As an American citizen living abroad, you may encounter tax-related financial burdens not shared by your U.S.-based counterparts. The foreign tax credit can afford at least a bit of help in reducing your tax bill.
This article provides an overview of the foreign tax credit, explaining what it is, who qualifies for it, what foreign source taxes are covered, and more.
Although the details concerning the foreign tax credit are highly complex, the idea underpinning it is straightforward: You should get some kind of break if you have to pay taxes to two different countries on the same income. Where that happens, you should be able to get a little help from the IRS in the form of either a tax credit or a tax deduction covering a portion of the twice-taxed foreign-source income at issue.
Either of these - the foreign tax credit or the deduction - will lower your ultimate U.S. tax liability. As is explained in more detail below, the tax credit is normally preferable to the tax deduction.
The effect of the credit is such that, in most cases, an American will pay no U.S. tax at all on foreign-source incomewhere that income is taxed by a foreign country at a rate higher than the U.S. tax rate would be for that particular taxpayer.
Where the foreign income is taxed by a foreign country at a rate lower than the U.S. rate, the taxpayer may still owe something to the IRS. However, the U.S. tax on that income will be limited to the difference between the U.S. tax rate and the foreign tax rate.
Any U.S. citizen, resident alien, or nonresident alien can generally claim the foreign tax credit if he or she:
For purposes of these requirements, “foreign-source income” can be thought of as anything you earn for workperformed abroad (irrespective of where you are when the credit is claimed or whether the payment goes into a U.S.-based bank account). Interest income is also foreign-source income when the payer is not located in the United States, as you receive dividends from a foreign-incorporated entity. Proceeds from the sale of foreign property would be foreign-source income as well.
To qualify for the U.S. foreign tax credit, the foreign-imposed tax must:
Each of the above requirements is replete with nuance and exceptions. For example, the requirement that the tax in question be an “income tax” means that it must be something you have to pay, for which payment you get no “specific economic benefit,” and that “the predominant character of the tax” must be “that of an income tax in the U.S. sense.” These requirements are defined by the IRS, yet plenty of grey area remains, which you may require a tax professional’s help to guide you through.
A list of foreign taxes for which a U.S. taxpayer cannot claim the foreign tax credit includes taxes on foreign income:
Figuring exactly how much you can claim for the foreign tax can be, simply put, painfully difficult. Intrepid readers can explore 12 pages worth of small-print explanation on the subject in IRS Publication 514 to get a feel for the complexities involved. Unless you are, say, a CPA or an international tax attorney, don’t be surprised if you’re unable to master the details if your foreign income involves anything beyond pure salary. A few important principles bear noting here:
The amount you can claim is figured on IRS Form 1116.
As noted, qualifying foreign source income can be offset from your U.S. tax liability, to a certain extent, in the form of either a tax credit or a tax deduction. The taxpayer chooses which to utilize. The vast majority of the time, the foreign tax credit will be more beneficial than the foreign tax deduction. This is because:
A tax professional can advise you as to whether your particular circumstances might warrant taking the deduction instead of the credit.
You may wish to explore the following issues with your tax adviser or attorney, as they touch on complex areas of law and can seriously impact your tax liability: