updated 11:52 PM CET, Nov 29, 2022

A comparative analysis, for Americans abroad: The Foreign Tax Credit vs. the Foreign Earned Income Exclusion

As most American citizens who have been abroad for more than a year or two know, U.S. expats are obliged to file U.S. tax returns every year that they remain abroad, even if they never intend to return to the U.S.... 
 
Because of the potential this creates for double-taxation situations to arise, tax experts have long warned of the need for such individuals to take advantage of the various tax breaks that the U.S. makes available to them, particularly if they currently happen to live in a high-tax jurisdiction, such as certain northern European countries.

 
Here, in an article that first appeared in the Summer 2022 edition of American in Britain, a UK-based quarterly magazine for American expatriates, Expat Legal Services Group's Roland Sabates discusses the importance in choosing correctly between the Foreign Tax Credit (FTC) and the Foreign Earned Income Exclusion (FEIE) options – especially since, as he points out, this decision can "continue to influence an expat's tax situation for years" to come.
 
What's more, he adds, despite the fact that this is one of the most important tax-planning opportunities facing the average American who is living abroad, it nevertheless "is often neglected..."
 
(Sabates stresses that his comments here, which were written for an audience of Americans living in the UK, are intended as "general tax information for Americans currently living abroad or contemplating" such a move, and that, as with all tax and legal issues, it is advisable to obtain qualified, tailored advice on this topic as well before taking any action, particularly as the U.S. expat tax regime is constantly changing...)
 
Choosing between the Foreign Earned Income Exclusion and the Foreign Tax Credit, and getting it right, is not a simple matter, but it's worth spending the time to try, rather than just opting for a roll of the dice.
 
Both options have the ability to reduce your U.S. tax exposure to zero, but the nuances of each, and the underlying tax planning opportunities they present, will vary.

This article will provide an overview of the basic eligibility guidelines for these two important benefits, and outline some of the specific scenarios that might lead you to choose one option over the other.

Foreign Earned
Income Exclusion

The Foreign Earned Income Exclusion allows employees and self-employed individuals to exclude up to US$112,000 (2022) of earned income from U.S. tax. 
 
To qualify, the following requirements must be satisfied:
 
    1. The taxpayer must receive earned income;
 
    2. The taxpayer’s tax home must be located outside of the United States; and
 
    3. The taxpayer must meet either:
 
        a. The physical presence test, or
 
        b. The bona fide residence test.
 
 
Earned Income Requirement
 
For our purposes here, "earned income" means "payments for the performance of personal services".  This can come in the form of salaries and wages or other taxable  benefits provided through employment.
 
Interest, dividends, capital gains, and other investment income are not treated as "earned", and not eligible to be excluded.
 
Pension distributions, though attributable to services previously performed, are also classified as "unearned income". This is a straightforward determination for freelance service providers or individuals drawing a salary. However, it can become a bit more complicated for partners in a partnership, or owners of businesses that require a substantial initial investment.
 
Income will also not qualify as "earned" if capital is a material factor in its production.
 
Tax Home Requirement

A U.S. taxpayer's "tax home" is defined as "the city or general vicinity of the taxpayer’s principal place of business or employment, regardless of the location of his or her residence".
 
As a rule, an overseas assignment that lasts less than one year will not result in a change of such a "tax home." 
 
Physical Presence Test
 
The physical presence test is based exclusively on the time a U.S. taxpayer spends outside of the United States during the tax year. 
 
Taxpayers qualify by spending 330 full days in a foreign country during a consecutive twelve-month period. Time spent in international waters or airspace, and partial days of presence, will not be counted.
 
The 330 days can be spent in any foreign country that is not subject to U.S. travel restrictions. A two-week holiday in Italy, for example, would still be counted, for the purposes of this test, for someone living and working in London.

Importantly, the twelve-month period does not need to coincide with the calendar year. This means that partial exclusions can be claimed when a foreign work assignment commences or concludes during a given year.
 
If a partial exclusion is claimed, the maximum exclusion amount for that year will be pro-rated to account, for the days from the other tax year that are used to qualify.
 
A twelve-month period that runs from July 1, 2021 through June 30, 2022, would allow for an exclusion of US$56,000 in 2022 (exactly half of the maximum exclusion amount of US$112,000).

