U.S. expatriates have three primary methods to prevent double taxation while residing abroad on a foreign assignment: the Foreign Earned Income Exclusion, the Foreign Housing Exclusion (available to employees), or the Foreign Housing Deduction (available to the self-employed). These can be found on Form 2555 - Foreign Earned Income, alongside the Foreign Tax Credit detailed in IRC Section 901 and on Form 1116 - Foreign Tax Credit.
Eligibility Criteria - Definition of a Foreign Tax
To claim the Foreign Tax Credit, one must utilize the IRS's two-page Form 1116. This credit provides a dollar-for-dollar reduction of U.S. taxes on foreign income taxed by foreign countries. Qualifying foreign taxes should be legally obligated, non-recoverable, and must pertain to profits exclusively.
Within U.S. law under IRC Section 901, Form 1116, along with various international tax treaties, provides mechanisms to mitigate “double taxation” through the Foreign Tax Credit.
The Foreign Tax Credit is categorized separately for passive income and general limitation income (such as wage or self-employment income). For general limitation income, reductions must reflect both excluded foreign tax and excluded foreign income. Essentially, one cannot claim a credit on income excluded via Form 2555, and eligible foreign tax amounts must also be adjusted for excluded income.
Thus, the Foreign Tax Credit ensures taxpayers are protected from double taxation on global income.
Impact of Tax Rate Variations
However, due to limitations, the Foreign Tax Credit’s effectiveness depends on the lower value between the foreign tax paid and the U.S. tax on unexcluded foreign income. If the latter is lesser, this is calculated on Form 1116 using the average U.S. tax rate.
For instance, if the U.S. average tax rate is 28% and the marginal rate is 39.6%, avoiding double taxation using the Foreign Tax Credit can be ineffectual owing to this discrepancy in rates.
Therefore, it’s often advisable to maximize exclusions before seeking a Foreign Tax Credit. However, in some high-tax jurisdictions, it may be advantageous to rely solely on the Foreign Tax Credit.
“Stacking” also diminishes the credit's effectiveness, reducing the potential for carryover. In certain high-tax scenarios, using the Foreign Tax Credit independently might be more beneficial.
Credit versus Deduction
Rather than opting for a credit, one can deduct eligible foreign income taxes via Schedule A (Form 1040), Itemized Deductions. Electing the credit forgoes that year’s foreign taxes as a deduction.
Foreign Taxes Eligible for a Credit
Eligible taxes include those on income, war profits, and excess profits paid or accrued during the tax year to any foreign nation, U.S. possession, or any political subdivision thereof. This encompasses taxes paid in lieu of standard foreign taxes.
Foreign Taxes Not Eligible for a Credit
Credits are not permitted for taxes not legally owed or amounts eligible for foreign refunds. A credit for any excess tax paid is disallowed without seeking reduction to the actual owed amount.
Accrual versus Cash Method
The Foreign Tax Credit can be calculated using either the accrued or paid method. Typically, the paid basis suits calendar year cycles akin to the U.S., whereas the accrued basis fits fiscal year foreign cycles. The accrued method aligns U.S. tax recognition with the foreign fiscal year-end, simplifying withholdings and future tax reconciliations. Once chosen, the accrued method must be consistently applied. While beneficial in the final year abroad, the accrued method may complicate initial assignment tax costs due to timing differences.
Definition of a Foreign Country
Under IRC Section 901, a ‘foreign country’ is any territory under a non-U.S. government. It encompasses foreign states and subdivisions, including cities or provinces, as well as U.S. possessions like Puerto Rico, Guam, the Northern Mariana Islands, and American Samoa.
Detailed Breakdown:
Form 1116 – Page 1:
At the top, this page is utilized to select the appropriate category of income. The subsequent Part I, titled "Taxable Income or Loss From Sources Outside the United States," is designated for listing the income received from various countries, along with the associated category of income and both direct and indirect expenses.
Form 1116 – Page 2 (Bottom):
Part II, known as “Foreign Taxes Paid or Accrued,” allows taxpayers to elect either the Taxes Paid or Accrued Method. Here, one should list applicable foreign taxes that qualify for the Foreign Tax Credit.
Form 1116 – Page 2:
Part III – Figuring the Credit: This section is for adjusting the Paid or Accrued taxes based on loss carrybacks and carryforwards, taking into account any reductions due to the Foreign Earned Income Exclusion. It also involves calculating the limiting factor that might reduce the allowable credit.
Part IV – Summary of Credits from Separate Parts III: This part should be completed only if you are filing more than one Form 1116 due to having multiple categories of income.
Foreign Currency Conversion:
All amounts on Form 1116 should be reported in U.S. dollars unless Part II specifies otherwise. If a conversion from foreign currency is necessary, a detailed explanation of the conversion rate calculation should be attached.
For credits claimed for taxes paid, use the exchange rate effective on the day the foreign taxes were paid, or withheld. In case of refunds, use the rate effective at the time of payment, not at refund receipt.
If accounting for foreign income taxes on an accrual basis, generally the average exchange rate for the relevant tax year should be used.
Categories of Income: A separate Form 1116 is required for each category of foreign source income listed above Part I:
a. Passive Category Income:
This includes both passive income and specified passive category income. However, it excludes gains from transactions related to business inventory and certain financial instruments and does not cover income from controlled foreign corporations (CFCs) based on ownership and role.
b. General Category Income:
This encompasses incomes not classified under passive. It includes employment income, income from active business operations, and gains from the sale of business-used inventory or depreciable property.
Financial Services Income: Typically treated as general category income if generated by a financial services entity engaged predominantly in banking, insurance, or similar businesses. This category includes both passive and some incidental income derived from these activities.
Professionals must ensure thorough documentation and accurate reporting when claiming the Foreign Tax Credit, utilizing Form 1116 comprehensively for compliance and maximization of eligible credits.