One of the main methods that US expats use to reduce and often eliminate the double taxation of their income is the foreign tax credit.
Foreign tax credit relief, however, comes with certain requirements and restrictions. In particular, while certain taxes are allowed as foreign tax credits, others are not. This can be confusing for an expat filer who is unfamiliar with the nuances of the foreign tax credit rules.
In this blog, we explore the foreign tax credit rules in the context of a particular tax, namely the wealth tax, because of its relevance for many of our expat clients. While the foreign tax credit rules can be extremely complex, we review them at a high-level to give you a better sense of how the rules may apply to taxes imposed in your particular country.
FOREIGN TAX CREDITS – THE BASIC RULES
In accordance with the Section 901 regulations, a payment to a government must meet three basic requirements in order to result in a US foreign tax credit:
(1) the payment must be a “tax”;
(2) the tax must be paid or accrued to a foreign country or a US possession; and
(3) the tax must be an income tax.
Over the past several decades, the IRS and US courts have analyzed these three criteria quite extensively.
THE INCOME TAX REQUIREMENT
In respect of the third criteria (the “income tax”) requirement, the US Supreme Court has ruled that “the way a foreign government characterizes its tax is not dispositive with respect to the US creditability analysis.” See PPL Corp. v. Comm’r, 133 S. Ct. 1897, 1902 (2013).
Due to the “income tax” requirement, the IRS has ruled that a number of non-income-based taxes are not available as a foreign tax credit against US taxes.
For instance, foreign real estate taxes, sales taxes, luxury taxes, turnover taxes, and value-added taxes have generally been found to not be creditable.
WEALTH TAXES AND THE FOREIGN TAX CREDIT
Recently, a client who resides in Spain asked us whether Spanish wealth taxes can be used as a foreign tax credit against US taxes. Our client mentioned that he must pay both an income tax (Modelo 100) and a wealth tax (Modelo 714) in his residence country.
While the IRS and US courts have not rule on Spanish wealth taxes specifically, the IRS has made clear that foreign wealth taxes are not creditable.
In Revenue Ruling 76-536, 1976-2 CB 224, the IRS analyzed the following fact pattern:
The taxpayer was a United States citizen residing in Ireland. The taxpayer was subject to tax on worldwide wealth. The IRS described it as a flat rate tax on the net market value of taxable wealth less allowable exclusions.
In this case, the IRS reasoned that since the tax at issue was a tax on the taxpayer’s holdings of property, as opposed to his income, the amount of tax paid to the Government of Ireland was “not an income tax within the United States concept thereof, and is not a creditable tax for purposes of section 901 of the Code.”
TAKEAWAY FOR US EXPATS
While wealth taxes may generally not be used a foreign tax credit, it’s important to keep in mind that there a number of additional methods and solutions available for reducing double taxation, including both domestic tax rules and treaty provisions.
A strong command of the US tax rules is essential for optimizing an expat’s tax return in order to utilize all the available tools and avoid over-paying US taxes.