US Expat Taxes: The Foreign Tax Credit (Form 1116)
In this edition we focus in on the Foreign Tax Credit. We explain how you can use this on your expatriate tax return.
Using the Foreign Tax Credit on Your Expatriate Return
US taxpayers required to pay foreign income taxes may elect to claim a credit for those taxes on their expatriate tax return. The Foreign Tax Credit is claimed on your expatriate tax return via Form 1116. You can attach this form to Form 1040. The credit cannot be taken against income for which the Foreign Earned Income Exclusion has already been claimed. It also cannot exceed the US tax liability on foreign earned income.
Background and Benefits
Moving abroad can often trigger US expat tax liabilities on your foreign earned income. You could be subject to dual taxation — in your host country and in the USA. In an attempt to ease this dilemma, the IRS allows US taxpayers to exclude up to $92,900 of foreign sourced income. You can also take a credit on their US expatriate tax return for any foreign taxes imposed. Taking advantage of all of these benefits on your expatriate tax return will reduce your US expat taxes liability and save you money.
The Foreign Tax Credit claimed on your expatriate tax return cannot exceed the amount of US expat taxes paid on foreign income. To determine the amount of the limitation, you can use the following formula:
Foreign source taxable income (FSTI) should include all income earned in a foreign country. Also, include interest received from foreign banks, dividends received from foreign corporations and rental income from foreign properties. Any deductions directly related to this income claimed on the expatriate tax return can and should be removed before arriving at the final FSTI. Is your income earned both in and out of the US? The income should be allocated based on days worked in the US and days worked in the foreign country.
Taking the Credit
Four criteria must be met to qualify to take the Foreign Tax Credit on your expatriate tax return:
- The tax must be assessed on income.
- You must have a tax liability that has either been paid or incurred.
- The tax must be imposed on you as an individual.
- The tax must have originated legally in a foreign country.
The Foreign Tax Credit can be claimed annually by completing Form 1116 and attaching it to your expatriate tax return. The credit reduces the US tax liability dollar for dollar.
Make sure to report all foreign taxes paid in US dollars. The IRS prefers that each transaction be converted at the foreign exchange rate at the date of each transaction. If transactions are excessive or the exchange rates not readily available, they will accept the annual average foreign exchange rate. If the taxes were imposed but have not yet been paid, you should use the exchange rate on the last day of the year for which the taxes were assessed.
There are certain foreign taxes that are not eligible for the Foreign Tax Credit on your US expat taxes. These include taxes paid to certain countries. These are countries that the Secretary of State has designated as supporting international terrorism. These countries include Cuba, Iran and North Korea. Other taxes that cannot be claimed on your expatriate tax return include financial services income or dividends from each 10 percent to 50 percent-owned foreign corporation. You also cannot claim shipping and aircraft income. With dividends, you cannot exclude “domestic international sales corporation” dividends or dividends from foreign sales corporations. Lastly, do not exclude foreign trade income of foreign sales corporations or foreign oil and gas extraction income.
While a credit cannot be taken for these expenses on your expatriate tax return, they can be claimed on the Schedule A as an itemized deduction.
Carrybacks and Carryforwards
What if you are eligible for a foreign tax credit larger than the US income tax liability calculated on your expatriate tax return? The credit can be carried back to the tax year immediately preceding the current. You can also elect to carry it forward for the next ten years. This means that you can use the excess credit to try to obtain a refund from the prior year. You could also choose to offset your future years’ tax liability on your domestic or expatriate tax return.
There are two ways the foreign taxes you paid this year can have a favorable impact on your expatriate tax return. Completing Form 1116 and taking the foreign tax credit on your US expat taxes is typically the most beneficial. The other methodology is electing to take the taxes as an itemized deduction on your Schedule A. The credit is typically more attractive because it offsets your tax liability dollar for dollar. In addition, you can choose to take the credit even if you are not itemizing your deductions. However, taking the foreign taxes as a deduction reduces the amount of income that is taxed and therefore may results in a higher tax liability on your expatriate tax return.
Assume in 2010 that you and your spouse have an adjusted gross income of $120,000 on your expatriate tax return, which includes $15,000 of consulting income you earned while in London. You paid $3,000 in foreign taxes on the consulting income. Not considering the foreign taxes paid, you claim $12,000 worth of itemized deductions and take $7,300 in personal exemptions. The taxable income on your expatriate tax return before the credit or deduction for foreign taxes paid is $100,700.
If you choose to take the foreign taxes as an itemized deduction, your revised taxable income is $99,700 and the resulting tax liability is $15,988.
If you elect the foreign tax credit instead on your expatriate tax return, your taxable income remains $100,700, but the resulting tax liability of $16,638 is reduced to $13,638 after the credit. You can save $650 on your eexpatriate tax return by choosing to take the credit rather than the deduction.
Using the formula above, we can calculate the amount of foreign source US tax to determine the limitation, if any.
($15,000 Foreign Income / ($120,000 – $12,000) Total Income Before Exemptions)
$16,638 US Tax Liability
$2,311 Foreign Sourced US Tax
Of the $3,000 potential tax credit, only $2,311 can be taken in the current year. The $689 of disallowed credit can be carried back to the year immediately preceding. The credit can also be carried forward for ten years on your domestic US or expatriate tax return.
The IRS website is also a great resource to understand more about how to apply the foreign tax credit on your expatriate tax return.