Bona Fide Residence Test

The Bona Fide Residence test does not require that the taxpayer is present in a foreign country for the entire 330-day period. Instead, it obliges the taxpayer to demonstrate considerable, ongoing connections to that country, including the nature of their in-country housing; whether their family members have also made the move; and general personal and economic connections.
 
Meeting the bona fide residence test requires a full calendar year of residency in that country, although short-term trips can be taken to the United States during the qualifying year.
 
Notably, taxpayers cannot qualify as bona fide residents if they have taken a position that they are non-residents of that country for tax purposes.
 
This would be an issue for someone who has taken a treaty-based position that they are not UK residents, for example; but electing remittance-basis in the United Kingdom would not eliminate their eligibility as a bona fide resident.
 
Waiver Of Time Requirements
 
The time requirements for both tests are only waived if the taxpayer must leave the country due to war, civil unrest, or similar adverse conditions. The IRS publishes a list of the countries where the waiver will be available during any given year.

Historically, the list has been limited, including only Burma, Chad, Afghanistan, Iraq, and Ethiopia in 2021.  

The Foreign Tax Credit

The foreign tax credit offers a dollar-for-dollar offset against a U.S. taxpayer's U.S. tax obligations, based on the amount of non-U.S. income and capital gains taxes they paid or accrued during the year in question. 

The credit can be claimed for tax paid or accrued, both on foreign earned income as well as on foreign investment income.
 
Tax Credit Baskets
 
Although the foreign tax credit is available for all types of taxable income, multiple “baskets” of foreign tax credits have been established to prevent income tax attributable to one type of income from offsetting tax due from another.
 
The two main baskets are the "general" category, which applies to wages and pensions, and the "passive" category, which applies to investment income.
 
The Tax Cut and Jobs Act of 2017 (TCJA)  created a new basket for “foreign branch” income, which may broadly impact the calculations for self-employed individuals.
 
A separate category also exists for foreign tax attributable to U.S. source income for which a credit is available, under terms of a US income tax treaty.

Tax Credit Carryovers


Foreign taxes within a given basket that are in excess of the effective U.S. rate on that basket of income can be carried back one tax year, and forward ten years.
 
As we will discuss below, these credit carry-overs can produce tremendous tax planning opportunities in a taxpayer's later years.  

Making the best decision
under the circumstances

With respect to earned income, most American expats living and working in the United Kingdom will be eligible for both benefits (the Foreign Earned Income Exclusion and the Foreign Tax Credit).
 
However, credits are not available for foreign tax paid on excluded foreign earned income, meaning that both benefits cannot be claimed for the same earnings.
 
The option that makes sense for you will depend on the attributes of your specific tax situation, with the following elements driving the decision-making:
 
      1. You want ease of tax compliance – exclusion: 
 
If you are working as an employee, and your only income source is a UK salary that's below the Foreign Earned Income Exclusion threshold, you will have a straightforward tax compliance obligation.

Just report your salary in U.S. dollars; provide some basic information about your employer and your travel dates; and call it a day.

For self-filers looking to easily eliminate their annual U.S. tax liability, this will be the path of least resistance.

      2. You receive tax-protected UK income or U.S. investment income below the standard deduction threshold – exclusion:

U.S. source income or tax-protected UK income would generally produce a US tax liability.

In some scenarios, the interaction between the Foreign Earned Income Exclusion and the standard deduction can shield up to US$12,950 (2022) of these income sources
from US tax exposure.

For example, if you earn a US$100,000 salary, generate US$5,000 of U.S. source capital gains, and U.S.$3,000 in interest from a UK ISA account, the salary would be exempt by claiming the Foreign Earned Income Exclusion, and the standard deduction would fully offset the U.S. gains, and UK interest income.

In this scenario, U.S. tax would likely be due if the foreign tax credit were to be claimed.

      3.  You have already been claiming the foreign earned income exclusion and will soon move to a low tax country – exclusion:
 
If you have been claiming the exclusion, and opt instead to claim the foreign tax credit in a particular year, this is treated as a "revocation of the exclusion election".
 
