Foreign Tax Credit
There are three ways U.S. expats can avoid double taxation while abroad on a foreign assignment: The Foreign Earned Income Exclusion; the Foreign Housing Exclusion- (if employed) or/ and the Foreign Housing Deduction – (if self-employed); all found on Form 2555- Foreign Earned Income and the Foreign Tax Credit found in IRC Sec 901 and on Form 1116- Foreign tax Credit.
Qualifications- What Qualifies as a Foreign Tax
The Foreign Tax Credit is claimed using the IRS 2 page Form 1116, Foreign Tax Credit. The Foreign Tax Credit is a dollar for dollar reduction of U.S. tax in respect of foreign tax paid on foreign income from a foreign country. The foreign tax must be a legally obligated tax, non-recoverable and must be a foreign tax in lieu of profits only.
Under U.S. domestic law IRC Sec. 901- Foreign Tax Credit, found on Form 1116 is also included in most federally negotiated international income tax treaties there is a provision to avoid “double taxation” the Foreign Tax Credit.
There is a separate Foreign Tax Credit for passive income and for general limitation income (wage and /or SE income), where for the general limitation income category there needs to be a reduction or scale down in respect both of excluded foreign tax and excluded foreign income. In other words, taxpayers may not claim a Foreign Tax Credit on income that has already been excluded on Form 2555 and the amount of foreign tax eligible for the Foreign Tax Credit must also be scaled down for excluded income.
As a result of the Foreign Tax Credit, taxpayers are always protected and theoretically should never pay double tax on their worldwide income.
However, as the Foreign Tax Credit calculation is limited to the lower of the actual foreign tax paid or the U.S. tax on that unexcluded foreign income (limiting factor), if the U.S. tax on that income is less this limiting factor is calculated on Form 1116 using the average rate of U.S. tax.
Double Tax not Always Avoided
Where the average rate of U.S. tax is 28%, but the marginal rate of U.S. tax (U.S. tax on your last dollar of income) is 39.6% then the avoidance of double tax using the Foreign Tax Credit is not always possible due to this 11.6% variance in tax rates and no perfect mechanism exists.
For the above reason and “stacking”, it is generally always preferable to maximize the available exclusions prior to using the available Foreign Tax Credit.
However in limited circumstances such as in high tax foreign countries, it may be preferable to use the Foreign Tax Credit alone.
The ‘stacking” mechanism in addition to a tax grab results in: 1) The usefulness or effectiveness of the foreign tax credit, 2) the potential for the Foreign Tax Credit carryover are both diminished and 3) in very limited circumstances in high tax foreign countries, it may be preferable to use the Foreign Tax Credit alone
Credit or Deduction
Instead of claiming a credit for eligible foreign taxes, you can choose to deduct foreign income taxes. Form 1040 filers choosing to do so would deduct foreign income taxes on Schedule A (Form 1040), Itemized Deductions. Generally, if you take the credit for any eligible foreign taxes, you cannot take any part of that year’s foreign taxes as a deduction.
Foreign Taxes Eligible for a Credit
You can take a credit for income, war profits, and excess profits taxes paid or accrued during your tax year to any foreign country or U.S. possession, or any political subdivision (for example, city, state, or province) of the country or possession. This includes taxes paid or accrued in lieu of a foreign or possession income, war profits, or excess profits tax that is otherwise generally imposed.
Foreign Taxes Not Eligible for a Credit
You cannot take a credit for the following foreign taxes paid to a foreign country that you do not legally owe, including amounts eligible for refund by the foreign country. If you do not exercise your available remedies to reduce the amount of foreign tax to what you legally owe, a credit for the excess amount is not allowed. The amount of tax actually withheld by a foreign country is not necessarily 100% creditable. See Regulations section 1.901-2(e)(2)(i).
Accrued versus Paid/ Cash Basis Method
There is an option to use either the accrued basis or paid basis to record foreign taxes for the purposes of calculating the Foreign Tax Credit. As a general rule use the paid basis if the foreign tax cycle is a calendar year tax cycle analogous to the U.S. and use the accrued basis if the foreign tax cycle is a fiscal tax year, unlike the U.S. tax system.
The accrued basis election forces recognition of the foreign taxes for U.S. tax purposes by looking at the U.S. calendar year in which the foreign fiscal year-ends. Thus, the need to calculate the individual withholdings separately or allocate subsequently received refunds or final tax due balances is obviated. However, once elected the accrued method must continue to be used indefinitely.
Furthermore, the accrued basis may be dangerous, since it creates a series of mismatching or timing differences of foreign tax to foreign income. While the accrued method provides tax relief in the last assignment year abroad, it can be tax costly in the first assignment year. So there are pros and cons to using the accrued basis. Please also consider foreign tax credit carry back options.
Foreign Country Defined
A ‘foreign country’ for the purposes of the Foreign Tax Credit, IRC Sec 901 is defined as any territory under the sovereignty of a government other than the United States. In this instance ‘foreign country’ tax and income are defined as a foreign country or a U.S. possession.
A foreign country includes any foreign state and its political subdivisions. A foreign city or province qualify. A U.S. possession includes Puerto Rico, Guam, the Northern Mariana Islands and American Soma.