Foreign tax credit helps Americans who pay taxes abroad avoid double taxation. If you are a US citizen who generates income outside of America, don’t miss your opportunity to claim your foreign tax credit and offset your foreign taxes.
Managing the foreign tax credit can be complex, but the potential consequences for your income are very significant. But that’s not all. Unusually, United States citizens and residents are obliged to report their foreign source income, even if they live abroad. Understanding your reporting requirements is therefore not just a question of optimising your taxes but ensuring you don’t breach reporting requirements or global VAT compliance.
Let’s first take a step back and consider why the foreign tax credit system even exists. As noted, Americans are required to file tax returns that include their foreign income. This applies even when they live abroad. However, many Americans living abroad will be obliged to file tax returns and pay taxes in the country in which they are residents.
That opens the door to double taxation. You could end up paying tax on your foreign earned income at the local rate and pay US taxes on the same earned income.
To address the issue of double taxation, the US government enables Americans to claim a tax credit against the foreign tax they pay. The tax credit is calculated at the dollar value of the income tax paid abroad. (For example, an American resident in Germany must convert the sum paid to the German state from euros to US dollars when claiming their tax credit.)
The foreign tax credit is not the only mechanism that enables US citizens abroad to avoid double taxation.
Through the Foreign Earned Income Exclusion (FEIE) benefit, you can exclude a portion of your foreign earned income from US income tax. The precise amount varies each year (in 2022 the amount is $112,000).
You can claim the FEIE and foreign tax credit together, but in many cases, it may be more sensible to opt for one or the other. A tax professional can help you make an informed choice.
US taxpayers can elect to either deduct their foreign taxable income or apply for a tax credit. These are not the same mechanism, and in many cases a tax credit offers greater tax relief. However, each case should be assessed on its own merits.
When filing your US tax returns, you need to include IRS Form 1116, detailing the value of tax credits claimed. You need to specify what taxes were paid and the value of those taxes in the local currency and their US dollar equivalent. You also need to specify relevant itemized deductions, expenses and other relevant tax information.
To claim your foreign tax credit you must demonstrate to the IRS that you are an ex-pat who lives abroad.
If you are a United States citizen living abroad, you may have reporting requirements that go beyond filing your regular tax reports. US citizens and residents must report foreign source income and, in some cases, foreign assets. You must also report foreign bank accounts and investments if these exceed the specified threshold.
While it makes sound financial sense in many cases to claim the foreign tax credit, there is no legal requirement to do so. Indeed, under certain circumstances, it may be prudent to use a different mechanism to seek tax relief.
However, regardless if you choose to claim the foreign tax credit or not, you will still be required to file your regular tax returns and report foreign income.
Also note that even if you live within the US, you may be required to report foreign assets. The requirements are different for US citizens living at home and abroad, so seek professional advice if you are unsure of your reporting obligations.
Not all Americans living abroad can claim the foreign tax credit. If you live and work abroad but do not pay overseas income tax, then the foreign tax credit does not apply. For example, a US citizen could choose to work remotely while travelling, without settling in any one country.
Similarly, if you live and work in a country with no income tax, then the foreign tax credit is not relevant.
Where the foreign income tax is lower than the US income tax rate, a mechanism such as the FEIE is likely to be more appropriate.
While the complexities of optimising your foreign and US income tax can be considerable, there is a useful rule of thumb that will help you decide whether or not to claim the foreign tax credit. If you are an American citizen who lives abroad in one specific foreign country where the income tax is higher than the US rate then you will probably benefit from claiming the foreign tax credit.
A complication arises when filing two sets of tax returns (foreign and US returns). In order to claim your foreign tax credit, you must first comply with your foreign VAT obligations. However, the deadline for filing abroad may make it infeasible to file with the ordinary US tax deadline. US citizens abroad thus automatically are entitled to an extension on filing their US returns. At VAT IT, we can help with most global vat obligations.
If the IRS finds that you have not complied with your obligation to file US tax returns, you could face penalties. Fortunately, there is an amnesty for Americans living abroad who have neglected to file their returns and want to avoid penalties. However, it is critical to take action before authorities serve you with a penalty notice.
It should now be clear that meeting your US tax obligations as an American living abroad is complex and administratively demanding. You need to file two sets of tax returns, taking into account multiple deadlines, as well as a host of supporting information. Moreover, it is not always obvious which approach will best optimise your expenditure in a given tax year.
A global tax specialist should help you with both elements of your tax and VAT compliance requirements: 1) managing the administrative burden and ensuring you are fully compliant wherever you have tax obligations and 2) optimising your tax compliance to minimise your financial burden.
As global specialists, VAT IT offers integrated solutions that make compliance simpler, more efficient, and more cost effective. Global taxation is complex, get in touch for a personalised solution to make VAT compliance simple.