Foreign Tax Rules, Exclusions and Credits

Tax professionals who have clients working beyond our borders will want to become familiar with foreign tax rules, exclusions and credits. Here’s a summary you can review and share with your clients.

Basic Rules

The following classes of tax filers are subject to U.S. income tax: U.S. citizens/persons, resident aliens, non-resident aliens (with U.S. sourced income and residents of U.S. possessions.

A bona fide resident of American Samoa, the Commonwealth of the Northern Mariana Islands, Guam, Puerto Rico or the U.S. Virgin Islands for the entire tax year can qualify for special tax benefits. Generally, you are a bona fide resident of one of these possessions if. during the tax year. you meet the presence test: You do not have a tax home outside the relevant possession, and you do not have a closer connection to the United States or a foreign country than the relevant possession.

Each country has its own tax department, and tax forms closely resemble Form 1040. Note one exception to filing returns with a taxpayer’s country of residence is Form 1040-SS, U.S. Self-Employment Tax Return (Including the Additional Child Tax Credit for Bona Fide Residents of Puerto Rico), which requires self-employment income to be reported and tax paid directly to United States.

Foreign Earned Income Exclusion

The foreign earned income exclusion is available to U.S. citizens and resident aliens as long as they meet the requirements. They must either meet the bona fide resident test or the physical presence test.

The foreign earned income exclusion only applies to earned income, which includes salaries and wages, commissions, bonuses, fees, and tips, and can also apply to self-employment income, whether you are a sole proprietor or a partner, as long as your personal services are an important part of producing the income. If capital investment is an important part of producing income, no more than 30 percent of your share of the net profits of the business is earned income.

Royalties and patents generally are a form of rent or dividends, and are unearned income. Royalties received by a writer are earned income if they are received for the transfer of property rights of the writer in the writer’s product, or under a contract to write a book or series of articles. Generally, rental income is unearned income. If you perform personal services in connection with the production of rent, up to 30 percent of your net rental income can be considered earned income.

Foreign earned income does not include the following amounts:

Pay received as a military.
Pay for services conducted in international waters (not a foreign country).
Pay in specific combat zones.
Pay received as civilian employee of the U.S. government.

To claim the foreign earned income exclusion, the foreign housing exclusion or the foreign housing deduction, you must have foreign earned income, your tax home must be in a foreign country and you must be one of the following:

A U.S. citizen who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year.
A U.S. resident alien who is a citizen or national of a country, with which the United States has an income tax treaty in effect, and who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year.
A U.S. citizen or a U.S. resident alien who is physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months.

The foreign earned income exclusion is calculated and reported on Form 2555, Foreign Earned Income, or Form 2555-EZ, Foreign Earned Income Exclusion.

Foreign Tax Credit

If you are a U.S. citizen working for the U.S. government, including the Foreign Service, and you are stationed abroad, your income tax filing requirements are generally the same as those for citizens and residents living in the United States. You are taxed on your worldwide income, even though you live and work abroad. However, you may receive certain allowances and have certain expenses that you generally do not have while living in the United States. Certain foreign area allowances, cost of living allowances and travel allowances are tax free.

You can claim a credit for foreign taxes imposed or you can elect to take as a deduction on Schedule A under “foreign taxes paid.” In most cases, it is better to take the credit. If you choose to exclude foreign earned income or foreign housing costs, you cannot take the credit for taxes on income that you excluded.

You can take the credit without filing Form 1116, Foreign Tax Credit, if you meet all of the following requirements:

All of your foreign source income is passive income.
All of your foreign source income and foreign source taxes are reported to you on a qualified statement (1099-INT, 1099-DIV or Schedule K-1).
Total qualified foreign taxes aren’t more than $300 ($600 if married filing a joint return).
If you make this election, then there is no carry back or carryover of any unused foreign tax to or from this year.

Which taxes qualify for the foreign tax credit or foreign tax deduction?

The tax must be imposed on you.
You must have paid or accrued the tax.
The tax must be the legal and actual foreign tax liability.
And the tax must be an income tax or in lieu of an income tax.

Which taxes are ineligible? A portion of taxes on combined foreign oil and gas income, taxes on U.S. persons controlling foreign entities who fail to file required information returns, and taxes related to a foreign tax splitting event and foreign taxes disallowed under Sec. 965(g).

The foreign tax credit is calculated on Form 1116. A separate Form 1116 must be created for each of the different categories of income: Sec. 951(a) income, foreign branch income, passive category income, general category income, Sec. 901(j) income, certain income resourced by treaty and lump sum distributions with special averaging treatment. On Form 1116, a separate column in Part I must be used for each country or possession.