How, When And Where Do You Deduct Foreign Tax Paid? + FAQs

In 2020, U.S. companies claimed over $67 billion in foreign tax credits – a clear sign of how much double taxation Americans avoid with the right moves.

Whether you’re an individual or a multinational business, knowing how, when, and where to deduct foreign tax paid can save you big.

• 💸 Maximize tax savings: Use the Foreign Tax Credit (FTC) rather than a deduction to cut your U.S. tax bill dollar-for-dollar for taxes paid abroad.

• 🗓️ Timing is everything: Claim foreign taxes in the proper year, utilize carrybacks/carryforwards for unused credits, and remember special deadlines (expats get automatic extensions!).

• 📑 Proper paperwork: Report foreign taxes on the correct forms (Form 1116 or Form 1118 for credits, or Schedule A for deductions) to ensure you claim every dollar.

• 🌎 All taxpayer types: Guidance for individuals, expats, small businesses, and multinational corporations – U.S. rules let every taxpayer avoid double taxation if they follow the steps.

• ⚠️ Avoid costly mistakes: Don’t double-dip exclusions and credits, and don’t miss out on relief by using the wrong method or form. Small errors can mean money left on the table.

How, When & Where to Deduct Foreign Taxes Paid (Quick Answer)

How: You have two choices for foreign taxes under U.S. law – take a tax credit or an itemized deduction. Most taxpayers opt for the Foreign Tax Credit, which directly reduces your U.S. tax liability for income taxes paid to a foreign country. Alternatively, you can deduct foreign income taxes as an itemized expense (on Schedule A) to reduce your taxable income. In practice, the credit usually yields a bigger benefit (a dollar-for-dollar tax reduction), while a deduction only saves you tax at your marginal rate. Importantly, you must choose one method for all your foreign taxes in a given year – you cannot both credit and deduct foreign taxes in the same tax year.

When: Claim foreign tax credits or deductions in the same tax year the foreign tax was paid or accrued (consistent with your accounting method). For example, if you paid foreign tax on 2024 income in 2025, you’d typically claim the credit on your 2025 U.S. return (if using the paid method). If you use the accrual method, you’d claim in 2024. Timing flexibility: If your usable foreign tax credit exceeds the IRS limit in a year, you can carry it back one year or forward up to ten years to get relief in a different year. (Deductions can’t be carried over, but you might choose to deduct in a year you can’t fully use a credit.) Also, expats living abroad get an automatic 2-month filing extension (to June 15) to claim credits/deductions on their federal return, though any tax due should still be paid by April 15 to avoid interest.

Where: On your U.S. federal tax return, foreign taxes are claimed in specific sections. Individuals claim the Foreign Tax Credit on Form 1116 (which flows to Schedule 3 and then Form 1040) – unless qualifying for the exemption that skips Form 1116 for small amounts.

Corporations use Form 1118 attached to their Form 1120 corporate return. If you choose the deduction instead, individuals include foreign taxes with other taxes on Schedule A (Itemized Deductions), and businesses deduct foreign taxes on their income statements (reducing profit). State taxes: Federal law is the primary relief for foreign taxes, but some states also offer credits or deductions at the state level (more on that later). Always keep documentation (like foreign tax returns or payment receipts) for where and when the tax was paid, as the IRS may ask for proof when you claim a foreign tax credit or deduction.

Foreign Tax Credit vs. Deduction – Which Saves You More?

If you paid tax to a foreign government on your income, should you take a foreign tax credit or a deduction? The short answer for most: take the credit. The Foreign Tax Credit directly subtracts the foreign tax from your U.S. tax bill, while a deduction only lowers your taxable income.

For example, if you paid $1,000 in foreign tax and you’re in the 24% U.S. tax bracket, a deduction might save you about $240 in U.S. tax – but a credit would save you the full $1,000. The credit is a dollar-for-dollar offset, making it far more powerful in reducing your tax liability.

