The foreign tax credit is meant to help reduce the double taxation that might occur if foreign income were to be taxed both by the other country and by the United States. The credit allows a taxpayer to either deduct the taxes paid (using Schedule A like all itemized deductions) or to use form 1116 to claim the foreign tax credit.
The credit is available for taxpayers if four tests are passed: the tax must be imposed on the taxpayer (as opposed to a trust or corporation), the taxpayer must have actually paid the tax, it must be an actual legal tax in the foreign country, and it must be an income tax. Optional taxes, excise taxes, sales taxes, property taxes, and bribes are all expenses that do not qualify for the foreign tax credit.
The United States also does not allow taxpayers to use the Foreign Tax Credit if the tax was paid to certain foreign governments that we are sanctioning. If the country is listed as a state sponsor of terrorism by the State Department, or if the United States has severed all ties to the country, any tax that you might have paid to that country will not be eligible for the credit. If in doubt, consult the IRS as to whether the tax is eligible for the credit. The rule gets even more complicated because the exclusion for terrorist states is applied at the time the income was earned.
To claim foreign taxes on Schedule A, you must only have had certain types of income and your ability to carry your deduction forward and backward is limited. The income must have all been from passive activity, such as interest and dividends. The income must all be accounted for through the use of normal income statements, such as a form 1099-INT or 1099-DIV. There is also a limit of $300 (or $600 if married filing jointly) in order to report the tax on form 1040 without filling out form 1116.
Many taxpayers will prefer to use form 1116 instead of itemizing the deduction, or are required to use form 116 because they cannot meet the requirements for itemizing. If any of the foreign income was from non-passive activity (such as wages) or if the taxes were not entirely reported on forms 1099-INT or 1099-DIV, then the taxpayer must use form 1116. In addition, using the extra form allows taxpayers to carryback the foreign tax credit to one previous year, or to carry forward the credit for as many as ten years. In those cases, using form 1116 will provide a better long term tax position, despite the extra two pages of calculations that come with it.
Form 1116 requires to you break out passive foreign income as a portion of total foreign income, and the tax credit is computed differently on each of those sources.
The IRS provides information about the foreign tax in the instructions for Form 1116 and in IRS Publication 514, Foreign Tax Credit for Individuals. In addition, the IRS has a hotline for international tax questions.