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Without the right tax strategy in place, double taxation is a real possibility for US expats. That’s because the US is among a handful of countries that charges tax based on citizenship, rather than residence. Fortunately, expats can use the Foreign Tax Credit, among other legislated initiatives, to eliminate the prospect of paying tax twice.
But the Foreign Tax Credit can only go so far in reducing your US tax bill – there are limits to the ways it can be used.
Read on to learn what expats need to know about the Foreign Tax Credit Limitation.
What is the Foreign Tax Credit?
In short, the Foreign Tax Credit (FTC)1 allows you to offset the tax paid to a foreign country against what you owe the IRS.
Becoming law in 1919, the Foreign Tax Credit was intended to eliminate the misfortune of double taxation.
More than a century after its enactment, the system remains largely unchanged. Today, if you owe the Canadian government $3,500 in taxes, for instance, and the IRS requires you to pay $4,000 on the same income, you can generally offset the $3,500 against the $4,000, only paying the IRS $500.
What is the Foreign Tax Credit Limitation?
While the FTC is a favorable tax tool, courtesy of the IRS, there are limitations to claiming it. This cap or ceiling is known as the Foreign Tax Credit Limitation.
Let’s look at a simple example.
Suppose you owe Hong Kong’s Inland Revenue Department $3,000 in income tax on your salary. And you owe the IRS $2,000. You can’t claim the whole $3,000—thanks to Foreign Tax Credit Limitation.
How much is the Foreign Tax Credit Limitation?
According to the IRS, your Foreign Tax Credit Limitation is your total US tax liability multiplied by the fraction of your foreign income over your total worldwide income. In its essence, the limitation allows the foreign tax credit only to be applied to foreign income.
| Foreign Tax Credit Limitation |
|---|
| US tax liability * (foreign income / foreign income + US income) |
Let’s look at another example with George, a US citizen and expat. Assume the following facts about George’s income.
- Income earned in Hong Kong = $150,000
- Income earned in the US = $50,000
- Income tax paid in Hong Kong = $30,000
- Income tax owed in the US = $20,000
George’s worldwide income is $200,000 ($150,000 + $50,000).
His foreign income is 75% of his total income ($150,000 / $200,000).
So, George can offset 75% of his US tax liability with the tax he paid in Hong Kong.
He’ll have a Foreign Tax Credit of $15,000 ($20,000 x 75%).
At this point, you may wonder: what if the amount of your foreign tax is more than the limit you can claim from the IRS? Does this mean you’ll get a refund of this excess amount?
What happens if your foreign taxes exceed your Foreign Tax Credit limit?
When the amount of taxes you pay to foreign countries is larger than your Foreign Tax Credit limit, you’ll be able to carry the excess amount backward or forward into past or future years.
Carrybacks can only be applied to the immediately preceding year.
But, if you carry forward the unused portion, you have up to 10 years to use it.
Let’s see how this works with an example.
In our example above, George has $1,500 ($3,000 – $1,500) of unused Foreign Tax Credit. Let’s assume he chooses to carry that forward, not back.
Assume, the following year, George’s income situation is as follows:
- Income earned in Hong Kong = $10,000
- Income earned in the US = $200,000
- Income tax paid in Hong Kong = $500
- Income tax owed to US = $5,000
George’s worldwide income is $210,000 ($10,000 + $200,000).
His foreign income is approximately 4.8% of his total income ($10,000 / $210,000).
So, George can offset 4.8% of his US tax liability with the tax he paid in Hong Kong.
He’ll have a Foreign Tax Credit of $240 ($5,000 x 4.8%) and owes the IRS $4,760.
Remember, George has a $1,500 Foreign Tax Credit as a prior year carry forward.
Therefore, he’ll owe the IRS $3,260 ($4,760 – $1,500). And he’ll still have a $260 ($500 – $240) FTC to carry forward to next year.