You can only use the credit up to the amount of U.S. tax on your foreign-sourced income. In other words, the IRS caps your foreign tax credit so you don’t offset more U.S. tax than the proportion of income that was foreign.

If your foreign taxes are very high relative to your income, you might not be able to use the full credit immediately (though you can carry it forward). In rare cases, if you have very low U.S. taxable income but paid some foreign tax, a deduction could be considered – especially if you aren’t able to use a credit over the carryforward period.

Electing the credit is more advantageous. The IRS even highlights that you can take the credit without giving up the standard deduction (since the credit doesn’t require itemizing), and you preserve the ability to carry over excess credits to future years. A deduction, on the other hand, only benefits you if you itemize and is subject to limits (for individuals, foreign income taxes deducted on Schedule A count toward the $10,000 cap on state and local tax deductions).

Key difference: A credit reduces tax, a deduction reduces income. This fundamental difference means the credit usually provides greater tax relief, preventing double taxation more completely. Below is a quick comparison of the pros and cons of each approach:

Bottom line: The Foreign Tax Credit is usually the superior choice to avoid double taxation. It was specifically designed to prevent Americans from being taxed twice on the same income. By contrast, deducting foreign tax paid offers a smaller and more limited benefit.

Most taxpayers will only consider the deduction route in edge cases (for instance, if you have minimal or no U.S. tax due and thus can’t use a credit, or if the foreign levy isn’t creditable as an income tax but is still deductible as a tax expense). Next, we’ll look at how to actually claim the credit or deduction, step by step.

Step-by-Step: How to Claim Foreign Tax Credits or Deductions

Claiming foreign tax relief on your U.S. return involves some paperwork but is manageable if you break it down. Here’s how to proceed:

1. Determine Eligibility and Method: First, confirm that the tax you paid to a foreign country qualifies as a foreign income tax. Generally, only income taxes (or taxes in lieu of income tax) qualify for the Foreign Tax Credit. For example, foreign income tax withheld on wages or interest, or foreign taxes on business profits, can be credited. If the foreign levy is not an income tax (for instance, a foreign VAT or sales tax, or a real estate tax on property), you cannot claim it as a credit.

   You might deduct those as business expenses or itemized taxes if allowable, but they won’t count for the credit. Once you identify qualified foreign income taxes, decide credit vs. deduction. Almost everyone should opt for the credit unless you have a special situation. Remember, the choice is annual – you can choose credit one year and deduction another, but within one year you must apply the same choice to all foreign taxes. (If you previously chose one and want to change, you’d generally file an amended return within the statute of limitations.)

2. Gather Documentation: Collect all records of foreign income and taxes paid. This includes pay stubs or employer statements showing foreign tax withholding, foreign tax returns if you filed any abroad, or Form 1099-DIV/INT forms showing foreign taxes withheld on investment income.

   If you’re an expat, also have your Form 2555 (Foreign Earned Income Exclusion) info ready if you used the exclusion, because taxes on excluded income can’t be credited. Having precise figures for foreign gross income and taxes by country and category (e.g. passive vs. general income) will be important for Form 1116 or Form 1118.

3. Fill Out the Right Form:

   • Individuals (Including expats, sole proprietors, partners): Complete Form 1116 (Foreign Tax Credit). This form calculates your allowable credit. You’ll input the foreign taxes paid or accrued, categorize the type of income (passive, general, etc.), and compute the limitation. Tip: If your total creditable foreign taxes are $300 or less ($600 or less if married filing jointly) and all your foreign income is from passive sources (like interest, dividends), you may not need Form 1116 – you can claim the credit directly on the 1040 Schedule 3. (This is an IRS de minimis rule to simplify small credits.) For most other cases, attach Form 1116.

   • C-Corporations: Use Form 1118 (Foreign Tax Credit – Corporations). Corporate filers will report foreign income and taxes in various separate categories (baskets) on this form. A corporation can claim credits for income taxes it paid directly on foreign branch income, and also for foreign taxes paid by certain subsidiaries (via deemed paid credits, in the case of subpart F or GILTI inclusions). Form 1118 is more complex, reflecting corporate-specific rules, but the principle is the same: calculating the credit limit for each category of foreign income.

