Foreign Tax Credit Exchange Rate: How to Convert Foreign Taxes for Form 1116 (Section 986)

The foreign tax credit turns income tax paid to another country into a dollar-for-dollar reduction of US tax. The foreign tax is assessed and paid in a foreign currency, so the size of the credit depends on the exchange rate used to translate it. Section 986(a) of the Internal Revenue Code and the Form 1116 instructions set that rate, and it is not the same for every taxpayer.

The rule in one table

The instructions for Form 1116 (2025) put the two main cases this way. Cash basis: "If you take a credit for taxes paid, the conversion rate is the rate of exchange in effect on the day you paid the foreign taxes (or on the day the tax was withheld)." Accrual basis: "If you choose to account for foreign income taxes on an accrual basis, you must generally use the average exchange rate for the tax year to which the taxes relate."

When the average rate is not allowed

An accrual-basis taxpayer cannot use the average rate if any of these apply:

• The foreign taxes are actually paid more than 2 years after the close of the tax year to which they relate.
• The foreign taxes are actually paid in a tax year prior to the year to which they relate.
• The foreign tax liability is denominated in an inflationary currency, meaning one with cumulative inflation of at least 30% over the 36 calendar months before the last day of the tax year.

In those cases the taxes are converted at the rate on the date of payment. There is also an election: for taxes denominated in a nonfunctional foreign currency you can choose to use the payment-date rate instead of the average. It is made by a statement attached to a timely filed return and, once made, "applies to the tax year for which made and all subsequent tax years unless revoked with the consent of the IRS."

Which "average rate"?

Neither the statute nor the instructions names a publisher. The IRS states that it "has no official exchange rate" and that "generally, it accepts any posted exchange rate that is used consistently." Two averages are commonly used for the euro in 2025:

The two differ by under 0.2%. What matters is that you pick one, apply it to every item that calls for an average, and keep doing so each year. The instructions add a documentation duty: "If you have to convert from foreign currency, attach a detailed explanation of how you figured the conversion rate."

Worked example

A US citizen living in Germany owes EUR 12,000 of German income tax for 2025. Part was withheld from salary through the year and the balance was paid with the German return on March 31, 2026.

A cash-basis taxpayer does not get to use one date for convenience: each withholding is converted at the rate on its own date and the final payment at the rate on March 31, 2026. That means twelve payroll dates plus one payment date. An accrual-basis taxpayer needs a single number, which is why the accrual method is the common choice for employees abroad. Once you choose to credit taxes in the year they accrue, you must continue to do so in later years.

When the tax is later adjusted

If the foreign tax you accrued differs from what you finally pay, or you receive a refund, that is a foreign tax redetermination and the credit has to be recomputed. The 2-year rule above is the common trigger: a liability accrued for 2025 and still unpaid at the end of 2027 loses the average rate and is translated at the rate on the day it is eventually paid. Keeping the accrual-year average and each payment-date rate on file makes that recomputation mechanical.

Getting the rates

The IRS yearly average table:

curl "https://allratestoday.com/api/open/central-bank/irs"
# "rate_date": "2025-12-31", "cadence": "yearly",
# "rates": [ ... { "base": "USD", "quote": "EUR", "type": "yearly_average", "value": 0.886 }, ... ]

A payment-date rate from the Federal Reserve H.10 series, and a year of daily rates to compute your own average:

curl -H "Authorization: Bearer YOUR_KEY" \
  "https://allratestoday.com/api/v1/central-bank/fed/2026-03-31"

curl -H "Authorization: Bearer YOUR_KEY" \
  "https://allratestoday.com/api/v1/central-bank/fed/history?symbol=EUR&from=2025-01-01&to=2025-12-31"

Dated tables and history are on paid plans. The H.10 series is also available as yearly CSV files; see Fed H.10 history download.

FAQ

Which exchange rate is used for the foreign tax credit?

It depends on the method. If you credit taxes when paid, use the rate in effect on the day you paid them or they were withheld. If you credit taxes on an accrual basis, you generally use the average exchange rate for the tax year to which the taxes relate, under section 986(a).

Can I use the IRS yearly average exchange rate for Form 1116?

An accrual-basis taxpayer generally uses an average rate for the tax year, and the IRS yearly average table is one posted source. The IRS says it has no official exchange rate and generally accepts any posted rate used consistently.

When can an accrual-basis taxpayer not use the average rate?

When the taxes are paid more than 2 years after the close of the year they relate to, are paid in a tax year before the year they relate to, or are denominated in an inflationary currency. Those taxes are converted at the payment-date rate.

Do I have to explain the rate on the return?

Yes. The Form 1116 instructions say that if you have to convert from foreign currency, you attach a detailed explanation of how you figured the conversion rate.

Can I elect to use the payment-date rate while on the accrual basis?

Yes, for taxes denominated in a nonfunctional foreign currency. The election is made by a statement attached to a timely filed return and applies to that year and all later years unless revoked with IRS consent.