The United States is one of the only countries that taxes income earned in foreign countries. However, US tax payers who have paid taxes to a foreign country are usually eligible for a foreign income tax credit on their US income tax returns. This provision also covers taxes paid to US possessions, such as the Virgin Islands. The foreign tax credit was designed to avoid double taxation. In 2005, US taxpayers received more than $90 million in foreign tax credits.
For foreign taxes to be eligible for a credit they must be legal taxes on income imposed upon and accrued or paid by the US tax payer. The taxes must be imposed by a legitimate country recognized by the US. If an agreement between the US and the foreign country exists mitigating the amount the country can tax a US tax payer, then the amount eligible for credit is the mitigated amount, not the withheld amount.
Residence or employment in a foreign country is not necessary to claim the credit. All that is required is that a country other than the US withheld income from you. For example, certain mutual funds investing with foreign businesses may withhold income for their respective countries.
A foreign tax may be reported as either a foreign tax credit or an itemized deduction. In cases where the tax payer is ineligible for a foreign tax credit, he may enter the tax as an itemized deduction. However, the itemized deduction is not as beneficial as the tax credit. The credit reduces your tax on a dollar-per-dollar basis, while the deduction only reduces the amount of income subject to taxation. A tax credit is entered on IRS form 1116. An itemized deduction is entered on Schedule A.
The tax credit can be taken even if you do not itemize your deductions. And you can claim the credit without even filling out form 1116 if: your income was passive, was 1099 income and if the total foreign taxes were $300 or less, or $600 or less for joint income. Mutual fund income often falls into this category.
Mutual fund investors other that retirement (401k, IRA) investors should pay particular attention to the possibility of foreign taxes. Foreign taxes are reported in box 6 of Form 1099-DIV, which is sent to holders at the end of each tax year.
Neither the tax credit nor the deduction can be taken if foreign-earned income or housing benefits were already excluded from US taxation. The deduction cannot exceed the total amount of taxes on your return. However, foreign taxes from previous years can be carried over to subsequent years.