An Example of Avoiding Double Tax
The United States is one of the only countries across the globe that utilizes a citizenship-based taxation system – – but it is not limited to only US citizens and includes lawful permanent residents and other US residents as well. It means that the United States taxes individuals on their worldwide income (this article is intended for individuals and not corporations). One common question that our international tax lawyers receive often is whether a US person has to file US tax returns and report their foreign income — and pay US tax — on that foreign income even if they pay already paid taxes abroad. While taxpayers are required to include their foreign income on the US tax return, if they already paid tax overseas then they may be entitled to a foreign tax credit to offset or eliminate any US tax liability.
Double Taxation Example
The issue of double taxation is relatively common. Here is a typical example: David is a US citizen who lives in the United States but has various foreign investments. They generate a total of $30,000 a year in income from one country. David pays 25% foreign taxes on the foreign income.
Full Foreign Tax Credit
Depending on David’s US tax rate — and whether the foreign passive income is interest, long-term capital gains, or qualified dividends can impact the application of the foreign credit. Let’s presume that the foreign income is the result of foreign interest income. David’s net effective tax rate in the United States is 23%. Therefore, there is a high likelihood that the foreign tax credit should be sufficient to offset any US income on the foreign income. Any unused portion of the foreign tax credit can be used in a subsequent year (a carryforward) but it is not refundable in the United States.
Partial Foreign Tax Credit
Instead, imagine that David is a high-income earner with a 34% net effective tax rate. As a result, since the interest income is taxed at a progressive tax rate (not at the qualified dividend or long-term capital gain reduced tax rates) the 25% paid in foreign taxes would not be sufficient to offset all the US tax liability on that income. Instead, David would apply the foreign tax credits to his US tax liability, but would not be able to completely offset the income — unless for example, he was able to carry forward the prior year’s unused foreign tax credits.
Foreign Earned Income Exclusion
If the US person resides overseas and meets either the Physical Presence Test (PPT) or Bona-Fide Residence Test (BFR) in addition to the tax home test — they may be able to exclude a certain portion of their foreign earned income from their US tax return. This only applies to earned income and does not include items such as dividends, interest, or capital gains. We have a separate article to assist you with the Foreign Earned Income Exclusion.
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