Like Canadian residents, U.S. citizens or resident aliens are taxed on their worldwide income. At the same time, they may also be subject to another country’s tax on the same income. Fortunately, U.S. tax rules provide some relief. If certain rules are met, foreign tax credits are available to offset this exposure to double taxation on the same income.
First, foreign tax credits are only available to be offset against foreign income. So, determining the amount of U.S. foreign tax credits that may be claimed requires a determination of how much income is “foreign” under U.S. tax rules. Income sourcing rules apply when trying to figure this out.
Income Sourcing
For both U.S. and Canadian tax purposes, the rules for sourcing employment income are similar. Two methods are generally applied:
- Time basis: This method is used for compensation that can be sourced based on workdays (e.g. base salary, vacation pay, overtime pay and incentive awards); and
- Geographical basis: This is often used for items of income that are fully sourced to a particular country (e.g. housing expenses, spouses or dependent education expenses, location expenses and local transportation).
Certain items such as bonuses, stock options and restricted stock units are sourced differently.
U.S. Tax Treaty Resourcing
U.S. tax rules include the flexibility to resource certain income that would otherwise be treated as U.S. source to foreign source. This allows for the use of foreign tax credits against that income. Income qualifying for treaty resourcing include:
- employment income;
- portfolio interest; and
- capital gains.
Claiming Foreign Tax Credits
To claim a foreign tax credit, foreign taxes must have been imposed on the income and must be compulsory. Canadian taxes that may qualify for U.S. foreign tax credits include withholding taxes and taxes on dividends. Taxes such as wealth taxes, sales or property taxes, or value added taxes do not qualify. The amount of credit that may be applied depends on which of the two common methods are used – accrued method or paid method. Now, while it is possible to move from the cash to the accrual method under U.S. tax rules, the reverse isn’t true. Moving from the accrual to the cash method requires making an election which may not be revoked in a future year.
Baskets of Foreign Income
Foreign income on a U.S. tax return is generally grouped into baskets or categories, with foreign tax credits calculated separately for each category. Baskets of foreign income on a U.S. tax return include:
- Passive category income: This is used for passive types of foreign income including interest, dividends, rent, capital gains and royalty.
- General limitation category income: This is used for foreign employment income or foreign business income. This category also includes “high-tax kick-out” for passive income – i.e. passive income subject to higher foreign tax rates than the highest U.S. tax rate.
- Certain income re-sourced by treaty: This would include employment income, portfolio interests and some capital gains that would ordinarily be treaty as US-sourced income but is treated as foreign under a tax treaty.
Foreign Tax Credit Limit
Foreign tax credits that may be claimed on a U.S. tax return is limited to the lesser of two amounts:
- The actual amount of U.S. tax on the net foreign source income; and
- The foreign tax paid or accrued.
The foreign tax credit claimed may be carried back one year, or forward for ten. The credits are claimed by filing a Form 1116, Foreign Tax Credit (Individual, Estate, or Trust) with a U.S. tax return. Each category of foreign income requires a separate Form 1116.
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Karlene J. Mulraine, EA, CPA, CA, CPA (NH) is the President of Cross-Border Financial Professional Corporation. Follow us on Linkedin and Twitter, or hang out on Facebook.
The views expressed in this article are those of the author and should not be relied on to make decisions. Consider discussing your specific circumstances with an appropriate specialist.