Using excess UK tax credits: carrying them back and forward

Why do Americans in the UK build up excess foreign tax credits?

Because UK income tax on a salary is generally higher than US tax on the same salary. Form 1116 caps the credit in each category at the US tax on that category's foreign-source taxable income. Where the UK tax is larger, the difference is unused foreign tax, and it is carried to other years rather than refunded.

Publication 514 (opens the official IRS page in a new tab), which sets out the rules behind Form 1116, defines the two amounts that drive every carryover. Unused foreign tax in a category is the amount by which the qualified foreign taxes paid or accrued exceed that category's limit. Excess limit is the reverse: the amount by which the limit exceeds the taxes for the year. A carryover can only be absorbed by excess limit in the same category, so a pool of unused tax has value only if a year with spare room comes along.

For most Americans on a UK payroll the pool sits in the general category, which holds wages, bonuses and self-employment profit. Passive income, such as interest, dividends and most gains, can move: where the foreign tax on it exceeds the highest US tax that could be imposed on it, Publication 514 treats it as high-taxed income in the general category. Some heavily taxed UK investment income can therefore add to the general pool instead of the passive one.

• General category. UK salary, bonuses and self-employment profit, where the largest excess usually builds up
• Passive category. UK interest, dividends and gains, unless reclassified as high-taxed income
• Certain income re-sourced by treaty. A separate limit for each amount of US-source income re-sourced under a treaty

How do the carryback and carryforward rules work?

Unused foreign tax in a category is carried back one year and forward ten years. It goes first to the year immediately before, then to the earliest following year with excess limit in the same category, and on in order. Whatever is still unused at the end of the tenth year after the year it arose expires.

Each year's own foreign tax is applied before any carryover. A carryover fits only into the room left after that, which is why a normal UK salary year rarely absorbs anything. The Form 1116 instructions (opens the official IRS page in a new tab) require the figures category by category, oldest balance first.

The credit has to be claimed for a year before a carryover can be used in it. Publication 514 says a carryover cannot be credited in a year in which foreign taxes are deducted instead, and that a deduction year still uses up carryovers as if the credit had been claimed, with no benefit. The IRS page on choosing the credit or the deduction (opens the official IRS page in a new tab) explains that choice. A year in which the taxpayer elects out of the limitation for a small amount of passive foreign tax also blocks carryovers to and from it.

• Carryovers stay in the category in which they arose
• They are used only within excess limit, after the year's own foreign tax
• The oldest balance is used first
• No carryover is used or created in a year in which foreign taxes are deducted
• Balances never become refundable, however large they grow

How is a foreign tax credit carryback claimed?

By amending the earlier year. Publication 514 says that when unused tax is carried back to the first preceding year, Form 1040-X is filed for that year with a revised Form 1116 attached. The carryback is limited to the excess limit in that year's category, and no earlier year can receive it.

The amendment is made on Form 1040-X (opens the official IRS page in a new tab), described on our page about Form 1040-X. The general period for amending is three years from filing or two years from payment, whichever is later, but Publication 514 gives a longer period for refund claims based on foreign tax: ten years from the regular due date, without extensions, of the return for the year the foreign tax was paid or accrued. The IRS also gets extra time to assess tax that results from a carryback.

A carryback is worth claiming where the earlier year had foreign income in the same category with little foreign tax set against it. The typical UK case is timing: a gain or a bonus taxed in one US year, with the UK tax landing in the next. Our post on paid or accrued UK tax explains how the crediting method moves tax between years. Where the earlier year's UK tax already filled its limit, there is no room, and the whole amount carries forward.

What does Schedule B of Form 1116 record?

Schedule B reconciles the carryover balance from one year to the next. It is attached to the Form 1116 for each category that has a carryover from earlier years, a new carryover from the current year, or both, and it shows a running balance of all activity since the previous return.

The IRS instructions for Schedule B call for a separate schedule for each category, with one box ticked on each. Its columns hold the ten preceding years, the current year and totals. The rows start from the closing balance on the prior year's schedule, adjust it, show how much is used against this year's excess limit, record anything from the tenth preceding year that expires unused, and then add the current year's unused tax, split between the part carried back and the part carried forward.

The balance is easy to lose, because a change of preparer or software, or a missed year, can break the chain. Refunds or increases of UK tax, which the instructions call foreign tax redeterminations, are also adjusted on Schedule B. When we take on a new client through our individual tax returns service, we rebuild the schedule from the earliest open return before relying on the figure.

• Line 1: the carryover brought forward from the prior year's schedule, by year of origin
• Line 2: adjustments, including corrections to carrybacks and foreign tax redeterminations
• Line 4: carryover used this year, starting with the oldest year
• Line 5: any balance from the tenth preceding year that expires unused
• Lines 6 to 8: this year's unused tax, the part carried back and the part carried forward

What happens to carryovers if you claim the FEIE?

UK tax on excluded earnings drops out of the calculation. The Form 1116 instructions require foreign taxes to be reduced by the taxes allocable to foreign earned income excluded on Form 2555, and the carryover is figured from the reduced amount. UK tax on excluded salary therefore never becomes a carryover.

The reduction is worked out by fraction. Where only part of the foreign earned income is excluded, UK tax on the earnings is multiplied by the excluded amount, less deductions allocable to it, over the whole foreign earned income, less its deductions. Only UK tax on the slice above the exclusion (opens the official IRS page in a new tab) limit, and on income the exclusion does not reach, remains creditable. Someone who has claimed the exclusion on Form 2555 for years usually has little or no general-category pool to show for it.

Exclusion years also give carryovers little room. Excluded earnings are not taxable income, so the general-category limit is small, and UK tax on any earnings above the exclusion usually fills it. Our post on revoking the foreign earned income exclusion covers the switch the other way and the five-year bar that follows it.

When can an excess UK tax credit actually be used?

Only in a year when US tax on foreign-source income in the same category exceeds the foreign tax on that income. For a general-category pool, that means foreign earnings taxed more lightly abroad than in the US. US-source income gives no room, and a balance in one category cannot shelter tax in another.

US dividends of a US citizen in the UK are relieved through the separate category for income re-sourced by treaty, explained in our post on re-sourcing US dividends under Article 24, and a general-category pool cannot be used there. Salary for work done in the United States is US-source, because Publication 514 sources compensation where the services are performed. Our treaty relief service keeps each category on its own Form 1116.

The pool can help where general-category earnings from abroad bear less foreign tax than the US tax on them, such as workdays in a low-tax country or a later posting somewhere with lower rates. Because the opportunities are narrow, we look at the size and age of the balance when modelling a move or a new contract through our tax planning service.

What happens to the pool after moving back to the US?

Take a US citizen employed in Manchester who has claimed the credit for several years and built a general-category carryover. She moves to Denver to work for a US employer. From then on her salary is US-source, the UK no longer taxes it, and her general-category limit falls to little or nothing.

The move does not cancel her pool. Each year's balance keeps its own expiry date, and Schedule B continues to carry it whether or not any is used. Unless she has foreign-source earnings in the general category that bear less foreign tax than the US tax on them, such as days worked abroad, nothing absorbs it, and the oldest years expire in turn on line 5.

Business trips abroad produce foreign-source earnings for the days worked there, which can draw on the pool. The practical steps are to keep Schedule B complete, to apportion pay by workdays where travel occurs, and to check the year of departure, when UK tax on the final months may land in a different US year from the income. Our cross-border tax service prepares the final UK and US returns together, and the guide to avoiding US-UK double taxation shows how the carryover fits with the other reliefs.