UNDERSTANDING INTERNATIONAL TAXES FOR US AND CANADIAN CITIZENS LIVING ABROAD
Do both Americans and Canadians living abroad have to pay foreign income tax on money they earn outside their respective countries? This is a common question, and if you’re one of the millions of U.S. or Canadian citizens who earn money abroad, you should be aware of two key concepts:
Generally speaking, yes—Both Canadians and US Citizens must pay taxes on foreign-earned income. In fact, the U.S. and Canada are the only two countries in the world as of this writing where taxes are based on citizenship alone, not place of residency. If you’re considered either a Canadian or U.S. citizen or U.S. or Canadian permanent resident, you pay income tax on earnings, regardless where that income was earned.
While there is no all-embracing or universal tax exemption for either Canadian or U.S. citizens abroad, each country’s respective tax agencies have created a few legal options that can help to lower your foreign income tax obligation.
What Types of Foreign Income are Taxable in the U.S.?
If you earn income abroad, you should be aware that most foreign income is taxable in the U.S., including:
Salary or Wages – This includes any form of income paid to you for goods or services sold, which includes if you’re employed by a foreign company or if you’re a self-employed contractor working independently abroad.
Interest – Interest includes any and all income earned from a foreign bank account or a Certificate of Deposit (CD,) for instance.
Dividends – Dividends include disbursements on any foreign-owned stock.
Rental Income – Perhaps you purchased a home in the Caribbean for a great price, and you turn it into a rental property. That rental income is also subject to taxation.
If you earn from any of these types of income, you almost certainly have a tax liability to the U.S.
You have a tax liability to the U.S., but how do you report it in your yearly U.S. tax filing? If you’re a private contractor, how do you report foreign income without a W-2?
If you earned foreign income abroad as previously described, you are legally required to report it to the U.S. on an IRS document known as Form 1040. Also, you may have to file a few other forms relating to foreign income, like an FBAR (FinCEN Form 114) and a FATCA Form 8938.
Even if you earned money while working as a freelancer or contractor offering professional services abroad, you’re considered self-employed and still pay taxes. Additionally, you may also have to pay self-employment taxes.
Reduce your foreign income tax obligations with the Foreign Tax Credit and Foreign Earned Income Exclusion
A question we commonly get is, “how much foreign income is tax-free?” No foreign income is tax-free, but there are mechanisms in place to help prevent you from paying too much or paying taxes twice on the same income—the Foreign Earned Income Exclusion (FEIE), and the Foreign Tax Credit (FTC). They both work to reduce your U.S. taxes on foreign income, one by excluding the income earned overseas from your taxes and the other by giving you a dollar-for-dollar credit on taxes you’ve already paid to your host country.
If you want to take advantage of the Foreign Income Exclusion or Tax Credit, you need to choose to claim the FEIE and the FTC. Not doing so cause endless financial headaches.
Am I Eligible to Claim the Foreign Tax Credit?
The Foreign Tax Credit works in the following manner: Let’s say you are working in a country that has a vague tax treaty with the U.S. Therefore, you end up paying taxes directly to that country. With the Foreign Tax Credit, you can demonstrate legally to the U.S. how much money you paid in taxes to that foreign government and receive a credit for every dollar you owe. Therefore, you don’t have pay taxes for that same income again on your U.S. tax filing.
If qualified, you may claim the Foreign Tax Credit by filing Form 1116.
How can I Claim the Foreign Earned Income Exclusion?
The Foreign Earned Income Exclusion is one of the most common legal tools to avoid double taxation on income earned overseas. Despite that fact, there’s still some confusion on how it actually works—it's not automatic. First, you must spend a certain number of days outside the U.S. per year and prove your ties to your new country of residence. You’ll also need to file a U.S. tax return, and you can only claim the exclusion if you file Form 2555 with your return—even if all your foreign earned income is legally excludible.
How Much is the Foreign Earned Income Exclusion?
The maximum foreign earned income exclusion amount is updated every year. For the 2021 tax year you can exclude up to $108,700 or even more if you incurred housing costs. (Exclusion is adjusted annually for inflation). For your 2022 tax filing, the maximum exclusion is $112,000 of foreign earned income. Married? The exclusion applies to each of you separately, so you each may qualify for the maximum amount unless only one of you works. (source: Foreign Earned Income Exclusion | Internal Revenue Service (irs.gov))
Whether working abroad or in the U.S., you are legally required to file a U.S. tax return if you meet the filing threshold which is generally equivalent to the standard deduction for your filing status.
