The U.S. government taxes its citizens, and greencard holders on their worldwide income regardless of whether they are U.S. residents for the tax year or not. Individuals who are born to U.S. parents in countries like Canada are also subject to U.S. taxes as they are considered U.S. citizens and have a U.S. Social Security Number (SSN). Being subject to the tax laws of two or more countries often leads to the possibility of double taxation.
To avoid double taxation, the U.S. Internal Revenue Service (IRS) provides two forms of relief: Foreign Tax Credit (FTC), and Foreign Earned Income Exclusion (FEIE). Many foreign resident U.S. taxpayers fail to understand the process for claiming these tax reliefs.
In order to provide some guidance regarding these relief measures from double taxation, the following is an overview on U.S. Foreign Tax Credit and Foreign Earned Income Exclusion (FEIE).
U.S. Foreign Tax Credit To Avoid Double Taxation
Income taxes paid to a foreign country can be claimed either as tax deductions, which reduce the taxable income on the US income tax return, or as a tax credit in which case the foreign tax paid are deducted from the total US tax liability, reducing the amount payable by the individual.
To claim the paid foreign tax as deduction, the individual needs to complete and file Schedule-A, Itemized Deductions along with the annual U.S. income tax return. To claim a credit an individual would file US Tax Form 1116, Foreign Tax Credit to claim the foreign taxes paid as tax credit.
Taxes paid on incomes, such as: wages, self-employment income, etc. can be claimed on the U.S. tax return as deduction or tax credit. If a taxpayers claims a FEIE, the taxes relating to the deduction will be disallowed. For example, if a taxpayer earns $150,000 in wages and used the FEIE to exclude $100,000 of these wages from income only the taxes relating to the $50,000 of wages not excluded will be allowed for credit or deduction.
Taxes must be an income tax. Credit is not allowed for taxes paid on foreign mineral income, oil and gas, sales tax, property tax, etc. In addition, social security taxes paid in Canada cannot be claimed for FTC, under the U.S. Canada Social Security Agreement.
It is important to note that a taxpayer may claim a credit OR deduction but not both or a combination of the two. As a result, a comparison should be made to determine which method results in the lowest amount of tax. In most cases, a credit will be more advantageous as it is deducted directly from the tax liability rather than taken as a deduction taken from the income before tax.
U.S. Foreign Earned Income Exclusion To Avoid Double Taxation
The Foreign Earned Income Exclusion is claimed on salary/wages income earned in a foreign country. Unlike FTCs, the FEIE may only be claimed against “Earned” income. The FTC is claimed irrespective of whether it is tax paid on active or passive income.
When a taxpayer used the FEIE, the U.S. taxpayer can exclude their salary or wages income up to $104,100 (for tax year 2018), from their total U.S. taxable income used to calculate the taxes. To do so, the income needs to reported on the U.S. income tax return and an election made to claim the exclusion. Taxpayers often assume that since their foreign salary income is less than the FEIE limit they do not need to file a US income tax return. However, this is incorrect, as a person subject to U.S. taxes, the U.S. income tax return has to be filed annually to report the foreign-earned income regardless of whether it will be taxable or not.
To claim the FEIE, the taxpayer needs to file US Tax Form 2555, Foreign Earned Income Exclusion (FEIE) to avail this foreign tax relief. For more details on FEIE, refer to our article on U.S. Foreign Earned Income Exclusion.
Both a FEIE and an FTC may be claimed on the U.S. return.
Tax Situation of a U.S. Citizen-Canadian Resident Taxpayer
Here is a sample situation of a U.S. citizen-Canadian resident taxpayer who has the following Canadian income for 2016:
- Salary – CA$150,000
- Capital Gains – CA$15,000
- Other income – CA$20,000
When filing the U.S. income tax return, the U.S. citizen-Canadian resident person can exclude $101,300. from the taxable income under FEIE. On the remaining income of $83,700 the person can claim FTC on the US income tax return. To do this, the Canadian tax liability on the $83,700 amount (excluding the salary) will have to be calculated.
As mentioned previously, an FTC and FEIE cannot be claimed for the same income on the US income tax return. Also, keep in mind that regardless of the income earned, a U.S. citizen residing in a foreign country has to file the annual U.S. income tax return to report their income for the year.
To know more about the tax troubles faced by a U.S. citizen residing abroad refer to our article: Common Tax Issues Faced by U.S. People Living Abroad
AG TAX LLP CAN HELP
If you have any tax-related queries, need assistance with tax planning or filing your tax returns please contact us. Our team comprises of highly experienced tax professionals with extensive knowledge of US and Canadian tax laws as well as cross-border compliance.
Furthermore, as a full service accounting firm, AG Tax assures complete assistance with even your most complex tax needs.
We can assist with:
- Canadian Personal and corporate tax returns
- Cross Border Taxation and Business Planning
- US Personal and Corporate Taxation
- Disclosure of Foreign Assets and other information filings
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- Estate Planning, Inheritance tax advice
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