Introduction
A very cold and windy day in New York airport, in 2009, when I saw in the airport, the lady sitting next to me was one third of my age, I presumed waiting for the arrival of Air India. As usual, after the take-off, I started talking about her career and place of abode. Being a British citizen who is pursuing her career in film directing, she expressed her desire to see her name on Oscar award one day. She also informed that though she was born in USA, she was holding a British passport but the immigration authorities recently enquired whether she was filing her US tax return. She wondered why she needed to file US taxation when she earned virtually nothing there. Obviously, she was filing UK taxation papers.When one introduces himself as a CPA from USA, some passengers do talk freely about taxation policies.
It was in 2016 during a casual meeting in the first class of Rajdhani express, when a co- passenger of mine, a leading nutritionist of India enquired about the above problem again. She went one step further calling her birth an accidental one in U.S.A.History repeated.
To explain the above two situations in a taxation language (US), this article on foreign earned income and foreign tax credit deals in depth the issues involved. Why not we dive together to understand them?
Foreign Earned Income
For a U S citizen or a resident alien, the US tax authorities are happy to get them paid the taxes even on their income earned abroad. The case goes back to 1930s when US companies started earning exports in France and UK particularly raising queries on adopting transfer pricing policies. The tax payers living abroad are subject to the same tax filing requirements as those apply to U.S. citizens living in the United States. A resident alien is an individual who is not a citizen of United States and who meets the green card test or substantial presence test for the calendar year:
- Green Card Test: A tax payer is a U.S. resident if he or she was a lawful permanent resident of the United States at any time.
- Substantial Presence Test: A tax payer is considered to be substantially present in U.S. if she lived 31 days in a current calendar year or a total of 183 days during the current calendar year and preceding two calendar years. This 193 days is divided as the whole presence in the current year, with .33% in the preceding year while 1/6th of the days in the second preceding year.
A tax payer may be able to exclude from income up to $1,00,800 in 2015 as per IRS web site information. It may be of interest to know that the figures are inflation adjusted and has shown a rising trend over the years. A tax payer may be able to either deduct a portion of housing expenses from income or treat a limited amount of income used for housing expenses as not taxable by the United States. In order to qualify for either of the exclusions or the deductions, tax payer is expected to have a tax home in a foreign country and have earned income from personal services performed in the foreign country.
Form 2555, Foreign Earned Income is used for these purposes. It can be seen as
https://www.irs.gov/pub/irs-pdf/f2555.pdf?_ga=1.203775894.701754534.1472665867
It consists of 3 pages and is a lengthy form and deserves to be filled in by a seasoned professional like a Certified Public Accountant from U.S.A. I have come across many queries being raised by IRS(Internal Revenue Service), Government of U.S.A. and becomes difficult to answer their enquiry.
Form Number 2555 – Foreign Earned Income
It starts from Line number 1 to Line number 50 with details to be noted under Part 1 to Part 9 as under:
1. General information
2. Taxpayers qualifying under Bona Fide Residence Test
3. Taxpayers qualifying under Physical Presence Test
4. All taxpayers (details of wages, income under business, partnership, allowances paid on behalf of services provided)
5. All taxpayers (details of claiming housing exclusion or deduction)
6. Taxpayers claiming Housing Exclusion and/or Deduction
7. Taxpayers claiming the Foreign Earned Income Exclusion
8. Taxpayers claiming Housing Exclusion, Foreign Earned Income Exclusion, or both
9. Taxpayers claiming Housing Deduction
Even if a self- employed person wants to exclude foreign earned income, self- employment tax can’t be avoided. Taxpayers pay SE tax when the net earnings from self- employment are $400 or more. Your CPA may be able to calculate SE Tax as per inflation adjusted figures. In a separate article, this may be covered in detail in future.
Rules to qualify for the exclusions and the deduction
To claim the exclusions or foreign housing deduction, the tax payer must satisfy all three of the conditions given as under:
- The tax home must be in a foreign country
- The taxpayer must earn foreign income
- The tax payer must be either a U.S. citizen who is a bona fide resident of a foreign country for an uninterrupted period that includes an entire tax year or a U.S. resident alien of a country with whom U.S. has an income tax treaty in effect and a bona fide resident of that country for an uninterrupted period of one entire tax year or a U.S.citizen or a U.S. resident alien who meets the substantial presence test – physically present in that country for a period of minimum 330 days over a period of 12 consecutive months. The minimum waiver requirements are subject to IRS Bulletin issued regularly. India is unlikely to be in that list.
Situation like war or civil unrest in any country may invite waiver from above conditions.
Tax home in a foreign country
A tax payer’s tax home is the general place of his business, or employment regardless of his family maintenance in some other country where his spouse or dependents are living.
Srinivasan Raghavan and Louisville Mary (imaginary names of spouses) are employed in Amazon, California, USA. In November 2015, they got shifted to Chennai for two years to take care of the booming business in India. Due to educational requirements of their children, they continue to maintain their dwelling in CA, USA where they own their house. After reaching Chennai, they rented out a house and started living and enjoyed the cultural life there during their employment. Yes, their tax home is Chennai, India. They satisfy the tax home test in Chennai.
Foreign Tax Credit
Yes, you recently heard this word when so many writers dwelt about the policy guidelines released by Income tax authorities, India. But for us, foreign tax consultants, it is an old word used perhaps during 1930 onwards in U.S.A. or Europe. Detailed guidelines on above subject are repeatedly issued by Internal Revenue Service, Government of U.S.A. vide their instructions under Form 1116.
