Foreign Tax Deduction

What Is the Foreign Tax Deduction?

The foreign tax deduction is one of the itemized deductions that might be taken by American taxpayers to account for taxes previously paid to a foreign government, and are commonly classified as withholding tax.

The foreign tax deduction is generally taken in lieu of the more normal foreign tax credit in the event that the deduction is more beneficial to the taxpayer than the credit.

The Basics of the Foreign Tax Deduction

To keep away from double taxation in the U.S. what's more, a foreign country, a taxpayer has the option of taking the amount of any qualified foreign taxes paid or accrued during the year as a foreign tax credit or as an itemized deduction. The foreign tax credit is applied to the amount of tax owed by the taxpayer after all deductions are produced using their taxable income, and it reduces the total tax bill of an individual dollar to dollar.

The foreign tax deduction reduces the taxable income of an individual that picks this method. This means that the benefit of a tax deduction is equivalent to the reduction in taxable income duplicated by the individual's effective tax rate. The foreign tax deduction must be itemized, that is to say, listed out on the tax return. The sum of the listed things is utilized to bring down a taxpayer's adjusted gross income (AGI). A taxpayer that decides to deduct qualified foreign taxes must deduct every one of them, and can't assume a praise for any of them. Itemized deductions are just beneficial on the off chance that their total value of the itemized expenses falls below the tax credit accessible.

The foreign tax deduction might be more favorable in the event that the foreign tax rate is high and just a small amount of foreign income relative to domestic income has been received. What's more, claiming a deduction requires less desk work than the foreign tax credit, which requires finishing Form 1116 and might be complex to complete, contingent upon the number of foreign tax credits guaranteed. Assuming that the foreign tax deduction is taken, it is reported on Schedule A of Form 1040.

Illustration of the Foreign Tax Deduction

By and large, the foreign tax credit will give greater benefits than the deduction. For instance, we should assume an individual gets $3,000 in dividends from a foreign government and pays $600 foreign tax on the investment income. On the off chance that she falls in the 25% marginal tax bracket in the U.S., her tax liability will be 25% x $3,000 = $750. In the event that she is eligible for a $500 tax credit, she can reduce her U.S. tax bill to $750 - $500 = $250. On the off chance that she claims a $500 deduction all things being equal, her taxable dividend income will be reduced to $3,000 - $500 = $2,500, and her tax liability will be 25% x $2,500 = $625.

For more information on foreign taxes paid by Americans, see IRS Publication 514.

Highlights

• The foreign tax deduction permits American taxpayers to reduce their taxable income by a portion of the amount of income tax paid to foreign governments.
• The goal is to keep American residents from being subject to double taxation for a similar income.
• The foreign tax deduction would be taken rather than the foreign tax credit, given that the deduction is more profitable for a taxpayer.