Before you start down the path of claiming the FEIE, there are some important things you should understand:
If used correctly, the FEIE can save you money on your U.S. taxes
It’s not a blanket or universal foreign income exclusion — there are conditions that dictate what you can exclude and what you can’t exclude.
You don’t automatically get the FEIE — you need to meet specific qualifications and then file the proper paperwork.
The FEIE isn’t the only tax relief option — you should ask your Tax Advisor what options are available to you based on your specific situation.
What Foreign Income can you Exclude with the FEIE?
The foreign earned income exclusion can help reduce or eliminate U.S. taxes on foreign income earned while working abroad, but it doesn’t apply to all sources of income.
This exclusion is only available for earned income and doesn’t apply to passive or investment income such as interest and dividends. Foreign earned income includes:
Salary
Wages
Bonuses
Commissions
Self-employment income
All income must have been earned in a foreign country to qualify as foreign-earned income.
You might also qualify for the foreign earned income exclusion, even if the country in which you're working doesn't assess income tax on compensation, like the UAE.
Who Qualifies for the Foreign Earned Income Exclusion?
The foreign income tax exclusion applies to those who have lived abroad for a certain period of time within the tax year. However, partial-year exclusions are available if you've recently moved to a foreign country or returned to the U.S. mid-year.
The FEIE is available to expats who:
Work outside the U.S. as employees, whether for a U.S. or non-U.S. employer
Work outside the U.S in a self-employed or partner capacity
AND
Pass either the Bona Fide Residency Test or the Physical Presence Test
Employees of the U.S. government cannot legally claim the foreign income exclusion. However, any employee of a private company under contract with the U.S. government might still be eligible.
Passing the Bona Fide Residency Test
To pass the Bona Fide Residence Test, you must effectively prove that you have more ties to a foreign country than the U.S. You are also required to be a resident of that country for an uninterrupted period that includes an entire tax year. If you go back to the U.S., you must have the intention of returning to your current foreign country of residence. Additionally, you must meet the following requirements:
You must be a U.S. citizen or be a resident alien of a foreign country with which the U.S. has an income tax treaty.
You must earn active income. Unearned, or inactive, income like pension payouts, interest, and dividends cannot be included.
You must be overseas for work for a period longer than a year.
You must have a permanent place of work in a foreign country.
It is possible to be a Bona Fide Resident for part of the year if you spent at least a full tax year outside the U.S. in a prior year. As a result, you can claim the FEIE for part of the year.
Passing the Physical Presence Test
To qualify under the Physical Presence Test, you must have been living outside the U.S. for 330 full days out of the year. Be cautious when tracking your time, because a "full day" counts as 24 hours starting at midnight, and you need to be in-country for every minute of those 24 hours!
For example, if you lived in Windsor, Canada and popped over the border to Detroit for Friday night and came back Saturday evening, you wouldn’t be able to count that time towards your 330 full days.
Claiming the foreign tax credit and filing Form 1116 might be the better option if any of these apply to your situation:
You are paying foreign tax at a higher rate than your U.S. tax rate
You wish to participate in an individual retirement arrangement (IRA)
You qualify for certain family-related credits based on non-excluded income
You wish to exclude or reduce taxes on passive or investment income
Foreign Earned Income Exclusion Extensions
Even if you haven’t been out of the country long enough to claim the exclusion by your filing deadline, you can request an extension to file until you’ve met these time requirements.
You generally must claim the exclusion either:
Within one year of the due date of your return
By amending a timely filed return
However, you may claim the exclusion if:
The IRS hasn’t discovered your failure to file your return claiming the exclusion, or
You owe no tax after taking the exclusion into account
If you haven’t filed returns in prior years, you still might be able to exclude your foreign earned income from U.S. tax. This could have the effect of eliminating your tax liability and any penalties and interest that would be assessed.
Foreign Housing Exclusion or Deduction
If you’re an expat and you incur foreign housing expenses, you might be able to exclude or deduct them. The Foreign Housing Exclusion is available for expats working as employees with housing expenses like rent and utilities.
The housing deduction is available for self-employed expats paying foreign housing expenses. The amount of your housing exclusion or deduction is based on the difference between the following:
Your actual foreign housing expenses
A base amount for your foreign country of residence
You can use the Foreign Housing Exclusion if your housing costs total more than 16% of that year’s FEIE.
