Digital Nomad Tax Guide Part IV - The Foreign Tax Credit

An Introduction

Although the General Rule allows the U.S. to tax its citizens on their worldwide income, the tax code has provisions that attempt to minimize the possibility of double taxation, two different nations taxing the same person on the same income.

The foreign tax credit is the main way to achieve this goal. The mechanism allows an individual to receive a credit against their U.S. tax in the amount of income taxes paid to other jurisdictions. Presumably, most digital nomads are moving often enough that they are not paying foreign governments taxes. Therefore, this section likely will not apply to most of you unless you have companies selling products in different countries.

The Rules

Here are the requirements for getting this credit:

1. The party seeking the credit must have been the payor of the credit; and
2. The foreign levy must have been a creditable tax

The first requirement is fairly straightforward. Being the payor of the tax means that the person seeking the credit is actually the one that owed the foreign tax, meaning that taxpayer may not get a foreign tax credit if taxpayer’s mom paid the foreign tax bill.

The second requirement has two subparts. First, to be creditable the tax must actually be considered a tax by U.S. standards. This means that amount paid to the foreign jurisdiction must not be certain to be credited, forgiven, or refunded. Also, fines, penalties, interest, royalties, and charges for specific economic benefits do not represent a tax for purposes of the credit. Second, the “predominant character” of the foreign tax must be the same as a U.S. income tax. The test has a few subparts in and of itself, but in short, it simply means that the tax charged by the foreign jurisdiction must look and act like a U.S. income tax.

The foreign tax credit can get quite a bit more complex particularly when there are corporations and subsidiaries involved. If your company pays a lot of income tax abroad, consult with someone who has expertise on foreign taxes and the foreign tax credit.

Example

Georgia is a web designer. She’s originally from Texas. While they travels extensively, their new home base is in Germany. Their net business income in 2022 is $150,000. Georgia also has additional sources of unearned income totalling $70,000. In 2022, Georgia paid $30,000 in taxes to Germany.

Georgia as an LLC formed in Germany taxed as an S Corp. Their annual salary is $60,000. Georgia owes 15.3% self-employment tax on that income totalling $9,180. 

(For more on how S Corps work, check out this post).

$112,000 of the $150,000 in earned income is exempt from tax using the foreign earned income exclusion. Thus, the difference of $38,000 plus the $70,000 in unearned income, totalling $108,000 is subject to income tax. Georgia’s estimated effective income tax rate is 22%. U.S. income tax would be 22% of $108,000 or $23,760.

Totalling their income and self-employment tax, Georgia’s total owed to the U.S would be $32,940. However, under the U.S. tax treaty with Germany, Georgia gets a $30,000 credit for taxes paid to Germany. Their balance owed to the U.S. is $2,940.

Please note these numbers are purely hypothetical.
 

Quick Links to Each Part of this Blog Series

Part I

Part II

Part III 

Part IV 

Part V