Optimal decision between foreign tax credit and foreign earned income exclusion

International Journal of Business Research, Jan, 2007 by James G.S. Yang, Agatha E. Jeffers

ABSTRACT

This paper explains that a U.S. citizen working abroad can choose either the foreign tax credit or the foreign earned income exclusion when calculating his U.S. income tax liability. By using the former, the foreign tax paid can be used as a credit against the U.S. tax to the extent of the U.S. tax liability attributable to the foreign income; while the latter is limited to $85,700 plus foreign housing cost allowance in excess of $13,712 with a limitation depending on the location in the world where the income was generated. The tax rate bracket is determined as if no foreign earned income exclusion were taken. This paper further identifies what factors should be considered in determining an optimal decision between these two approaches. These factors include the foreign tax rate, the U.S. tax rate, the taxpayer's income and the statutory $85,700 foreign earned income exclusion. Our findings suggest that if the U.S. tax rate is lower than the foreign tax rate, coupled with the taxpayer's foreign earned income being much more than $85,700, it would be more beneficial to adopt the foreign tax credit approach. Otherwise, in all other situations, it would be more profitable to employ the foreign earned income exclusion approach. This paper presents numerous illustrations to demonstrate the tax implications associated with the two reporting choices under various scenarios. It further offers tax strategies for the situation where there are two foreign countries with two different tax rates. It also investigates the advantages and disadvantages of foreign active income and foreign passive income. In addition, this paper illustrates some tax planning techniques for high and low wage earners at different locations in the world.

Keywords: Foreign earned income, foreign tax credit, foreign earned income exclusion, foreign housing cost allowance, gross income, adjusted gross income, standard deduction, personal exemption, taxable income, tax bracket, tax liability, active income, passive income.

1. INTRODUCTION

A U.S. expatriate is given a choice of foreign tax credit or foreign earned income exclusion. On the one hand, under the foreign tax credit approach, a taxpayer is required to add the foreign income to the U.S. income in determining the worldwide tax liability, but this taxpayer can claim the income tax paid to a foreign country as a credit against his U.S. tax liability (Code [section] 164(a)(3)), but not exceeding the U.S. tax liability attributable to the foreign source income (Code [section] 904). On the other hand, under the foreign earned income exclusion approach, the taxpayer can exclude the foreign earned income up to $85,700 in 2007 (Code [section] 911(b)(2)) plus a housing cost allowance in excess of a base amount. Under the old law, the second approach immediately reduced the tax bracket. Therefore, if the foreign housing cost allowance was very substantial, then the tax rate reduction would also be very big. This resulted in a possible tax loophole. However, the Tax Increase Prevention and Reconciliation Act of 2006 (The Act, P.L.109-222) eliminates this potential tax abuse. In addition, The Act further limits the foreign housing cost exclusion but, under Internal Revenue Bulletin 2006-43, provides relief for foreign locations with very high housing costs. This paper explains the difference between the old law and the new law by using many examples. It also greatly emphasizes the factors to be considered in making an optimal decision between these two approaches.

2. FOREIGN TAX CREDIT VERSUS FOREIGN EARNED INCOME EXCLUSION UNDER THE OLD LAW

A U.S. citizen is taxed on the basis of his worldwide income. If the taxpayer has foreign source income and paid income tax to a foreign country, it will result in double taxation. In order to alleviate this burden, the taxpayer is given two options. The first option is to claim the "foreign tax credit," under which the foreign source income is included in the taxpayer's worldwide income and taxed at the U.S. tax rate. The tax paid to a foreign country can then be claimed as a tax credit against the U.S. tax liability, but cannot be more than the U.S. tax liability attributable to the foreign source income. In other words, the foreign tax credit is limited to the foreign tax multiplied by the ratio of the foreign source income over the worldwide income, i.e.

Maximum foreign tax credit = Foreign source income/Worldwide income

This means that, if the foreign tax paid is less than the U.S. tax liability on the foreign source income, the foreign tax paid can be fully deducted from the U.S. tax liability. However, if the foreign tax paid is greater than the U.S. tax liability on the foreign source income, the foreign tax credit is limited to only the U.S. tax liability attributable to the foreign income. The excess foreign tax paid is not deductible during the current year but can be carried back for one year and then forward for ten more years to offset the U.S. tax liability of the taxpayer (Code [section] 904(c)). The new law did not change the status of this foreign tax credit.