EP 13: Between A Rock & A Hard Place: A Quick Guide To Mitigating Double Taxation
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The U.S. taxes you on your worldwide income, regardless of where you live. If you live in the U.S. and have foreign income, or live abroad, you have to report your foreign income on your U.S. return.
The other country in the equation is also very interested in your income, especially if you live there. And so the fear of being double taxed is real and justified.
We are going to talk about Avoiding Double Taxation.
In this episode, we'll discuss the two main ways of mitigating this issue.
FEIE - Foreign Earned Income Exclusion and Foreign Tax Credits
In addition, we'll also discuss how income is classified, income sources, and tax treaties, as well as some ideas on dealing with stock options (RSU's ISO's, etc).
We'll end it by talking about some financial planning opportunities, that you can use in this situation, as well as the idea that we are not just focused on saving taxes now, but we are looking at a long-term approach.
The speakers' views and opinions discussed in this episode, should not be considered financial, tax, or legal advice. Consult your advisor for any legal, cross-border tax, and financial advice.
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Speaker 1 (00:06):
Welcome to the International Money Cafe Podcast, the show where we filter out the noise on cross-border taxes, finances, and life in the us. I'm your host, Jen Hams, certified financial planner, founder and owner of elgon Financial Advisors,
Speaker 2 (00:21):
And I'm your host, man, Nadi, enrolled agent, owner and founder of Amman Tax and Business Services. Join us on this journey as we explore the unique challenges faced by inbound outbound families and businesses on taxes, compliance and financial planning. Let's get to the show.
Avoiding Double Taxation
Speaker 1 (00:43):
Since we are recording this on the cusp of tax season, our thoughts are a lot about taxation, tax planning, tax savings, and so we are going to talk about a subject that everybody who lives in the US and has foreign income or you live abroad and you have to report your foreign income on your US return is probably going to be really, really interested in. And the topic today is avoiding double taxation.
Mitigating Double Taxation
Speaker 2 (01:19):
Yes, Jane. And most important for those of you, like Jane just said, have a footprint in more than one country or you live abroad and you have to report your worldwide income on your US taxes. Your biggest worry is my income subject to double taxation. And if it is, how can I find ways to mitigate that? Right. So let's break this down. There are several ways of mitigating double taxation and we'll talk about the two most important ones.
Foreign Earned Income Exclusion - FEIE
The first one is the FEIE or the foreign earned income exclusion. So by its very definition, you can see that this is an exclusion that you can take from reporting some or all of your earned income from foreign sources. So when we look at earned income, we can see that that necessarily means it's either wages and salaries or some kind of self-employment income from a foreign source.
Speaker 2 (02:29):
And also because it is a foreign earned income exclusion, it becomes necessary that you pass one of two tests, which is either the bonafide test or the physical presence test. And under each of these, there are some nuances, but the biggest point is that you should have been living outside the country that is outside the United States for more than 330 days in a year. Sometimes this can be a rolling period and we can go into those details maybe at a later date. But just to explain what the foreign earned income exclusion is, there are these annual limits every year. And so for example, for 2023, it's $120,000 that you can exclude against your foreign earned income. You should have lived outside the country and you should have been able to claim either the bonafide test or the physical presence test. All of this is reported on Form 25 55 where you will provide the internal Revenue Service information on your employer, again about the number of days you were outside the country and even if you made trips to the US and went back, what that was so that the IRS has a chance to see that even though you came in and went out, the total number of days you were outside the country was at least 330 days or more.
Speaker 2 (04:20):
And also your spouse can claim a foreign earned income exclusion on their foreign earned income if they had any, if you are filing married filing jointly. Now you'll wonder what if my income was more than the $120,000 it was for 23, right? Which is the foreign earned income exclusion limit. Now for the overage that goes past the exclusion, if the same income was taxed in the foreign country that this income is from, then you have that tax that you paid in the other country for use as a foreign tax credit. Also, if you were in a country where there was no taxation, there are a lot of countries that don't have taxes on their earned income, then that income that goes over the foreign earned income exclusion limit will be subject to US taxes. And of course, what and how much taxes you pay on this will depend on how you file, what is your filing status, whether you have dependents, whether you claim the standard deduction or the itemized deduction, et cetera. So basically that's a 3000 feet view of the foreign earned income exclusion, which is one of the ways that you can mitigate double taxation up to a certain limit.
