If you are an American permanently living overseas, you should know three things about your tax liabilities:
- You must follow the taxation rules and laws of the foreign country you are currently living
- As an American citizen, you must also still file annual tax forms with the U.S. Internal Revenue Service (IRS)
- There are tax credits and deductions available to help prevent double taxation, but you have to claim them when you file
The Foreign Tax Credit is just one tool the IRS offers to offset the taxes you’ve already paid in your new homeland, but it is a good one. It recognizes that you’ve already paid taxes on your income, such as paycheck withholding and other income taxes, such as those required on tips, dividends, commissions, interest, bonuses, self-employment income and royalties. So, it is designed to reduce your U.S tax liabilities by giving you credit for some of those taxes already paid.
The Foreign Tax Credit can be claimed up to the amount of tax paid to a foreign jurisdiction. It is available to anyone who either worked in a foreign country or draws investment income from a foreign source. It does not apply to any type of income earned in the United States.
For the vast majority of expats, no U.S. taxes will be owed thanks to the Foreign Tax Credit. However, an additional advantage is that if the taxes paid exceed the annual credit limit, expats may be able to carry over for 10 years or carry back the excess for one tax year, providing even greater tax savings.
There are certain restrictions on the foreign taxes that qualify under the Foreign Tax Credit. The tax must be:
- Imposed by the foreign government and you had no choice but to pay
- Actually paid by you during the tax year
- A legal and actual foreign tax liability
- An income tax or its equivalent
In addition, it does not apply to taxes you could have legally avoided, taxes accrued to or paid to governments that are not recognized by the United States government or tax payments to governments that the United States recognizes as terrorism supporters. Tax treaties the U.S. has with other countries may also impact your Foreign Tax Credit.
Some expats believe that the Foreign Tax Credit and Foreign Earned Income Exclusion offer the same benefits, but that is generally a false conclusion. You can only claim one or the other, so it is worth the time to see which one is most beneficial for your family. It should be noted that if you earn income in a country where there the foreign tax is similar or higher than the U.S., the Foreign Tax Credit is typically your best option.
To claim the Foreign Tax Credit, make sure to complete and return Form 1116 on your federal tax return.