On the one hand it’s scary… on the other hand it’s exciting… working for a time in a foreign country!
A new culture, but not as a tourist.
The same job, but in a completely different part of the world.
Language, food, pace of life, office culture—learning to navigate the differences can be daunting.
And, by the way, what about all your stuff back home?
And don’t forget about taxes…
Lots to think about.
This short article is most definitely not intended to be a “how to” course on preparing a tax return if you’ve taken an expat assignment. It is, however, intended to answer some basic questions and to share enough information to get you thinking in the right direction.
One question we usually get from clients heading into an expat assignment:
Do I have to file a return in the United States?
Easy, quick answer: Yes, you do!
The US is one of only a couple of countries in the world that assess tax based on the taxpayer’s legal status with respect to citizenship. (If you’re curious, the other is the Philippines.)
US citizens are taxed on worldwide income. A short, sweet, concise fact to remember.
And you’ll most likely be taxed in the country where you’re working as well.
There’s the rub. You might think: “How is that fair? Aren’t I being taxed twice on the same income? If I were doing this same job in the US, I’d only be taxed once!”
There is a whole body of tax law to alleviate this very real inequity.
Are you hoping that this part of the tax law is “easy?”
Of course… it’s not.
Congress has come up with three ways to tackle this problem of double taxation on foreign earned income.
- Foreign Earned Income Exclusion (FEIE)
- Foreign Housing Exclusion (HE)/Foreign Housing Deduction (HD) (depending on whether you’re an employee or an independent contractor working abroad)
- Foreign Tax Credit (FTC)
Theoretically, in a year in which you only had foreign earned income (i.e., no income in the US), you would owe NO TAX in the US.
That’s the goal of the law, but it can be quite tricky to get there.
The ability to take advantage of the first two bullet points above is driven almost exclusively by the number of days you spend in the foreign country compared to the number of days you spend in the US.
The Foreign Earned Income Exclusion is the big-ticket item in this scenario. For 2019, the FEIE is $105,900.
This means that $105,900 of foreign earned income may be excluded from US taxation.
So, how do you get this deduction? How do you qualify?
It’s all tied to the aforementioned number of days and, of course, it’s a bit convoluted.
You have to pass a two-prong test, and deal with another set of terms and acronyms.
The first Test is the “tax home test” (THT).
The second test is one of the following:
- Second Test A: “bona fide residency test” (BFRT), or
- Second Test B: physical presence test (PPT).
Yep, those are the hoops set before you to jump through.
So, what do those terms mean?
Tax Home Test – This test requires you to have your “tax home” in a foreign country for a full 12-month “fiscal” period.
What’s a “tax home”? One of the following three things:
- Main place of business or employment (or deployment) where you are permanently or indefinitely engaged to work as an employee or independent contractor, or
- The place you live regularly if you don’t have a regular or main place of business, or
- Where you work if you’re itinerant.
Bona Fide Residency Test – This test requires you to be in a foreign country for one full calendar year (January 1 – December 31).
That would be easy if that’s where it ended…
However, BFRT includes factors like: intention, purpose, and nature of the job. The law also says that you must establish bona fide residency to the “satisfaction of the Secretary”—the Secretary of the Treasury that is. Which is to say, the IRS has grounds to challenge bona fide residency and it’s up to you to prove it.
Physical Presence Test – Whereas the BFRT had some very qualitative aspects involved, the physical presence test is purely quantitative: just count the days. To pass this test, you must be in the foreign country for 330 full days out of any 12 month period.
The amount of the exclusion warrants the effort of jumping through the hoops.
The Foreign Housing Exclusion (HE)/Foreign Housing Deduction (HD) is the second of the tax law’s ways of alleviating double taxation.
The Foreign Housing Exclusion (HE) is for employees and the Foreign Housing Deduction (HD) is for independent contractors.
This little-known part of the law allows you, basically, to increase the FEIE that we discussed earlier by taking into account your reasonable (i.e., not lavish or extravagant) qualified foreign housing expenses.
An expat assignment will sometimes include employer-paid housing income or allowance. That is NOT an expense, so not what we’re talking about here. It is simply a component of your compensation.
