U.S. Taxation: The Foreign Tax Credit
by George Gonzalez
Are you a U.S. citizen moving to a foreign country for work or investing in a foreign country for income? If so, read on.
As a U.S. citizen you are subject to taxation of worldwide income regardless of where you live. “Worldwide income” means income from all sources, both U.S. source and foreign source. You must file the annual 1040 tax return If your worldwide income is above the filing requirement threshold (currently approximately $13,000 for single filers and $26,000 for joint filers, although for self-employed individuals there is also an additional threshold). Nevertheless, U.S. citizens who reside on a full-time basis outside of the U.S. are entitled to some tax breaks.
There are three main tax breaks that I discuss in these web pages. In this article I focus on the Foreign Tax Credit and, in separate articles, the Foreign Earned Income Exclusion and the Housing Exclusion.
Foreign Tax Credit in General
If you reside in the U.S. and invest in a foreign country, it is quite possible that you will pay income tax to that country on the investment income you earn from sources within that country. If you reside in a foreign country, it is quite possible that you will pay income tax to that country on earned income, investment income, and other non-earned income.
Since as a U.S. citizen you are always subject to taxation of worldwide income, it is entirely possible that you are subject to U.S. taxation of the same income on which you pay income taxes to a foreign country. In the absence of relief, this would result in double taxation.
There is relief, however, in the form of the Foreign Tax Credit (FTC). The essence of the relief provided by that FTC is that you get a credit for the amount of foreign taxes paid on the income on which you are subject to U.S. taxation.
Take a simple example. You invest in rental income property in Brazil. During the year the rental income property generated the equivalent of $10,000 in rental income (converted from Brazilian reales). Brazil imposed income tax of $2,000 on this income. In your U.S. income tax return the amount of tax on the rental income is $3,500 (assuming a marginal tax rate of 35%).
Given these assumptions, you are entitled to a FTC of $2,000 on your U.S. income tax return, and the end result is that you pay a net amount of $1,500 in U.S. taxes on the rental income ($3,500 less $2,000). The total amount of income tax that you pay to Brazil and the U.S. would be $3,500 ($2,000 to Brazil and $1,500 to the U.S.). Note that this is the same amount that you would have paid if there had been no tax payable to Brazil and tax paid only to the U.S. (refer back to the example). Thus, the FTC achieves its objective: the elimination of double taxation.
Foreign Tax Credit Limitation
There is a limit to how much of a FTC you can claim in any taxation year. The limit is based on the amount of U.S. tax that is applicable to the income. In the previous example the foreign tax paid on the rental income ($2,000) was less than the corresponding U.S. tax on that income ($3,500), therefore the limitation did not apply.
Let us assume a different example. Let’s say that the foreign tax paid on the rental income was $2,000, as before, but the corresponding U.S. tax on that income was $1,500. The limitation would apply in this case. The FTC would be $1,500, resulting in a net U.S. tax on the income of $0 ($1,500 less $1,500). There would still be $500 in foreign taxes paid that were not allowed as a FTC ($2,000 less $1,500). This excess is referred to as unused FTC, which can be used as a carryover to another taxation year.
A FTC carryover would first be used as a carryback to the previous taxation year and applied to the extent possible in that year (i.e., if there is sufficient foreign income and room for additional FTC in that year). Any remaining excess is then used as a carryforward to future years, for up to 10 years. After 10 years, the FTC carryover expires and cannot be used further.
Multiple Foreign Tax Credit Income Categories
While in theory there is one FTC, in practice there are actually separate FTCs that must be calculated for different categories of income. The income categories are:
- Passive Category Income
- Foreign Branch Category Income
- Section 951A Category Income
- Section 901(j) Income
- General Category Income
I won’t go into the definitions or details of each type of income category. However, I will say this: the first category (Passive Category Income) includes interest income, dividend income and passive rental property income, among others; the last category (General Category Income) includes employment income and self-employment income, among others.
If you had, for example, employment income on which you paid $35,000 in foreign income tax and dividend income on which you paid $10,000 in foreign income tax, you would calculate a separate FTC for each of these. Assuming you were entitled to the full credit on each, your total FTC would be $45,000 ($35,000 plus $10,000), and your U.S. tax liability would be reduced by this amount.
