Foreign Tax Credit

Simon Misiewicz

Simon Misiewicz

Expat & Property Tax Specialist

13th April 2022

What are the basics of Foreign Tax Credits?

As property accountants serving thousands of UK landlords who purchase buy to let properties, we know that working through foreign tax credits is a complicated task for many clients.

The US Foreign Tax Credit allows Americans who pay income taxes to claim US tax credits on a dollar-by-dollar basis to the same value as income taxes they have already paid to another country.

This reduces their US tax liability.

Some Americans in the US have foreign source income which they may pay foreign income tax on.

These Americans can claim US tax credits up to the value of the foreign taxes paid to avoid double taxation.

It is worth looking at IRS guidelines on Foreign Tax Credits.

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Fed up using an American CPA or EA in one firm to file your 1040 tax return and a UK based accountant to file your UK tax return?

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When can expats claim the Foreign Tax Credit?

FTC does not include a property tax in another country.

Expats can claim the Foreign Tax Credit if they have paid foreign income taxes on non-US source income.

Foreign income taxes are legally imposed and must be paid.

Expats with income that meet these criteria can use the Foreign Tax Credit to claim US tax credits to the dollar value of the foreign income taxes paid.

Expats who live abroad but are paid by a US company into a US bank account may have their wages taxed at source. These wages may still be liable to foreign income taxes. These expats may have to claim tax credits in the foreign country where they live to avoid double taxation.

They may be able to exclude this income from US taxation by claiming the Foreign Earned Income Exclusion.

Expats with US and foreign source income may have to file one tax return paying the total tax rate. They may have to file a return to benefit from the tax credits. Finally, they may need to 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 credit on the respective incomes.

We recommend that you also read these Foreign Tax Credit compliance tips from the IRS.

Free Online Tax Calculators

We continue to develop brand new U.S and UK tax calculators for you to use. We focus on tax calculators such as: Income Tax, Capital Gains Tax, Stamp Duty Land Tax, Inheritance/Estate Tax

Use our online tax calculators today to help you make money-saving decisions tomorrow

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How can expats reduce their US tax bill?

Not all expats can or should claim Foreign Tax Credits.

Some expats either live in a low-taxed country compared to the US or move between countries without establishing tax residence in any single one.

These expats may not be required to file foreign taxes at all.

If expats pay foreign income tax at a lower rate than the US whilst claiming Foreign Tax Credits, this won’t eradicate their US tax liability. They can only claim US tax credits based on the value of foreign income taxes paid. They may have to pay some US tax as well.

Expats such as Digital Nomads who don’t pay foreign taxes as they move from country to country without establishing tax residency don’t charge US income taxes. They won’t be able to claim the Foreign Tax Credit.

IRS provisions exist to help these expats reduce their US tax bills, notably the Foreign Earned Income Exclusion.

The Foreign Earned Income Exclusion allow American expats to exclude the first circa $112,000 (2022) of their earned income from US taxation.

The exact amount is increased annually based on inflation.

Earned income includes all income that is paid for services provided, such as salaries, wages, self-employment income, tips and bonuses.

It does not include passive income such as dividends, interest, rental or pension income, social security benefits, capital gains or alimony payments.

The Foreign Tax Credit doesn’t distinguish between earned and unearned income, so long as foreign income taxes have been paid.

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 365 days outside of the US, called the Physical Presence Test.

The second test is whether they are a permanent resident in another country. This is called the Bona Fide Residence Test.

Expats earning over $112,000 and renting their home abroad can also exclude a proportion of their housing expenses by claiming the Foreign Housing Exclusion.

It is called the Foreign Housing Deduction for self-employed expats.

Expats who live in a single foreign country and pay foreign income taxes at a higher rate than the US rate on all of their global income are best off claiming the Foreign Tax Credit.

Expats who don’t pay foreign taxes or who pay them at a lower rate, whose only income is earned and doesn’t exceed over $112,000 and who can meet either the Physical Presence Test or the Bona Fide Residence Test are better off claiming the Foreign Earned Income Exclusion.

We also recommend that you utilise US and UK tax treaties if you’re living in the UK as an American expat.

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How do I claim Foreign Tax Credits?

To claim Foreign Tax Credits, expats must file their foreign tax returns and pay foreign taxes first.

The IRS acknowledges that this may not be possible before 15th April. This is particularly if they live in countries with a different tax year, such as the UK, which has a tax year from 6th April to April 5th.

Expats have an automatic IRS filing extension to 15th June and can claim an additional extension online to 15th October.

