Understand foreign tax credit for USA ex-pats.

 

One of the most common problems US ex-pats face is double taxation—paying taxes twice on the same income. Fortunately, the IRS offers multiple tax credits and deductions to help expats avoid this costly burden. One example is the Foreign Tax Credit (Form 1116). Using this credit, many Americans living abroad are able to erase their US tax debt entirely.

Here’s what you need to know to take advantage of the Foreign Tax Credit.

What Is Foreign Tax Credit?

The Foreign Tax Credit lets US expats use their foreign income tax obligations to offset their US tax debt. To get a better understanding of how Foreign Tax Credit works, we need to take a look at how tax deductions and tax credits work in general.

• Tax deductions reduce how much of your income is subject to taxation. Specifically, a deduction lowers your taxable income by the percentage of your federal income tax bracket. For example, if you fall into the 22% tax bracket, a $1,000 deduction would reduce your final tax bill by $220.
• Tax credits reduce your tax bill by a dollar-for-dollar amount. This means that a $1,000 tax credit would reduce your final tax bill by the exact same amount—$1,000.

Because the Foreign Tax Credit is a tax credit, it will reduce your final tax bill by whatever amount you can claim, dollar for dollar. If you owe $2,000 in US taxes but can claim a $500 Foreign Tax Credit, you’ll only have to pay $1,500 ($2,000 – $500 = $1,500).

The amount you can claim as a Foreign Tax Credit will be based on how much you’ve paid in income taxes to a foreign (non-US) government. Americans living abroad in countries with a higher tax rate than the US, such as China, can typically use the Foreign Tax Credit to erase their US tax debt entirely.

However, there are limitations to what forms of tax you can count toward the Foreign Tax Credit, as well as the maximum amount you can claim.

Who Qualifies for the Foreign Tax Credit?

You will be eligible for the Foreign Tax Credit if you meet the following criteria:

• You are a US citizen or tax resident
• You earn income from a foreign source
• You pay taxes on that income to a foreign government

For example, an American who works in Singapore—and whose income is thus taxed by the Singaporean government—would likely be able to claim their Singaporean income tax bill under the Foreign Tax Credit to offset their US tax bill.

What Taxes Can Expats Claim toward the Foreign Tax Credit?

For an income tax payment to count toward the Foreign Tax Credit, all of the following must apply:

1. The tax must be an income tax
2. The tax must be your “legal and actual” foreign tax liability
3. The tax must be mandatory
4. You must have paid or accrued the tax

Let’s look at each of these qualifications in detail.

The Tax Must Be an Income Tax

You can’t claim just any tax under the Foreign Tax Credit, such as a property tax or estate tax. It has to be an income tax. (Or, if you live in a country without an income tax, you may be able to claim another tax imposed in place of an income tax.)

Some forms of income tax are excluded, however, such as:

• Taxes on excluded income (for example, if you’re also claiming the Foreign Earned Income Exclusion)
• Taxes for which you can only take an itemized deduction
• Taxes from an international boycott operation
• Taxes paid to a country deemed to support international terrorism
• Taxes on foreign mineral income
• A portion of taxes on combined foreign oil and gas income
• Social security taxes paid to a foreign government that has a totalization agreement with the US

The Tax Must Be Imposed on You

The foreign income tax you are claiming for the Foreign Tax Credit must be mandatory. If the tax is optional in any way, you won’t be able to claim it against your US tax bill.

The Tax Must Be Your “Legal and Actual” Foreign Tax Liability

This means that you must actually owe or have paid the full amount of foreign income tax you’re claiming. Under IRS law, you are responsible for taking advantage of all possible means of reducing your foreign tax bill, such as foreign credits and deductions. If you fail to do so, the excess amount you didn’t truly need to pay won’t count toward your Foreign Tax Credit.

You Must Have Paid or Accrued the Foreign Income Tax

In order to claim the Foreign Tax Credit, you will need to show that you have already paid the qualifying foreign income tax you are claiming, or that you have accrued the tax and intend to pay it. You also cannot claim income taxes that have been (or will be) refunded to you.

As you can see, the rules for what forms of taxation count toward the Foreign Tax Credit can be complicated. We always recommend consulting an expat tax professional when calculating your US tax bill. Otherwise, you could end up overpaying—or neglecting to pay the full amount you owe.

The Foreign Tax Credit vs. The Foreign Earned Income Exclusion

You may have heard of the Foreign Earned Income Exclusion (FEIE), mentioned above. In case you’re wondering how the FEIE relates to the Foreign Tax Credit, let’s go over some of the differences.

The FEIE is another method that Americans living abroad can use to lower their US tax bill. The FEIE works by letting you exclude foreign income from US taxation, similarly to a tax deduction.

To qualify for the FEIE, you must meet at least one of the two following criteria:

• Be a bona fide resident of a foreign country (or multiple foreign countries) for an entire tax year
• Be physically present in a foreign country (or multiple foreign countries) for at least 330 full days during a given 12-month period

The FEIE will then allow you to exclude a set amount of your foreign income. The exact amount changes from year to year. For foreign income earned in 2022, Americans who qualify can exclude up to $112,000. (Of course, you will need to convert any income received in foreign currency to US dollars to calculate this.) 

