How U.S. Foreign Tax Credits May Work to Keep Money in the Pocket of a Canadian Filing a U.S. Tax Return?
As a U.S. citizen, or resident alien living in Canada, you may be concerned about filing taxes based on your worldwide income in Canada and again in the US. Fortunately, there are several elections, credits and deductions you may take to reduce, or even eliminate a U.S. tax liability.
With income generally taxed at a higher rate in Canada, claiming foreign tax credits on a US tax return remains one of the most effective tax tools for U.S. persons resident in Canada.
Deduction or Credit?
If you’re wondering which option is best for your tax situation, it’s important to understand the difference between a foreign tax credit and deduction. The good news is that you have many options to choose from when it comes filing your U.S. expat taxes.
The U.S. allows taxpayers the ability of offsetting duplicate payments on income subject both American and Canadian taxation by taking foreign credits or claiming deductions in other countries where they are applicable under their laws – this could save you lots!
For many Canadians, claiming foreign tax credits on their U.S. return often yields a better result. In addition to reducing taxable income dollar-for-dollar and providing an opportunity for up ten years of use against future U.S. liability payments – it can be carried back as well!
For Canadians, this may be a useful strategy to use in the year where foreign tax credits won’t fully reduce U.S. taxes owed. Though Canadian taxes on individuals are generally higher, the use of foreign tax credits in a subsequent year could be useful.
For example, a U.S. person resident in Canada that sells their principal residence can still be subject to tax by the United States even though it would not incur any taxes under Canadian law. The gain on your primary residence under U.S. tax laws is taxable if it exceeds U.S. $250K for single taxpayers or U.S. $500K on joint returns.
In a nutshell, the foreign tax credits available for use in a year when US taxes payable turn out to be higher than those payable in Canada could very well be nothing short of “good news” for such taxpayers.
Sourcing Income
In order to appropriately categorize income, it’s important that you follow the rules set in place for sourcing income.
The first thing to know about claiming a U.S. foreign tax credit is that only income derived from outside the U.S. can be factored into the claim for a foreign tax credit. Some common ways of sourcing income include employment income – generally sourced based on where the services are performed, rental income – generally sourced based on where the property is located and capital gains – generally sourced based on the taxpayer’s country of residence.
In addition, if the foreign earned income exclusion is claimed, foreign tax credits must be reduced to reflect this. In some instances, the Canada/U.S. tax treaty permits the resourcing of U.S.-soured income to foreign-sourced income, which could allow some Canadians to take more foreign tax credits than would otherwise be allowed on their U.S. tax return.
Buckets of Income
When filing U.S. taxes, foreign taxes credits must be grouped into various buckets such as “passive,” for items such as dividend and interest, or “general,” for items such as wages earned outside the U.S.. These amounts are grouped on Form 116, Foreign Tax Credit with a separate Form 116 required for each category of income.
If your foreign creditable taxes are under US$300, or US$600 if married filing jointly, it may be possible to choose to claim foreign tax credits without completing the lengthy Form 116.
Cash vs Accrual
Claiming U.S. foreign tax credits may be done using either a “cash” or an “accrual” method. With the cash method, taxes are reported in the year they are paid, while the accrual method generally permits a taxpayer to claim the taxes that actually relate to the relevant year – even though they may not yet have been paid.
Each case is unique, but a U.S. and Canadian tax professional can help you decide how to proceed.
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Karlene J. Mulraine, EA, CPA, CA, CPA (NH) is the President of Cross-Border Financial Professional Corporation. Follow us on Linkedin and Twitter, or hang out on Facebook.
The views expressed in this article are those of the author and should not be relied on to make decisions. Consider discussing your specific circumstances with an appropriate specialist.