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Tax Advice For Expats as published in The 2020 Expatriate's Guide To Living In The UK click here
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Foreign Tax Credit vs. Foreign Earned Income Exclusion – A Comparative Analysis
As an American Expat, you are required to comply with long-standing US tax policy that creates an obligation to continue filing US tax returns, even after a permanent move abroad. With the potential for double taxation to arise, taking advantage of the various tax breaks available in the United States is crucial. To this end, one of the most important tax planning opportunities impacting American Expats at all income levels is often neglected.
The choice between electing the foreign earned income exclusion or opting instead to claim a foreign tax credit can produce a variety of different outcomes that will continue to influence your tax situation for years after this initial decision is made. While both options may have the ability to reduce your US tax exposure to zero, the nuances of each and the underlying tax planning opportunities will vary. This article will provide an overview of the basic eligibility guidelines for these two important benefits and outline some of the specific scenarios that might lead you to choose one option over the other.
Foreign Earned Income Exclusion
The foreign earned income exclusion allows employees and self-employed individuals to exclude up to $107,600 (2020) of earned income from US tax. To qualify, the following requirements must be satisfied:
1. The taxpayer must receive earned income;
2. The taxpayer’s tax home must be located outside the United States; and
3. The taxpayer must meet either:
a. The physical presence test, or
b. The bona fide residence test.
Earned Income Requirement. For this purpose, earned income means payments for the performance of personal services. This can come in the form of salaries and wages or other taxable benefits provided through employment. Interest, dividends, capital gains, and other investment income are not treated as earned and not eligible to be excluded. Pension distributions, though attributable to services previously performed, are also classified as unearned income.
This is a straightforward determination for freelance service providers or individuals drawing a salary. However, it can become a bit more complicated for partners in a partnership or owners of businesses that require a substantial initial investment. Income will not qualify as earned if capital is a material factor in its production.
Tax Home Requirement. Tax home is defined as the city or general vicinity of the taxpayer ’s principal place of business or employment, regardless of the location of his or her residence. An overseas assignment that is less than one year generally will not result in a change of tax home.
Physical Presence Test. The physical presence test is based exclusively on time spent outside the United States. Taxpayers qualify by spending 330 full days in a foreign country during a consecutive twelve-month period. Time spent in international waters or airspace and partial days of presence will not be counted. The 330 days can be spent in any foreign country that is not subject to US travel restrictions. A two-week holiday in Italy would still be counted for purposes of this test for someone living and working in London.
Importantly, the twelve-month period does not need to coincide with the calendar year. This means that partial exclusions can be claimed when a foreign work assignment commences or concludes during a given year. If a partial exclusion is claimed, the maximum exclusion amount for that year will be prorated to account for the days from the other tax year that are used to qualify. A twelve-month period that runs from July 1, 2019, through June 30, 2020, would allow for an exclusion of $53,800 in 2020 (exactly half of the maximum exclusion amount of $107,600).
Bona Fide Residence Test. The bona fide residence test does not require presence in a foreign country for the entire 330-day period. Instead, it obliges the taxpayer to demonstrate considerable, ongoing connections to that country, looking to the nature of in-country housing, whether family members have also made the move, and general personal and economic connections. Meeting the bona fide residence test requires a full calendar year of residency in that country, though short-term trips can be taken to the United States during the qualifying year.
Notably, taxpayers cannot qualify as bona fide residents if they have taken a position that they are nonresidents of that country for tax purposes. This would be an issue for someone who has taken a treaty-based position that they are not UK residents, but electing remittance-basis in the United Kingdom would not eliminate eligibility as a bona fide resident.
Waiver of Time Requirements. The time requirements for both tests are only waived if one must leave the country due to war, civil unrest, or similar adverse conditions. The IRS publishes a list of the countries where the waiver will be available during any given year. Historically, the list has been limited, including only Democratic Republic of Congo, Cuba, Iraq, and Nicaragua, in 2018; however, whether this list could be expanded in 2020 on account of the recent Coronavirus pandemic is unclear.
The Foreign Tax Credit
The foreign tax credit offers a dollar-for-dollar offset against US tax for UK income and capital gains taxes paid or accrued in that year. The credit can be claimed for tax paid or accrued both on foreign earned income as well as foreign investment income.
Tax Credit Baskets. Although the credit is available for all types of taxable income, multiple “baskets” of foreign tax credits have been established to prevent income tax attributable to one type of income from offsetting tax due from another. The two main baskets are the general category, which applies to wages and pensions, and the passive category, which applies to investment income. The Tax Cut and Jobs Act of 2017 created a new basket for “foreign branch” income that may broadly impact the calculations for self-employed individuals.
A separate category also exists for foreign tax attributable to US source income for which a credit is available under terms of a US income tax treaty.
