By claiming the Foreign Tax Credit, many expats won’t owe any US taxes.
Whether this is true for you depends on several factors, notably where you reside and whether you pay or accrue foreign income taxes.
In this article we’ll look at how the Foreign Tax Credit works, how to claim it, and whether it’s the best option for you.
In this article, you’ll learn about:
• What is the Foreign Tax Credit?
• What types of foreign taxes can you claim credits for?
• How to claim the Foreign Tax Credit?
• How to file IRS Form 1116
• What is the Foreign Tax Credit Carryover?
• Should you claim the Foreign Tax Credit or the Foreign Earned Income Exclusion?
• Roth IRAs and the Foreign Tax Credit
• Can you claim the Child Tax Credit and the Foreign Tax Credit?
What is the Foreign Tax Credit?
The Foreign Tax Credit is an IRS provision that helps expats can claim to reduce their US tax liability.
Claiming the FTC gives expats US tax credits based on the equivalent value of foreign income taxes that they’ve paid abroad.
This means that if you’ve paid higher rates of income tax abroad in your host country compared to the US tax rates, you generally will not owe any US tax. This applies to most expats who are residents in European countries as well as Canada, or any other country with higher income tax rates than the US.
The Foreign Tax Credit isn’t applied automatically; you have to claim it when you file your US federal tax return from abroad each year.
There are a number of restrictions, qualifications and other factors to consider though, including whether it’s preferable to claim the Foreign Earned Income Exclusion and/or the Foreign Tax Credit.
What types of foreign taxes can you claim the FTC for?
There are some limitations in terms of which foreign income taxes you’ve paid that you can claim US tax credits in lieu of, namely:
1. The tax must be imposed on you
To claim the Foreign Tax Credit, the foreign taxes must have been imposed on you, which means that you are legally obliged to pay them. This includes income taxes deducted from your wages at source, as well as those you have to pay when you file at the end of the tax year.
2. You must have paid (or accrued) the foreign tax
You are required to have actually paid or accrued the foreign income tax at the time you are claiming the FTC, and you must be able to demonstrate this to the IRS.
3. The tax must be the legal and actual foreign tax liability
The amount of US tax credits you can claim with the FTC cannot exceed the exact amount of tax you were legally required to pay in the corresponding period. So, if you overpay a foreign tax for example, either unintentionally or because you are required to pay an estimated amount in advance for the next tax year, you couldn’t claim the FTC on the additional amount despite having paid it.
4. The tax must be an income tax
Examples of taxes that might seem like an income tax but that aren’t creditable with the Foreign Tax Credit are foreign social security taxes, wealth taxes, fines and penalties, and inheritance taxes.
Special care is to be taken and expert advise should be sought in your residence country. For example, if you like in France the CSG (Cotisation sociale generalisée) and the CRDS (Contribution de Remboursement de la Dette Sociale) are considered for US tax purposes to be the equivalent of income taxes, irrespective their being referred to in France as social charges. - Jonathan Hadida, Hadida Tax
5. Paid or Accrued
As mentioned earlier, the foreign tax must have been either be paid or accrued in the tax year. The question as to whether you should claim on the paid or accrued basis depends on where you live and your plans in the future. For example, a taxpayer in the UK is more likely to be on the paid basis as opposed to a taxpayer in many other countries due to the UK’s odd (April 6-April 5 tax year). Guidance from a tax professional is recommended to be sought.
How to claim the Foreign Tax Credit?
To claim the Foreign Tax Credit, you are required to file IRS Form 1116 with Form 1040.
Form 1116 is used for claiming the Foreign Tax Credit for individuals, estates, and trusts. There’s a separate form for claiming foreign corporation tax credits, IRS Form 1118.
Filing IRS Form 1116
You have to file a separate Form 1116 for each type of income you have, such as general limitation income (e.g. employment income) and passive income (e.g. from rents or dividends). You will also need to file multiple Form 1116s if you have income in more than three different countries.
Before adding your income to Form 1116, you have to convert it to US dollars, generally using the average FX rate for the year.
Form 1116 is a two page form with four parts. It’s not a simple form, and most expats should seek professional assistance.
In Part I, you input your foreign income and the deductions and expenses relating to that income.
In Part II, you report the foreign income taxes you’ve paid or accrued, in US dollars.
