Being a dual citizen opens the door to two countries’ systems, healthcare, and the advantages of development. However, it also brings a negative aspect, which is double taxation. Simply put, if you have two passports, you will have to pay taxes to both nations. This can be very costly, especially if you are living in one country and do not have any connection to the other. The article here will guide you on how to avoid double taxation and what you can do if you are in the other situation, so just follow along.
What is double taxation?
Dual-citizen individuals are located at the intersection of diverse taxing systems, and their situation is a bit clearer if they do not have an income in multiple countries. The U.S.A. operates a system of taxation based on citizenship, and thus, U.S. citizens, including dual nationality holders, are required to report their total income to the IRS wherever it is earned. Things get even messier when many foreign countries tax the income in their territories, as we, l l causing income to be taxed twice.
U.S. Tax Laws: Who is Eligible?
The U.S. has an unusual system of taxation referred to as “citizenship-based taxation,” which requires all Americans to pay U.S. taxes even if they relocate to a different country or possess a second passport. Every U.S. citizen or permanent resident whose income reaches the minimum reporting threshold is obliged to file a federal tax return and possibly pay federal taxes as well. In case of doubt regarding the requirement to file a return, the IRS has a very useful tool for determining tax filing obligations.
Explained: Avoiding Double Taxation as a Dual Citizen
In case you are subject to income tax in two countries, one being the US, you might still be liable for taxes in a foreign country if you qualify as a tax resident there. A foreign citizen’s status does not mean that he/she is automatically liable to pay taxes in that country, though. By the latest regulations, only the US and Eritrea practice citizenship-based taxation systems.
Factors to Determine Your Status as a Dual Taxpayer
All the countries vary in their definitions of a tax residence; hence, it is paramount to check the rules in the country or countries that are pertinent to you. However, a person might still be considered a tax resident in the country of his/her citizenship (or any other foreign country) if he/she:
- Has a permanent home/residence there.
- Stays there for more than 180 days a year.
- Has a job or maintains significant social or economic ties there.
Tax Breaks You Can Claim: File US Expat Taxes
One of the great benefits of expat living is that one can claim almost all tax credits that are available to a US resident (for example, the Child Tax Credit) while residing in a foreign country. Moreover, there are a couple of transactions, like the citizenship-based taxation, that are exclusive to Americans living abroad, and the list includes the following:
- Foreign Tax Credit (FTC)
- Foreign Earned Income Exclusion (FEIE)
- Physical Presence Test
- Bona Fide Residence Test
- Foreign Housing Exclusion (FHE)
- Tax treaties
- Totalization agreements
What Is the Foreign Tax Credit?
The Foreign Tax Credit is a U.S. tax benefit that gives taxpayers an opportunity to reduce their US tax liability by the amount of taxes they have already paid to the foreign government. This way, the income is not taxed twice—first by the foreign country and then by the US. It is a very appealing choice for both single taxpayers and entities, provided they meet the eligibility criteria.
Who Is Eligible for the Foreign Tax Credit?
In order to apply for the Foreign Tax Credit, taxpayers need to meet the following requirements:
Foreign Tax Must Be a Legal and Actual Tax Liability
Taxes should have been either paid or accrued in a recognized foreign country.
The Tax Must Be an Income Tax
Only income tax from foreign sources is accepted, not sales tax, property tax, or VAT, etc.
The Tax Must Be Paid by You
If your employer pays the foreign tax, you cannot include it in your claim.
You Must Have Foreign-Sourced Income
Only the income generated outside the country is considered.
The Tax Must Not be Refundable
If you get a tax refund or tax benefit from a foreign country, you cannot claim the credit for that portion.
How Can Dual Citizens Use the Foreign Tax Credit?
Let’s see how this can work out in your favor.
Step 1: Calculate Your Foreign Tax Liability
Dual citizens who work, own property, or earn passive income (like dividends or interest) in a foreign country must first find out how much tax they will pay in that country. The foreign tax documents, such as tax returns and payment receipts, must be kept in order to report accurately.
Step 2: Opt Between Foreign Tax Credit/ Foreign Earned Income Exclusion
The Foreign Earned Income Exclusion (FEIE) allows U.S. taxpayers not to pay tax on a specified portion of their foreign-earned income. For 2024, $126,500 is the limit for a qualifying taxpayer. Nevertheless, FEIE does not lessen U.S. tax liability on passive income at all. Such income can be through capital gains or rental income.
What Works?
Most dual citizens prefer claiming the Foreign Tax Credit rather than the FEIE, as it gives them more benefit, st especially in case their foreign tax rate is higher than the U.S. tax rate.
Step 3: Prepare IRS Form 1116
In order to obtain the Foreign Tax Credit, individuals are required to submit Form 1116 containing:
- The country where the foreign income originates.
- Nature of income (salaries, interest, dividends, etc.)
- Taxes paid or accrued abroad.
- Calculation of the credit limit. Form 1118 is used for businesses or corporations.
Step 4: Take the Foreign Tax Credit Calculation
The Foreign Tax Credit is restricted to the lower of the two values, namely:
- The foreign taxes actually paid, or
- The U.S. tax responsibility on the above-mentioned foreign earnings (computed as a fraction of total taxable income)
In circumstances where the foreign taxes you have paid are more than the limit, then the excess credit can be either rolled back to the previous year or rolled forward to be used in the next ten years’ future tax years.
