Utilising Excess Foreign Tax Credits

Foreign tax credits (FTCs) tend to accumulate in the General Limitation (‘Gen Lim’) Foreign Income category due to the relatively low Federal Tax rate on general earnings. The top Federal tax rate is 37% whereas the top rate in the UK is 45%.

To understand how to best use these credits, now and in the future, we need to understand what income these credits can be applied against. General Limitation Income is not specifically defined. Instead, it captures any income that cannot be defined by one of the other foreign income categories (Passive, Foreign branch and so on). This would generally include foreign employment, related allowances and certain drawings/distributions from pensions.

It is also worth bearing in mind that this is only relevant to foreign (non-US) income, so would only include income that is not US sourced (derived from sources within the US).

The IRS allows taxpayers to carry unused excess FTCs forward for up to 10 years, after which point, the credit carryover expires. This presents potential tax planning opportunities for US expats, especially if they expect to accumulate significant credits over the next decade. Some examples include:

  • Building “Basis” in foreign pensions – The tax treaty between the UK and US enables tax relief on pension contributions by, and on behalf of, US taxpayers (up to certain limits). Initially, it would seem like a good idea to deduct the pension contributions from taxable income. However, it is possible to disregard this benefit of the treaty and instead add the pension contributions back into taxable income on the US tax return. The pension will now contain income that has already been subject to US tax and will therefore payout US tax-free on retirement. The additional income will be considered as Gen Lim and excess credits will be utilsed accordingly. This should have a limited, if any, effect on the US liability with the tax return.
  • Taking a 25% pension drawdown – In the UK, up to 25% of a pension pot can be taken as a tax-free lump sum. A US taxpayer, who is a resident of the UK at the time of the distribution, would report this 25% lump-sum as taxable income on their US return. Excess FTCs from prior years can be used to mitigate the US tax liability.
  • Receiving certain lump sum payments, e.g. UK redundancy payments – While up to £30,000 of redundancy pay is tax-free in the UK, the same exemption does not apply in the US, with the entire £30,000 being fully taxable. No tax will have been withheld on this income in the UK and the taxpayer must therefore rely on excess foreign tax credits.
  • Earning employment income in a low tax jurisdiction – Normally, working in a country with a low income tax rate or those without a US double taxation agreement, would give rise to a US liability, often even when claiming the Foreign Earned Income Exclusion. The reason here is that the Federal rate is now higher than the local foreign tax rate and there are insufficient foreign taxes paid to cover the US tax. If the taxpayer were to move to the low tax country with a pool of excess credits, they would, in theory, be able to alleviate their US tax liability.
  • Non-US Business Travel – Income earned on days working outside of the US is considered as foreign income. Foreign tax credits can be applied to the liability arising on those foreign workdays (subject to limitations of the tax treaty). This is particularly advantageous for individuals returning to the US and traveling for work as a US employee.

The area which provides the most scope for efficient use of excess ‘Gen Lim’ FTCs is undoubtedly pensions. However, due to their complex nature, this requires further reading, so for an introduction on the interplay between FTCs and pensions, please have a read through our article here.

To summarise, without prudent tax planning, hard-earned ‘Gen Lim’ FTCs can be left unused and potentially squandered. Fortunately, there are a variety of options available to make efficient use of them, particularly with regards to pensions. This can however be a complicated area, so for more detailed and bespoke advice, please contact one of the team here at PJD, who will be happy to guide you through the process.