Working Abroad – Easing the Burden of Double Taxation

The Direct Foreign Income Tax Credit

So, you’ve been working abroad for a whole year and now it’s tax time.  In spite of the excitement of a new culture, the professional and monetary rewards, you now experience for the first time what the phrase “double taxation” really means.  The U.S. is going to tax your worldwide income (i.e., your foreign earnings) in the same way as if you had been living in Topeka all year.  At the same time your new overseas home country wants to collect its income tax, too, on those very same wages.

For example, suppose you earned $150,000 working and living in Paris (you lucky dog) and the French impose income taxes on you at, say, an effective 35% rate.  That’s $52,500, leaving you with net income of $97,500.   At the same time, the U.S. government wants to tax that same $150,000 at, say, a 30% effective rate, a second hit for $45,000.  If you had to pay both taxes in full your net income for the year would drop from $150,000 to $52,500, an effective combined tax rate of sixty-five percent.  Ouch!

Lucky for you the U.S. has long recognized this unfair consequence of its worldwide taxation system and the Code does something about it.  In fact, for 2013 you’re allowed to exclude up to $97,600 of foreign earnings and maybe some housing costs, too (more about this here).  Better still, if there’s any income left-over (as there would be in our example here) any French income taxes attributable to the remaining portion can be taken as a direct credit against your U.S. taxes owed for the year.

This direct “foreign tax credit”, or FTC, is the one provided for by §901 of the Internal Revenue Code.[1]  There are lots of technicalities here, and each one is a potential trap for the unwary, but the gist of the thing is that if you paid or accrued “income taxes” (i.e., not royalties for mineral extraction, government fees, and so on) to a foreign country you get to deduct that amount dollar-for-dollar from your U.S. taxes owed, up to the maximum allowed.

A big caution note here (there are lots so this isn’t the only one):  The total amount of foreign taxes paid that can be taken as a direct credit against your U.S. tax is capped at the total U.S. tax amount owed.

Let’s do a quick, back-of-the-envelope example using our Parisian expatriate as an example.  Suppose she earned the $150,000 and paid the French their $52,500 in tax.  In figuring her U.S. taxes our expatriate first excludes the allowed $97,600 (for the sake of simplicity, assume she has no housing costs to exclude), and pays U.S. tax on the remaining $150,000 – $97,600 = $52,400.  At 30% that’s a federal tax bill of  $15,720.

Can our expatriate take a credit against her U.S. taxes for the any of the $52,500 in paid French taxes?  Yes, but alas, not all of it.  Her maximum credit is the smaller of the U.S. tax bill ($15,720) and the foreign taxes admitted (those allocated to her remaining income taking the exclusion into account).

Still, if there are any “leftover” non-creditable foreign taxes they can be carried back and possibly used to reduce our expatriate’s prior year tax burden (and get her a refund).  If not that, they can also be carried forward up to ten years and hopefully used to offset other U.S. taxes later.

Sounds pretty good, right?  Well, it is.  Of course, she did have to pay the French all that money in the first place so it’s not like she’s getting off scot free.  And a lot of these calculations (which I’ve denominated in dollars) would have actually been carried out in euros so there are some exchange rate difficulties to be included (as well as deduction allocations, housing allowances, and lots of other stuff).

But this post at least lays out the gist of what’s going on.  I hope it helps you see how working abroad may complicate your tax life, and how a good tax advisor can help you when you need it.

[1] There’s a different foreign tax credit allowed for taxes paid “indirectly”, i.e., through an intermediary.  That’s the  §902 tax credit, a discussion of which can be found here.

This article is for informational purposes only and does not constitute legal advice.  You should consult a qualified attorney before taking any action.