How to Avoid Double Tax with the Foreign Tax Credit
Because paying tax once is bad enough.
The foreign tax credit is probably the easiest to understand of the “Big Three” expat tax benefits (the other two of which are the foreign earned income exclusion and the foreign housing deduction/exclusion). However, there are definitely some misconceptions about how it works, and it can get a little complicated in certain situations.
So, let’s discuss.
Before We Go Any Further
Let’s first make sure this is a topic you even need to know about.
If you’re a digital nomad, travelling around spending less than 180 days in each country, then you’re probably not paying tax in any country outside the US. Click here for an article with more detail on how non-US tax works in this situation.
In that case, the foreign tax credit won’t do you any good. The foreign tax credit allows you to reduce your US tax bill dollar-for-dollar by the amount of non-US tax you pay. So, if you don’t pay any foreign income tax at all, you don’t get (or need) any help from the foreign tax credit.
What Sort of Foreign Taxes are We Talking About?
Only foreign income taxes. Not foreign sales, property, excise, or any other tax. It must be a tax that’s pretty much like the US federal income tax.
Some nuances here:
- The US federal income tax is imposed on net income after allowable deductions. However, a foreign tax imposed on gross income can still be considered an income tax for purposes of the foreign tax credit.
- Negotiated amounts that you pay in lieu of an income tax can be treated as an income tax (and therefore be creditable against your US income tax).
- Any sort of income here works—it doesn’t have to be foreign earned income (as is the case with the foreign earned income exclusion and foreign housing deduction/exclusion). So, if you a pay a foreign income tax on investment income (interest, dividends, capital gain, etc.), you can reduce your US tax on that same income by the amount of foreign tax you paid.
What’s a “Credit” Exactly?
The powers that be actually did pretty good naming this tax term. If you pay a foreign tax, then you get credit against your US tax—you’re basically treated as already having paid that amount of US tax when you compute your final US tax bill.
Mechanically, your tax return first computes your adjusted gross income, and then you take out the standard deduction (or itemized deductions) to reach taxable income, on which you compute the amount of tax you owe. Then, if you paid any tax for which you can claim a foreign tax credit, you simply reduce the amount of US tax you owe by the amount of foreign tax you paid.
Does the US Need to Have a Treaty with the Other Country?
Nope. This is probably the biggest misconception with the foreign tax credit. Many people think you can take a foreign tax credit only if the US has a treaty in place with the country in which you paid the foreign tax.
But that’s simply not the case at all. The foreign tax credit is a matter of US law—you don’t need to use the benefits of a treaty to claim it.
Then, the terms of the foreign tax credit don’t require there to be a treaty in place for a foreign tax to be creditable. As long as the requirements discussed above are met, then you can claim the foreign tax credit on your return.
Let’s Look at an Example
Say that you move to a country with an income tax, and you live there permanently, so you’re subject to their tax. Then, you earn $100 of income, and the country imposes a 30% tax on that item of income. So, when you do your tax return in that country (or earlier if there’s a withholding or estimated payment regime), you’ll have to pay a $30 tax to the foreign country on that income.
Now, when you do your US tax return for that same year, let’s assume that the US tax rate on that item of income is also 30%. So, your US tax return will compute that you also owe $30 of US tax on that $100 of income.
However, this is where the foreign tax credit saves the day. Because you paid $30 of tax to a foreign country on this same item of income, you simply reduce your US tax bill on this income by $30 (down to $0). Easy peasy.
Things obviously get more complicated if the rates are different:
- If the US rate is higher than the foreign rate, then you’ll still have to pay some US tax. So, if the US tax rate is 40% in the example above, you’ll have to pay $10 to the US (and you already paid $30 to the foreign country).
- If the US rate is lower than the foreign rate, then you’ll have an “excess foreign tax credit” that you can carry forward and potentially use in later years. So, if the foreign rate is 40% in the example above, you’d only be able to reduce your US tax bill by $30 this year (because it’s only $30 in the first place), but you can carry $10 to a later year to potentially use to reduce the US tax on a similar item of income.
Bottom Line #1: You’ll Pay Tax Once, at the Highest Rate
Unlike the foreign tax credit, the foreign earned income exclusion can reduce the absolute amount of your worldwide tax bill. For example, if you live in the US and have a job making under about $100,000 per year, then you’ll pay a bunch of US tax. But you can reduce your worldwide tax bill down to $0 by simply being a digital nomad and qualifying for the foreign earned income exclusion.
With the foreign tax credit, on the other hand, you only reduce your US tax bill by the amount of non-US income tax you pay. So, you’ll always pay tax once, and the rate at which you pay is the higher of the foreign or US rate.
Bottom Line #2: Your Tax Base is Broader than if you Only Paid US Tax or Only Paid Foreign Tax
The US tax rules exempt certain income from US tax. Foreign tax rules can do the same thing.
When you’re an American living in another country, you only have to pay tax once (at the higher of the two rates), but the income on which you pay tax is broader than if you either (i) just lived in the US or (ii) were just a tax resident of the country where you live and were not an American.
For example, when you sell your principal residence, the general rule is that you are not subject to US tax on the first $250,000 of gain (or $500,000 if you are married). However, the country where you live may not have that rule–you may have to pay tax in that country on that income.
To illustrate it the other way, New Zealand doesn’t tax capital gain at all. So if you were only a New Zealand tax resident, you wouldn’t pay any income tax on your capital gain. But if you’re an American living in New Zealand, the New Zealand exemption from income tax only helps to the extent that the New Zealand tax would have otherwise been greater than US tax–you’re still required to pay US tax on your capital gain.
Should I use the Foreign Earned Income Exclusion or Foreign Tax Credit?
If you’re not a digital nomad (i.e., you’re a tax resident of a non-US country) and you have foreign earned income (i.e., you have a job, work as a freelancer, or own your own business), then you may be wondering whether you should use the foreign earned income exclusion or the foreign tax credit on your income below about $100,000. The answer is . . .
It depends. Sorry, but it does.
There are some common situations where one is better than the other, and these are discussed in my online course Tax-Savvy Expat Entrepreneur. Click here to learn more.
What if I Own my Own Business?
If you’re a digital nomad with a location-independent business, then this isn’t an issue you need to worry about. Neither you nor your business are subject to non-US income tax, so this issue just doesn’t come up.
However, if you plant yourself in a new country and have a business on the ground, then things can get a little complicated. Here are the three ingredients for this complicated scenario:
- You’ll probably operate your business through a legal entity (as opposed to just owning it in your own name) so you can have the liability protection and other benefits offered by using that structure.
- This legal entity will probably be classified as a corporation for US tax purposes—that’s the default treatment of almost all non-US legal entities.
- Finally, your resident country may impose an income tax on that legal entity (instead of, or in addition to, imposing an income tax on you personally).
You can take the foreign tax credit only for tax imposed on you. The tax here is imposed on your corporation, not you, so you can’t take a foreign tax credit for this tax.
Instead, the foreign tax essentially operates as a deduction, which is generally a bad result. You can generally avoid this result by electing for the non-US corporation to be “disregarded as an entity” separate from you for US tax purposes (or classified as a partnership if it has more than one owner). After that election, the entity’s income directly hits your US tax return, so you’re treated as paying the tax paid by the entity, meaning that you can now take the foreign tax credit.
Whether this election is a good idea in any particular circumstance requires a careful consideration of all relevant facts. It depends on the relative tax rates, absolute amount of income, and your plans for the money from this business. Click here if you have a situation like this and we can discuss the right way to go for you.
Ready to become an expert on this stuff? Click here to take the US Tax Masterclass for Americans Abroad (absolutely free).