Five-Year Rule: FEIE
Speaker 1 (05:56):
Ashley, before we jump to the FTC, which you've mentioned, can we stay on this for just one more second and have you talk about the five year rule that you and I talk a lot about when you're using the FEIE? Could you just briefly explain what that five year rule is?
Speaker 2 (06:16):
Yes, definitely Jane. It's an important rule to remember, especially when you are planning on using the FEIE and a lot of things that goes into this, which we will discuss more as we go along. But the five year rule basically is that if you were using the foreign earned income exclusion on your taxes and then you decide that that was not the best way for you or that was not mitigating taxes or you had enough of a foreign taxes credit that you could offset for whatever reason you decided to stop using the FEIE, then remember that you cannot go back to using the FEIE for five years. You have to wait for five years before you can make the foreign earned income exclusion again.
Speaker 1 (07:11):
So
Speaker 2 (07:11):
That's the five year rule.
Speaker 1 (07:13):
Yeah, so the path that's crazy that I think trips a lot of people. So we tell them you can't go back to using it for five years. Does it matter how long you've used it? So could I have used it for five continuous years, 10 continuous years, and then I stop and it's like, okay, James, sorry, you have to wait for five years. Is that what you're saying? It doesn't matter how long you've used it before.
Speaker 2 (07:35):
Yeah, it doesn't matter for how long you've used it. If you stop, then you have to wait for five years to go back to it. Yes.
Speaker 1 (07:43):
Okay. Okay. Sounds good. It really does make taxation complex. But let's talk about then some other important aspects on top of this that we want people to know as they figure out how to avoid double taxation. And I know there's a whole bunch of things you and I have talked about. So let me have you actually talk about income and the source of income.
Foreign Tax Credit
Speaker 2 (08:08):
Yes. So the other tax mitigation strategy is the foreign tax credit. The foreign tax credit basically is a way for you to claim taxes that you have paid in the country where your income is sourced from and you claim that on your US taxes and therefore you avoid double taxation. A from the very nature of the fact that it's foreign tax credit, you should have paid these taxes or that you should have owed these taxes on the same income to another country. And how the taxes calculated is kind of complicated and it's not something that you can just sit and do on the back of an envelope. But again, 3000 feet view, right? So we look at the taxes that you have paid or you owe to the other country, you adjust the income and the taxes paid in the other country to fit the year.
Speaker 2 (09:19):
In the United States, say for example, and we've talked about this before, there are countries which are on the same cadence as the US which is the calendar year, or they could be on a different cadence where their financial year could go for different months. So you have to make sure that the income and the taxes that you're calculating is adjusted. For the US tax year, which is the calendar year, you have to look at the exchange rates, right? So the treasury announces exchange rates for most countries every year, and these treasury exchange rates come out in the end of the year around December or beginning of January. And then you can apply these exchange rates to the foreign tax credit, which is usually an average tax rate for the whole year, and that makes a difference. And then the calculation itself is the foreign tax credit is a proportion of your foreign income to your total worldwide income.
Foreign Tax Credit Calculations
Speaker 2 (10:28):
So there's that math. The numerator is the total foreign taxable income and the denominator is your total worldwide taxable income. And I like to point out to my clients that the closer this fraction is to one, the bigger will be your foreign tax credit. And like I said, again, this is a very broad overview of this topic, and the most important thing to remember is that your foreign tax credit on your US tax return cannot go over your US tax liability, which means that you cannot claim a refund from the IRS for taxes that and over what you paid to the other country. Now obviously your next question is, Hey, I paid a lot of taxes to the other country, what about all of that that I couldn't use? So don't worry, those taxes can be carried forward for 10 years and as long as you have foreign income, you have to have foreign income to be able to use these foreign tax credits against that foreign income. How about that, Jane?
