When the Foreign Tax Credit Doesn't Cover It All: The Limitation, the Baskets, and the Residual You Still Owe

Short version: Form 1116 Explained: The Foreign Tax Credit for Individuals

The foreign tax credit prevents double taxation only up to a point. It is capped, basket by basket, at the US tax on the foreign-source income in that basket, and it is available only for foreign tax on income the US treats as foreign-source. A cross-border filer can pay tax in both countries on the same dollar and still owe a residual to one of them: when the foreign rate is below the US rate, when the income is US-source under US rules even though the other country taxed it, when the net investment income tax applies, or when the credit sits in a basket with no limitation room. Here is where the credit runs out.

Key takeaways

• The formula: credit allowed in a basket equals the lesser of the foreign tax paid on that basket's income and the US tax multiplied by the fraction (foreign-source taxable income in the basket over worldwide taxable income).
• Lower foreign rate: if Canada taxes an item of income at a lower rate than the US (Canadian eligible dividends, capital gains at half inclusion for a low-income taxpayer), the credit covers only the Canadian tax and a residual US tax remains.
• Wrong source: income the US treats as US-source (US wages, US dividends, US real estate gains) is not foreign-source, and Canadian tax on it produces no US credit; the treaty's resourcing rule (Article XXIV) fixes this for US citizens resident in Canada by treating certain US-source income as foreign-source for the credit.
• NIIT: the 3.8% net investment income tax is not offset by the foreign tax credit under the IRS's position; an American in Canada with investment income above the threshold owes it in full.
• Expense allocation: the limitation fraction uses taxable income, so deductions allocated against foreign income reduce the limitation even though the foreign country did not allow them.

The limitation in operation

A US citizen in Vancouver has $120,000 USD of Canadian wages and $40,000 USD of Canadian capital gains. Worldwide taxable income after the standard deduction is about $145,000. US tax is about $24,000, of which roughly $19,900 is attributable to the wages (general basket) and $4,100 to the gains (passive basket, at preferential rates).

• General basket. Canadian tax on the wages: about $33,000 USD. Limitation: $19,900. Credit: $19,900. Excess: $13,100, carried forward.
• Passive basket. Canadian tax on the gains (half inclusion at marginal rates): about $9,000 USD. Limitation: $4,100. Credit: $4,100. Excess: $4,900, carried forward.
• Residual US tax. None; both baskets fully covered.

Change the gains to $40,000 of Canadian eligible dividends. Canadian tax on them (with the gross-up and credit) for this taxpayer: about $6,000 USD. US tax on qualified dividends: about $6,000 plus NIIT of $1,520. Passive basket credit: $6,000. Residual: the $1,520 of NIIT, which the credit cannot offset.

The resourcing rule

A US citizen resident in Canada who earns US-source income (a US pension, US dividends, wages for days worked in the US) is taxed by Canada on it as a resident and by the US on it as a citizen. Under US domestic rules the income is US-source and Canadian tax on it produces no credit. Article XXIV(4) to (6) of the treaty resource the income: the US allows a credit for Canadian tax on the US-source income to the extent of the US tax that a Canadian resident who is not a US citizen would have paid under the treaty (the withholding rate), and Canada credits the rest. The mechanics require a separate Form 1116 for treaty-resourced income and a careful split. Without it, a US citizen in Canada with a US pension is double-taxed on the portion above the treaty withholding rate.

Expense allocation

The limitation fraction uses foreign-source taxable income, after allocating deductions. Itemized deductions, the standard deduction, and certain interest and other expenses are apportioned between US-source and foreign-source income by the regulations, which reduces the foreign-source numerator. An American in Canada with large itemized deductions can find the general-basket limitation reduced below the Canadian tax paid even when all the income is Canadian, producing excess credit rather than a residual, but also reducing the credit available in a year when it is needed.

When the credit is stranded

• Post-departure corporate wind-up: Canadian withholding on the deemed dividend is a passive-basket credit; the US gain after the basis step-up is small; the limitation is small; most of the credit is stranded.
• Departure-year timing: Canadian departure tax is paid on gains the US does not tax (after the XIII(7) election); no US tax on the same income means no limitation and no credit.
• State tax: most states give no credit for foreign tax; a Californian with Canadian income pays California tax on it in full.

Worked example

A US citizen in Toronto receives a $40,000 USD US Social Security-equivalent pension (a US employer pension), $100,000 USD of Canadian wages, and $20,000 USD of US dividends.

• Wages. General basket; Canadian tax exceeds US tax; full credit; excess carried forward.
• US pension. US-source; taxed by Canada as a resident (about $12,000 USD) and by the US (about $6,000). Under the treaty, Canada would withhold 15% if he were a non-citizen Canadian resident; the resourcing rule lets the US credit Canadian tax up to that 15% ($6,000) on a separate Form 1116; Canada credits the US tax above it. Residual: none if both sides are done correctly.
• US dividends. US-source; Canada taxes them with a credit for the 15% treaty rate; the US taxes them at qualified rates plus NIIT with no credit for Canadian tax beyond the resourced amount. Residual: the NIIT.

Official sources

"If you paid or accrued foreign taxes to a foreign country or U.S. possession 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." — Internal Revenue Service, Foreign Tax Credit, https://www.irs.gov/individuals/international-taxpayers/foreign-tax-credit

Practitioner note

The credit fails in predictable places: NIIT, Canadian dividends taxed lightly, US-source income of a US citizen in Canada without the resourcing computation, and stranded passive-basket credits after a corporate wind-up. We compute the limitation by basket before the return, not after, and we tell the client which residual they will owe and why.

See also: Planning a move? Start with the Canada-to-US tax checklist and browse every corridor by city, province, and state.

Next step

Fairlight prepares the Form 1116 computations by basket including treaty-resourced income, the NIIT analysis, and the residual tax planning. See cross-border pricing or book a call.