The US Foreign Tax Credit - A Guide For Americans Living Abroad

Quick gut check. Does this sound like you?

1. You’re an American expat living abroad.
2. You earn income in your host country (or anywhere!)
3. Your annual global income is more than IRS Foreign Tax Credit minimum filing thresholds¹.

If you’re checking all the boxes above, you have to file an annual US tax return. This realization typically sparks concern about double taxation for some Americans living and working abroad to — hopefully — defuse concerns, let’s start with the good news.

The Internal Revenue Service (IRS) has provisions in place to prevent citizens from being taxed twice. In many cases, with the proper planning and guidance, expats can eliminate their US tax liability altogether.

📑 Table of Contents
Why do Americans living abroad have to file US taxes? How are tax treaties used to eliminate double taxation for Americans? What is the US Foreign Tax Credit? When should Americans living abroad use the Foreign Tax Credit? Pay US tax or receive an IRS refund with Wise

This article has been written in collaboration with Katelynn Minott, CEO and Managing CPA at Bright!Tax US Expat Tax Services.

This article builds on just one example. For those paying taxes in another country, the Foreign Tax Credit may offer relief for your US return. Otherwise known as the FTC, this deduction can reduce your US tax liability and help ensure you aren’t taxed twice on the same income².

Below, we will run through essential info about how the Foreign Tax Credit works. We’ll also touch on how to claim it on Form 1116³.

If you’re paying US tax from abroad or if you are due a refund from the IRS, you could save on the costs of international payments and currency conversion with Wise and the Wise multi-currency Account. But we’ll get to that later.

Why do Americans living abroad have to file US taxes?

The answer is simple. The US is one of only two countries in the world that has a citizenship-based tax system. What does this mean exactly?

If you are a US citizen or resident alien, you need to report and pay taxes on your worldwide income. Reiterating, even if you’re living abroad you’ll need to file your US taxes and pay any owed amounts.

How are tax treaties used to eliminate double taxation for Americans?

The US has international tax treaties with almost 70 foreign nations. Countries create these agreements with the intention of settling issues involving double taxation for each other’s citizens.

This works effectively in eliminating double taxation sometimes — one example being if the treaty changes the “source” of income from the US to a foreign source.

However, these treaties contain what’s called a ‘savings clause,’ which says that the US has the right to tax its citizens as if the treaty did not come into effect in the first place. As a result, American expats still have to file a US tax return in most cases.

There are some exceptions to the savings clause, but they vary by country.

In countries where there are exceptions, treaties allow expats to claim tax credits when they file in one country against income that has been taxed in another country.

Because treaties can’t entirely eliminate double taxation, the Foreign Tax Credit becomes a useful tool for American expats when filing a US tax return from abroad once they have already filed their foreign taxes.

What is the US Foreign Tax Credit?

The Foreign Tax Credit eliminates double taxation by providing dollar-for-dollar credits, for the amount of foreign taxes already paid. The amount of foreign tax paid or accrued (used to calculate the Foreign Tax Credit) is known as qualified foreign tax.

The IRS offers a few key criteria to determine whether or not you qualify⁴:

1. The tax must be imposed on you
2. You must have paid or accrued the tax
3. The tax must be the legal and actual foreign tax liability
4. The tax must be an income tax or a tax in lieu of an income tax

The tax must be imposed on you

An example of this is a tax that is automatically deducted from your wages. If the tax is not mandatory, you will not qualify for the FTC.

You must have paid or accrued the tax

The amount of the foreign tax that qualifies for the credit must not be reduced by any refunds of foreign tax made by the government of the foreign country. So, if you paid taxes abroad, but then later received a refund on some or all of the amount, you can’t claim TFC for the refunded amount.

The tax must be a legal and actual foreign tax liability

The taxes must be a legal tax and you must be required to pay the tax. This refers to most Americans who settle in another country and are required to pay income taxes.

An example of someone who wouldn’t be able to claim the FTC is a digital nomad. They have no formal country of residence (and therefore no imposed income tax).

The tax must be an income tax or a tax in lieu of an income tax

The IRS has stipulations on what counts as a foreign ‘income’ tax. The following are some foreign taxes that cannot be offset using the US Foreign Tax Credit:

Taxes on excluded income (such as the foreign earned income exclusion) Taxes for which you can only take an itemized deduction Taxes on foreign mineral income Taxes from international boycott operations A portion of taxes on combined foreign oil and gas income Taxes of US persons controlling foreign corporations and partnerships who fail to file required information returns Taxes related to a foreign tax splitting event Social security taxes paid or accrued to a foreign country with which the United States has a social security agreement

Some expats live in countries that do not have income tax but have other types of taxes. If you paid foreign taxes in lieu of income taxes, you still may be able to offset them with the FTC. Taxes that qualify must be imposed in place of an income tax.

Since this differs from country to country, it’s important to seek assistance from an expat tax professional. By using credits and exclusions, sometimes even retroactively, American expats can often eradicate any US tax liability. In some cases, they even receive a refund.

In general, the FTC is the best option for expats whose foreign income tax payments exceed what they would otherwise pay to the US on all of their global income.

When should Americans living abroad use the Foreign Tax Credit?

If you are paying taxes abroad on your worldwide income, the FTC can help reduce or eliminate your tax bill.

Unlike The Foreign Earned Income Exclusion (FEIE), which allows expats to exclude the first 108,700 USD of their earned income from US taxation, the Foreign Tax Credit can be used on both earned and unearned income, as long as foreign income taxes have been paid.