What constitutes a “qualified housing expense” is laid out pretty clearly in the law. And here’s an interesting thing: even if you didn’t pay the expense, but your employer did, the expense can be included in this calculation!
Once you’ve determined what your qualified housing expenses are, then it becomes a math problem.
Of course, it’s sort of a multi-step math problem—why make it easy?
The “floor” is 16% of the maximum foreign earned income exclusion, so for 2019 that would be:
$105,900 x 16% = $16,944
And, the “ceiling” is 30% of the maximum foreign earned income exclusion, so for 2019 that would be:
$105,900 x 30% = $31,770
What that means: If you have a qualified housing expense of more than $16,944 up to a maximum of $31,770, you will add either all of it or a portion of it (depending on number of days in the foreign country in that year) to your foreign earned income exclusion.
You’ll need form 2555 to figure this: form 2555 is the IRS form where the calculation of the FEIE and HE/HD is handled. If you’ve never had a foreign assignment, then you’ve likely never heard of this form… it’s a lot of fun!
Here’s a kind of weird anomaly regarding Form 2555: You’re not allowed to include Form 2555 in your tax return until you have passed the two-pronged test I described above. This results in the unusual situation of simply not being able to file your tax return on time.
What do you do in that situation?
You have to file Form 2350 to apply for a special extension of time to file. (Another form you would almost certainly never have heard of.)
So, what if you diligently count the days you’re in the foreign country, you’ve passed the two-prong test, you’ve calculated your income exclusion related to FEIE and HE/HD, and you have NOT eliminated all of your foreign earned income?
In other words, you are reporting foreign earned income on your US tax return and you are paying tax on it, both in the United States and in the foreign country.
At this point, the third part of the tax law designed to help you avoid double taxation kicks in: the Foreign Tax Credit.
This is calculated on the infamous Form 1116.
Unlike the forms we’ve mentioned already, this is a form that many of our clients may have seen in their tax returns. Not many will have looked closely at it or understood it, but might simply have noticed that it is there.
If you have foreign stocks in your portfolio or hold mutual funds that invest in foreign stocks, then you may see “foreign tax paid” on your broker’s statement. You actually get a credit on your tax return due to having paid this foreign tax, and the information related to the calculation of that credit is on Form 1116.
Form 1116 is fairly complicated, but it is basic in its intent and purpose: you get to take a credit on your US tax return for foreign taxes paid on income that was also taxed in the US. Thus the double taxation is theoretically eliminated.
I say “theoretically” because there are some complicated sort of things that can happen with regard to tax rates and brackets that can spoil the theoretical zeroing out of the double taxation. But you’ve gotten really close!
In a nutshell, that’s how the problem of unfairness of double taxation of foreign earned income is solved by the US tax code!
Daunting. I know.
But, here’s some good news: Most large multinational companies will handle the preparation of your personal tax return for you. That’s quite a perk considering the complexity of your new situation.
Another unique concept you’ll likely encounter if you work on an expat assignment for one of the large multinationals is “tax equalization.”
What is tax equalization?
When your company gives you an expat assignment, very often part of the agreement will be that you will pay neither MORE nor LESS tax from taking the foreign assignment than if you had remained in the United States.
This is accomplished via an adjustment to your overall compensation through what can be a pretty elaborate calculation—the goal of which is to just make sure that you remain economically whole, with respect to taxes, during your expat assignment. The formula for this is sometimes treated as if it is somewhat proprietary, which is why the company will very often require you to have your tax return prepared by one of the international accounting firms which they choose for you.
It’s a best practice to maintain your relationship with your States-side tax advisor throughout your expat assignment and perhaps engage that person to review your tax filing annually.
Your takeaway from this should NOT be: “There are too many complexities with an expat assignment, so I’ll just pass on it.”
Don’t do that! Go see the world. Experience another culture.
Just know there are a few new tax concepts you need to include in your vocabulary and that your tax returns are going to look quite different during your exciting, life-enhancing expat assignment.
From the desk of David Freeze, CPA/PFS.