To calculate the maximum amount you can exclude, you’d multiply that year’s maximum income exclusion by 0.3 to get 30% of the full exclusion amount. So, for 2020, you’d take $107,600 x 0.3 = $32,280. Something to know is that most large metro areas have higher limits, so, again, we can only stress that it is vitally important to have a Tax Advisor who knows the ins and outs of taxes in your specific area and who can help you successfully navigate these tricky waters.
Common problems U.S. expats have with the foreign income exclusion and Form 2555
U.S. expats have a lot of the same questions and issues when they file their FEIE, but these are the most common problems associated with the FEIE:
You didn’t file Form 2555 – Many assume that if they qualify for the FEIE it will be automatically added to their tax filing. To claim the FEIE you must file Form 2555.
You’re a government employee — Unfortunately, U.S. government employees cannot claim this foreign income exclusion.
You failed to calculate the FEIE correctly – If you calculate your FEIE incorrectly you won’t get the correct amount excluded.
You claimed the FEIE when you should have claimed the FTC – For example, if you’re retired abroad and you only have investment and passive income, you may have been better off claiming the FTC.
You didn’t track your time properly – You must be vigilant about tracking your time if you want to pass the Bona Fide Residency or Physical Presence tests. Even being off by a few hours can mess up your qualifications.
You had no active income for that year – If you’re living abroad off investment or passive income, you don’t qualify for the FEIE.
You didn’t pay your U.S. self-employment taxes – You still have to pay self-employment taxes when you’re claiming the FEIE.
A Common Question we get is "Am I required to file Form 1116?"
No, you don’t need to—not doing so doesn’t lead to penalties, however, you might miss out on the benefit of getting a tax credit.
The IRS sets limitations on who qualifies for the FTC. You’re eligible if you are an individual, estate, or trust, and you paid or accrued certain foreign taxes to a foreign country or U.S. possession. There are a few stipulations—the IRS generally uses four tests to determine if you qualify:
The tax must have been imposed upon you.
You must have already paid or accrued the tax.
The tax must be a legal and actual foreign tax liability.
The tax must be an income tax (or a tax in lieu of an income tax).
You can’t choose to pay foreign taxes and then, afterward, claim the FTC—you must have been legally obligated to pay.
How is the Foreign Tax Credit is calculated on tax form 1116?
Each case is different, but generally, to calculate your foreign tax credit for individuals, you’ll take your foreign sourced taxable income divided by your total taxable income before exemptions. Then you’ll take that number, multiply it by your total U.S. tax obligation, and you’ll generally get your available foreign tax credit.
As an added perk, you can use the difference between foreign taxes paid and your FTC as a carryover credit to apply to the next year’s taxes.
Form 1116 Foreign Tax Credit
Before you decide to apply, you need to make sure you qualify. If you do, then you’ll need to make sure you’ve converted the proper amount of tax you paid into U.S. dollars. Then, you’ll classify your income into one of two categories:
General: For earned income such as wages and salaries.
Passive: For investment income such as interest, capital gains, and dividends.
General and passive tax credits are calculated separately, as are the credits from the other categories. Any unused credits first carry back to the prior year and then carry forward for ten years to offset U.S. taxes on that category of foreign sourced income. You should note that you cannot apply carryover credits from one category to another. For example, you can’t use carryover credits from wages on capital gains.
Foreign Tax Credit rules put limitations to what foreign taxes can be included. The following taxes can’t be offset with the FTC:
Taxes paid to a country designated as supporting international terrorism
Taxes on excluded income (such as the foreign earned income exclusion)
Taxes for which you can only take an itemized deduction
Taxes on foreign mineral, oil, and gas income
Taxes from international boycott operations
Taxes related to a foreign tax splitting event
Social security taxes paid or accrued to a foreign country with which the United States has a social security agreement
You can find IRS Form 1116 instructions and IRS Publication 514 on the IRS’ website
Tax Rules for Canadians Abroad
Residence status is one of the main ways to determine your tax obligations to Canada under the law. Therefore, it's always advisable to check your residence status if you plan to live or work abroad, because, depending on your residence status, you may still need to pay income tax even if you live or work abroad.
The Canadian Revenue Agency (CRA) determines your residency status based on whether you intend to leave the country permanently or temporarily.
There are two types of residency status in Canada:
● Resident
● Non-resident
Resident Status
If the Canada Revenue Agency (CRA) establishes your residence status as a Canadian resident, you will pay income tax on income earned anywhere in the world. Even if you spend some time working outside Canada, you'll still be legally obligated to pay both federal and territorial tax. The amount of money you pay as a tax is dependent upon on the amount of money you earn.