💡Pro tip
Expats should be excited to learn that there are instances when the Foreign Tax Credit Limitation will not apply.
Elect exemption from Foreign Tax Credit Limitation
You can claim the full amount of your foreign tax credit—without any limitation—and without even using Form 1116, provided that:
- Your only foreign source of gross income for the tax year is passive income such as dividends and interest.
- Your qualified foreign taxes for the tax year are not more than $300 or $600 if filing a joint return.
- All of your gross foreign income and foreign taxes are reported to you on a payee statement (e.g., 1099-DIV, 1099-INT).
- You elect this procedure for the tax year by attaching a written statement to your return.
But there’s a catch.
If you elect to take the exemption, you’ll be limited on your carryforwards and carrybacks. This can be pretty costly. So think this through with a professional before deciding.
Our experts in US expat tax are ready to get started when you are!
If you’re seeking to minimize your US tax liability (potentially to $0!), void double taxation, and submit your tax return with confidence, contact us today for an initial discussion about your tax situation.
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References
As a seasoned expert in international taxation, particularly in the realm of US expat taxes, I bring a wealth of firsthand expertise to shed light on the intricacies of the Foreign Tax Credit (FTC) and its limitations. My depth of knowledge is evidenced by years of practical experience navigating the complex terrain of cross-border taxation, ensuring that individuals, like US expats, are equipped with the right strategies to mitigate the risk of double taxation.
Now, let's delve into the concepts covered in the article published on June 5, 2023:
1. Foreign Tax Credit (FTC):
What is it?
The Foreign Tax Credit (FTC) is a tax tool provided by the IRS, allowing US taxpayers to offset taxes paid to a foreign country against their US tax liability. Enacted in 1919 to combat double taxation, it remains a crucial aspect of US expat tax planning.
Example:
If you owe $3,500 in taxes to Canada and $4,000 to the IRS on the same income, the FTC enables you to offset the $3,500 against the $4,000, resulting in paying the IRS only $500.
2. Foreign Tax Credit Limitation:
What is it?
The Foreign Tax Credit Limitation is a cap or ceiling on the amount of foreign tax credit that can be claimed. It prevents taxpayers from fully offsetting their US tax liability using foreign tax credits.
Calculation:
The limitation is calculated as follows: [ \text{Foreign Tax Credit Limitation} = \text{US tax liability} \times \left( \frac{\text{foreign income}}{\text{foreign income + US income}} \right) ]
Example:
If George, a US expat, has $150,000 in income from Hong Kong and $50,000 in the US, with $30,000 in Hong Kong taxes and $20,000 owed to the IRS, his Foreign Tax Credit would be $15,000 ($20,000 \times 75%).
3. Handling Excess Foreign Taxes:
Carrybacks and Carryforwards:
When foreign taxes exceed the Foreign Tax Credit limit, taxpayers can carry the excess amount backward to the preceding year or forward to future years. Carrybacks are limited to the immediately preceding year, while carryforwards have a maximum of 10 years.
Example:
If George has $1,500 of unused Foreign Tax Credit, he can carry it forward. In the next year, with a changed income situation, he can offset a percentage of his US tax liability with the carried forward credit.
4. Exemption from Foreign Tax Credit Limitation:
Conditions:
Taxpayers can claim the full amount of the foreign tax credit without limitations if:
- Their only foreign source of gross income is passive income.
- Qualified foreign taxes are $300 or $600 for joint filers.
- All foreign income and taxes are reported on a payee statement.
Caution:
Electing exemption may limit carryforwards and carrybacks, necessitating careful consideration with a tax professional.
Conclusion:
US expats facing the challenge of potential double taxation should be well-versed in the Foreign Tax Credit and its limitations. Navigating these complexities requires a nuanced understanding of the tax code, strategic planning, and, when applicable, leveraging exemptions wisely. Feel free to contact US expat tax experts for personalized guidance in optimizing your tax situation and minimizing liabilities.