   • If Deducting: If you choose to deduct instead of credit, individuals will enter the foreign tax paid on Schedule A under “Taxes You Paid” (it will be labeled as foreign income tax). This adds to your itemized deductions (subject to the $10k SALT cap). Businesses (including partnerships and S-corps) deduct foreign taxes as part of normal business expenses on their income statements or Schedule C, E, etc., wherever relevant.

4. Complete the Calculations: Follow the form instructions to compute your credit. The core calculation on Form 1116 is: Foreign Tax Credit = (Foreign Tax Paid or Accrued), limited by (Total U.S. Tax * (Foreign taxable income / Total taxable income)). This formula ensures you only credit up to the U.S. tax attributable to foreign-source income. If your foreign taxes paid exceed that limit, you’ll have an “excess credit” which gets carried over. On Form 1116, you’ll also convert foreign taxes to U.S. dollars (use the average exchange rate for the year or actual paid rate) and list each country if required. Double-check that you aren’t claiming credit for any taxes on income you excluded (such as income excluded by the Foreign Earned Income Exclusion – those taxes must be prorated out). If you’re filing Form 1118 as a corporation, you’ll perform similar calculations but often on a country-by-country or basket-by-basket basis.

5. Report on Your U.S. Tax Return: Once the credit is calculated, transfer the credit amount to your Form 1040. For individuals, the credit from Form 1116 flows to Schedule 3 (Additional Credits), line 1, and then into the Form 1040. The foreign tax credit will appear on the 1040, reducing your overall tax owed. If you’re using tax software, ensure you input data in the foreign tax section so it generates Form 1116 properly. For the deduction route, the total foreign taxes paid would be part of your itemized deduction total on Schedule A, which then flows into the 1040 (line for itemized deductions). Remember, you cannot claim the same tax both ways – it’s either on Form 1116 or on Schedule A, not both.

6. Retain Records and Carryovers: Keep copies of Form 1116/1118 and note any carryover of unused foreign tax credits. Form 1116 has a schedule for carryback and carryforward (unutilized foreign tax credit from prior year or carried to future). For example, if in 2024 you could only use $5,000 out of $8,000 foreign taxes, the extra $3,000 can be carried to future years (or back to 2023). Maintain a worksheet each year of your foreign tax credit carryover balances. These credits can be a valuable asset in future years if your U.S. tax on foreign income increases. Also, keep all proof of foreign taxes paid for at least 3-6 years (until the statute of limitations expires for the return) – if the IRS audits your credit, you’ll need to show you indeed paid the foreign taxes claimed.

Following these steps will let you confidently claim your foreign tax credit or deduction. Next, we explore special situations for different taxpayer types, and important things to watch out for.

Individuals vs. Expats: Foreign Tax Credit and the FEIE

All U.S. individuals reporting foreign income face the same basic choice of credit vs deduction, but Americans living abroad (expats) have an additional tool: the Foreign Earned Income Exclusion (FEIE). The FEIE (IRS Form 2555) allows eligible expats to exclude up to $120,000+ (adjusted annually, $120k is a ballpark figure for recent years) of foreign earned income from U.S. taxation.

This can be a huge benefit – if you earn a salary abroad under the limit, you might eliminate U.S. tax on it entirely by excluding it. However, you can’t double-claim: any income you exclude with the FEIE cannot also get a foreign tax credit. Nor can you deduct foreign taxes attributable to that excluded income.

So, FEIE or Foreign Tax Credit? It depends on your situation, and sometimes you can use both on different portions of income. Here are some considerations for expats:

• If you live in a low-tax country (or no-tax country) – for example, you work in Dubai or Singapore and owe little to no income tax locally – the FEIE is your best friend. By excluding your foreign salary, you avoid U.S. tax up to the limit. Since you didn’t pay much foreign tax, the credit would be less useful here. (You can’t credit taxes you didn’t pay, and if your income is fully excluded, there’s no U.S. tax on it anyway.)

