TAXING ISSUES Foreign Tax Credit vs. Foreign Earned Income Exclusion A Comparative Analysis The following is designed to provide general tax information for Americans living abroad or contemplating a foreign move. As with all tax and legal issues, seeking tailored advice from qualified counsel is advisable. 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 $112,000 (2022) 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 20
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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.
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 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 twelvemonth 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, 2021 through June 30, 2022, would allow for an exclusion of $56,000 in 2022 (exactly half of the maximum exclusion amount of $112,000). 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 shortterm 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 Burma, Chad, Afghanistan, Iraq, and Ethiopia, in 2021.
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.
