The Foreign Tax Credit
The United States is one of the only two countries in the world that has a citizenship based taxation system. What this means is that the US requires all its citizens and green card holders to report their worldwide income to the IRS even if they are living abroad. In addition to this, US citizens and Green Card holders living abroad may also have to pay foreign income tax in their country of residence.
Paying the full rate of tax on the same income to two different countries is called double taxation.
The Foreign Tax Credit is the primary provision that allows US citizens living abroad to avoid double taxation.
How exactly does the Foreign Tax Credit Work?
Claiming the Foreign Tax Credit allows US taxpayers to reduce their US federal income tax bill on a dollar by dollar basis. This works by claiming a credit for every dollar of foreign income tax that US citizens and Green Card holders have paid on the same income abroad.
What Taxes Qualify for the Foreign Tax Credit?
The tax payments that qualify for the Foreign Tax Credit, are taxes paid in any foreign country during the tax year. Specifically, 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 receive a refund for them
- The United States has not sanctioned the country where you paid these taxes at
Eligible taxes include income taxes paid to:
- Provincial governments
But don't include:
- Sales tax
- Real estate, nor 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. For an official list of the sanctioned countries, visit the IRS page which is updated yearly.
How can You Claim the Foreign Tax Credit?
US Expats can claim the Foreign Tax Credit by filling out and filing Form 1116 attached to their US tax return Form 1040. The Foreign Tax Credit must be calculated in US dollars. This means that if for example, you paid taxes in your foreign country of residence in Euros, or in CAD, or in GBP, etc. you must convert the amount of Foreign Taxes you paid in the local currency to USD with the official IRS yearly conversion rate.
Is the Foreign Tax Credit the Best Option for You?
Whether it’s beneficial to claim the Foreign Tax Credit depends on each individual expat’s situation. The Foreign Tax Credit is typically a good option for expats who live in a country where the income tax rate is higher than the US tax rate. This is because they can claim more tax credits than the amount of tax they owe to the IRS, and the difference can be carried forward for use in the US towards tax payments in future years.
Expats who claim the Foreign Tax Credit and who have children under the age of 17 can also claim the Child Tax Credit. When claiming the Child Tax Credit, it is also possible to receive a refundable credit in the form of a payment if the US income tax liability has already been reduced to zero by the Foreign Tax Credit.
On the other hand, Expats who live in a country with lower income tax rates than the US may benefit from claiming the Foreign Earned Income Exclusion rather than the Foreign Tax Credit. Some expats may be able to claim both, although you should be very careful because the Foreign Tax Credit and the Foreign Earned Income Exclusion cannot be applied to the same income.
Solutions for You:
Whether or not it’s beneficial to claim the Foreign Tax Credit depends on individual circumstances, so it’s always worth seeking advice from an expat tax specialist. More often than not, the potential savings outweigh the cost.
On the other hand, if you haven’t been filing US taxes from abroad because you weren’t aware of this obligation, you may have catch up on your tax filing requirements and have the option of doing it without facing penalties under the IRS Streamlined Procedure program.
If you need further assistance understanding your U.S. tax requirements and options, please don't hesitate to contact me for a consultation, I'd gladly help you sort your tax matters out, as well as filing your U.S. tax return from abroad.