• If you live in a high-tax country (like many European countries) – you likely pay income tax abroad at a rate equal to or higher than U.S. rates. In these cases, the Foreign Tax Credit often fully offsets U.S. tax. For example, if you pay 35% tax in Country X on your earnings, and the U.S. tax on that income would be 22%, the foreign tax credit can wipe out the U.S. 22% completely (you’d carry forward the rest of unused credit). You might not need the FEIE at all. In fact, using the FEIE could be unnecessary because your foreign tax credit already makes your U.S. tax zero. Some expats in high-tax countries skip the exclusion to preserve other benefits (like the ability to contribute to an IRA, which the exclusion can affect by reducing earned income).

• If your income exceeds the FEIE limit – you can do a combination: exclude the first chunk (up to ~$120k) and then use the foreign tax credit on the remainder of income (and the foreign taxes associated with that remainder). This requires prorating the foreign taxes between excluded and included income. The portion of foreign tax allocated to excluded income can’t be credited, but the portion for the included income can. This combo strategy can maximize benefits if you have a high salary and also pay foreign tax.

  • Just be cautious: using the FEIE has a “stacking rule” – the income you exclude still counts in determining the U.S. tax rate on your non-excluded income. In other words, you don’t escape the higher tax brackets on the rest of your income just because you excluded some. The U.S. will calculate tax as if the excluded amount were included, then only apply that tax rate to your taxable (non-excluded) income. This prevents someone from dropping into a low bracket on remaining income after excluding a big chunk. The foreign tax credit, on the other hand, doesn’t have a stacking rule; it just offsets the tax.

Expats must also mind state taxes: If you maintained residency in a U.S. state while abroad, your state might tax your foreign income too (though many states allow you to break residency when you move overseas). States generally do not have an equivalent to the FEIE, but some might allow a credit for foreign taxes paid.

For example, New York will tax your worldwide income but offers a state foreign tax credit in some cases (though not if that income was excluded federally via FEIE). California, infamously, offers no credit or exclusion for foreign income – if you’re a California resident abroad, you could end up paying California tax on the income even if you paid foreign tax. Many expats therefore change their state residency when they move overseas to avoid this double state tax problem.

U.S. individuals and expats should usually lean on the foreign tax credit to avoid double taxation. The foreign earned income exclusion is a powerful alternative for those in low-tax countries or under the exclusion cap. Some careful planning is needed to decide which to use – and remember, if you choose the exclusion and later want to use the credit, you can, but there are IRS rules about revoking the exclusion (if you revoke the FEIE to switch to credit, you generally can’t claim the exclusion again for 5 years without IRS approval). Always evaluate the math: calculate your hypothetical U.S. tax with the exclusion versus with the credit, to see which leaves you better off.

Multinational Businesses and Corporations: Foreign Tax Credit in Action

U.S. corporations and multinational enterprises deal with foreign tax credits on a much larger scale, but the concept remains similar: use credits to avoid double taxation of overseas profits. Under U.S. tax law, corporations are taxed on worldwide income, but since 2018 there’s a partial territorial system. Here’s what that means for foreign tax credits:

• 100% Dividend Exemption: Thanks to the Tax Cuts and Jobs Act of 2017, U.S. C-corporations can generally exclude dividends received from their foreign subsidiaries (owned 10% or more) from U.S. income via a 100% dividends-received deduction. This effectively means if your overseas sub earns profit and pays foreign tax, then gives you a dividend, you don’t pay U.S. tax on that dividend – so you don’t need a foreign tax credit for those taxes (this is the “territorial” aspect). However, not all foreign income falls under that exemption.

• Foreign Branch Income: If a U.S. corporation operates abroad through a branch (not a separate subsidiary), those earnings are directly included in the U.S. return. Here, the corporation can use the foreign tax credit to offset U.S. tax on that foreign branch income. For example, a U.S. company with a branch in Brazil will include the branch’s income in its U.S. taxable income, but it can claim credit for Brazilian income taxes paid on that branch’s earnings.