In Part III, you work out the amount of the US tax credits you can claim, looking at such elements as the income already excluded by the foreign earned income exclusion.
In Part IV, you report figures from any other Form 1116s you are filing, if applicable.
Due to the complex nature of this form, we highly recommend the use of a tax professional.
Is the Foreign Tax Credit a refundable credit?
No, the Foreign Tax Credit is not a refundable credit, so if you paid more foreign income tax than the US tax that you owe, you cannot claim the difference as a refund. The difference can be carried over to future years or carried back one year, however.
What is the Foreign Tax Credit Carryover?
If you can claim more US tax credits than the US tax you owe with the FTC, the difference is known as the FTC ‘carryover’ amount, and you either can carry it back to the previous year, or carry it forward for up to 10 years.
So for example, if you are single and live in the UK in 2022 and earned the equivalent of $100,000, your UK tax would be approximately $24,800 . If you file Form 1116, you would receive $24,800 of US tax credits. Your US income tax liability would be approximately $15,000 though. This means that you can carry over the difference of approximately $9,800 ) of US tax credits to carry forward.
While you may not need to use the Foreign Tax Credit carryovers while you’re still in the UK, you can carry them forward for up to 10 years, or. They may come in handy should you move to a lower taxed jurisdiction or should you receive a tax free payment in your country of residence (e.g. a tax free severance payout in France). Additionally, if you did not have enough foreign tax credits to offset your foreign sourced income in the preceding year, you may be able to carry back the foreign tax credit (one year.) Again, assistance from a tax professional is always recommended.
Should expats claim the Foreign Tax Credit or the Foreign Earned Income Exclusion?
One of the most common questions that expats should ask is whether they should claim the Foreign Tax Credit or the Foreign Earned Income Exclusion, or both?.
While the FEIE can only be applied to earned income, and only up to a maximum threshold, the FTC can be applied to any income that has been taxed abroad and up to a value dependent on the value of the foreign income taxes that you’ve paid.
As an example, if all of your income is from employment abroad and your total earned income received is less than the FEIE limit, you might claim the FEIE, especially if you haven’t had to pay foreign income taxes (or if you paid foreign tax at a lower rate than the IRS rates), perhaps because you live in a country with low or no income taxes, or if you’re a digital nomad and you travelled between different countries working remotely without becoming a tax resident anywhere.
If you paid foreign income tax at higher rates than the US rates however, or if your income is more than the FEIE limit, and if you have different income types, you are often better off claiming the Foreign Tax Credit. There are circumstances when you might also claim both to apply to different types of your income.
The best advice is to have a conversation with your expat tax professional.
Ron rented out his apartment in Florida and moved to London, UK in December 2021, to take the opportunity to live in Europe for a while thanks to working remotely. In 2022, his income from employment was $140,000. As his income from employment is more than the Foreign Earned Income Exclusion limit for 2022 and he also has passive income from rent from his apartment in the US, and UK income taxes are higher than US rates, he claims the Foreign Tax Credit, which eradicates his US tax bill and leaves him with excess US tax credits that he can carry forward and use when he returns to live in the States.
Roth IRAs and the Foreign Tax Credit
Just like in the US, expats can contribute to Roth IRAs from taxable income to receive tax-free distributions when they retire. If you claim the Foreign Earned Income Exclusion though, your taxable income may be reduced to zero, meaning you can’t make Roth IRA contributions.
If you claim the Foreign Tax Credit on the other hand, you can generally, make these contributions (subject to other terms of Roth IRA eligibility), so retirement planning may be a factor that affects the decision of which to claim.
Can you claim the Child Tax Credit and the Foreign Tax Credit?
The Child Tax Credit lets American parents of dependent children who have US social security numbers claim a $2,000 tax credit per child. This applies to expats too (although the additional Child Tax Credit amount and advance payments provided as part of Covid-19 relief measures weren’t made available to most expats).
If you have used the Foreign Tax Credit to reduce your US tax bill to zero already, you can still claim the Child Tax Credit and receive a $1,400 tax refund per child each year.
If you claim the Foreign Earned Income Exclusion on the other hand, you won’t be able to claim the refundable part of the Child Tax Credit, so this can be another factor that determines which is best to claim.
If you have any questions, don't hesitate to contact us.
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