This is especially noteworthy for expats with dependent children. Expat parents who claim the FEIE, cannot claim the refundable child tax credits.

The Foreign Tax Credit allows them to do so. In other words, when comparing the FEIE and FTC, claiming the latter would allow you to take advantage of the refundable Child Tax Credit⁵.

This can result in a refund of up to 1400 USD per dependent child (for those who reside abroad). It’s even available to those who haven’t paid into the US tax system.

As with all things tax, US foreign tax credit can be relatively complex. Seeking professional advice is especially helpful in defining your obligations & tax strategy — both in the US and abroad.

What is the IRS Form 1116?

IRS Form 1116 — Foreign Tax Credit — ⁶ is a two-page form that determines the value of US credits available to claim. This figure ultimately is based on the amount of foreign taxes paid.

Here’s a quick look at the type of information this form captures:

• Which country your foreign taxes were paid (in both foreign currency and USD)
• Income info for these foreign taxes

It also digs into the nuances of different categories of foreign earned income:

• Passive (ex. investments, rental income)
• General (ex. pension, wages, self-employment income)
• Income resourced by Treaty Deductions and expenses related to that income are also disclosed, as well as any carryover or carryback credits. But we’ll get to this later.

Foreign Tax Credit limitations

Not all expats are eligible to claim the Foreign Tax Credit nor should they. If you live in a country with a lower tax rate than the US or if you live in an income tax-free country⁷, the Foreign Tax Credit may not be effective in completely eliminating your US tax bill.

Digital nomads moving between countries and not attracting foreign taxes, will also not be able to use the FTC. Some foreign taxes paid that are not creditable are sales taxes, luxury taxes, foreign real estate taxes, turnover taxes, and wealth taxes.

The FTC can only be applied to foreign income. Whether your income is foreign or not depends on what type of income it is and where it was earned.

For example, if the type of income is wages, where locationally you perform this work will be the determining factor. For interest income, the location of the bank is required to determine if the income is foreign.

The same follows for rental income and dividends. The location of the rental property and the payer company location, in the case of dividends, determine what is considered foreign income or not.

Another key thought — you can only use the FTC up to the amount of the US tax related to your income.

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For example:

If you earn 100 USD in wages, and owe the IRS 25 USD tax on those wages, but have paid 30 USD in France, you can only take 25 USD of credit, to reduce your US tax bill to 0 USD. But, the excess 5 USD can be carried forward up to 10 years for use in another tax return.

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As promised earlier, this leads us into carryover credits.

Foreign Tax Credit carryover and carryback

In cases where you claimed more foreign income tax credit than the US income tax you owe, you can use the amount to fully eliminate your US tax bill.

The remaining, unused US tax credits can be carried forward up to ten tax years and carried back to the previous tax year. This can also mitigate potential timing differences between different countries’ tax years

The carryover mechanism can be especially useful for American expats who live abroad for several years.

What about US social security taxes?

The United States has entered into agreements, called Totalization Agreements⁸, with several nations for the purpose of avoiding double taxation on income, as it relates to social security taxes.

Foreign social security taxes are generally not considered a foreign income tax qualifying for the Foreign Tax Credit. The agreement helps fill gaps in the coverage records of people who have divided their careers between two countries by combining, or totalizing, the periods of coverage earned in each country.

Based on your circumstances, the Totalization Agreement determines which country you must pay Social Security tax⁹. And it’s not all bad news if you find yourself paying US social security.

You are ultimately accumulating benefits for an eventual US social security retirement payment, which you are entitled to collect from anywhere in the world!

Pay US tax or receive an IRS refund with Wise

If you’re paying your US tax from overseas, or if you need to receive an IRS refund but live overseas you could save with Wise and the Wise multi-currency account.

If you’re paying US taxes using an international transfer, then Wise could mean that you save significantly versus using your regular bank. All Wise international payments use the real mid-market exchange rate with no markups, and low transparent fees — making this a far cheaper, faster, and easier option than a traditional bank.

And if you’re waiting on a refund from the IRS but usually manage your money in a different currency, why not check out the Wise multi-currency account? Open a Wise account online and for free, and get paid fee-free by local transfer in USD.

You can then switch your funds to the currency you need, using the real exchange rate, and spend without foreign transaction fees on your linked Wise international debit card. Accounts can hold and handle 54 currencies, making them a great choice for Americans living all over the world.

Pay your taxes
the Wise way

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Tax isn’t a favorite topic for many Americans living abroad — but with the US foreign tax credit, you may be able to eliminate double taxation on income, reducing your US tax bill. And don’t forget, if you’re living an international lifestyle and need to send or receive payments across borders you could save, with Wise and the Wise multi-currency account.

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This article has been written in collaboration with Katelynn Minott, the CEO and Managing CPA at Bright!Tax US Expat Tax Services. Katelynn is the CEO at Bright!Tax US Expat Tax Services, and has helped thousands of American expats become compliant with their US filing obligations over the last 10 years. She spent time as an expat herself, residing in both Chile and Brazil. She was recognized by CPA Practice Advisor's with a 40 under 40 award in 2021 and is a regular contributor to various media outlets including CNBC, Forbes, and Fast Company.

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Sources:

1. IRS - Tax inflation adjustments
2. Investopedia - Double taxation
3. IRS - Form 1116
4. IRS - Foreign taxes that qualify for foreign tax credit
5. IRS - Child free tax credit
6. IRS - Form 1116 (pdf)
7. Investopedia - Countries without income taxes
8. SSA - Totalization agreements
9. IRS - Totalization agreements

Sources checked on 05.13.2022