Speaker 1 (11:48):
Pretty nerdy, but I think it's what it is and that's what it entails. If you find yourself in this situation, lemme pull you back out a little bit. Could you say something about, because this is one that I see people bring up foreign housing exclusion and just give it a brief treatment?
Foreign Housing Exclusion
Speaker 2 (12:08):
Yes, yes. The foreign housing exclusion is based off of essentially where you live. If you are claiming the foreign earned income exclusion and each country has a certain calculation, which is on the IRS website, it's very readily available. You can go and look it up, it's based on where you live with city, et cetera, and there's a certain additional housing exclusion available to you and there is a top limit. You can't go over a certain number and claim that housing exclusion, but if you are spending that much money or your employer provides housing to you, that's another option that you can look at, which is the foreign housing exclusion, which is a part of the foreign earned income exclusion. And it gets also calculated and claimed on the same form as the FEIE.
Speaker 1 (13:06):
Does that help? It really does, but I'm going to just keep throwing these questions that I'm seeing as we are talking through this obviously. So we've talked about the FTC, there's also the whole idea of the active passive buckets. Do you want to say something briefly about
Foreign Tax Credit Explained
Speaker 2 (13:22):
That? Absolutely, yes. So the foreign tax credit basically is there are various different categories of income on which the foreign tax credit can be claimed. Sometimes you look at a foreign tax return and you can easily DeMar how much income went against what. But let's step back a little bit to what Jane was saying earlier. There is income that's active, which is your earned income from wages, salary, self-employment, et cetera. And then there is the passive income, which is your income from investments and rentals, et cetera. And there is also certain other income which is like GTI income, et cetera, and GTI is not guilty. It's an acronym G-I-L-T-I. And there are different categories of income and it is important when you are calculating your foreign tax credit to be able to assign brackets to these income sources and what categories that they would fall into and what taxes can be assigned again to these different sort of categories. So how much of the tax was towards active income and how much of it was towards passive income, et cetera. And that's the breakdown. And the form on which the foreign tax credit gets calculated is the 11 16 1 1 1 6, and there is a way that you can show the internal revenue service what incumbents was from which category and how much of the tax is going towards which, and all of that good stuff.
Speaker 1 (15:10):
Great explanation. And you saying that has actually brought to mind something I've seen with clients who were working in the US and now they've moved overseas when it comes to their stock options. So the whole idea of active passive buckets really comes into this. And so if you have options, and this could be all kinds of different options, RSUs, ESOPs, let's see, epps, ISOs, you really want to pay attention to this bit or you really want to be thinking about it. So let's use the example of somebody though here. They moved to another country overseas and they had RSUs or other options that had been granted to them. Now using RSUs as an example, because we know you don't really choose when that vast and when invest, it actually becomes your income. You are actually going to find, let's say as soon as that vest in the US because that's part of your compensation, the US will tax you if you happen to live in a country where they don't tax overseas income or worldwide income, you'll be okay.
Speaker 1 (16:25):
But if you happen to live in another country where they tax you on your worldwide income, this is really the case of double taxation, they will tax you on that. But this is where as MANA has explained, using FTC and other mitigating strategies, really I think the foreign tax credit, you'll be able to get some of that credit back. And so one of the things we've said, it's really not business as usual for you. So if you have foreign income and you've got SOC options, the best thing you can do is really get a little bit nerdy, draw yourself a little chat that says, this is what I have here, this is the date when I got this and this is the type of options that I got. I then moved over to these other country and this is when this vest and really using that will be able to help you hopefully figure out what is being double taxed and what you can do to mitigate some of that. So I think what we are really saying manasa is it's not business as usual, right?