When a revocation occurs, you would be unable to claim the exclusion again for five years without requesting IRS consent.
 
If you end up working in a country with lower tax rates than the United States during this window, the inability to claim the exclusion would have serious negative tax consequences.

      4. You may be working in a country with tax rates relatively lower than the U.S. in the future – credit:
 
Subject to the "exclusion revocation" issue discussed above, if a possibility exists that you will be relocating to a country with low personal income tax exposure, being able
to leverage the prior ten years of excess foreign tax credit carryovers from your time working in the United Kingdom can produce a considerable windfall.

Foreign tax credits for UK tax paid in prior years could be carried over to offset U.S. tax on income earned in a later year in Dubai, Hong Kong, or Zurich.
 
      5. You have children and are eligible for refundable tax credits – credit:
 
The Child Tax Credit is available to American expats, and can produce cash payments from Uncle Sam, even in a situation in which no U.S. tax was actually paid in. 
 
Eligibility for the Child Tax Credit was broadly expanded to higher income individuals with President Trump's 2017 tax reform package, but the pandemic-era legislation increasing the amount of the credit requires the taxpayer to live in the U.S. for more than half of the tax year.
 
Nevertheless, the original provisions and US$1,400 refundable credit remain available to American expats.
 
Importantly, the credit requires that you have reported earned income on your U.S. tax return. And if you claim the Foreign Earned Income Exclusion, you will not qualify for the refundable portion of the Child Tax Credit, irrespective of whether you meet the other eligibility requirements.
 
      6. You want to continue funding a Traditional IRA or Roth IRA account – credit:

Funding an IRA (individual retirement account) also requires that you have generated "earned income". This means that you either need to opt to claim the Foreign Tax Credit, or to have generated income in excess of the Foreign Earned Income Exclusion threshold if you still wish to participate.
 
Excess contribution taxes would be due on contributions to an IRA in a year that you have excluded all of your UK earnings from U.S. tax.
 
      7. You are funding a UK pension – credit: 
 
Because of the relatively higher rate of tax in the UK, it can potentially be beneficial to forgo treaty-based benefits that would otherwise shield contributions to registered UK pension arrangements from US tax.
 
Instead, using the excess UK tax credits to offset the U.S. tax on the contributions in that year can result in the build-up of an amount that would not be subject to U.S. tax once they're distributed at retirement age – potentially producing meaningful future tax savings for you.

      8. You are receiving equity compensation from your employer – credit:
  
The Foreign Earned Income Exclusion is only available for income received less than one year after it was earned. Claiming the foreign tax credit will often be the only way to reduce U.S. tax on the compensation component of stock options and grants that vest over several years.

      9. You are working in a self-employed capacity – it depends:
 
For self-employed individuals, the Foreign Earned Income Exclusion is applied against gross income, with expenses attributable to excluded income being disallowed.
 
For example, if you were to generate US$200,000 in revenue, with US$100,000 of expenses, although your net income would be below the exclusion threshold, you would still be showing taxable income.
 
Furthermore, with the new “foreign branch” basket impacting Foreign Tax Credit calculations and carryovers for self-employed individuals, examining the details of the specific business operations is necessary.
 
      10. You have retained state-level residency back in the US – it depends:

If you are still filing tax returns at the state level, it will be imperative to first determine whether your state of residency permits its residents to claim one of these benefits.
 
With all states having different rules for handling foreign income, you may need to start the credit v. exclusion analysis with a determination of state tax exposure.
 
Many American expats will often be balancing several of these competing intentions.
 
Making a choice that will provide you with the best overall benefit, and create  the greatest opportunity for future tax planning, should ultimately be the goal.
_________________
Roland Sabates is the founder and managing member of Kansas City, Missouri-based Expat Legal Services Group, which advises the American expatriate community in the areas of international tax, immigration law, and cross-border business and estate planning. The views he expresses above are for general information purposes only, and should not be construed as recommendations or advice for any individual, nor should any action be taken on account of the information presented, without further advice. Furthermore, the choosing of of one's attorney is an important decision that should not be based solely on advertising. Further information may be obtained by contacting Expat Legal Services, via This email address is being protected from spambots. You need JavaScript enabled to view it.or visiting the website at www.expatlegal.com.