This week we´re going to talk about Child Tax Credit and Foreign Tax Credit.
One of the most difficult topics of financial literacy is understanding tax matters. Let’s try to grow our knowledge about taxes in this post by learning about two important subjects:
- The expanded child tax credit under ARPA – I want to clarify a comment I made about it in our last post.
- The Foreign Tax Credit (FTC) – a mechanism that helps us AVOID PAYING TAXES TWICE on income that is taxed by the USA and a foreign country.
Let’s get to it, shall we?
THE 2021 ARPA EXPANDED CHILD TAX CREDIT
This expanded child tax credit is available to families with incomes below certain thresholds, and can be worth up to $3,600 per qualifying child under six years old and $3,000 per qualifying child up to 17 years old.
The phaseout amounts begin at:
- $150,000 for joint filers
- $112,500 for heads of household
- $75,000 for all others
For families living in the USA the credit can be fully refundable. For families living outside the USA, the credit is not refundable.
This is an important clarification I wanted to emphasize.
Families with US citizen qualifying children and the right income levels qualify for this credit no matter where they live, but only for US resident families can this expanded credit create a tax refund.
We covered this in prior issues of CBPs, but let’s review the difference between a refundable credit and a non-refundable one.
A non-refundable tax credit can offset income tax until it is reduced to zero and a refundable credit can reduce US income tax below zero, generating a payment from the government to the taxpayer for the negative amount. This negative amount paid out to the US taxpayer is considered a refund.
What does this mean in practice for US families with qualifying children living abroad?
- If you live in a low tax jurisdiction, such as Hong Kong, where the foreign tax credits do not fully offset your US income tax, the expanded child tax credit will help you reduce your US tax balance.
- If you have taxable US source income that causes you to owe US income tax, the expanded child tax credit can help you reduce the tax on that US source income.
- If your income is too low to pay any income tax in the foreign country but you owe US income tax, the expanded child tax credit will help you reduce how much you owe to the US government.
In a nutshell, if you are an American abroad that meets all the requirements for the credit and normally owes US income tax, this credit will help you reduce that balance.
If you normally don’t owe US income tax, this expanded credit will not benefit you because you have no US income tax to reduce.
FOREIGN TAX CREDIT – FREQUENTLY ASKED QUESTIONS
Understanding foreign tax credits is of critical importance both for Americans living overseas and for foreign born Americans or foreign nationals living in the USA.
In my decades working with families with foreign ties, I have seen too many situations where income is taxed by multiple countries due to lack of planning around the foreign tax credit or for lack of claiming the foreign tax credit.
Whether you live in the USA or abroad, if you have foreign source income and want to avoid paying income tax on that income more than once, understanding how the foreign tax credit works will help you meet this goal.
#1 – WHAT IS THE FOREIGN TAX CREDIT?
The foreign tax credit is a mechanism under US tax law that helps avoid double taxation on foreign income that is taxed by the USA and that is also taxed by a foreign country. If two countries tax the same income, that leads to double taxation, and double taxation can be extremely costly.
When can US taxpayers have income that is taxed by a foreign country?
If the US taxpayer lives stateside, this happens when they have foreign source income that is taxed at source, mostly through withholding tax, by the foreign country. Common examples include:
- Dividends paid by foreign companies, due to investing in global, international, or emerging markets ETFs or mutual funds that hold shares of multiple foreign corporations.
- Rents received from rental property located in a foreign country.
- Royalties received from users of intellectual property in foreign countries. For example, if you are a musician and you have fans who purchase and listen to your music abroad; or you are a writer, and your book is purchased by a reader who lives overseas.
- Interest paid by a foreign bank on cash held in a foreign bank account.
For American living overseas, common sources of foreign income include:
- Wages for work performed abroad.
- Foreign social security benefits.
- Distributions from a foreign employer pension.
- Profits from business activities conducted in a foreign country.
The foreign tax credit allows us to reduce the income tax we owe on that foreign income, dollar for dollar, by giving us a credit for the foreign income tax already paid abroad on that income.
Let’s use an easy example that everyone will understand:
Say you are a US citizen working abroad and receiving $100,000 of foreign compensation for which you paid $20,000 in foreign income tax to the foreign country where you live and work.
You are a US citizen, so you also must file a US tax return due to Citizenship Based Taxation.
When preparing and filing your US tax return, you determine that you owe $15,000 of US income tax on those wages.
If the foreign tax credit didn’t exist, this would be the situation:
$100,000 gross wages – $20,000 foreign income tax – $15,000 US income tax = $65,000 net wages after income tax.
Total income tax paid on the foreign wages = $35,000.
How does the foreign tax credit change this?
It allows you to take the $20,000 of income tax paid abroad, do some calculations on the Foreign Tax Credit Form 1116 as explained in Form 1116 instructions, and determine how much of those $20,000 you can use to reduce the $15,000 tax otherwise owed to the IRS.
The most likely outcome? You will not owe any US income tax on those foreign wages because the foreign tax is higher than the US income tax. If the foreign tax was lower, say, $10,000 instead of $20,000, you would likely reduce the US tax by $10,000 and owe the IRS the $5,000 difference.
A question I get all the time is this:
I paid $20,000 to the foreign country but the US tax is only $15,000. I paid too much!!! $20,000 is a lot more than $15,000. I want the difference back! Will I get it from the IRS?
The short answer to this question is NO.
The foreign tax credit is a nonrefundable credit. We talked about nonrefundable credits above. Because it is nonrefundable, it can reduce your income tax on the foreign income all the way to zero, but not below zero.
This makes total sense if you think about it this way:
You paid nothing to the IRS on those wages. You paid tax to the country that is the source of that income. Why would the IRS pay you back tax money that you paid to another country? You are the one who is responsible for fulfilling your tax obligations in the foreign country, not the IRS.
The purpose of the foreign tax credit is not to reduce or eliminate your foreign tax, but to avoid you paying tax twice on the same income.
What happens with the $5,000 difference, then? Is it lost?
Not necessarily.
It can be carried back one year if you have foreign source income in the prior year; or it can be carried forward up to ten years to offset future US income tax on foreign source income that you may earn in the next ten years.
This is what the outcome would look like:
$100,000 gross wages – $20,000 foreign income tax – $15,000 US income tax +15,000 foreign tax credit = $80,000 net wages after income tax.
$20,000 foreign income tax + $15,000 US income tax -$15,000 foreign tax credit = $20,000 total tax on the foreign income.
$15,000 of tax savings and $5,000 of excess foreign tax credits to carry back or forward, depending on your situation.
This concludes our introduction to the foreign tax credit.
As with everything in taxes, it’s more complicated than this brief explanation may make it seem. We have yet to discuss foreign tax credits category baskets, source limitations, accrual or payment requirements, limitation on what foreign taxes are eligible for the credit, countries that have fiscal tax years instead of calendar tax years like the US does, and a host of other issues that make the calculation of foreign tax credits quite interesting and sometimes frustrating and complex!
We will dive into some of those issues in coming publications of CBP.
For now, I let you enjoy the rest of your weekend and leave you with this picture of a friend who greeted me during my morning walk earlier today:
Until next time. Un abrazo y buena onda,
Much love,
Marina