Foreign Tax Paid
Credit can be taken for the tax paid to a foreign country on income which is also taxed by U.S. In our example, Srinivasan Raghavan would have to apply this concept for the income tax which would be paid in India. This credit is the lesser of foreign tax paid or U.S. tax allocated to foreign source income. U.S. tax is allocated to foreign income by dividing foreign income (after deductions) by income from all sources and multiplying U.S. tax by the result.
Tax payers can opt for deducting foreign taxes paid instead of taking the credit. Individuals can claim the deduction under itemised deductions on line 8, Schedule A, Form 1040. Detailed instructions on Schedule A can be learnt from my earlier article on that subject in Tax Guru web site.
Foreign income is passive and not earned income, then what?
Passive income as the name indicates income arriving without active participation like self- employment or employment as an employee. Instances are interest, dividends, royalties, rents, agricultural income without active involvement, or annuities. Capital gains without actual active conduct of trade or business are also passive income. I have a large number of U.S. citizens of Indian origin who have huge agricultural income in India but need to show the same for U.S. tax authorities under foreign income.
Tax payers can enter amounts directly on line 47, Form 1040 if the above income category is chosen for the income earned. This requires non- use of Form 1116.
Just a look at Form 1116
Form 1116 can be viewed as under:
https://www.irs.gov/pub/irs-access/f1116_accessible.pdf
It consists of Part 1, Part 2, Part 3 and Part 4. Form 1116 is attached with Form 1040, 1040R, 1041 or 990-T.
Various categories of income covered are as under:
- Passive category income
- General category income
- Section 901(1) income
- Certain income re-sourced by treaty
- Lump-sum distributions
Part 1
It contains taxable Income or Loss from sources outside United States for various categories mentioned above. It requires the name of the foreign country or U.S. possession. Whether it is from compensation for personal services is also mentioned. Items 2 to 6 expects the tax payer to fill up the details of various deductions and losses (Details may be sorted out from the instructions to 1116).
Part 2
Foreign taxes paid or accrued. TDS at source for income earned in foreign country on interest earned, dividends, rents and royalties.
Part 3
Headed as Figuring the credit, this section from items 9 to 22 runs through the process of arriving at the credit finally.
Part 4
Expectedly, Part 4 finally arrives at foreign tax credit.
When one covers the foreign tax credit provisions in U.S. , he is expected to touch the relevant provisions as recently notified in India by Indian tax authorities. The Director (Tax Policy and Legislation)-4 Central Board of Direct taxes, has in a communication dated April 18, 2016 has invited comments and suggestions on “Granting Foreign Tax Credit”.
A detailed look may be made on the following link:
http://incometaxindia.gov.in/Lists/Latest%20News/Attachments/25/Draft-rules-for-granting-relief-or-deduction-18-04-2016.pdf
A tax payee will be offered credit for tax paid on a country with whom India has already arrived at a treaty for avoidance of double taxation of income. Obviously, it does not cover the amount paid as penalty, interest, surcharge or cess. As usual, the amount of foreign tax paid on the date of transmission of tax will be converted into Indian rupee.
I expect an expert from India to dwell deeply on this subject in near future.
U.S. States and Income tax
One can easily understand why this writer does not touch the income tax structure of the States of U.S.A. which differ in complexity and culture. Some abhor income tax while others survive on the taxes earned. States like California or New York which offer lots of facilities to poor residents of their states are sticklers for income tax and subject defaulters to heavy penalty or interest burden. Do the instructions contained on pages 1 to 4 of this article apply to the States of U.S.A.? Simply, the answer is “No“. The role of an experienced C.P.A. may be required to make a detailed study of the available rules and regulations to arrive at the resolution of the problem.
Many of my clients pay reasonably for the research or telephonic talks involved in arriving at resolution of their problems. For each State of U.S.A. one has to apply exclusively for unearthing the unknown riddles.
Conclusion
Unfortunately, the writer has not been able to do the full justice with the subject since each situation requires detailed research and many of my clients had varied requirements. It is easy to generalize the rules but difficult to guide the reader to implement them. An attempt has been made to analyse the foreign earned income, instructions under Form 2555, various categories of income for arriving at Foreign Tax Credit, instructions under Form 1116, various sections of Form 1116 and a detailed understanding of the instructions in filling up the columns.
Since the writer invariably comes across wrong advice or misguiding being imparted to Indians earning foreign income living in India, case of foreigners living in India subjected to multi tax requirements of different nations and Indians living in India but were born in foreign countries inviting foreign global income criteria, an attempt has been made to cover the subject. Please do get the help of an experienced C.P.A. to solve your tax problems.
References
- https://www.irs.gov/pub/irs-pdf/f2555.pdf?_ga=1.203775894.701754534.1472665867
- https://www.irs.gov/pub/irs-access/f1116_accessible.pdf
- http://incometaxindia.gov.in/Lists/Latest%20News/Attachments/25/Draft-rules-for-granting-relief-or-deduction-18-04-2016.pdf
- https://www.irs.gov/uac/about-form-2555
- https://www.irs.gov/pub/irs-pdf/i2555.pdf
About the author : Subramanian Natarajan C.P.A. (USA), M.Sc., CAIIB took voluntary retirement in 2000 from Punjab National Bank after handling various facets of banking like deposit mobilization, foreign exchange, auditing and borrower accounts. After living in USA for 12 years during which period he worked in international auditing firms specializing in international tax, auditing, IFRS etc, he continues his practice in New Delhi, India. He can be reached at subcpa@gmail.com. Tel: 7503562701, 9015613229. He currently lives in Delhi. His name appears as tax consultant in web site of American embassy, New Delhi. He is thankful to various suggestions received from readers and is delighted to see the enormous enthusiasm of readers.
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