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

Example-1
FORM 1040 - U.S. Individual Income Tax Return (under the old law)

                                                 Foreign     Foreign
                                                   tax        earned
                                                  credit      income
                                                             exclusion

U.S. wages                                       $10,000     $10,000
  Chinese wages                                   90,000      90,000

GROSSS INCOME                                    100,000     100,000
- Foreign earned income exclusion (Lesser             (0)    (85,700)
of $90,000 or $85,700, Form 2555)

ADJUSTED GROSS INCOME                            100,000      14,300
- Standard deduction (single)                     (5,350)     (5,350) e
- Personal exemption ($3,400 x 1 exemption) =     (3,400)     -3,400

TAXABLE INCOME                                    91,250       5,550

TAX LIABILITY (see below, 28%                     19,661 a       555 b
tax rate versus 10%)
- Foreign tax credit allowed                      (9,000) c     (266) d
(from Form 1116 below)
- U.S. tax withheld                               (2,800)     (2,800)
TAX DUE (REFUND)                                   7,861      -2,511

a = $15,699   28% x (91,250-77,100) = 15,699   3,962 = 19,661.

b = $5,550 x 10% = 555.

c =

FORM 1116 - Foreign Tax Credit

Tax paid to China                                              9,000
U.S. tax on Chinese wage = 19,661 x
  [90,000/(100,000-5,350 e)] = 19,661 x 95 %.=                18,678
Foreign tax credit allowed (Lesser of 9,000 or 18,678) =       9,000 c

d =

FORM 1116--Foreign Tax Credit

U.S. wages                                          $10,000
  Chinese wages after the $85,700
  exclusion = $90,000 - 85,700 =                      4,300
Adjusted gross income =                              14,300

U.S. tax liability on Chinese wages
  after the exclusion
               = $555 x [4,300/(14,300-5,350 e)]
               = 555 x 48% =                                    266

Reduced foreign tax credit
= 9,000 foreign tax - 9,000 x (85,700 exclusion/
  90,000 foreign gross income)
= 9,000 - (9,000 x 95%) = 9,000 - 8,550 =                       450

Foreign tax credit allowed (Lesser of 266 or 450) =             266 d

On the other hand, if Andy adopts the option of foreign earned income exclusion, he can immediately exclude $85,700 from his $90,000 Chinese wages. The remaining $4,300 Chinese wages are still subjectto U.S. taxation. His taxable income is now greatly reduced to only $5,550, resulting in a U.S. tax liability of $555 at a minimum tax rate of 10%. Further, the remaining $4,300 Chinese wages account for 48% of worldwide income of $8,950 ($14,300-5,350). The U.S. tax liability attributable to the Chinese income is $266 ($555 x 48%). Considering the $9,000 tax paid to the Chinese government, Andy has excluded $85,700 from his $90,000 Chinese income. The exclusion rate is 95% ($85,000/90,000). The $9,000 Chinese tax eligible for the foreign tax credit must also be reduced by 95%. The remaining amount is $450 ($9,000 x 5%). Andy's maximum allowable foreign tax credit is the lesser of $266 or $450, i.e., $266. In other words, Andy can claim not only the $85,700 foreign earned income exclusion but also an additional $266 in foreign tax credit. Since Andy has paid $2,800 tax to the Internal Revenue Service, he ends up with a tax refund of $2,511 ($555--266--2,800). This is the procedure for the foreign earned income exclusion under the old law. However, the new law changes the procedure to determine the new tax rate bracket.