The purpose of the foreign tax credit is to prevent income that is earned in a foreign country from being taxed twice. Once by the country it was generated in and again by the United States government. If you paid or accrued foreign taxes to a foreign country on income that was generated from a foreign source and are subject to US tax on the same income, you may be able to take either a credit or an itemized deduction for those taxes.
The difference between taking the amount as a deduction or as a credit is rather simple. If you choose to take the amount as a deduction on your tax return, the foreign income taxes paid will reduce your US taxable income. This means that the amount of income you will have to pay taxes on will be lessened before your tax rate is applied. If you choose to take the credit, the foreign income taxes paid will reduce your US tax liability. This means that the amount of tax that is calculated that you owe will be reduced by the amount of foreign taxes paid. To choose the deduction, you must itemize deductions on Schedule A, Form 1040. To choose the foreign tax credit, you generally must complete Form 1116, Foreign Tax Credit, and attach it to your Form 1040. However, if you meet the following requirements, you will not need to abide by any limit when it comes to claiming a foreign tax credit and do not need to file Form 1116:
If you choose to take a deduction for qualified foreign taxes, you must take deductions for all foreign taxes. The same applies to choosing a credit. You may only choose one method, credit or deduction, each year and apply that method to all of your qualified foreign taxes. The only exception to this rule is if you choose to use the credit method but a certain foreign tax is not allowed to be taken as a credit. In this case, you may use all other taxes on a credit basis and use the deduction method for the taxes that are not allowed to be taken as a credit.
Taxes that are not allowed to be taken as a credit are as follows:
It is usually more advantageous to you to choose to take a credit over a deduction. This is because: