The American Foreign Tax Credit – What Expats Need to Know
Americans working abroad have always had to worry about double taxation. US citizens and green card holders living abroad are required to report their worldwide income to the IRS, as well as pay tax in their country of residence.
The same person paying the full rate of tax to two different countries on the same income is called “juridical” double taxation. This kind of double taxation hinders meaningful commerce between countries.
The US Congress has legislated to avoid double taxation in several ways, while still retaining the much-resented principle of taxing Americans on their worldwide income wherever they live. The Foreign Tax Credit is the primary mechanism to allow US citizens living abroad to avoid double taxation.
What exactly is it?
The Foreign Tax Credit allows all US taxpayers to reduce their federal income tax bill by a dollar for every dollar that they’ve already paid on the same income abroad.
Taxes paid in other countries qualify for the Foreign Tax Credit when:
– They were levied on your income.
– You were legally obliged to pay them.
– You did pay them.
– You did not gain from paying them, and
– The United States has not sanctioned the country.
Eligible taxes include income taxes paid to local and provincial governments, but not sales tax, VAT, real estate, or luxury taxes paid to a foreign government.
The Foreign Tax Credit doesn’t apply to any taxes paid to countries that the US has sanctioned as supporters of terrorism, Syria and North Korea, for example.
How can I claim it?
You can claim the Foreign Tax Credit using Form 1116, otherwise known as ‘dreaded’ Form 1116. You need to file a separate Form 1116 for every foreign income stream. Also note that the Foreign Tax Credit cannot be claimed against income which has already been excluded by the Foreign Earned Income Exclusion.
Should I always use it?
Not necessarily. It depends on your individual situation. The Foreign Tax Credit is typically a good option if you live in a country where the income tax rate is higher than in the US, as you can claim a higher amount of credit than the amount of tax you would owe the IRS, and the difference can be carried forward for future years. If you have children under the age of 17, it can also be combined effectively with the Child Tax Credit, depending on your circumstances. If you live in a country with lower income tax rates than the US though, it may make more sense to use the Foreign Earned Income Exclusion rather than the Foreign Tax Credit, or, if your income is greater than the FEIE limit (around $100 thousand), it is sometimes beneficial to claim both.
Hopefully this article has given you a better understanding of the principle and workings of the Foreign Tax Credit. It does very much come down to individual circumstances though, and for that reason it is always worth seeking advice from an expat tax specialist. More often than not, the potential savings in your tax liability greatly outweigh the cost.