Foreigners and the Foreign Tax Credit

Being in Florida, we are a melting pot. In Orlando, it is common to see clients from all over the world. Perhaps it is because of all the different nationalities and foreigners that I have become intimately familiar with the foreign income rules. However, from past tax returns I have seen, from other preparers, it’s probably a good idea to review these rules. About six months ago, I picked up a Canadian client. She lived in Florida for a short time in 2012, and had a work visa. With this visa she was allowed to work in the US and obtain a Social Security Number. In 2012, she was a US subject, and filed Form 1040.

In 2013, she moved back to Montreal. She had a rental property in Florida, and for some reason her tax preparer filed Form 1040 for the consecutive years, instead of Form 1040-NR. Everything was fine, until 2016 when her tax preparer filed Form 1040-X for 2013, and the IRS assessed $3,900 in additional taxes.

I pulled the wage and income (W&I) transcripts for 2013, to see if I found any additional income. The only thing the IRS has listed is the mortgage interest she paid on her rental. She doesn’t have a copy of the amended return that was filed, and subsequent calls to her tax preparer have not been returned. Although, I don’t have all of the information, something came to mind as I reviewed her information.

In 2013, the taxpayer did not meet the substantial or physical presence test to be considered a US subject. Therefore Form 1040-NR should have been filed. As a Canadian citizen, she pays tax in Canada on worldwide income. Therefore, any amount of income she claimed in the US, should have been wiped out by a Foreign Tax Credit for the amount of tax that she paid in Canada on the same income. Because we have a tax treaty with Canada, it would preclude the taxpayer from double taxation. Even if we didn’t have a tax treaty, the taxes paid in the other country on the same income, should be wiped out by the subsequent credit here. For example, let’s say you are a US citizen, and you have a rental property in Canada. You would be required to file a non-resident Canadian return, and pay any taxes owed. The reason is because you have created a nexus in Canada by the simple fact that the rental is there. In the US, any taxes that you paid in Canada would be picked up as a Foreign Tax Credit in the US. The credit should wipe out the taxes you owe in the US.

A few years ago, I had a client that was British. He was a US citizen, but had earned a pension in the UK. This pension required him to file a tax return and pay tax in the UK. Because he was a US citizen, he was required to pay tax on worldwide income. The pension was claimed here as well, and the taxes that were paid in UK was taken as a Foreign Tax Credit in the US. Because the tax rate was so low in the UK, the credit received in the US didn’t wipe out the tax on the income claimed. It took several conversations to explain this to him, but he finally got it.

Another example, is when you have a US citizen or subject that works overseas. In the US, they have to claim the income, and they might qualify for the Foreign Earned Income Exclusion. If there is a balance of tax owed in the US after the exclusion, you need to look at the other country’s tax return to see if any taxes were paid in the Foreign country. Typically, because the income was earned in the Foreign country, that country will require a tax return, and taxes to be paid on the income. However, it is important to point out, not all countries have an income tax. If there were taxes paid, then you can probably wipe out the taxes here with the credit.

The exception to this rule is when you have a client that lives in the US, but earned their money in Puerto Rico, US Virgin Islands, Guam, or any other US Commonwealth or territory. By law these taxpayers are US Citizens. In Puerto Rico, for example, there is a tax, and the taxpayer has to file Form 1040-PR and pay any tax to Puerto Rico that is owed. However, any amounts paid to a Commonwealth or US Territory, is treated like a tax that is paid to a state. It would be deductible on Schedule A, and not a credit.

These rules can get complicated, so make sure you review them.