How Foreign Tax Credit May Reduce Tax Bill for an American Expat

U.S. citizens or residents living abroad may avoid double taxation by use of a U.S. tax credit.

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.

How the Foreign Tax Credit Works

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.

Who Qualifies for the Foreign Tax Credit

Any U.S. citizen, resident alien, or nonresident alien can generally claim the foreign tax credit if he or she:

  • paid qualifying income tax to a foreign country for foreign-source income, and
  • is subject to U.S. foreign-source income tax for the same income.

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.

What Taxes by a Foreign Country Qualify for the U.S. Foreign Tax Credit

To qualify for the U.S. foreign tax credit, the foreign-imposed tax must:

  • have actually been imposed on you
  • be a legal, actual foreign tax liability
  • have either actually been paid by you to the foreign country, or you must have formally accrued the obligation to pay it, and
  • be for income tax (as opposed to, for example, property taxes), or a “tax in lieu of income tax.”

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:

  • that is to be “excluded” for U.S. tax purposes, which crucially includes income for which you claim the foreign earned income and housing exclusions (these are popular and often extremely beneficial exclusions for those who qualify)
  • from ownership of foreign minerals
  • for operations subject to boycott by the U.S. government
  • concerning activities for which only an itemized deduction is allowed
  • related to foreign tax-splitting events
  • from foreign oil and gas activities (or at least a portion of those), and
  • earned by U.S. persons who control foreign businesses and fail to file required information returns for them

How to Determine How Much You Can Claim for the Foreign Tax Credit

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 credit cannot be more than your total U.S. tax liability, multiplied by a fraction; the numerator of that fraction is your taxable income received from foreign sources, while the denominator is represented by yourtotal taxable income (for U.S. tax purposes), which includes income from both foreign and U.S. sources
  • the amount you can claim for the credit will be limited to the lesser of: the amount of qualifying foreign tax you paid or accrued, and a limit on the credit, which to figure involves separating your foreign source income into various categories.

The amount you can claim is figured on IRS Form 1116.

Deciding Whether to Take the Credit or the Deduction

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:

  • With the credit, you can usually carry over (or carry back) to another year the amount of taxes you paid on qualifying income that exceeds the limit you can claim in a given year for your U.S. taxes. This means you can usually eventually recoup most, if not all, of the amount you were taxed by the foreign country.
  • The credit has the effect of reducing one’s taxable income on a “dollar-for-dollar” basis, whereas the deduction just reduces income that is subject to tax - and the former ends up benefiting your bottom line more.
  • You can elect to not itemize your deductions when claiming the foreign tax credit, which allows you to also take the standard deduction. Choosing the foreign tax deduction requires itemizing your taxes, which means no standard deduction.

A tax professional can advise you as to whether your particular circumstances might warrant taking the deduction instead of the credit.

Potential Issues of Concern in Claiming the Foreign Tax 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:

  • Determining amount of foreign tax that qualifies for the credit. The amount of tax actually withheld by a foreign government and the amount that qualifies for the U.S. foreign tax credit sometimes differs, owing to tax treaties between the foreign country and the United States.
  • Charitable contributions. These cannot be apportioned against income from a foreign source.
  • Foreign investments. Capital gains and dividends from foreign sourced investments require special attention in calculating your U.S. tax burden.
  • Tax redetermination by the foreign country. If you are subject to a tax redetermination by a foreign country with respect to taxes related to which you have already claimed the U.S. foreign tax credit, you normally have to undergo a redetermination for United States taxes as well.

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