Understanding the U.S. Foreign Tax Credit

Tax Professionals' Resource
September 7, 2012 — 1,309 views  
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Many American citizens choose to leave the United States and live abroad for a variety of reasons. Members of the Foreign Service are posted in troublesome nations, engineers flock toward the thriving tech market in Asia and savvy businessmen head to the oil fields of the Middle East. InMotion estimates that there are between four and six million Americans living abroad as of 2012. In any case, these individuals are subject to the tax laws of both their destination country and the United States.

Fortunately, tax provisions have been set in place by the Internal Revenue Service (IRS) to help expatriates and others avoid the "double taxation" that can result from such situations. These stipulations should be studied by accounting and tax professionals who deal in global tax law.

Foreign Tax Credit

According to the IRS website, four conditions must be met by a person who wishes to qualify for foreign tax credit. These are listed below.

1.) A foreign tax must be imposed upon an individual.

2.) A foreign worker must have paid or accrued the tax over time in the respective country.

3.) The tax must be a legal and actual foreign tax liability.

4.) The tax must be an income tax - property and other legal taxes are not covered.

Deductions and forms

Over the course of a year, a person can choose the specific amount of foreign income taxes that he or she wants to count as an itemized deduction. These must be explicitly specified on Form 1040, Schedule A, according to the IRS. For more detailed foreign tax credit, Form 1116, Form 1040 and Form 1040NR should be completed.

One thing to look out for is excluded tax underneath the foreign earned income or housing exclusion - it is illegal to claim this as a deduction because this specific income is not taxed by the United States.

If you are planning on living in a foreign country, or are a tax professional who is working with people who do, you need to be aware of the IRS' strict position on foreign tax credit. If a person does not meet the above criteria, unfortunately he or she will be subject to the double taxation that applies to some expatriates.

If all else fails, one could simply revoke their United States or foreign citizenship to avoid taxation - however, this is a severe step and should only be used as an utter last resort.

Tax Professionals' Resource