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 American expats to provide details about which country their foreign taxes were paid in. The IRS wants to know the value of foreign taxes paid (in a foreign currency and US dollars). In addition, the IRS wants to know the types of income the taxes were paid on and any foreign deductions and expenses.

US & UK Tax return Services

Fed up using an American CPA or EA in one firm to file your 1040 tax return and a UK based accountant to file your UK tax return?

Optimise accountants hires both UK qualified tax accountants and US qualified tax accountants under the same roof to help you streamline your international expat tax affairs.

Learn about our services



Who is eligible for Foreign Tax Credit?

You are eligible for Foreign Tax Credit if you’re a US citizen or resident who earns foreign income abroad and paid taxes to your country of residence.

Amerian Expats will often owe no US tax when working in a country with a higher tax rate than the US, such as China. The tax rules depend on the country you earn money in and the foreign tax credit limitations.

There are limitations for US expats claiming foreign tax credits, including:

* The tax must be imposed on you

* You must have paid or accrued the tax

* The tax must be the legal and actual foreign tax liability

* The tax must be an income tax

It is also worth noting that you won’t qualify for the FTC if paying taxes to your resident country isn’t mandatory.

The IRS states the following types of foreign taxes are not eligible for foreign tax credits:

* Taxes on excluded income (for example, if you’ve already used the Foreign Earned Income Exclusion)

* Taxes refundable to you

* Taxes paid to a foreign country deemed to support international terrorism

* Taxes for which you can only take an itemised deduction

* Taxes on foreign mineral income

* Taxes from international boycott operations

* Taxes related to a foreign tax splitting event

* A portion of taxes on combined foreign oil and gas income

* Social security taxes paid or accrued to a foreign country in which the US has a social security agreement

The IRS has stipulations on what counts as a foreign income tax.

Some expats live in countries that do not have an income tax, like the UAE but have other forms of taxes.

If you paid foreign taxes instead of income taxes, you might still be able to offset them by claiming foreign tax credits.

Free Online Tax Calculators

We continue to develop brand new U.S and UK tax calculators for you to use. We focus on tax calculators such as: Income Tax, Capital Gains Tax, Stamp Duty Land Tax, Inheritance/Estate Tax

Use our online tax calculators today to help you make money-saving decisions tomorrow

Free online tax calculators

What is the Foreign Tax Credit Carryover?

Your unused amount can carry over to the next tax year or carry back to the previous year if you don’t use the full tax credit amount allowed.

If you were short on tax credits in the previous year, your leftover amount must be carried back.

Example: You have a $500 carryover amount in the previous year. You were short $600 in credits on foreign income. Instead of carrying it forward, you must carry back that $500 from that year earlier.

Your foreign tax credit can carry over for up to 10 years.

To get the maximum credit amount, you’ll divide your foreign-sourced taxable income by your total taxable income, and then multiply that result by your US tax liability.

Example: You’re a US citizen who moved to Germany for a teaching job. You have a salary of $60,000  and paid $26,400 in taxes to the German government.

You also have $10,000 in US trust income. At the end of the year, you have a US tax liability of $16,000.

To calculate your allowable foreign tax credit amount, you’d take:

$60,000 (foreign-sourced taxable income)

Divided by

$70,000 (your total taxable income)

= .86

You’d then take that .86 and multiply it by your US tax liability ($16,000) = $13,760.

You could receive up to $13,760 as an FTC.

The difference between $26,400 (German taxes paid) and $13,760 is your Foreign Tax Credit carryover amount.

Foreign Tax Credit vs the Foreign Earned Income Exclusion

Foreign Tax Credits (FTC) are not the only tool to offset US taxes for expats.

The Foreign Earned Income Exclusion (FEIE) lets you deduct foreign income from your yearly tax filing like any other deduction.

The FTC is different because it lets you claim a dollar-for-dollar tax credit to reimburse you for taxes already paid to your host country.

A significant difference between the FTC and FEIE is what counts as income.

The FEIE only applies to income from your wages.

The FTC applies to gross income from all sources, including passive income like interest or dividends.

However, it only works if you pay taxes to the country you now reside in.

Factors to consider when choosing between the FTC and FEIE include:

* Your income type and source

* Your housing expenses

* Your future plans for life and work abroad

* Your dependents and their US citizen status

* Whether you pass the Physical Residence Test or the Bona Fide Residency Test

* Your current country of residence and their tax laws

* Your foreign tax liability to your country of residence

We recommend you review the information on Foreign Tax Credit vs the Foreign Earned Income Exclusion for further guidance.

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