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KPMGUS­­U.S.TaxationofAmericansAbroad

2/5/2015 KPMGUS­­U.S.TaxationofAmericansAbroad U.S.Taxationof AmericansAbroad Contents | Chapter1 | Chapter2 |

U.S.Taxationof

AmericansAbroad

Chapter4­­ForeignTaxCredit

CashVersusAccrualMethod|ForeignTaxesEligibleforCredit|DisallowanceofCreditAllocabletoExempt

Income|LimitationonCredit|CarrybackandCarryoverofUnusedCredits|PlanningforUseofExcessCredits

Alloraportionofanexpatriate'sincomemaybesubjecttotaxinaforeignjurisdictionasaresultofeitherthe

individual'sresidenceorpresenceintheforeigncountry.SinceU.S.citizensandresidentsaresubjecttoU.S.taxon

theirworldwideincome,theexpatriatemaybesubjecttotaxbothintheforeigncountryandintheUnitedStates.The

foreigntaxcreditprovisionsoftheInternalRevenueCode(IRC)aredesignedtoeliminatethedoubletaxationof

foreignsourceincomebyallowingacreditagainstU.S.taxforqualifyingforeigntaxes.Thiscreditisgenerallylimited

totheU.S.taxontheindividual'sforeignsourceincome,anditcannotexceedtheactualforeigntaxpaidoraccrued.

Itshouldalwaysbekeptinmindthatdouble­taxationreliefisalsoprovidedintaxtreaties.Individualswhoincurtax

inacountrywithwhichtheUnitedStateshasenteredintoataxtreatyshouldconsidertherelevanttreatyprovisionsin

additiontotheIRC.AlistoftreatycountriesisprovidedinAppendixA.

Anindividualmayeitherdeductforeigntaxespaidasanitemizeddeductionorelecttoclaimthemasacredit. Generally,thecreditoptionismorebeneficial,sinceitcanresultinadollar­for­dollarreductionintaxliability. However,sinceitisanannualoption,thedecisionshouldbebasedonallthefactsavailableandreviewedeachyear.

TheelectiontoclaimtheforeigntaxasacreditismadebycompletingForm1116(ComputationofForeignTax

Credit)andincludingitwiththetaxreturn.

CashVersusAccrualMethod

Althoughmostindividualsreportincomeanddeductionsunderthecashreceiptsanddisbursementsmethodwhen

theyfiletheirreturns,theforeigntaxcreditmaybeclaimedusingeitherthecashoraccrualmethod.Ifthecash,or

"paid,"methodiselected,theforeigntaxavailableforcreditisthetotalamountofqualifyingforeigntaxesactually

paidduringtheyear.Iftheaccrualmethodiselected,ataxpayerclaimstheforeigntaxcreditintheyeartherelated

incomeisreportedandinwhichtheforeigntaxliabilityaccrues,regardlessofwhenitisactuallypaid.Oncethe

accrualmethodiselected,itmustbeusedinsubsequentyears.Ataxpayermaychangefromthepaidmethodtothe

accrualmethodandclaimcreditbothforforeigntaxes"paid"foraprioryearandtaxes"accrued"butunpaidforthe

currentyear.

PlanningPoint:

Theaccrualmethodofclaimingtheforeigntaxcreditmaybebeneficialifthetaxpayerisresidinginacountrythat

doesnotrequirepaymentoftaxuntilayearaftertheliabilityarises.Conversely,whenanindividualalreadyhas

sufficientforeigntaxcredits,thecashmethodmaybepreferableinordertoaddanadditionalyearormoretothe

foreigntaxcreditcarryoverperiod.

Itshouldbenotedthatthecreditmaynotbeclaimedforforeigntaxattributabletoayearinwhichanelectionto

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deductforeigntaxeswasmadeintheU.S.return.

Someforeigntaxjurisdictionsdeterminetaxableincomeusingayearthatisotherthanacalendaryear.TheIRStakes

thepositionthatforeigntaxesaccrueonthelastdayofthetaxableyearofsuchforeignjurisdictions.Thismaycause

theaccrualmethodofclaimingforeigntaxcreditstobedisadvantageoustoindividualslivingincountriesthathave

taxableyearsotherthanthecalendaryear.

