U.S. Tax Break for Foreign Income Taxes on Investments Overseas

Claiming an Itemized Deduction or the Foreign Tax Credit

If you had income in a foreign country, for example from investments in stocks on a foreign stock exchange, mutual funds, or partnership interests, you may have paid or been charged for foreign income tax. The foreign income tax is normally withheld in the source country from payments and distributions. A mutual fund that invest overseas, for example, may incur foreign taxes on interest or dividends. If the fund meets certain requirements, it can pass the foreign tax along to its shareholders. And, you may be able to reduce your U.S. income tax for any foreign tax that you were charged on that income. 

Who Can Claim the Credit?

If you are a U.S. citizen or resident, you are generally subject to U.S. income tax on your worldwide earnings. But foreign income taxes can be taken as either a deduction, reducing your income subject to U.S. tax, or as a credit, directly reducing your U.S. tax burden. The intent of this foreign tax deduction or credit is to reduce or eliminate the double tax burden that would otherwise result when the same income is taxed in both a foreign country and in the United States. The foreign tax credit is generally the lower of the actual foreign income tax paid or accrued, or the amount of U.S. income tax that would apply on that foreign-source income.

Generally, if you were a nonresident alien for U.S. tax purposes, or you were a citizen of a U.S. possession (except for Puerto Rico) but not a U.S. citizen, you are not eligible to claim the foreign tax credit. Bona fide residents of Puerto Rico are subject to the same rules as U.S. citizens and residents, and qualify for the foreign tax deduction or credit. And there is an exception for nonresident aliens of the U.S. who pay tax to a foreign country or U.S. possession on income that is effectively connected with a trade or business in the United States.

In order to qualify for the foreign tax credit, the tax must have been imposed on you, and you must have paid or accrued the tax. But there are instances in which you can claim the credit for foreign taxes that you did not directly pay or accrue yourself.