THE FOREIGN TAX CREDIT
U.S. citizens and green card holders living in a foreign country are generally subject to the same U.S. income tax laws that apply to U.S. citizens and green card holders living in the United States. Therefore, you are subject to U.S. tax on your worldwide income and are required to file a U.S. tax return each year. However, if you live and work in a foreign country and pay income tax in that country, you may elect to take a credit for the foreign income taxes against your U.S. tax liability. This is called the foreign tax credit. Together with another important provision, the foreign earned income exclusion, the foreign tax credit often significantly reduces the U.S. tax liability of Americans living abroad.
Creditable Foreign Taxes
For a foreign tax to be creditable, the predominant character of the tax must be that of an income tax in the U.S. sense. Foreign income taxes on wages, dividends, and interest generally qualify for the credit. A foreign tax imposed on your net wealth is not creditable. Also, social security taxes are generally not deductible or creditable against your U.S. income tax. Finally, foreign income taxes that are likely to be refunded cannot be claimed as a foreign tax credit on your U.S. tax return.
Some foreign tax authorities can take a long time to issue a final tax assessment, confirming the total amount of foreign income taxes that are due. In case you do not expect to receive the final tax assessment in time to prepare and file your U.S. tax return, a foreign tax credit can be taken up to the amount for which there is reasonable certainty that it will not be refunded. In case the foreign tax refund is larger than expected, you may be required to adjust your foreign tax credit by filing an amended U.S. tax return.
Your foreign tax credit cannot be more than the U.S. tax you would have owed with respect to the foreign income without the foreign tax credit. For example, if your foreign income is $50k, on which you pay $25k in foreign taxes, you can take a credit for the foreign taxes up to the amount of your U.S. tax liability on that foreign income without the credit. Therefore, if your U.S. tax liability with respect to your foreign income of $50k would have been $20k, your foreign tax credit is limited to $20k. The $5k that is left, is your excess foreign credit. It can be carried forward to the next tax year, or backward to the previous tax year. If the foreign tax credit taken on your previous year tax return in less that the limit, it may be worth filing an amended tax return.
The Foreign Tax Credit and the Foreign Earned Income Exclusion
Foreign taxes on foreign income that is excluded under the foreign earned income exclusion cannot be used as a credit against your U.S. tax liability. If you meet specific requirements as to residency or physical presence in a foreign country, you may elect to use the foreign earned income exclusion to exclude from your gross income up to $101,300 of your foreign earnings.
If you live in a country where the taxes on income are relatively high, it may be beneficial to not use the foreign earned income exclusion. Instead, taking a credit for the foreign taxes on the foreign income may result in a lower U.S. tax liability.
Whether not using the foreign earned income exclusion in your specific situation is beneficial depends on a number of other factors in addition to the income tax rate in the foreign country where you live. For example, the alternative minimum tax rules, and phasing-out of itemized deductions and exemptions must be taken into consideration. When preparing your U.S. tax return, we will calculate your tax liability both with and without the foreign earned income exclusion. That way, we make sure you’re not paying more tax than required by law.
The foreign tax credit rules are complex. If you have any questions about the foreign tax credit or any other tax rules that apply to Americans living abroad, don’t hesitate to contact us.