Interplay Between the FTC and the Foreign Earned Income Exclusion
In a separate article in these web pages I discuss the Foreign Earned Income Exclusion (FEIE). The FEIE is an election that is available for foreign earned income, whether foreign employment income or foreign self-employment income. It is a tax break available to U.S. citizens who reside long-term in a foreign country and receive foreign earned income.
An FEIE election affects how much FTC can be claimed. Let us consider two examples to illustrate. In the first example, assume the following during a taxation year:
- Foreign employment income of $100,000
- Foreign income tax paid on the employment income of $25,000
- U.S. income applicable to the foreign employment income, if FEIE not elected, of $30,000.
- Pre-adjusted FTC calculated on the employment income of $25,000.
If the FEIE is elected, all of the $100,000 would be excluded from U.S. income, since it falls under the $120,000 FEIE exclusion limit (refer to the article on the FEIE). Accordingly, there would be $0 U.S. tax on that income (whereas if the FEIE had not been elected, there would have been U.S. tax of $30,000 as stated above).
With a FEIE election, FTC attributable to the excluded income must be reduced. The formula to do this is multiply the percentage of income that is excluded by the FTC on that income, to give you the reduction in FTC.
Using the amounts in the example:
- reduction in FTC = (excluded earned income / total earned income) x pre-adjusted FTC
- reduction in FTC = ($100,000 / $100,000) x $25,000 = $25,000
The resulting FTC is therefore $0, calculated as: pre-adjusted FTC of $25,000 less reduction in FTC of $25,000 = $0.
Under this scenario, the total income taxes paid on the foreign employment income would be $25,000, i.e., foreign income tax of $25,000 plus U.S. tax of $0 = $25,000.
Let us now change the numbers a bit in the next example:
- Foreign employment income of $200,000
- Foreign income tax paid on the employment income of $50,000
- U.S. income applicable to the foreign employment income, if FEIE not elected, of $60,000.
- U.S. income applicable to the foreign employment income, if FEIE is elected, of $24,000.
- Pre-adjusted FTC calculated on the employment income is $50,000.
If the FEIE is elected, $120,000 of the $200,000 in employment income would be excluded from U.S. income. As stated above, there would be a $24,000 U.S. tax on the $80,000 portion of the income that is not excluded ($200,000 less $120,000 = $80,000). The reduction in FTC would be:
- reduction in FTC = (excluded earned income / total earned income) x pre-adjusted FTC
- reduction in FTC = ($120,000 / $200,000) x $50,000 = $30,000
The resulting FTC is therefore $20,000, calculated as: pre-adjusted FTC of $50,000 less reduction in FTC of $30,000 = $20,000.
Under this scenario, the total income taxes paid on the foreign employment income would be $74,000, i.e., foreign income tax of $50,000 plus U.S. tax of $24,000 = $74,000.
Optimization of FTC and the FEIE
Given the above examples, for each case would it be better to elect the FEIE or not elect the FEIE? Let us consider the possible outcomes:
|
FEIE is elected: |
||
|
Example #1 |
Example #2 |
|
|
Foreign taxes |
$25,000 |
$50,000 |
|
U.S. taxes |
0 |
24,000 |
|
Total taxes |
$25,000 |
$74,000 |
|
FEIE is not elected: |
||
|
Foreign taxes |
$25,000 |
$50,000 |
|
U.S. taxes |
30,000 |
60,000 |
|
Total taxes |
$55,000 |
$110,000 |
|
Decrease in total taxes if FEIE is elected |
$30,000 |
$36,000 |
Given the assumptions in each of the two examples, there is a benefit to electing FEIE in both cases: the decrease in total taxes if FEIE is elected is $30,000 in the first example and $36,000 in the second example.
An analysis may not always indicate that an FEIE election results in a decrease in total taxes, however. Under some combinations of circumstances total taxes paid may be greater with a FEIE election than without a FEIE election. Several years ago when I emigrated from the U.S. to another country I initially elected the FEIE for my earned income because it resulted in lower total taxes than without the election. However, a few years later, with changes in income levels and marginal tax rates that I was subject to, it became more beneficial to not elect the FEIE and instead make full use of the FTC. At that point I revoked my FEIE election and started using the full FTC to which I was entitled.
The main point is that it is important go through the calculations to determine which alternative is more beneficial: elect the FEIE or not.