Foreign Tax Credits in the U.S. and Canada: Avoid Double Tax

Map income before calculating the credit

• Identify the legal recipient and country of residence for the year.
• Classify employment, business, interest, dividend, rental, pension, and capital-gain income separately.
• Determine source under the rules of each country and the treaty.
• Record gross income, deductions, foreign tax withheld, final tax, and refunds in the original currency.
• Match the foreign tax to the income and year to which it relates.

How the U.S. limitation works

U.S. individuals generally use Form 1116 unless an exception applies. Publication 514 explains that the credit is limited and separated into income categories. A tax must generally be imposed on the taxpayer, paid or accrued, be the legal and actual liability, and qualify as an income tax or tax in lieu of one.

How the Canadian calculation works

Canadian residents generally report worldwide income and may calculate the federal foreign tax credit on Form T2209. The CRA describes the credit for each country as generally limited to the lesser of qualifying foreign income or profit tax paid and the Canadian tax otherwise payable on the net income from that country. Provincial or territorial calculations can also apply.

Common mismatch problems

• The two countries source the same item differently.
• Tax was withheld at a rate above the treaty rate.
• A foreign tax refund changes a credit claimed earlier.
• The income and tax fall in different calendar years.
• Expenses reduce the foreign-source income used in the limitation.
• Different exchange rates were used for income and tax.

Create a reusable credit schedule

Maintain a country-by-country and category-by-category schedule showing income, deductions, source analysis, foreign tax, treaty rate, exchange rate, current credit, and carryover. Reconcile it to both tax returns before filing either return.