• Subpart F and GILTI: The tax law brings certain foreign subsidiary income immediately into the U.S. tax base (even without a dividend). Two key concepts are Subpart F income (certain types of passive or easily moveable income of foreign subs) and GILTI (Global Intangible Low-Taxed Income), which is a category of income from foreign subs that exceeds a routine return on assets. U.S. shareholders of controlled foreign corporations must include these incomes on their U.S. return each year. The good news: they can also claim foreign tax credits associated with these inclusions. For GILTI, there’s a twist – only 80% of foreign taxes on GILTI can be credited, and GILTI has its own separate FTC “basket” with no carryover allowed. Still, this credit is crucial for companies operating in higher-tax countries so they don’t pay full U.S. tax on top of foreign tax.

• Separate limitation categories: Corporations must track foreign tax credits by category of income. Historically categories (or “baskets”) include general income (active income), passive income (investment income), and now GILTI (post-2018) as its own category, plus others like foreign branch income separated from general in recent regulations. A credit from one basket can only offset U.S. tax on income in that basket. This prevents, say, excess credits from high-tax active income from offsetting U.S. tax on low-tax passive income. It adds complexity: a company might have unused credits in one basket but still owe U.S. tax in another. Planning is needed to utilize credits efficiently (such as generating overall domestic losses or income shifting between baskets, which goes beyond our scope).

• Form 1118: Corporations report all this on Form 1118, listing foreign taxes paid or accrued, by country and by basket. The form is quite detailed – for 2020, only 7,605 corporations filed FTC claims, reflecting that mostly larger companies deal with these issues. As mentioned earlier, those companies claimed roughly $67 billion of foreign tax credits in one year, showing how significant this is to U.S. multinationals.

Can corporations choose deduction instead of credit? Yes, in principle a corporation could elect to deduct foreign taxes (just like an individual can). However, almost all corporations choose the credit because it generally provides greater relief. One scenario a corporation might deduct is if it has a U.S. net operating loss – a credit in an NOL year isn’t usable (since there’s no U.S. tax to offset, and using a credit in a loss year wouldn’t make sense when they could carry it forward).

By deducting foreign taxes in an NOL year, they effectively increase the NOL, which can then offset future income. But this is a niche strategy. Another consideration: once a corporation elects the deduction for a year, none of the foreign taxes that year can be credited, and the carryback/forward for credits doesn’t apply for that year’s taxes. They’d lose the potential to carry those taxes to another year as credit. Thus, corporations overwhelmingly rely on foreign tax credits to relieve double taxation, unless they have a specific tax planning reason to do otherwise.

Tax Treaties: Many U.S. tax treaties include provisions about foreign tax credits. Typically, the country where the income arises gets primary taxing rights, and the other country gives a credit. As a U.S. taxpayer, you often get relief under U.S. domestic law (the FTC rules we’ve discussed) without needing to invoke the treaty.

But treaties can clarify tricky situations – for example, they might deem certain taxes creditable or address double taxation of specific types of income (like social security taxes). For corporations, treaties might reduce withholding tax rates on dividends, interest, royalties – which lowers the foreign tax paid and thus the credit needed. A corporation will plan considering both treaty benefits and credit limitations.

In summary, multinational businesses use the foreign tax credit system extensively to avoid double taxation on foreign profits. Post-2018 reforms mean fewer types of income need the credit (due to the participation exemption on dividends), but for things like branch income and GILTI inclusions, credits remain vital. The principles that apply to individuals – credit limits, carryforwards, choosing credit vs deduction – apply to companies too, just with more moving parts. The end goal is the same: to ensure you aren’t paying tax twice on the same income.

