If you paid or accrued foreign taxes to a foreign country on foreign source income and are subject to U.S. tax on the same income, you may be able to take either a credit or an itemized deduction for those taxes. Taken as a deduction, foreign income taxes reduce your U.S. taxable income. Taken as a credit, foreign income taxes reduce your U.S. tax liability. In most cases, it is to your advantage to take foreign income taxes as a tax credit. Once you choose to exclude either foreign earned income or foreign housing costs, you cannot take a foreign tax credit for taxes on income you can exclude. If you do take the credit, one or both of the choices may be considered revoked. Generally, the following four tests must be met for any foreign tax to qualify for the credit: 1. The tax must be imposed on you 2. You must have paid or accrued the tax 3. The tax must be the legal and actual foreign tax liability 4. The tax must be an income tax (or a tax in lieu of an income tax) Foreign Country A foreign country includes any foreign state and its political subdivisions. Income, war profits, and excess profits taxes paid or accrued to a foreign city or province qualify for the foreign tax credit. U.S. Possessions For foreign tax credit purposes, all qualified taxes paid to U.S. possessions are considered foreign taxes. For this purpose, U.S. possessions include Puerto Rico and American Samoa. Tax Must Be the Legal and Actual Foreign Tax Liability The amount of foreign tax that qualifies is not necessarily the amount of tax withheld by the foreign country. Only the legal and actual foreign tax liability that you paid or accrued during the year qualifies for the credit. The amount of the deductible foreign tax must be reduced by any refunds of foreign tax made by the government of the foreign country or the U.S. possession. Foreign Tax Refund You cannot take a foreign tax credit for income taxes paid to a foreign country if it is reasonably certain the amount would be refunded, credited, rebated, abated, or forgiven if you made a claim. Tax Must Be an Income Tax Generally, only income, war profits, and excess profits taxes (income taxes) qualify for the foreign tax credit. Foreign taxes on wages, dividends, interest, and royalties generally qualify for the credit. Furthermore, foreign taxes on income can qualify even though they are not imposed under an income tax law if the tax is in lieu of an income, war profits, or excess profits tax. Pension, Unemployment, and Disability Fund Payments A foreign tax imposed on an individual to pay for retirement, old-age, death, survivor, unemployment, illness, or disability benefits, or for similar purposes, is not payment for a specific economic benefit if the amount of the tax does not depend on the age, life expectancy, or similar characteristics of that individual. No deduction or credit is allowed, however, for social security taxes paid or accrued to a foreign country with which the United States has a social security agreement. For more information about these agreements, refer to Totalization Agreements. Reduction in Total Foreign Taxes Available for Credit You must reduce your foreign taxes available for the credit by the amount of those taxes paid or accrued on income that is excluded from U.S. income under the foreign earned income exclusion or the foreign housing exclusion To choose the foreign tax credit, you generally must complete Form 1116, Foreign Tax Credit and attach it to your U.S. tax return. However, you may qualify for an exception that allows you to claim the foreign tax credit without using Form 1116. To choose to claim the taxes as an itemized deduction, use Schedule A (Form 1040), Itemized Deductions. If you choose to take a credit for qualified foreign taxes, you must take the credit for all of them. You cannot deduct any of them. Conversely, if you choose to deduct qualified foreign taxes, you must deduct all of them. You cannot take a credit for any of them. It is generally better to take a credit for qualified foreign taxes than to deduct them as an itemized deduction. This is because: 1. A credit reduces your actual U.S. income tax on a dollar-for-dollar basis, while a deduction reduces only your income subject to tax, 2. You can choose to take the foreign tax credit even if you do not itemize your deductions. You then are allowed the standard deduction in addition to the credit, and 3. If you choose to take the foreign tax credit, and the taxes paid or accrued exceed the credit limit for the tax year, you may be able to carry over or carry back the excess to another tax year. Credit for Taxes Paid or Accrued You can claim the credit for a qualified foreign tax in the tax year in which you pay or accrue it, depending on your method of accounting. "Tax year" refers to the tax year for which your U.S. return is filed, not the tax year for which your foreign return is filed. Foreign Currency You must express the amounts you report on your U.S. tax return in U.S. dollars. If you receive all or part of your income or pay some or all of your expenses in foreign currency, you must translate the foreign currency into U.S. dollars. For information about converting foreign currencies to U.S. dollars refer to Foreign Currency and Currency Exchange Rates. Foreign Taxes for Which You Cannot Take a Credit • Taxes on excluded income, • Taxes for which you can only take an itemized deduction, • Taxes on foreign mineral income, • Taxes from international boycott operations, • A portion of taxes on combined foreign oil and gas income, • Taxes of U.S. persons controlling foreign corporations and partnerships who fail to file required information returns, and • Taxes related to a foreign tax splitting event.