Example

AnindividualmovestoLondon,England,onMay1,2003.UnitedKingdomincometaxesforindividualsare

determinedbasedonataxableperiodbeginningApril6ofoneyear,andendingApril5ofthefollowingyear.Forthe

yearendedApril5,2004,theindividualincursaU.K.taxliabilityof£15,000,noneofwhichispaidduring2003.

BasedontheIRSposition,noforeigntaxcreditcanbeclaimedintheindividual's2003U.S.returnbecausenothing

hasbeenpaidandbecausethetaxdoesnotaccrueforforeigntaxcreditpurposesuntilApril5,2004.

PlanningPoint:

Toavoidtheoutcomeoftheexampleabove,individualslivingincountrieswithfiscalyearendsshouldgenerally

utilizethecashmethodforclaimingforeigntaxcreditsandmonitortheirforeigntaxpaymentstoensurethedesired

amountispaidduringtheU.S.returnyear(calendaryear).

TopamountispaidduringtheU.S.returnyear(calendaryear). ForeignTaxesEligibleforCredit

ForeignTaxesEligibleforCredit

Foreigntaxesthatareeligiblefortheforeigntaxcreditincludeincometaxes,warprofitsandexcessprofitstaxes,and

taxespaidinlieuofanyofthese.Thetaxmustbeimposedbyaforeigncountryoritspoliticalsubdivisions,orbya

U.S.possession.Theemployeeportionofforeignsocialsecuritytaxesisgenerallyconsideredtobeforeignincometax

availableforthecredit.Socialsecuritytaxesarenotcreditable,however,ifpaidtoacountrywithwhichtheUnited

Stateshasasocialsecuritytotalizationagreement(seeAppendixB).Otherforeigntaxes,suchasrealestatetaxes,sales

taxes,luxurytaxes,turnovertaxes,value­addedtaxes,andwealthtaxes,arenotcreditable.Determiningwhethera

foreigntaxiscreditableornotmaybedifficult,andacompetenttaxadvisershouldbeconsultedtodetermineifthe

foreigntaxqualifiesforcredit.

Topforeigntaxqualifiesforcredit. DisallowanceofCreditAllocabletoExemptIncome

DisallowanceofCreditAllocabletoExemptIncome

Otherwiseallowableforeigntaxespaidoraccruedcanbeusedascredits,excepttotheextentthattheforeignincome

taxwasimposedonforeignsourceearnedincomeexcludedfromgrossincomeundersection911.Thetheoryofthis

statutorilyimposeddenialofdoublebenefitsruleisthatanindividualshouldnotbeabletobothexcludeearned

incomefromtaxationandclaimcreditforforeigntaximposedonsuchincome.Thecomputationofthedisallowance,

ornon­creditabletax,isasfollows:

Amountsexcludedundersection

911(a)lessdeductibleexpenses

allocabletosuchamounts

Foreignearnedincomeless

deductibleexpensesallocableto

suchincome

Foreigntaxespaid

x oraccruedonforeign earnedincome

Iftheforeigntaxisimposedonearnedincomethatisexcludedandonsomeotherincome,andthetaxesontheother

amountcannotbesegregated,anallocationmustbemade.

Examples

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1. For2003,anindividualresidentinGreeceearns$90,000andpays$8,000inGreektaxonsuchincome.She

claimsaforeignearnedincomeexclusionof$80,000andahousingexclusionof$10,000.Herentireincome

isthereforeexemptfromtax.Accordingly,allofherGreektaxesaredisallowedandthereforeareineligible

foruseasaforeigntaxcredit.

2. Thesameindividualdoesnotelecttoclaimahousingexclusion.Sincenotallofherincomeisexemptfrom

U.S.taxation,theforeigntaxcreditdisallowanceiscomputedasfollows:

Exemptincome

$8,000

80,000

Foreign

$7,111

x taxon = Disallowed

Totalforeignearned

earned

foreigntax

income$90,000

income

PlanningPoint:

Theforeignearningsexclusionsweremadeelectivesothatindividualslivinginhigh­taxforeigncountrieswouldnot

bepenalizedbytheforeigntaxcreditdisallowancerules.Individualslivinginhigh­taxcountriesshouldconsidernot

electing,orrevokingifpreviouslyelected,theforeignearningsexclusionsinordertomaximizeforeigntaxcreditsand

carryoversorcarrybacks.

