There are certain situations where people will be subject to tax on the same income twice. Who are these people? People who are residents of one country and earn income in another.
For example, US citizens and residents are subject to tax on their worldwide income. That means a US citizen has to pay US income tax on income they earn anywhere in the world—and that even includes when they pay tax on that income to the other country where it was earned.
Doesn’t seem too fair, does it? Well, luckily the US government agrees with you. The Internal Revenue Code (IRC) provide several types of relief from dual taxation so you’re not paying tax twice on the same income.
The main two types of relief you will see from dual taxation provided by the Internal Revenue Code is the Foreign Earned Income Exclusion (FEIE) and the Foreign Tax Credit (FTC).
Foreign Earned Income Exclusion (FEIE)
The FEIE allows qualifying US citizens and residents, who have a tax home in a foreign country, and earn income in said foreign country to exclude from their US taxable income their foreign income up to a specified amount. This exclusion also applies to certain amounts related to employees who receive housing allowances from their employees while living overseas.
So how much can you exclude on an annual basis? For the 2019 tax year, $105,900 can be excluded. For the 2020 tax year, $107,600 can be excluded. Just to note—this is the maximum possible exclusion. The exclusion is limited to the lesser of the individual’s foreign earned income over their exclusion for foreign housing costs, or the maximum exclusion amount time the number of qualifying days the taxpayer spends overseas in a foreign country.
The first thing a person must have to be eligible for the FEIE is “foreign earned income”. Generally, this includes foreign source wages, salaries, commissions, bonuses, lodging, car use, tips and other forms of compensation for the rendering of personal services. It does not however include passive income, such as rents, royalties, interest, dividends, etc. or other income that is investment in nature and not from the person’s everyday job. For example, lets say John, an US citizen and an attorney, works overseas in Country X. During the year John worked there, John earns $100,000 in wages and $1,000 in interest from a bank account he set up in Country X. Of the income he earned, only the $100,000 would qualify as “foreign earned income” and could qualify for the exclusion where the $1,000 in interest income would not qualify.
Second, a person must be a qualifying US citizen or resident. This generally requires two things—(1) that your tax home be in a foreign country; and (2) that either (A) you are a “bona fide resident” of the foreign country or (B) you meet the physical presence of being in a foreign country for the tax year.
Generally, a tax home is where an individual keeps their primary place of business regardless of where they maintain a family home. This rule is dependent upon whether the individual’s work assignment is temporary or indefinite. For example, if John moved to Country X to work for his new employer on an indefinite contract, while still maintaining a home in the US for his wife and children, he may be able to argue that his tax home was in Country X. However, if we change one fact, such that John’s employment contract was only for a two year period, it would seem that his work assignment is temporary and not meet this tax home test. This test is highly fact dependent and requires a deep review of case law if you are on the fence of making this test.
After considering the tax home test, you have to consider whether you meet either the “bona fide residence” test of the “physical presence” test.
Generally, the “bona fide residence” test is met if a US person establishes that they are a “bona fide resident” in a foreign country or countries for an uninterrupted period that includes a full tax year. The “bona fide resident” definition is a test that requires the analysis of many factors, including, the person’s intent of the trip, and the nature and length of the stay abroad. This again if a very fact dependent test and requires a careful review of court cases on point. However, as a rule of thumb, if you live in a foreign country or countries from January 1 through December 31 of a given year and qualify as a citizen of the foreign country or countries, you will likely meet this test.
Alternatively, if you cannot show that you meet the “bona fide residence” test, then you maybe to show that you meet the “physical presence” test. This test is much more bright line that the rules covered for either the “tax home” test or the “bona fide residence” test—the US person must have been present in a foreign country or countries for 330 days out of any consecutive 12-month period. For purposes of this test, any period of 12 consecutive months may be used, so long as the 330 days falls within the period.
Once you can show that you have foreign earned income, you meet the tax home test, and either the bona fide residence test or the physical presence test, you have to consider any potential limits on the FEIE you are allowed. The max FEIE for the 2020 tax year is $107,600, this max exclusion can be lowered for a variety of reasons.
