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Foreign tax credit does not seem to prevent double taxation

Personal Finance & Money Asked by Joris Kinable on July 23, 2021

The foreign tax credit is intended to relieve you of a double tax burden when your foreign source income is taxed by both the United States and the foreign country. The IRS limits the foreign tax credit you can claim to the lesser of the amount of foreign taxes paid or the U.S. tax liability on the foreign income.

While looking into foreign tax credit, it seems that this does not really avoid double taxation. I wonder whether I misunderstood something. Please see below a small numerical example based on fictional data where one person gets taxed more than the other despite a foreign tax credit reduction.

Person X, who’s single, earned 200,000$ in 2020. This person has a standard deduction
of $12,400. His taxable income (line 15 on 1040) is:
200,000-12,400=187600$. Since this amount is over 100k$, the tax owed
(line 16 on 1040) is computed using the Tax computation worksheet
(page 77 of the 2020 1040 instruction) as: taxable_income x .32 –
18984.50. Applied to this example we get: 187600 x .32 – 18984.50 = 41047.5$. In summary, person X must pay 41047.5$ tax.

Person Y, who’s single, earned 210,000$ in 2020: 200k$ in the US, and 10k$ abroad. Over the 10k$, person Y payed 5k$ tax to a foreign
country (note: a 50% tax rate is higher than any U.S. tax liability).
This person has a standard deduction of $12,400. His taxable income
(line 15 on 1040) is: 210,000-12,400=197600$. This person’s tax (line
16 on 1040): 197600 x .32 – 18984.50 = 44247.5$.
Person Y can claim foreign tax credit to avoid double taxation.
Foreign tax credit is calculated via Form 1116, where foreign_income
(line 17)=10k$, total_taxable_income(line 18)=197600, line 19=10,000/197600=0.0506,
tax(line 20)=44247. The foreign tax credit is calculated as:
(foreign_income / total_taxable_income) x tax=(10,000/197600) x
44247=2239$. Since 2239$ is less than the 5k$ taxes payed in the
foreign country, person Y can claim 2239$ tax credit. In summary,
person Y ends up paying 44247.5-2239=42008.5$ tax.

Now here’s my misunderstanding: Person Y ends up paying 42008.5-41047.5=961$ more tax than person X! I would have expected that person X and person Y would pay an equal amount of US tax (41047.5$) since person Y already payed an amount of tax over the 10k$ extra income to the foreign country that exceeded person Y’s US tax liability.

Does anyone know how to get this problem fixed on Form 1116?

————-Update ————–

The problem I try to illustrate here, is caused by the 18,984.50$ adjustment in the tax calculation. Had the foreign tax credit been calculated as:
(foreign_income / total_taxable_income) x (tax+18984.50)=(10,000/197600) x (44247+18,984.50)=3199.97, then person Y would have payed 44247.5-3200=41047.5$ which indeed is the same as person X.
I still don’t know how to represent this correctly on Form 1116.

4 Answers

(This is what I've been able to understand from doing this tax form for several years. Not tax advice ....)

In the calculation in your Update:

(foreign_income / total_taxable_income) x (tax+18984.50)=(10,000/197600) x (44247+18,984.50)=3199.97

you are essentially saying Person Y would like their credit to be:

foreign_income * 32%

where 32% is the marginal tax rate; which is to say, they want to assume that Person Y's foreign income is taxed at the marginal tax rate. Unfortunately, that isn't how Form 1116 works.

Instead, as you demonstrated, the calculation in this form computes the credit based on their effective tax rate. Specifically, observe that another way of writing the computation in Form 1116 is:

credit = effective_tax_rate * foreign_income

= (gross_tax / total_taxable_income) * (total_taxable_income - taxable_domestic_income)

= (1 - taxable_domestic_income / total_taxable_income) * gross_tax

Put another way, the credit prorates Person Y's gross_tax by the fraction taxable_domestic_income / total_taxable_income. Concretely, for Person Y, this fraction is 94.94%, and applied to Person Y's gross_tax yields their net_tax of $42008, which accords with your computation.

Person Y might feel better if this credit were explained as "getting a discount on their tax in proportion to their foreign income, capped at the amount of foreign tax they had already paid".

  1. Person Y can carry over the unused foreign taxes paid back for one year and forward for ten years.
  2. Person Y would prorate their standard deduction over their foreign income using Line 3a, which slightly decreases Line 17 and further decreases their credit.
  3. (unrelated rant) Form 1116 handles qualified dividends in a way that is actually unfair, by "adjusting" them with a discount as though they had been taxed at the top marginal tax rate, causing the credit to plummet.

Correct answer by user106227 on July 23, 2021

It is true that foreign income can cause a net increase in US tax liability even when the maximum foreign tax credit is applied. This is because the limit on the credit ("US tax liability on foreign income") is defined using the effective US tax rate, which in our progressive system is lower than the marginal US tax rate. The latter determines the actual effect on tax liability from incremental income.

The "preventing double taxation" feature is more operative when foreign tax rates are lower than US tax rates, in which case the foreign tax can be fully offset. This might be more typical in an example like yours, where Person Y has a fairly small amount of foreign income, since the foreign country may also have progressive tax rates (with a low rate on small amounts of income, unlikely to be 50%).

Answered by nanoman on July 23, 2021

I think you misinterpreted the concept. Person Y has a 10k higher global income, so he has to pay more taxes (everything else being equal). The foreign tax credit will be considered as 'tax already paid', but it doesn't reduce the total tax due.

So person Y has a 936 $ higher total tax (trusting yojr calculation), minus 5000 $ already paid, which means that the net amount he pays to the US government is 4064$ lower, but the over tax amount (including the 5000 paid already) is higher - as it should be.

The direct foreign tax credit ('deduction') has also an upper limit (which I don't know by heart), so it will probably not work with the full 5000$. If you build your example with 500 $ foreign tax already paid, it will work as described above.

There is a second option for foreign tax credit, which works for larger amounts, but it is generally less favorable - as you calculated. In the end, the US government's logic is that they want their money, and if you pay a lot of taxes in other countries, too bad for you.

Answered by Aganju on July 23, 2021

There is nothing unreasonable about your result. Person Y has a higher global income than person X, so should have a higher US effective tax rate, since the US has progressive tax brackets. In this case, since the foreign tax is higher, the foreign tax credit effectively reduces the income that is taxed by the US to the US income, but for Person Y it is still taxed at the higher effective tax rate determined by Person Y's higher global income, and therefore, Person Y's US tax is higher.

Your idea that Persons X and Y should pay the same US tax, basically means that you think that the US effective tax rate should only be calculated on the US income, and so the two people should have the same US effective tax rates because they have the same incomes, but that is unfair in the progressive tax bracket system.

Imagine another scenario, where two people, Person A and Person B both earn $400k. Person A earns it all in the US, while Person B earns $200k in the US and the other $200k in a foreign country with the exact same tax structure as the US. Person B is a US citizen or resident and nonresident in the other country, and is eligible to claim the Foreign Tax Credit. If we follow your idea that the effective tax rate should only be calculated on the US income, then the person should pay US tax equivalent to someone with only $200k income, all from the US. So then Person B would pay twice the tax of someone with $200k income, whereas Person A would pay the tax of someone with $400k income. The tax of someone with $400k income is much more than twice the tax of someone with $200k income, because of progressive tax brackets. So it is fundamentally unfair for the US effective tax rate to be calculated only from the US income, because it allows someone to lower their tax rate by spreading the same income over more countries.

Answered by user102008 on July 23, 2021

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