Caveat:Althoughthetaxbenefitoftheforeignearningsexclusionsmaybeminimalonemploymentincomefor

individualsinhigh­taxforeigncountries,apotentialsideeffectonunearnedincomeshouldnotbeoverlooked.The

combinedexclusionsmayreducetheoveralltaxableincometothepointwhereinvestmentincomeistaxedateithera

verylowrateornotatall.Thus,acurrenttaxsavingsmayhavetobeweighedagainstpossiblefutureuseofhigher

foreigntaxcreditcarryoversiftheexclusionsarenotelected.

foreigntaxcreditcarryoversiftheexclusionsarenotelected. Top LimitationonCredit

Top

LimitationonCredit

Theportionoftheforeigntaxesthatisnotdisallowedcanbeclaimedasacredit,subjecttolimitations.Theamountof

creditallowableinataxableyearislimitedtothelesseroftheactualforeigntaxespaidoraccrued(afterdisallowance)

ortheamountofU.S.taxonforeignsourcetaxableincomefortheyear.TheamountofU.S.taxattributabletoforeign

sourcetaxableincomeisdeterminedasfollows:

Foreignsource

taxableincome

Totaltaxableincome

 

Limitationon

U.S.tax

credit(U.S.tax

x before = attributedto

credits

foreignsource

taxableincome)

Taxableincomeinthisfractiondoesnotreflectpersonalexemptions,butitreflectsitemizeddeductions.

Sincethelimitationisbasedonacalculatedtaxon"net"foreignsourceincome,itisapparentthatmaximizingforeign

sourceincomehastheeffectofincreasingthelimitationandreducingtheU.S.tax(assumingsufficientcreditsare

available).Foreignsourceincomeincludesearningsfromservicesperformedabroad,movingexpensereimbursements

(undercertaincircumstances),andcertainotherkindsofincomearisingabroad,includingdividendsfromsomeforeign

corporations,foreignpensions,andannuities.

Specialrulesapplytotwocategoriesofincome.First,capitalgainsaregenerallysourcedbasedonthelocationofthe residenceofthepersonrealizingthegain.However,gainfromasaleofpersonalpropertyoutsidetheUnitedStatesby

aU.S.citizenorresidentalienwillnotbeconsideredforeignsourceunlessaforeignincometaxofatleast10percent

ofthegainisactuallypaid.

Second,passiveforeignsourceinterestincomesubjecttoforeignwithholdingtaxat5percentormore(high

withholdingtaxinterest)andotherpassiveforeignsourceincomearesubjecttoseparateforeigntaxcreditlimitations

designedtoallowcreditwithineachcategoryonlyforforeigntaxesactuallyimposedonincomeineachcategory.

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Thus,excessforeigntaxesincurredonearningsmaynotbeutilizedagainsthighwithholdingtaxinterestorother

passiveincomefromforeigninvestments.

U.S.sourcedeductionsarealsobeneficialfromthestandpointofmaximizingthelimitationandincreasingtheforeign

taxcredit.Mostdeductionsareconsideredtobegeneralinnatureandthereforemustberatablyapportionedbetween

foreignsourceandU.S.sourceincome.However,deductionsthataredirectlyrelatedtoaclassofincomeareallocated

againstsuchincome.Forexample,investmentadvisoryfeespaidtomanageaportfolioconsistingentirelyofU.S.

securitieswouldnormallybeconsideredtobeadeductiondirectlyallocabletoU.S.sourceincome.

Thefollowingisasimplifiedcalculationoftheforeigntaxcreditlimitation.

Example

AmarriedexpatriatewithtwochildrenlivesinBrussels,Belgium.Hehas$114,000ofcompensationincome,

includingallowances,and$6,000ofU.S.sourcedividendandinterestincomein2003.Hespentanumberofwork

daysintheUnitedStates,towhich$6,000ofhiscompensationincomewasallocatedasU.S.sourceincome.His

Belgiantaxliabilityfor2003was$28,000,allattributabletosalary,and$25,000wasdisallowedasallocableto

excludedincome.His2003U.S.incometaxandforeigntaxcreditwouldbecomputedasfollows:

Earnedincome

Dividendsandinterest

Grossincome

Percentageoftotal(rounded)

Foreignearnedincomeexclusion

Housingexclusion(assumed)

Adjustedgrossincome

Itemizeddeductions

(apportionedbasedon

grossincomepercentages

beforeexclusions)

