The US Foreign Tax Credit – A Complete Guide for Expats
All Americans, including those who live abroad, are required to file US taxes, reporting their worldwide income.
The US is the only country (besides African minnow Eritrea) that requires all of its citizens to file and pay taxes on their global income even if they live abroad. In contrast, the majority of foreign countries either only tax folks who either have income sourced in that country, or who are residents in that country.
American expats are also required to report their foreign registered bank accounts, financial assets, investments, and business interests, subject to minimum IRS value and ownership thresholds.
Overall, US expats often have more US tax and financial filing than Americans living in the States.
Expats who are also subject to filing requirements in a foreign country, because they either qualify as a tax resident by living there or they have income there, may also have to file foreign taxes too.
While every country has slightly different rules governing who is liable to file and pay tax there, most Americans who have settled in another country (rather than those who move from country to country, such as Digital Nomads) are required to pay income taxes in that country, often on their worldwide income. So what happens when both another country and the US want to tax an American ’s global income at the same time?
The US has signed international tax treaties with around 70 foreign countries, however these treaties contain what’s called a ‘Savings Clause’ meaning American expats still have to file both tax returns. Instead, to prevent double taxation on the same income, these treaties allow for expats to claim tax credits when they file in one country against income they’ve paid in the other country. Most often for US expats this means claiming the US Foreign Tax Credit when they file their US federal tax return from abroad, after having filed their foreign taxes first.
“If you are a U.S. citizen or resident alien, the rules for filing income, estate, and gift tax returns and paying estimated tax are generally the same whether you are in the United States or abroad.” – the IRS
What is the Foreign Tax Credit?
The US Foreign Tax Credit allows Americans who pay foreign income taxes to claim US tax credits on a dollar for dollar basis to the same value as income taxes that they’ve already paid to another country, so reducing their US tax liability.
So if for example an expat who lives and works in the UK for a British company pays the equivalent of $70,000 of foreign (UK) income tax on their salary income, which may have been deducted at source, when they file their US federal tax return they can claim $70,000 of US tax credits. Because UK income tax rates are higher than US income tax rates, claiming the Foreign Tax Credit will give them more than enough US tax credits to eradicate their US tax liability.
Some Americans who live in the US have foreign source income too, which they may pay foreign income tax on, and these Americans can claim US tax credits up to the value of the foreign taxes are paid, to avoid double taxation, too (so not just expats necessarily).
To claim the it, Americans must file IRS Form 1116 when they file their federal tax return.
When can expats claim the Foreign Tax Credit?
Expats can claim the Foreign Tax Credit if they have paid foreign income taxes on non-US source income.
The foreign income tax must be a true income tax (so not a property tax for example), must be a legally imposed obligation, and must already have been paid.
Expats with income that meets these criteria can use the Foreign Tax Credit to claim US tax credits to the exact dollar value of the foreign income taxes that they’ve paid.
Expats who have US source income, such as if they live abroad but are paid by a US company into a US bank account and their wages are US taxed at source (i.e. Payroll Tax) but are still liable to foreign income taxes on their worldwide income may have to claim tax credits in the foreign country where they live to avoid double taxation of their US source income, or they may be able to exclude this income from US taxation by claiming the Foreign Earned Income Exclusion (see below for further information on the Foreign Earned Income Exclusion).
Expats who have both US source and foreign source income and so who have to claim both foreign and US tax credits may have to file one tax return paying the full tax rate, then file the other claiming tax credits, then file an amended version of the first return to claim the other tax credits. This allows evidence of taxes paid to be provided to both countries when claiming the tax credits on the respective incomes.
Expats with any queries or who require assistance to ensure that they file in the most economical and beneficial way and in line with final regulations should consult a US expat tax specialist.
When should expats claim the Foreign Tax Credit?
Not all expats can, or should, claim the Foreign Tax Credit.
For example, some expats either live in a country where the income tax rates are lower than in the US, or move between countries without establishing tax residence in any single one, so that they aren’t required to file foreign taxes at all. (such as many American Digital Nomads).
If expats pay foreign income tax at a lower rate than the US rate, claiming the US Foreign Tax Credit won’t eradicate their US tax liability, as they can only claim US tax credits based on the value of foreign income tax that they’ve paid, so they would have to pay some US tax too (the difference between the foreign tax they’ve paid and the US tax they owe).
Expats such as Digital Nomads who don’t pay any foreign tax as they are moving from country to country without establishing tax residency in any single one, or expats who live in a country that doesn’t charge income taxes (either at all, or on income not paid in that country), won’t be able to claim the Foreign Tax Credit.
Other IRS provisions exist to help these expats reduce (and hopefully eliminate) their US tax bill, notably the Foreign Earned Income Exclusion.
The Foreign Earned Income Exclusion allows expats to simply exclude the first around $100,000 of their earned income from US taxation. The exact amount is increased a little each year based on inflation.
Earned income includes all income that is paid for services provided, such as salaries, wages, self-employment income, tips, and bonuses, but not passive income such as dividends, interest, rental or pension income, or social security benefits, capital gains, or alimony.
(The Foreign Tax Credit on the other hand doesn’t distinguish between earned and unearned income, so long as foreign income taxes have been paid on it.)
