bill by up to $50.
• Deduction. Reduces taxable income instead, and only if you itemize. $50 deducted saves $50 times your marginal rate, perhaps $11 at a 22% bracket.

The IRS notes that the credit is usually the better deal, and for portfolio investors it nearly always is. You can't mix the two: in a given year, you choose credit or deduction for all your qualifying foreign income taxes.

The $300/$600 election to skip Form 1116

Most small investors never need Form 1116. The Form 1116 instructions allow you to claim the credit directly on your return if you meet all three conditions:

1. All of your foreign-source gross income is passive category income. Ordinary dividends and interest qualify.
2. All of that income and the foreign tax paid on it were reported to you on a qualified payee statement, such as Form 1099-DIV or Form 1099-INT (Schedule K-1 and K-3 statements also count).
3. Your total creditable foreign taxes are not more than $300, or $600 on a joint return.

Box 7 of your 1099-DIV, "Foreign tax paid," is the figure you'll usually use. If you hold international mutual funds or ETFs that pass through foreign tax, those amounts appear there too.

When Form 1116 is required

You need Form 1116 if any condition above fails. Common triggers for investors:

• Your foreign taxes exceed $300 ($600 joint). A $40,000 position in a 4%-yielding stock with 15% withholding generates $240 of tax; two or three such holdings will cross the line.
• You hold shares at a foreign broker that doesn't issue a 1099-DIV.
• You have non-passive foreign income, such as wages earned abroad.
• You want to use a carryover from another year.

Form 1116 isn't hard for a pure dividend portfolio, but tax software tends to ask questions in ways that are confusing. Expect to report gross foreign-source dividends, the foreign tax paid (the instructions explain how to handle amounts that a 1099 reports in aggregate), and some allocation of deductions.

The limitation: you can't credit more than the U.S. tax on that income

The credit is capped at the U.S. tax attributable to your foreign-source income. Conceptually:

Limit = U.S. tax before credits × (foreign-source taxable income ÷ worldwide taxable income)

The idea is that the U.S. will give up its tax on foreign income, but it won't use foreign tax to reduce the tax on your U.S. income. For dividend investors taxed at 15% or more in the U.S. on dividends that were withheld at 15% abroad, the limit is rarely the binding constraint. It bites when your U.S. rate on the income is lower than the foreign rate, such as qualified dividends taxed at 0%, or when the foreign withholding is unusually high.

Carryback and carryforward

Foreign tax that exceeds the limit isn't necessarily lost. Under the general rule, unused foreign tax is carried back one year and then forward up to ten years, filed on Form 1116. That carryover is not available for years in which you used the $300/$600 election.

Over-withheld tax is not creditable

This is the rule that catches the most investors. Only tax you legally owe counts. Publication 514 explains that when a treaty country withholds at its full rate and makes you claim a refund, your creditable tax is the amount figured at the lower treaty rate. The Form 1116 instructions say the same thing more bluntly: tax you don't legally owe, including amounts eligible for refund, isn't creditable.

Your 1099-DIV may show the full amount withheld in box 7 regardless. Tax software will often credit it all. That doesn't make it correct, and the IRS can disallow the excess.

Practical tips

• Compare box 7 against the gross dividends by country. If the ratio exceeds the treaty rate for a holding, see why you may be over-withheld and whether a reclaim makes sense.
• Foreign tax withheld inside an IRA produces no credit at all. That changes where you might hold foreign dividend payers; see foreign stocks in IRAs.
• Whether the dividend itself is taxed at qualified rates is a separate question, covered in qualified dividends on foreign stocks.
• If you're near the $300/$600 line, or have carryovers, a tax professional can tell you whether filing Form 1116 is worth the extra step.

Educational content only, not investment, tax or legal advice. The Stateside Report does not recommend buying or selling any security. Tax rules depend on your situation; confirm with a qualified tax professional. Full disclosures.