What to Avoid: Common Mistakes in Claiming Foreign Tax Credits

Claiming a foreign tax credit or deduction can get complicated. Here are some frequent pitfalls and what to avoid:

• Double-Dipping with Exclusions: Don’t try to claim a credit for foreign taxes on income you excluded via the Foreign Earned Income Exclusion. This is a big no-no. If you exclude income, you must also exclude the taxes related to that income from the credit calculation. Similarly, if you take the foreign housing exclusion, you cannot credit taxes on that portion of income. Attempting to use both could invalidate your elections or draw IRS scrutiny.

• Choosing the Wrong Method: Occasionally taxpayers make the wrong election. For instance, someone might deduct foreign taxes on Schedule A when a credit would have saved them much more. Conversely, someone might file Form 1116 for a tiny amount of foreign tax when they didn’t need to (and complicate their return unnecessarily). Solution: Evaluate credit vs deduction each year and remember the default – credit is usually better. If you find you chose incorrectly, you can generally amend your return within 10 years to switch from deduction to credit (the IRS gives a longer period for claiming a missed foreign tax credit), or within the regular amendment period to switch from credit to deduction.

• Exceeding the Credit Limit (and Ignoring Carryover): Some people compute the credit incorrectly and try to claim the full amount of foreign taxes paid even if it exceeds the IRS limit. This will get adjusted by the IRS. Always use the formula or Form 1116 to find the allowed credit. If you have an excess, don’t forget to carry it over. A common mistake is not tracking the carryforward – those unused credits can be valuable in future years, but if you fail to keep records, you might lose track and never claim them.

• Incorrectly Sourcing Income: The foreign tax credit limit calculation hinges on what portion of your income is foreign-source. Misidentifying U.S. vs. foreign source income can misstate your limit. For example, if you are a U.S. expat who also earned some U.S. investment income, only your foreign income counts in the ratio for the credit limit. Or if you sold stock – capital gains sourcing can be tricky (generally based on residency for personal transactions). Be careful to properly allocate income and deductions between U.S. and foreign sources on Form 1116. The IRS has rules for this; not following them can lead to denied credits.

• Crediting Non-Income Taxes: As mentioned, only foreign income taxes qualify for the credit. A mistake is trying to claim a credit for other taxes like foreign real estate taxes, value-added taxes, sales taxes, luxury taxes, or social security taxes paid to a foreign government. These are not income taxes, so they are not creditable (one narrow exception: a foreign tax in lieu of an income tax might qualify – for instance, some countries have payroll taxes that substitute for an income tax; these can be creditable if they meet IRS criteria). If you mistakenly treat a non-qualifying tax as an income tax, the IRS will disallow it. Instead, see if you can deduct it as an itemized deduction or business expense. For example, foreign property taxes on a rental property can be deducted against rental income, but you can’t take a foreign tax credit for them.

• Forgetting Form 1116 When Required: If you have more than $300/$600 of creditable foreign taxes, you must file Form 1116. Some taxpayers overlook this and just put a number on the “Foreign Tax Credit” line. This can delay processing or cause the IRS to reject the credit. Always include the form if required, and make sure to fill it out completely, including Part II (country, taxes paid) and Part III (calculation of limit).

• Currency Conversion Errors: Foreign taxes paid in foreign currency must be reported in U.S. dollars. Using the wrong exchange rate or forgetting to convert at all is an error. Typically, you use the average exchange rate for the year if the taxes were paid evenly throughout, or the actual rate on the payment date if you paid a lump sum. If the foreign currency was volatile, you might want to use actual payment date rates. Keep records of how you converted. Inconsistent or unreasonable conversion can raise flags.

• Not Adjusting for Refunds or Credits from Foreign Country: If you get a refund of foreign taxes or a rebate after you’ve claimed a U.S. credit, you must recompute and possibly pay back the IRS for the portion of credit that was too high. This is called a foreign tax redetermination. Example: you claimed a credit for $5,000 foreign tax, but a year later the foreign government audits and refunds you $1,000. You only ultimately paid $4,000, so you have to file an amended U.S. return reducing your credit to $4,000 (which may result in $1,000 plus interest to pay back). A mistake is ignoring this – the IRS can come back on it even years later. Similarly, if you know you are due a foreign refund or subsidy, you should not claim that portion as credit.