Taxableincome,

beforepersonalexemptions

Personalexemptions

Taxableincome

U.S.tax,beforecredits

Foreign U.S. Total Source Source $114,000 $6,000 $108,000 $ 6,000 $6,000
Foreign
U.S.
Total
Source
Source
$114,000
$6,000
$108,000
$ 6,000
$6,000

$120,000

$108,000

100%

90%

(80,000)

(80,000)

(10,000)

(10,000)

$30,000

$18,000

(8,000)

(7,200)

$22,000

$10,800

(12,000)

$10,000

$1,000

$12,000

10%

$12,000

(800)

$11,200

Theforeigntaxcreditwouldbecalculatedasthelesserof(1)actualforeigntax

availableforeachcredit,$3,000($28,000less$25,000),or(2)thelimitation,

whichwouldbecomputedasfollows:

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Foreignsourcetaxableincome $10,800

=

Totaltaxableincomebefore

personalexemptions

$22,000

x $1,000

U.S.tax = $491

Thetaxpayer'sU.S.taxafterforeigntaxcreditandthestatusofhisforeigntaxcreditsareasfollows:

GrossU.Stax

$1,000

Foreigntaxcredit

(491)

NetU.S.taxdue

$509

Foreigntaxincurred

$28,000

Disallowed(allocabletoexcludedincome)

($25,000)

Usedasacreditin2002

(491)

Availableforcarrybackandcarryover

$2,509

Top(491) Availableforcarrybackandcarryover $2,509 CarrybackandCarryoverofUnusedCredits

CarrybackandCarryoverofUnusedCredits

Foreigntaxcreditsthatexceedthelimitationmaybecarriedbacktwotaxableyearsandforwardfivetaxableyears.The

excesscreditmustfirstbecarriedbacktotheearliesttaxableyear,andthenforwardtoeachsucceedingtaxableyear.Foreign

taxcreditscarriedtoaparticulartaxableyeararetreatedasforeigntaxesthatarepaidoraccruedbythetaxpayerinthatyear.

Furthermore,theiruseissubjecttothelimitationcalculationforthatyear.

Iftheforeigntaxisdisallowedinanyyearduetoitsallocationtoexcludedincome,theforeigntaxcreditisforfeitedandis

notavailableforcarrybackorcarryover.

Foreigntaxcreditscarriedtoanotheryeararenotattributabletoforeignearnedincomeexcludedinthatyear.Theforeigntax

creditwouldthereforenotbesubjecttothedisallowanceformulainthecarryoveryear.

TopPlanningforUseofExcessCredits

PlanningforUseofExcessCredits

Anexpatriatewhowasabroadforanextendedperiodmayhaveincurredexcessforeigntaxcredits(notallowedinfull,due

tolimitation)resultingfromassignmentsinhigh­taxforeigncountries.TheseexcesscreditsmaybeusedtoreducetheU.S.

taxliabilityifcarriedovertoayearwithforeignsourceincomethathasnotbeentaxedbyaforeigncountryorthatwas

taxedataratelowerthantheU.S.rate.Generatingforeignsourceincomewithinthecarryforwardperiodmaybeparticularly

usefulafterreturningtoliveintheUnitedStates.Somepossibilitiesforthisare:

Taxablepensionandprofit­sharingdistributionsattributabletoemployercontributionswhileforeignservicesare

performed;

Stockoptionincomeattributabletoforeignservicecompensation;and

Businesstripsabroad,eitherbeforeoraftermovingtothelocationoftheforeignassignment.Incomewouldbe

attributedtotheworkdaysabroadandwouldbeconsideredforeignsourceincomeandprobablynottaxedina

foreigncountry.

Itisimportanttonotethatgeneratingforeignsourceincomewhilelivingabroadwillnotnecessarilybenefitataxpayer

becausetheforeigncountryofresidencemaytaxtheincomeatrateshigherthanintheUnitedStates.Localtaxrulesmust

alwaysbeconsiderediftaxplanningiscontemplatedandifitinvolvestheuseofexcessforeigntaxcredits.

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Notetousers:Allinformationprovidedisofageneralnatureandisnotintendedtoaddressthecircumstancesofanyparticularindividualorentity.Althoughwe endeavortoprovideaccurateandtimelyinformation,therecanbenoguaranteethatsuchinformationisaccurateasofthedateitisreceivedorthatitwillcontinuetobe accurateinthefuture.Nooneshouldactuponsuchinformationwithoutappropriateprofessionaladviceafterathoroughexaminationofthefactsoftheparticular situation.

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