The first limit to the max FEIE allowed is the amount of foreign earned income over any exclusion provided for foreign housing costs. The calculation of the exclusion for foreign housing costs is discussed later. Second, the max FEIE is limited by multiplying the max limit by the number of qualifying days the taxpayer spends in a foreign country or countries. Qualifying days for purposes of this calculation are the number of days a taxpayer meets the tax home requirement and either the bona fide residence or physical presence test. Lets continue our example with John. John, who moved to Country X, earned $100,000 of income from his employment as an attorney, meets the “tax home” test and the “physical presence” test as he spent 330 days in the current year in Country X. The maximum exclusion John will be entitled to is $107,600 times 330 days in a foreign country over 365 days in the given year. In other words, John would be entitled to a max FEIE of $97,282—less than the full amount of foreign income he earned in the year.
In addition to claiming an exclusion for foreign income earned, US persons who live and work abroad may elect to exclude or deduct an additional amount based upon their foreign housing expenses. The amount excludable under this additional provision of the FEIE is beyond the scope of this article, but simply stated is subject to a floor of 16% of the FEIE exclusion and a ceiling of 30% of the FEIE. To bring this amount to a hard number, for the 2020 tax year the max foreign housing cost exclusion is $15,064. The foreign housing expense exclusion applies to foreign housing costs and employer-provided amounts, which includes amounts paid to an individual or paid on their behalf by their employer.
Foreign Tax Credit
In addition to providing the FEIE as a mechanism to prevent the double taxation of foreign earned income, the IRS also provides a credit against an individual’s gross tax liability for foreign tax paid, This is better known as the Foreign Tax Credit (FTC). The FTC is a complex calculation and is subject to numerous limitations. However, it is worth noting that you cannot take a tax credit for foreign taxes paid upon the same income that the FEIE is taken. If you did this, you would be receiving a double benefit.
For example, lets expand our example with John and assume that he paid $1,000 of tax on his foreign earned income and that he additionally earns $50,000 of US source income. Before considering the FEIE or the FTC, if we assume that all $150,000 of his worldwide income was subject to the top marginal US tax rate of 37%, John’s gross US tax liability would be $55,500. Now, lets assume John lives in a world where he can elect both the FEIE to completely eliminate his $100,000 in foreign earned income, reducing his taxable income $50,000, and then take a FTC for the full $1,000 against his remaining US tax liability, he would be able to take a credit for foreign taxes against his remaining US tax liability for income that was never subject to dual taxation in the US.
Generally, the FTC is allowed for any income, war profits and excess profits taxes paid or accrued in a given tax year to a foreign country. This also includes taxes paid in lieu of income, as well as taxes withheld on income earned in foreign countries.
As we mentioned earlier, the FTC is subject to several limitations. Simply put, the FTC is limited such that it is only credited against US tax on foreign source income. The FTC limitation calculation can be expressed by the following equation:
(Foreign Source Income / Worldwide Income) X US taxes
While this calculation looks simple, its chalk full of complex nuances and even had tax professionals who dedicate their entire careers to understanding and applying the credit correctly.
So what is foreign source income? The definition of foreign source income is dictated by Internal Revenue Code 861 and its regulations, but as a rule of thumb includes income from all geographic sources outside the US. It does not matter whether the foreign income is from one country or many countries.
The denominator of this calculation, worldwide income, is exactly what it sounds like—it is the taxpayer’s income from both US and foreign sources.
To further the complication of this limitation, the limitation is tracked amongst separate types of income. Specifically, there are four buckets of income that the FTC tracked against—general category income, passive category income, IRC 951A Global Intangible Low Tax Income (“GILTI”), and foreign branch income. General category income follows its general definition, and generally includes income from a individual’s everyday business. Passive income also follows its normal definition, and generally includes rents, royalties, interest, dividends, and other investment income that the individual does materially participate in. IRC 951A GILTI income and foreign branch income are beyond the scope of this article, but generally include income from foreign corporations or operations.
Overall losses (an “OFL”) in each one of these categories can be used to offset US source income in the denominator of the FTC limitation calculation but must be first offset against income in the other foreign categories. If a OFL from one category is great enough to be offset against US source income, the individual must recapture an OFL loss in a later year by recharacterizing foreign source taxable income as US source income to the extent of the prior OFL.
Foreign taxes paid or accrued that exceeds the amount of the overall limitation may be carried forward up to 10 years, and even carried back in the preceding year to the extent allowed by the FTC limitation calculated for the preceding or carryforward year.
IN closing, both the FEIE and the FTC are complex and nuanced provisions that are aimed at preventing US taxpayers from being subject to two layers of tax on their foreign source income. If you have questions as to how these provisions and potentially other dual taxation mitigating provisions could be applicable to you or your business, please schedule a consultation to discuss your questions with us.