Last Update: December 2021
One of the main challenges facing expat tax filers is ensuring they can avoid the double taxation of their income – that is, taxation of their income by both their country of residence and the United States. After all, U.S. citizens who move abroad continue to be subject to U.S. income taxation on their worldwide income.
For many expats, the best way to accomplish this is to utilize the foreign tax credit, which is a key expat tax basic concept.
In this blog, we review the rules of foreign tax credit relief in the United States, including its limitations, as well as some reporting aspects.
FOREIGN TAX CREDIT RELIEF – THE BASICS
As a general rule, foreign taxes are creditable only if they are taxes on income. In this regard, it is important to note that a number of foreign taxes appear as “income” taxes, but do not qualify 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 in certain countries can be considered a foreign income tax available for the foreign tax credit. However, social security taxes are not creditable if paid to a country with which the United States has a so-called totalization agreement (for example, the UK and Australia).
It is important to keep in mind that the foreign tax credit needs to be calculated both for regular tax purposes and for Alternative Minimum Tax (AMT) purposes.
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.
LIMITATIONS ON FOREIGN TAX CREDIT RELIEF
The amount of foreign tax credits that can be claimed is limited to the amount of one’s foreign source taxable income (meaning, income that is generated outside the United States).
More technically speaking, your foreign tax credit cannot be more than your total U.S. tax liability multiplied by a fraction. The numerator of the fraction is your taxable income from sources outside the United States, while the denominator is your total taxable income from U.S. and foreign sources.
If the foreign taxes available for credit exceeds this foreign tax credit limitation, you may be able to carry the credit back to the previous tax year and forward to the next 10 tax years.
Foreign tax credits are also subject to certain “basket” matching rules, such that foreign taxes on so-called “passive” basket income (for instance, dividends, interest and royalties) may not be creditable against U.S. taxes on non-passive or “general” basket income (for instance, wages and salary).
It is important to note also that the foreign tax credit cannot be used to reduce the Net Investment Income Tax. 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.
FOREIGN TAX CREDIT RELIEF – FILING ASPECTS
In order to claim the foreign tax credit, an individual must file IRS Form 1116 with their U.S. federal tax return. Thus, the due date of the form is the same as the due date of your tax return, including extensions.
Separate Forms 1116 must be filed if you have multiple categories and baskets of income.
Unlike other sites offering U.S. expat tax return services, our standard U.S. tax return (Form 1040) service includes the filing of the Form 1116 with your return, with no extra cost.
TAKEAWAY FOR U.S. EXPATS
Claiming the foreign tax credit is one of the key mechanisms for you to avoid the double taxation of your income. The availability of foreign tax credits can be a complex issue depending on your particular circumstances.
Sensitivity to the nuances of the U.S. tax rules is essential for optimizing your U.S. tax return filing.
