If you own shares of stock in a company taxable under a foreign legal system or participate in an emerging markets mutual fund, a foreign government may tax your dividends. Although you must report dividends from foreign companies on your Form 1040 tax return, the Internal Revenue Service allows you to claim a tax credit for the foreign taxes you paid.
To claim the foreign tax credit, you must have actually paid or accrued the tax during the tax year in question. If you use the cash method of accounting for your personal finances, you can claim the credit during the tax year you actually pay it, not the tax year you are billed. A corporation that uses the accrual method of accounting can take the credit during the tax year it is billed, even if the tax is not paid until the following tax year. You cannot claim the credit if you are contesting your foreign tax liability, even if you have already paid it.
You might owe less tax than was withheld from your dividends under the terms of a tax treaty between the U.S. and the foreign country in question. In that case, you may claim only the amount you owe, not the amount withheld. This rule applies even if you fail to contest the withholding amount and end up paying more taxes to the foreign government than you actually owe. If the foreign government makes a reassessment of your tax liability after you have claimed the credit on your U.S. tax return, you must file an amended return with the IRS. If this reduces the amount of your credit, you must pay the extra tax.
To claim the foreign tax credit, an individual, estate or trust must file Form 1116; corporations must file Form 1118. These forms must be attached to the taxpayer's income tax return (Form 1040 for individuals, for example), and the amount of the credit must be entered on the appropriate line of the return.
Alternative: The Foreign Tax Deduction
The IRS offers an itemized deduction for foreign taxes paid. The deduction cannot be used together with the foreign tax credit -- you must choose one or the other. Since credits are subtracted from your total tax owed, whereas deductions are subtracted from your taxable income, you will probably save more money taking the credit. However, taking the deduction might be more advantageous if it puts you in a lower tax bracket.
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