Speaker 2 (17:34):
Absolutely. And since we are talking about foreign tax credit, you should also, and to your point earlier, if you are in a country where there is taxation or you have income from maybe more than one country where one country has taxation and another country does not have any taxation, it happens. People move around a lot these days. There is a lot of things that can apply to you. And then maybe you have to look at how maybe you can combine these factors where you can take both the FEIE and the FTC. That can be another planning option and also a way that you can classify if you have probably income from more than one country and you're paying taxes to both those countries, then how are you mitigating those double taxation if you're subject to it. Also, Jane, when you are talking about RSUs and ESOPs and all that good stuff, I think we should also look at tax treaties.
Double Tax Avoidance Agreements (DTA)
Speaker 2 (18:49):
And in other parts of the world they're called double tax avoidance agreements or dta. So tax treaties, the provisions and the tax treaties and the DTA also become a very, very important aspect of your tax planning and that is something that's always in the background of what we do. The tax treaty sometimes points you to what you should be doing in terms of tax planning and financial planning, especially if let's say for example, if you are one of those auto workers who has income from maybe both Canada and Mexico and the United States and all of these countries are taxing your income, what are your options then? Where were you? How long were you outside the country? That becomes another thing. And also remember if you are a green card holder and if you live outside the US then you might have even more options to look at maybe closer connections or other things where double taxation can be mitigated. So definitely tax treaties are important as well to take into consideration when you are looking at mitigating double taxation.
Speaker 1 (20:08):
So you mentioned green cards and being outside the US and I think we probably need to do a whole different post on this. I do get a lot of questions on, okay, I'm living the country at my green card. But anyway, coming back to the whole idea of double taxations and double taxation avoidance, one of the things as we mentioned to keep in mind is you really want to do, take a long term view on this. So we're not just focused on helping you reduce or avoid double taxation this minute. We need to be thinking long-term five, 10 years because at the end of the day, we still want you to be able to save obviously for your future, for your retirement. So one thing that comes to mind is if you apply the FEIE for example, you exclude your income and you want to contribute to, let's say you I or anything like a Roth that costs for earned income.
Speaker 1 (21:07):
You need to be mindful of the fact that if you end up excluding all your income, then as far as the US is concerned, you won't have money to put into some of these retirement vehicles. So you want to be careful about how far you exclude your income if you are thinking of saving for the long term. But other things like let's say the 5 29 1 of our favorite accounts, you should be able to save into that with your after tax dollars as long as the beneficiary has such a security number or 19 number. So keep in mind, I think really the whole idea is it's long term and you want to keep that in mind. Is there anything else you want to add to this? Man, I don't want to go too far on this.
Speaker 2 (21:53):
No, no, no. I think this is really great. One thing that I would like to add to the FEIE is to remember that it cannot be a partial FEIE if you decide to go down that route. To your point earlier about having enough earned income to be able to make these contributions is you can't say, oh, I'm going to take the FEIE, but I'm going to only take maybe $60,000. You can't do that if you decide to take it. It has to be up to the annual limit, which your income may be lower than that, and then therefore all of it might get excluded. So this is kind of what we were talking about earlier, right Jane before we started recording, is how much of these nuances go into tax and financial planning when you have a footprint in more than one country, and how important it is to keep those conversations going with both your tax and your financial professional and have them maybe talk to each other as well.
One Size Does Not Fit All
Speaker 2 (23:00):
And also remember that where cross-border matters are involved, not one size fits all, sorry, it has to be a unique planning that goes for each of you. So you can't go with, oh, my friend is doing this. So that's another important thing that I remember having to say to a lot of my clients. Yeah, but I think we spoke about good double tax avoidance strategies today and we're good to wrap up today's episode. And dear listener, we love to bring you this content and if you have questions that want us to answer or have topics you would like us to cover, please go to our website, the i am cafe.com, subscribe to our newsletter and please share and subscribe. Bye for now. Hi.
Speaker 3 (24:00):
Thank you for listening to the International Money Cafe podcast. The content is for informational and educational purposes only and should not be used as a substitute for professional advice. Seek the advice of your qualified service provider with any questions you may have regarding your cross order finances and tax needs.