• State Tax Misconceptions: Some assume that if the IRS gives a credit, their state will too (or that moving abroad frees them from state tax). State rules are different. As noted, California gives no foreign tax credit – a big mistake would be not paying your state tax because you thought foreign tax paid covers it. Or in New York, claiming a state credit when you actually excluded the income federally (NY won’t allow it in that case). Always check your state’s stance – this ties into our next section.

By avoiding these pitfalls, you can confidently navigate foreign tax deductions/credits. When in doubt, consult a tax professional, as foreign tax issues can become complex quickly (for instance, corporate taxpayers have even more traps like overall foreign loss recapture, which is beyond our scope here). Now, let’s explore how state taxes come into play.

State Tax Variations: Do States Credit or Deduct Foreign Taxes?

Federal law largely takes care of international double taxation through the foreign tax credit. But what about U.S. state taxes on foreign income? If you live in a state that taxes income, and you have income taxed by another country, you could face double taxation at the state level. States have differing rules on this:

• States that Allow Foreign Tax Credit: A handful of U.S. states offer a credit for taxes paid to foreign countries, somewhat analogous to the credit for taxes paid to other states. New York is one example – it allows a foreign tax credit to residents for income taxes paid to another country if that income is also subject to New York tax. However, New York’s credit has nuances: if you claimed the federal Foreign Earned Income Exclusion, that income isn’t taxed by NY (because NY starts with federal taxable income which is after the exclusion), and thus NY won’t give a credit since it’s not double-taxed by NY. Maryland offers a foreign tax credit but only for full-year residents (if you’re part-year, they prorate it). Arizona and Indiana have limited foreign tax credits, sometimes restricted to specific types of income or requiring that the foreign country has a reciprocal tax treaty with the U.S. Virginia even has some reciprocity agreements with certain foreign countries; in some cases you might get relief through those rather than a standard credit.

• States with No Foreign Tax Credit: Many states simply do not offer any credit for foreign taxes. California is a prominent example – California taxes its residents on worldwide income and gives zero credit for taxes paid to foreign governments. So a California resident working abroad could pay, say, 30% to a foreign country and still owe full California tax (e.g. ~10%) on the same income. This is essentially double taxation at the state level. It’s a harsh outcome, and one reason expats from California often change their residency if possible. Other states without an explicit foreign tax credit will treat foreign income like any other income.

• Deducting foreign taxes on state return: If no credit is available, is there at least a deduction? Generally, if you itemize on your state return, the itemized deduction for state and local taxes might include foreign taxes as part of your deduction on the federal return. But remember, the federal SALT deduction cap ($10k) also covers “foreign income taxes” for federal purposes. States that conform to federal itemized deductions will inherently include that, but many high-tax states have their own SALT workaround or decoupling. It gets complicated, and many states don’t allow you to deduct state income taxes on the state return (to avoid a circular deduction). Foreign taxes might not be deductible on a state return at all, aside from flowing through the federal Schedule A if the state uses federal taxable income as the starting point.

• Compliance differences: If your state does allow a foreign tax credit, there’s usually a form to fill out. For example, New Jersey has a form for foreign tax credit details, and it expects documentation similar to the IRS (copies of foreign returns, translations if not in English, proof of payment). Wisconsin integrates the credit into its tax form but might ask for supplemental info. Be prepared to substantiate foreign taxes to state authorities just as you would to the IRS.

• Moving abroad and residency: One effective way to avoid state taxation of foreign income is to change your state residency when you move overseas. Many expats become residents of no-income-tax states (like Texas or Florida) or simply are considered non-residents by their home state once they establish a tax home abroad. Each state has its own rules on when they consider you to have broken residency (it could depend on where your domicile is, how long you’re out of state, intention, etc.). If you truly sever ties, you might not have to file a resident return at all, meaning foreign income wouldn’t be subject to state tax in the first place.