To claim the Foreign Earned Income Exclusion, expats must also demonstrate that they meet one of two IRS definitions of living abroad. The first is that they spend at least 330 full days in a 365 day period that is normally the tax year outside of the US (this is called the Physical Presence Test), and the second is that they are a permanent resident in another country (this is called the Bona Fide Residence Test).
Expats who earn over $100,000 and who rent their home abroad can additionally exclude a proportion of their housing expenses by claiming the Foreign Housing Exclusion (or the Foreign Housing Deduction for self-employed expats). Both the Foreign Earned Income Exclusion and the Foreign Housing Exclusion (and Deduction) can be claimed on IRS Form 2555.
In general, expats who live in a single foreign country and pay foreign income tax at a higher rate than the US rate on all of their global income are generally best off claiming the Foreign Tax Credit. Expats who either don’t pay foreign taxes or who pay them at a lower rate, whose only income is earned (and doesn’t exceed over $100,000), and who can meet either the Physical Presence Test or the Bona Fide Residence Test are generally better off claiming the Foreign Earned Income Exclusion.
Expats whose circumstances don’t fit into either of the above categories may need to claim a combination of IRS provisions, and may still end up owing some US tax.
The bottom line is that no expat should end up paying more than the higher of the two income tax rates that they’re subject to in total. All expats should seek advice from a US expat tax specialist though to ensure that they pay the least possible tax that they need to.
Deadlines and extensions
To claim the US Foreign Tax Credit, expats have to file their foreign tax return and pay their foreign taxes first. The IRS acknowledges that this may not be possible before April 15th (particularly if they live in countries with a different tax year, such as the UK which has an April 6th to April 5th rather than January 1st to December 31st) tax year. For this reason, expats have an automatic US filing extension to June 15th, and, furthermore, they can claim an additional extension (online) to October 15th if they need to. This should give almost all expats enough time to file and pay their foreign taxes before filing their US tax return.
IRS Form 1116
“If you paid or accrued foreign taxes to a foreign country or U.S. possession and are subject to U.S. tax on the same income, you may be able to take either a credit or an itemized deduction for those taxes.” – the IRS
IRS Form 1116 is a two page form that requests the information and figures necessary to calculate what value of US tax credits can be claimed based on foreign taxes paid.
It requires that expats provide details about what country their foreign taxes were paid in, their value of foreign taxes paid (in both foreign currency and USD), what types of income the taxes were paid on, and any foreign deductions and expenses.
The Foreign Tax Credit Carryover
If expats who pay more foreign income tax than the US income tax they owe claim the US Foreign Tax Credit, they can claim a greater value of US tax credits than they need to eradicate their US tax liability. This leaves them with excess US tax credits that they can carry forward for up to ten tax years to apply to future income, or carry back to apply to the previous tax year. This tax credit carryover function can be particularly useful for expats who work abroad for at least several years.
Claiming the Child Tax Credit
The US Child Tax Credit changed as part of the recent tax reform, allowing expats with children who have US social security numbers to claim either a $2,000 tax credit per child, or, if they have already reduced their US tax bill to zero using tax credits, a refundable $1,400 refundable tax credit (i.e. payment) per child.
Expat parents who claim the Foreign Earned Income Exclusion often can’t claim the refundable child tax credits though, meaning expat parents who could eliminate their US tax liability by either claiming the Foreign Earned Income Exclusion or the Foreign Tax Credit may be better off claiming the latter so that they can claim the refundable Child Tax Credit too.
Roth IRAs are useful pensions saving plans that Americans can contribute to. Contributions are made from (post tax) reportable earned income, while distributions in retirement are completely tax free.
Expats who exclude all their income by claiming the Foreign Earned Income Exclusion however don’t have any reportable earned income, so they can’t make contributions to Roth IRA plans. Expats who claim the Foreign Tax Credit on the other hand can, so similarly to expat parents wishing to claim the Child Tax Credit, expats who wish to contribute to Roth IRA retirement plans are better off claiming the Foreign Tax Credit than the Foreign Earned Income Exclusion, if they have the choice.
Can expats claim the Foreign Tax Credit on corporate income?
Americans with a foreign corporation are also liable to report it and pay US corporation taxes on their global profits.
Americans who pay foreign corporation taxes however may also claim US tax credits to reduce their US corporation tax bill. Instead of using IRS Form 1116 though, expats should file IRS Form 1118 to claim US foreign corporation tax credits.
New French ruling
Americans living in France should note that a recent IRS ruling states that it has recently changed its stance on two French social taxes (Generalized Social Contribution Taxes) that the IRS didn’t used to consider income taxes (so that expats couldn’t claim US tax credits to offset these taxes). Thanks to the newly announced final regulations, expats in France can now use the Foreign Tax Credit to offset these taxes.
American expats who have been living abroad but not filing US taxes because they didn’t know that they had to can catch up without facing penalties using an IRS amnesty program called the Streamlined Procedure.
The Streamlined Procedure requires expats to file their last three US tax returns, and their last six FBARs (to report their bank and other financial accounts), and to self-certify that they weren’t willfully avoiding filing. The program allows expats to claim the Foreign Tax Credit (or Foreign Earned Income Exclusion) in retrospect.
Expats who are only one or two years behind can simply back file.
Expats should note though that if they don’t catch up before the IRS contacts them (and the IRS is receiving financial data from foreign banks and governments), they may face penalties.