Step 5: Keep Proper Documentation
The IRS needs proof that foreign taxes have been paid. The following should always be kept as records:
- Foreign tax returns.
- Receipts of payments.
- Statements from the employer (if taxes were deducted at the source).
- Bank statements indicating tax payments made to the foreign country.
Foreign Earned Income Exclusion (FEIE)
FEIE is a tax provision that gives US expats the option of paying less on their taxes. It is one of the options that allows for a certain part of your foreign income not to be taxed. The max that can be excluded for 2023 (the taxes you would file in 2024) is $120,000.
Bona Fide Residence Test
The Bona Fide Residence Test allows the IRS to require you to show that you had habitation in a foreign country for at least one calendar year, and this should be supported by your official documents. Some of the documents that you can submit to support your residency claim are residency permits, foreign tax returns, and utility bills.
Totalization Agreements
Totalization agreements can also cut down on the chances of double taxation. Just like tax treaties, the US has totalization agreements with several other countries, such as Canada, the UK, and most of the EU. The agreements say that the nationals of one country living in another will not have to pay social security taxes to both countries.
Tax 5 Years or Less?
Pay US social security taxes.
Tax Over 5 Years?
Pay your country’s social security taxes according to your residency.
Understanding Tax Treaties
Tax treaties are yet another way for US expats to lessen their tax burden. The US has treaties with many countries, such as Canada, Mexico, and the UK, that theoretically prevent double taxation. However, in reality, a “saving clause” that allows the US government to tax Americans as if the treaty did not exist makes most of it a dead letter for US citizen taxpayers.
Advantages of Expat Taxes
US expat taxes come with some benefits, like
- The foreign-earned income exclusion (FEIE) lets you keep your income overseas free of tax.
- Receiving US tax credits equal to the amount of foreign income taxes paid.
- The foreign housing exclusion (FHE) allows you to increase the amount of income subject to exclusion.
- Taking advantage of tax treaty benefits and totalization agreements.
Disadvantages
- Having to file two tax returns.
- Being liable for taxes in two countries.
- More reporting obligations and paperwork (e.g., FBAR, Form 8938)
Reporting Foreign Bank Accounts
This is an important step. Dual citizens who own foreign bank accounts or assets are subject to extra IRS reporting requirements, such as:
FBAR (Foreign Bank Account Report)
This is needed if the total balance of foreign accounts exceeds $10,000 at any point during the year.
FATCA (Foreign Account Tax Compliance Act) Reporting
This applies to those with significant foreign financial assets. Non-reporting of foreign accounts could lead to severe penalties; thus, compliance is very important.
Conclusion
The issue of double taxation with dual citizenship could be seen as something very negative for people, but it only depends on their attitude. However, as we reached the end, it can be resolved with the FTC. Knowledge of the eligibility criteria, tax treaties, proper filing methods, and compliance with both countries’ tax laws can allow a person to legally reduce the U.S. tax liability. It is very important to know the clauses and to be up to date with the latest changes in order not to fall under the international law’s clutches.
FAQs (Frequently Asked Questions)
1. If I have dual citizenship, will I be required to pay taxes in both countries?
The answer is: it depends. The U.S. taxes its citizens on global income, no matter where they are situated, while not all countries do so. If the state that granted you the second citizenship does not do such taxation based on citizenship, then you won’t be required to pay taxes there unless you fulfill some residency or income criteria.
2. What is the Foreign Tax Credit for?
The Foreign Tax Credit (FTC) allows one not to pay taxes two times on the same income. In case you have already paid the income tax in the country of your residence, the FTC permits you to offset that against your U.S. tax liability up to a specified limit. How does it help you? It is one of the best tools for dual citizens.
3. Is the Foreign Tax Credit superior to the Foreign Earned Income Exclusion (FEIE)?
It all boils down to the situation. If you are subjected to higher taxation abroad, the Foreign Tax Credit might be the one to save you. The FEIE will let you discard a portion of foreign-earned income, but it will not help with passive income like dividends or rental income. Some expats actually take advantage of both tax benefits when allowed.
4. I am living and paying taxes abroad; do I still have to file a tax return in the U.S.?
Yes, as a U.S. citizen or a resident alien holding a green card, if your income is at least equal to the minimum filing threshold, you are obligated to file a U.S. tax return, irrespective of foreign tax payments. Penalties may apply for not filing. But on the other hand, filing allows you to claim credits and exclusions that limit or eliminate your tax liability.
5. What documentation do I need to have in hand to substantiate my Foreign Tax Credit claim?
Good documentation will be required to back up your foreign tax credit claim. Those are foreign tax returns, proof of payment, employer statements of tax withholding, and possibly even bank statements for payments.
6. What happens if I’ve paid more tax outside the U.S. than I owe stateside?
If you have paid foreign tax that is greater than your U.S. tax liability on the same income, you will be able to claim only a portion of the credit for the year. But here is the good news: you can either carry over the unused part for one year or carry it forward for up to ten years.
7. Is the Foreign Tax Credit applicable to every kind of foreign tax?
The answer is no; only income taxes are eligible for this credit. Property taxes, VAT, sales taxes, and any taxes paid by others on your behalf (such as your employer) are not eligible. Moreover, if the foreign government reimburses you for the taxes you have paid, this amount cannot be claimed on your U.S. return.
Also Read: Managing Concentrated Stock Positions – Strategies to Reduce Exposure and Taxes