In essence, state-level relief for foreign taxes is not uniform. Check your state’s tax code: it could save you some money or alert you to a double-tax you weren’t expecting. As of now, only a few states provide a foreign tax credit, and often with limitations. If you remain a resident of a state without such a credit (or any relief), factor that into your tax planning – it may influence decisions like where to establish residency or how much time to spend in the state.

Examples: How Foreign Tax Deduction Works in Real Scenarios

Let’s break down a few real-world scenarios to see how the foreign tax credit vs deduction choice plays out for different taxpayers:

Scenario 1: U.S. Expatriate with Foreign Salary

Scenario 2: U.S. Investor with Foreign Dividends

Scenario 3: U.S. Corporation with Foreign Branch Profits

These scenarios illustrate a common theme: the foreign tax credit typically provides full relief from U.S. tax on the foreign-sourced income, as long as the foreign tax rate isn’t extraordinarily low. The deduction, in contrast, only partially relieves the burden. Individuals and companies should calculate both when in doubt, but the credit’s benefit shines in most cases.

Notable Court Ruling: PPL Corp. v. Commissioner

It’s worth noting a famous case that shows the nuances of what counts as a creditable foreign tax. In PPL Corp. v. Commissioner (2013), the U.S. Supreme Court ruled that a one-time “windfall tax” imposed by the U.K. on certain companies was essentially an income tax for U.S. purposes, even though it was structured unconventionally. The IRS had denied PPL’s foreign tax credit for that U.K. tax, claiming it wasn’t an income tax. The Supreme Court analyzed the tax’s intent and economic effect, concluding it was akin to a tax on excess profits – thus allowing it as a foreign tax credit.

This case is a reminder: sometimes the nature of a foreign levy isn’t clear-cut. But the U.S. courts and regulations will look at whether the foreign levy predominantly taxes income (or profits) – if yes, it’s likely creditable; if it’s a fee or a different kind of tax, it might not be. After this and other cases, the Treasury tightened regulations in 2022 to more strictly define what is an income tax (for example, requiring a realization, gross receipts, and net income test). Most everyday scenarios aren’t affected by these nuances, but big corporations with novel foreign taxes pay attention to such rulings.

FAQ: Deducting Foreign Taxes (Reddit & Forum Real Questions)

Q: Should I use the Foreign Earned Income Exclusion or the Foreign Tax Credit as an American working abroad?
A: If you pay high foreign taxes, the Foreign Tax Credit usually maximizes your benefit. If you pay low/no foreign tax, the exclusion is often better. Sometimes a mix of both is optimal. (~35 words)

Q: Can I take both the foreign earned income exclusion and a foreign tax credit?
A: You can use both in the same year on different income, but not on the same dollars of income. Any income you exclude under FEIE can’t have its taxes credited against U.S. tax.

Q: When would someone ever choose to deduct foreign taxes instead of taking the credit?
A: Only in unusual cases – for example, if you have no U.S. tax liability (so a credit is wasted) or you can’t use the credit in 10 years. The credit almost always saves more.

Q: My foreign tax credit is larger than my U.S. tax bill – do I get a refund for the difference?
A: No, the foreign tax credit is nonrefundable. It can bring your U.S. tax down to zero, but any excess credit is carried to other years (1 year back or up to 10 forward), not refunded.

Q: Can I carry over unused foreign tax credits to future years?
A: Yes. If your foreign tax credit exceeds the limit in a given year, you can carry it back one year (amending last year) or forward up to 10 years to offset U.S. tax in those years.

Q: Do I need to file Form 1116 for a small amount of foreign tax paid?
A: Not if you meet the exemption criteria. If your total creditable foreign taxes are $300 or less ($600 for joint) and all your foreign income is passive (interest, dividends, etc.), you can claim the credit without Form 1116.

Q: Does my state give credit for taxes I paid to a foreign country?
A: It depends on the state. Some, like New York or Arizona, provide a limited foreign tax credit. Others, like California, offer no credit at all. Check your state’s tax rules – many states do not mitigate foreign taxes.