A QUICK REFRESHER ON THE FOREIGN TAX CREDIT
One of the fundamentally important tax concepts for U.S. expats to know is that the U.S. tax system has built-in mechanisms for preventing the “double taxation” of your income (i.e., tax in both your new host country and in the United States). These mechanisms provide a measure of relief for U.S. expats who remain subject to U.S. taxation, despite living and working abroad.
The two main mechanisms under U.S. domestic tax law are – (1) the foreign earned income exclusion (FEIE) and foreign housing exclusion/deduction (FHE), and (2) the foreign tax credit (FTC). We’ve focused quite heavily in recent blogs on the FEIE/FHE, and thought it would be useful to revisit the foreign tax credit, its requirements, limitations, and advantages in certain cases over the FEIE.
DEFINING “FOREIGN TAX"
Foreign taxes eligible for the foreign tax credit are generally limited to income taxes imposed by a foreign country. It is important to note that often certain foreign taxes may appear as income taxes but will not qualify as income taxes for purposes of taking the foreign tax credit. For instance, foreign real estate taxes, sales taxes, luxury taxes, turnover taxes, value-added taxes, and wealth taxes, are generally not creditable.
The employee portion of foreign social security taxes is generally considered a foreign income tax available for the foreign tax credit. Social security taxes are not creditable, however, if paid to a country with which the United States has a so-called totalization agreement. Determining whether a foreign tax is creditable can at times be difficult, and an expat tax professional should be consulted to determine foreign tax credit eligibility.
Aside from specific situations, in order to claim a foreign tax credit, an individual must file Form 1116 with their U.S. federal income tax return.
FOREIGN TAX CREDIT LIMITATIONS
The amount of foreign tax credits that may be taken is limited to the amount of foreign source taxable income and cannot be used to offset U.S. source income.
The foreign tax credit, with limitations re-calculated applying AMT rules, may be used to reduce the alternative minimum tax.
It is important to note that the foreign tax credit cannot be used to reduce the Net Investment Income Tax (which remains on the books while Congress continues to struggle legislating a repeal). Consequently, a U.S. expat who otherwise has 100% foreign source income and sufficient foreign tax credits to credit against such income, can still end up paying U.S. federal income taxes.
POTENTIAL ADVANTAGES OVER THE FEIE
For expat parents, assuming sufficient credits are available (i.e., your creditable foreign tax exceeds your U.S. tax on your foreign income), it is likely that the foreign tax credit is preferable to the FEIE because legislation was enacted providing that taxpayers who utilize the FEIE cannot claim the child tax credit (which may be refundable up to an amount of $1,000 per child). This limitation does not apply, however, when the FTC is utilized.
Additionally, excluding earned income under the FEIE can adversely affect one’s ability to qualify (or fully qualify) under retirement plans like an IRA, because this requires having reportable earned income. If you choose the FTC, however, you can report taxable earned income, which alleviates this adverse consequence.
At Expat Tax Professionals, our experts have extensive experience in utilizing all of the tax benefits available to U.S. expats, including the FEIE, FTC, foreign housing exclusion, treaty benefits, and more. We have helped many expats significantly reduce or eliminate their U.S. tax obligations using one or more of these benefits. We are ready to help you with your U.S. tax filings. Contact us today!
