Foreign Tax credit Vs. Foreign earned income exclusion: Which is better?

The US tax regime is recognized for its many peculiarities. The most prominent one is its expatriate tax system. According to the American tax rule, everyone, including the green card holders and even ex-pats, are accountable for filing their taxes even after their expatriation to another country. Such persons have to report their global income to the US tax authority.

In most countries, the tax liability gets imposed on the residents and the ones working locally in the country. The expatriates are usually excluded from tax filing requirements. But, that is not the case with the American ex-pats who need to consider adhering to dual tax obligations. They need to follow the tax regulations of not just their current country of residence but also their home country.

However, there is a silver lining to these burdensome compliances. If American ex-pats want to avoid such double taxes, they can avail of some exemptions. IRS gives the US expatriates an option of claiming certain relief in the form of credits or exclusions. Foreign Tax Credit (FTC) and Foreign Earned Income Exclusion (FEIE) are among such options available with ex-pats to lower their overall tax onuses.

What is Foreign Tax Credit (FTC)?

If you are paying qualifying income tax in a foreign country, you can claim an equivalent amount as a credit on your US tax liability. This benefit is referred to as the Foreign Tax Credit. If you are paying more tax to the foreign country, you can even be excluded from paying any US taxes because of the higher amount of credit available. Ex-pats need to file IRS Form 1116 with their federal tax return to garner the Foreign Tax Credit. It is imperative to note that this foreign tax credit is non-refundable in nature. US ex-pats can claim FTC for active as well as passive earnings earned outside the US. However, foreign property tax or real estate tax do not come other the purview of the credit.

There is a checklist of four things that US ex-pats must satisfy to be eligible for the foreign tax credit.

• The tax paid abroad must be imposed on the ex-pat himself
• The ex-pat must have accrued or made payment of the tax liability
• The taxes paid should be of the nature of income tax 
• The tax liability must be actual and legal

What is Foreign earned income exclusion (FEIE)?

If you are earning foreign income in a given year, you can use FEIE to exclude such overseas earnings, subject to a pre-determined limit, from the purview of US taxation. As per the threshold for the tax year 2020, it allows exclusion of up to $107,600. One can apply for this exclusion with IRS Form 2555.

There is a checklist of three things that you must review before filing a claim for this exclusion:

• Firstly, this is applicable on any earned income of the ex-pat, provided he is living abroad. 
• Secondly, this exclusion is available for only the active income, and one cannot claim it for passive income like rents and interest from any retirement scheme.
• Lastly, to be eligible for this exclusion, the American ex-pat needs to cater to one of the two tests called the Bona Fide Residence Test and the Physical Presence Test. As per the Physical Presence Test, they should be living in another country for 330 days in the 12-month duration and have set up their tax home overseas. The Bona Fide Residence Test needs the ex-pat to be a resident of another country for an uninterrupted period of one tax year and establish his tax residence in that foreign country.

FTC VS FEIE- What Important Pointers should you evaluate?

• Foreign Tax Credit is available to lower your overall tax liability, calculated using your global income. In contrast, the Foreign Earned Income Exclusion allows one to factor out a chunk of their foreign income as per the threshold from their total reportable income.  
• FTC applies to all types of income that are used to claim the amount of credit. As for FEIE, it applies to only foreign income less than $107,600. 
• With Foreign earned Income Exclusion, you can have zero tax liability. With Foreign tax credit, there are carryovers for future years. Even if you are moving to another low-tax country, you can use the foreign tax credit carryovers. 
• There are no specific qualification conditions to claim FTC. One needs to qualify for either the Bona Fide Residence Test or Physical Presence Test to get FEIE.

How to choose between the two options?

To make the apt decision, ex-pat taxpayers should check for certain important aspects. Whether to choose foreign tax credit or foreign earned income exclusion depends on your individual situation. You can judge the right option using the following parameters:

• Foreign tax liability: 

If you are not eligible to pay any taxes in the foreign country and are not paying them, you cannot go for the foreign tax credit. The foreign tax credit is only applicable when you pay the tax on the earned income in the foreign country. 

• The place of residence: 

The American ex-pats must prove that they live abroad. They need to corroborate that they spent nearly 330 days away from the US in the past financial year. If that is not the case, then you are not eligible for the Foreign earned income exclusion for the given tax year. 

• The nature of income earned: 

You cannot claim foreign earned income exclusion if the tax is on passive incomes like rent or interest from retirement plans. You can only claim the exclusion for actively earned income in a foreign country. 

• The location from where your income is sourced:

If your income is sourced from the US, you are not eligible for the foreign earned tax credit, even if the income is taxed abroad. If you want to claim the foreign tax credit, you should gain the respective income from a foreign source. Many countries also offer a tax credit on the taxes paid in the US; expatriate taxpayers must properly consider the same.

• Income tax rules in the ex-pats’ country of residence: 

It is better if the income tax on the earned income is more in the expatriates’ country of residence as the excess credit can be carried forward to the following year if we consider the foreign tax credit.

Is it possible to claim both Foreign Tax Credit and Foreign Earned Income Exclusion in a given year?

Yes, it is possible to claim both the exclusions together, but they cannot be claimed on the same income. However, suppose you are an American ex-pat who pays lower income tax than the applicable US tax rates. In that case, you can claim for the Foreign earned income exclusion against the taxes paid aboard and Foreign tax credit to reduce the tax on passive income. Thus, you can claim for both.

How can tax service for your ex-pat taxation necessities help you?

Expatriate taxation is seen as one of the most perplexing realms for many accounting firms, CPAs, individuals, and businesses. Hiring assistance with expat tax preparation needs can be a fruitful alternative for many firms. It enables you to tackle the nuances of ex-pat taxes for your diverse clientele with enhanced efficiency. Smart Accountants LLC is one such illustrious CPA firm you can contact for your tax dilemmas.

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