As a Canadian resident, you are required to file a T1 tax return covering your income and expenses from Jan 1 to Dec 31 each year. Note that the fixed deadline for filing tax returns and payment of income tax each year is 30th April.
If you're a resident, as described above, you are required to declare your income earned outside of Canada when filing your tax returns, because the income will be taxed in Canada, but you can claim it as a foreign tax credit if you have already paid tax outside Canada.
Non-Resident Status
You would be considered a non-resident if you don’t maintain strong residential ties with Canada and are not a deemed resident
Even if you're a non-resident, you'll still be liable to pay withholding tax from net income sourced in Canada, e.g., company pension plans and investment income, Old Age Security and Canada pension payments, etc.
Non-residents leaving Canada permanently are likely to pay a departure tax calculated as the marginal rate on the taxable capital gains earned if they sold all their Canadian assets. In addition, they'll be required to file the T1243 or departure tax return form.
This form is required for people who ceased to be a resident of Canada in the year and were deemed to have disposed of their property when they left Canada.
The form details the amount of capital gains (or losses) for the properties of which non-residents were deemed to have disposed. Do notice that paying a departure tax does not have any implications on your citizenship, however, it is recommended to consult a professional tax lawyer before deciding whether or not to keep residential ties with Canada.
If you're a Canadian living abroad, taxes regulations require you to declare the net income earned outside of Canada when filing your tax returns to avail your non-refundable tax credits. So, even though you won't be paying income tax, the amount of non-refundable tax credits you can claim in Canada will still be impacted.
Examples to Consider
Let’s say that you're a non-resident and 90% of your income was sourced in Canada and 10% from outside Canada. In that case, you're eligible for a tax-free income of up to $12,069. But you won't be eligible for the tax-free income if you sourced more than 10% of your total income from outside Canada.
If you're a non-resident and you have earned income from property, dividends, or royalties and gross rents in Canada, these forms of income are subject to 25% federal tax, but the CRA can reduce the tax rate, depending on Canada's applicable tax treaty with your country of residence.
Canadian residents fall into the following categories:
Deemed Resident
Deemed residents of Canada are individuals who sojourn in Canada for not less than 183 days and are not a resident of another country. They may not have significant residential ties but are still considered to be residents of Canada. Tie-breaker rule will apply if the individual is also a resident of another country with which Canada has a tax treaty.
Factual Resident
Those who are considered factual residents of Canada have “significant residential ties” with Canada even when they travel abroad. For instance, the CRA considers you a factual resident if you're among Canadians working overseas for four months while spending the rest of the year in Canada.
Be aware that members of the Canadian armed forces and government employees stationed abroad retain their resident status, regardless of their time in Canada or their residential ties.
Factors Involved in Determining Residency Status
The CRA weighs multiple several factors when assessing an individual's residency status, such as whether:
● You have a home in Canada
● You have a Canadian spouse or common-law partner
● You have Canadian dependents
● You have personal property in Canada
● You have a Canadian passport, bank account, driver's license, and health insurance
● Your total amount of time spent in Canada
● Your travel intentions
● Your preferred permanent location
The following are some Canadian tax tips that you should be aware of to meet your tax obligations:
Foreign Tax Relief
Generally speaking, any tax you pay as foreign tax is allowed as a tax credit. This is to effectively reduce double taxation if you've already paid foreign tax. However, the foreign tax credit can vary, depending on what foreign country you're residing in. This is another of many reasons why having a tax expert help you is so crucial.
Provincial Foreign Tax Credit Relief
This type of tax credit is limited to the total foreign tax paid that exceeds the amount of tax allowed for non-business foreign income taxes.
Double Tax Treaties
Many developed (and several developing) countries have negotiated a tax treaty with Canada. These treaties comply with the Organization for Economic Cooperation and Development (OECD) model treaty, other than those signed prior to 1971. As of this writing, there are approximately 95 countries that have negotiated a double tax treaty with Canada.
Concluding Remarks
As you can clearly see, foreign income taxation isn’t a simple process. While there are a general set of universal rules and guidelines, due to multiple stipulations, schedules, and various requirements in each individual case, it’s always in your best interest to let a trusted foreign income tax expert advise you on your taxes, such as our experts at Borderless Counsel. Incorrect reporting or errors can lead to large penalties, including civil and criminal ones. Having someone on your side who knows the ins and outs of all the forms, processes, and legal requirements can save you money and give you peace of mind. Let us help you today!
EMAIL US: info@borderlesscounsel.com