Expats can claim both the FEIE and Foreign Tax Credit, but they can’t be claimed for the same income. This often raises the question of which option is the better choice for a given stream of income. Answering that requires a thorough review of the details of your income and tax obligations, and it’s always wise to consult an expert when making that call.

How to Claim the Foreign Tax Credit

In most cases, you will claim the Foreign Tax Credit by filing IRS Form 1116. This two-page form requires you to fill out some basic information, including:

• What country you owe your foreign income tax to
• What types of income the foreign government is taxing
• How much you owe (in both the foreign currency and US dollars)
• What deductions, exclusions, and credits apply to your foreign tax debt

There are rare instances when you won’t need to file Form 1116 to claim the Foreign Tax Credit, such as:

• Your foreign income for the full tax year is entirely passive
• Your qualified foreign income for the tax year is $300 or less ($600 or less if filing a joint return)
• The entirety of your gross foreign income and foreign taxes is reported to you on a payee statement, such as forms 1099-DIV or 1099-INT, and you elect for this procedure for the full tax year

If any of the above conditions apply, you may be able to claim Foreign Tax Credit directly on Form 1040, Schedule 3, without needing to file Form 1116.

How to Calculate the Foreign Tax Credit

In theory, the amount you can claim under the Foreign Tax Credit is a dollar-for-dollar representation of the amount you’ve paid in qualified foreign income taxes. However, there is a limit to how much of your claim you can apply to a single tax year. To find that limit, you must divide your taxable foreign income by your total taxable income, then multiply that by your US tax liability.

Sound confusing? Hopefully, an example will help clear things up.

Let’s say Jenna moved to Germany to work as an English teacher at a German school. Her salary in euros is equivalent to $50,000, and she earns the equivalent of $1,000 in interest from her German bank account. She also has investments in the US that bring her a total of $10,000 in dividends.

As for taxes, Jenna pays $20,000 in income taxes out of her salary to the German government, and another $200 for her interest income. She also owes $14,000 in taxes to the US government.

To calculate her Foreign Tax Credit, Jenna will need to separate her foreign income into passive and general categories, then apply the Foreign Tax Credit limit formula to each.

Jenna’s total taxable foreign income is $51,000. Of that, $50,000 is general (her salary), and $1,000 is passive (the interest on her bank account).

• General Income: Jenna will divide her general foreign income ($50,000) by her worldwide taxable income ($61,000). This creates a percentage of roughly 81.2%. Jenna will then multiply that percentage by her US tax liability ($14,000), coming to $11,368. That will be the maximum Foreign Tax Credit Jenna can claim for general income.
• Passive Income: Jenna will divide her passive foreign income ($1,000) by her worldwide taxable income ($61,000). This creates a percentage of roughly 1.64%. Jenna will then multiply that percentage by her US tax liability ($14,000), coming to roughly $230. That will be the maximum Foreign Tax Credit Jenna can claim for passive income.

The total dollar-for-dollar Foreign Tax Credit that Jenna can hypothetically claim is $21,000 ($20,000 + $1,000). However, because of the limit in place, she can only actually use $11,598 for the current year ($11,368 + $230).

In the end, Jenna’s $14,000 US tax bill will be reduced to $2,402 ($14,000 – $11,598).

Reality is rarely as simple as the above example, though. The factors determining what income taxes you can include and how they should be calculated are incredibly complex.

Does the Foreign Tax Credit Carry Over?

Yes. If you do not use the full Foreign Tax Credit potentially available, the excess will carry over to future years, up to a limit of 10 years later. Or, if you were short on credits the previous year, you can—and must—carry the excess back to cover them.

In the example shown above, Jenna could only use $11,598 of the $21,000 Foreign Tax Credit technically available. This leaves an unused excess of $9,402 that she could carry back one year and/or forward up to 10 years, helping to protect even more of her foreign income from double taxation by the US government.

What Is the Deadline for Claiming the Foreign Tax Credit?

Once you’ve completed Form 1116, you must attach it to your annual income tax return (IRS Form 1040) and file both at the same time. This means that the due date for Form 1116 is the same as your tax return: April 15. The good news is that expats get an automatic extension to June 15 to file taxes, and you can even request an additional extension to October 15 if necessary.

What If I Haven’t Filed My US Taxes?

Every US citizen is required to file a US tax return every year, regardless of where they live. To claim the Foreign Tax Credit, you will have to be up to date on this US tax obligation—as well as any others you may have.

If you weren’t aware that you were required to file a US tax return as an expat, don’t panic. The IRS provides an amnesty program to help expats come into compliance without facing any penalties: the Streamlined Filing Compliance Procedures. All you have to do is:

• Self-certify that your failure to file was not willful
• File the last three delinquent income tax returns and pay any delinquent taxes you owed during that time (with interest)
• File Foreign Bank Account Reports (FBARs) for the last six years

This will bring you into compliance with the IRS and allow you to claim the Foreign Tax Credit. You will even be able to claim the Foreign Tax Credit for past years.

Get Expert Help with Your Expat Tax Return

We hope that this guide has given you a better understanding of what Foreign Tax Credit is and how it might help you reduce your tax bill. If you have more questions, we’d be happy to answer them. In fact, we can help you prepare and file your expat tax return.

At Greenback Expat Tax Services, we’ve spent years helping expats around the world meet their US tax obligations. Just contact us, and we’ll get to work helping you in any way we can.