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Monday, June 17, 2013

Foreign Tax Credit as Applicable to Individuals


What are the tax results when two U.S. taxpayers earn the same amount but one works in the U.S. and the other in a foreign country?

Cindy is a U.S. citizen and earns $100,000 working in the U.S. Assuming her average U.S. tax rate is 20%, her U.S. tax liability on $100,000 will be $20,000.

Justin is a U.S. citizen and earns $100,000 from working in Italy. Because the U.S. taxes its citizens (as well as resident aliens and domestic corporations) on their worldwide income, Justin will be subject to U.S. tax on the income he earns in Italy. Assuming his average U.S. tax rate is also 20%, his U.S. tax liability on the $100,000 earned in Italy will be $20,000 as well.

Italy will also want to tax Justin’s income since it was earned there. If Italy’s average tax rate is 15%, Justin will have a $15,000 Italian tax liability in addition to his $20,000 U.S. tax liability. In aggregate, Justin will pay tax of $35,000 on $100,000 of income, an effective 35% tax rate.

Though Cindy and Justin earn the same amount (i.e., $100,000 each) during the year, one will pay a total of $20,000 in tax and the other $35,000. This doesn’t seem fair, does it?

If Life and Taxes Were Fair…
Let’s briefly suspend reality and discuss what should happen in this case. Justin is taxed twice on his income. The questions is, can his tax liability be equalized so that Justin does not have to worry about having to make a business and/or economic decision based on tax considerations?

One approach would be for Italy to try to rectify the situation. Italy could exclude Justin’s earned income from the tax base. Alternatively, Italy could provide a credit for U.S. taxes paid on this income.

Alternatively, the U.S. could try to correct this inequality by allowing Justin a deduction for foreign taxes paid, just as it would for any other legitimate expenses he incurs in earning his income (such as travel expenses). If a deduction were permitted by the U.S. for foreign taxes, Justin would still pay tax in Italy of $15,000. He would then deduct this tax payment on his U.S. tax return. This would reduce his income to $85,000 ($100,000-$15,000= $85,000).

Again, assuming an average 20% U.S. tax rate, his U.S. tax liability would be $17,000. He will pay a total of $32,000 in taxes. Although this is less than the $35,000 he would otherwise be paying, Justin is still being treated more harshly than Cindy as she only pays $20,000.

There is another scenario that is even better for Justin. If, instead, the U.S. allowed a credit for foreign taxes, Justin would end up paying U.S. tax of $5,000 (i.e., U.S. tax of 20% on $100,000, or $20,000, less a credit of $15,000 paid in Italy).

In total, Justin would pay tax of $20,000, the same amount of tax paid by Cindy. In this situation Justin will be on an equal footing as his U.S. counterpart.

Now, Back to Reality…
In actual fact, Italy will not give Justin any benefit for U.S. taxes he may have to pay. The U.S., however, will give Justin a choice between deducting Italian taxes, or taking a credit. However, the foreign income tax credit benefit may not exceed the U.S. tax on the foreign source income. Foreign tax credits exceeding this limitation may generally be carried back one year and forward ten years to reduce the U.S. tax liability in those years.

In the example we have used, the U.S. tax rate exceeds the Italian tax rate, and Justin receives a credit for all his foreign tax paid.

The result is somewhat different when the foreign tax rate is higher than the U.S. tax rate. This is how it would work out for Justin:

Let’s assume that Justin’s average Italian tax rate is 25%, while his average U.S. rate remains 20%. His U.S. tax liability will be $20,000 before foreign tax credits. His Italian tax, however, will be $25,000. Justin will be allowed to claim a credit of only $20,000 on his U.S. return. In total, Justin will have paid $25,000 of tax ($25,000 in Italy, $0 in the U.S.), increasing his effective tax rate to 25%. Cindy, remember, paid $20,000 in taxes.

Obviously, this discussion is very general in nature. The example has been simplified to make specific points, and ignores many issues (some of which will be addressed in future articles).

If you will be earning income outside of the U.S., please consult an Armanino tax advisor. We can help you determine how claiming a foreign tax credit or deduction may impact your U.S. tax liability. We can also advise you on possible tax planning opportunities to absorb any excess foreign income tax credits.

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