Tax Credit Carryovers. Foreign taxes within a given basket that are in excess of the effective US rate on that basket of income can be carried back one tax year and forward ten years. As will be discussed below, these credit carryovers can produce tremendous tax planning opportunities in later years.
Making The Best Decision Under The Circumstances
With respect to earned income, most American Expats living and working in the United Kingdom will be eligible for both benefits. However, credits are not available for foreign tax paid on excluded foreign earned income, meaning that both benefits cannot be claimed for the same earnings. The option that makes sense for you will depend on the attributes of your specific tax situation, with the following elements driving the decision-making.
1.You want ease of tax compliance – exclusion. If you are working as an employee and your only income source is a UK salary below the foreign earned income exclusion threshold, you will have a straightforward tax compliance obligation. Just report your salary in USD, provide some basic information about your employer and your travel dates, and call it a day. For self-filers looking to easily eliminate their annual US tax liability, this will be the path of least resistance.
2. You receive tax-protected UK income or US investment income below the standard deduction threshold – exclusion. US source income or tax-protected UK income would generally produce a US tax liability. Nevertheless, the interaction between the foreign earned income exclusion and the standard deduction can shield up to $12,400 (2020) from US tax exposure. For example, if you earn a $100,000 salary, generate $5,000 of US source capital gains and $3,000 in interest from a UK ISA account, the salary would be exempt by claiming the foreign earned income exclusion and the standard deduction would fully offset the US gains and UK interest income. In this scenario, US tax would likely be due if the foreign tax credit were to be claimed.
3. You have already been claiming the foreign earned income exclusion and will soon move to a low-tax country – exclusion. If you have been claiming the exclusion and opt instead to claim the foreign tax credit in a particular year, this is treated as a revocation of the exclusion election. When a revocation occurs, you would be unable to claim the exclusion again for five years without requesting IRS consent. If you end up working in a country with lower tax rates than the United States during this window, the inability to claim the exclusion would have serious negative tax consequences.
4. You may be working in a country with tax rates relatively lower than the US in the future – credit. Subject to the exclusion revocation issue discussed above, if a possibility exists that you will be relocating to a country with low personal income tax exposure, being able to leverage the prior ten years of excess foreign tax credit carryovers from your time working in the United Kingdom can produce a considerable windfall. Foreign tax credits for UK tax paid in prior years could be carried over to offset US tax on income earned in a later year in Dubai, Hong Kong, or Zurich.
5. You have children and are eligible for refundable tax credits – credit. The child tax credit is available to American Expats and can produce cash payments from Uncle Sam without having actually paid in any US tax. Eligibility for the child tax credit was broadly expanded to higher income individuals with the 2017 tax reform package. Importantly, the credit requires that you have reported earned income on your US tax return. If you exclude all earned income from US tax by claiming the foreign earned income exclusion, you will not qualify for the child tax credit irrespective of whether you meet the other eligibility requirements.
6. You want to continue funding a US IRA account – credit. Funding an IRA also requires that you have generated earned income. This means that you either need to opt to claim the foreign tax credit or have generated income in excess of the foreign earned income exclusion threshold if you still wish to participate. Excess contribution taxes would be due on contributions to an IRA in a year that you have excluded all your UK earnings from US tax.
7. You are funding a UK pension – credit. Because of the relatively higher rate of tax in the UK, it can potentially be beneficial to forgo treaty-based benefits that would otherwise shield contributions to registered UK pension arrangements from US tax. Instead, using the excess UK tax credits to offset the US tax on the contributions in that year can result in the build-up of an amount that would not be subject to US tax once distributed at retirement age, potentially producing meaningful future tax savings for you.
8. You are receiving equity compensation from your employer – credit. The foreign earned income exclusion is only available for income received less than one year after it was earned. Claiming the foreign tax credit will often be the only way to reduce US tax on the compensation component of stock options and grants that vest over several years.
9. You are working in a self-employed capacity – it depends. For self-employed individuals, the foreign earned income exclusion is applied against gross income with expenses attributable to excluded income being disallowed. For example, if you were to generate $200,000 in revenue, with $100,000 of expenses, although your net income is below the exclusion threshold, you would still be showing taxable income. Furthermore, with the new “foreign branch” basket impacting foreign tax credit calculations and carryovers for self-employed individuals, examining the details of the specific business operations is necessary.
10. You have retained state-level residency back in the US – it depends. If you are still filing tax returns at the state level, it will be imperative to first determine whether your state of residency permits its residents to claim one of these benefits. With all states having different rules for handling foreign income, you may need to start the credit v. exclusion analysis with a determination of state tax exposure.
Many American Expats will often be balancing several of these competing intentions. Making a choice that will provide you with the best overall benefit and create the greatest opportunity for future tax planning should ultimately be the goal.
