Overseas Isn’t Out of Reach of U.S. Income Tax for Americans Working Abroad

(RIVERWOODS, ILL., January 2008) – Americans working abroad may already be feeling financial pressure if trying to live in a foreign city on income earned in U.S. dollars. Add to that tax laws that restrict how much can be deducted from income taxes for foreign housing, and overseas assignments may not look as attractive to some expatriates as they once did, according to CCH, a Wolters Kluwer business and a leading provider of tax, accounting and audit information, software and services (CCHGroup.com).

“Tax law changes made in recent years have greatly limited how much U.S. workers abroad can deduct for foreign housing for income tax purposes and may put them in a higher tax bracket on their taxable income, all at a time when the buying power of the U.S. dollar is well below most other currencies,” said CCH Principal Federal Tax Analyst Mark Luscombe, JD, LLM, CPA.

U.S. citizens’ worldwide income generally is subject to U.S. income tax regardless of where they live. Under provisions of the Tax Increase Prevention and Reconciliation Act of 2005, the amount of foreign earned income that is excluded from taxes was increased. For 2007, the amount of foreign earned income that U.S. citizens can deduct from their income tax is $85,700 ($87,600 for 2008). To be eligible for the foreign earned income exclusion, an individual generally must meet either the bona fide residence test or the physical presence test. The bona fide residence test requires individuals to establish residence in one or more foreign countries for an uninterrupted period that includes a full tax year. The physical presence test requires that the main place of business is in a foreign country and that you have been present in a foreign country or countries for 330 days out of any consecutive 12-month period.

Home Exclusions Limited

While the Tax Reconciliation Act raised the foreign earned income that can be excluded from U.S. taxes, it also put a lid on the tax breaks for foreign housing for U.S. taxpayers working abroad.

The housing exclusion now sets a new base housing amount at 16 percent (computed on a daily basis) of the foreign earned income exclusion multiplied by the number of days of foreign residence or presence for that year. The maximum foreign housing exclusion is the excess of the individual’s reasonable foreign housing expenses over this base amount.

Using 2007 figures, this would mean the base housing amount exclusion for a full-year resident would be 16 percent of $85,700 for 2007, or $13,712. And, it sets the maximum amount of the reasonable foreign housing expenses that may be used in the calculation at 30 percent of the foreign earned income multiplied by the number of days in residence, which would be a maximum of $25,710 for 2007 ($85,700 x 30 percent) if the taxpayer lives year-round in a foreign residence.

Recognizing, however, that this would be extremely unrealistic in many cities, the IRS has issued Housing Expense Limitation Notices that provide exceptions for foreign cities that have high housing costs. For example, rather than a maximum of $25,710 for 2007 housing expenses, someone living in Hong Kong for the full year can claim $114,300 in housing exclusions, $90,900 if they live in Moscow or $86,700 if they live in Paris. As with the foreign income exclusion, individuals must meet the bona fide residence or physical presence test to qualify for the housing exclusion.

“If you’re considering an overseas assignment, it’s important to understand the housing expense deduction in relation to where you plan to live. Because, unless the IRS has made an exception for the city you’re moving to in one of its Housing Expense Limitation Notices , the maximum that can be excluded is $25,710,” said Luscombe. He added that how the IRS guidance treats cities in different countries also varies. For example, the IRS Notices for France provide guidance for specific cities that have higher exclusions with all non-listed cities defaulting to the $25,710 maximum housing exclusion, while for the United Kingdom, IRS guidance provides specific higher exclusions for certain cities, such as London, and then instructs that all other cities beyond those specifically named have a maximum housing exclusion of $38,300.

The maximum exclusion amounts for higher cost cities also are subject to regular review and change by the IRS and new cities are regularly added. For example, several cities in China and the Middle East that had not been covered previously have been added, including Beijing, Shanghai, The Holy Sea and Dubai.

“There’s a good chance the IRS will revisit the high-cost city exclusion costs during the spring again and could make any adjustments retroactive for the entire year, so it’s important you keep up to date on the exclusions,” cautioned Luscombe.

Expats Watch Income Tax Brackets Rise

Another change for U.S. citizens working abroad as a result of the Tax Reconciliation Act is that they must now add back in any exclusion amounts taken to determine their income tax bracket. Previously, employers could increase expats income to help offset any extra taxes or expenses they may realize in taking an overseas assignment, with employees then free to deduct all these expenses and push their income into a lower bracket.

“With the housing exclusion, many employees who had been able to push their tax bracket down to the 10-percent level are now looking at tax rates of 25 percent or higher because even the more restricted amount they can deduct for housing must be added back in for determining their tax bracket,” said Luscombe.

However, Americans working abroad still have other means available for helping them reduce their taxes, including deduction or credit for foreign income tax paid. If they are unable to exclude all of their income under either the foreign earned income exclusion or the housing exclusion, they can still claim a deduction or a credit for the amount of income tax paid to a foreign government. The deduction would be claimed as an itemized deduction on Schedule A of the 1040 Form; the credit would be claimed on a special form, Form 1116, Foreign Tax Credit. Whether the deduction or credit would be more advantageous to claim depends on the situation, although the credit is often more advantageous. Individuals may need to figure out their taxes both ways (or have a tax professional do this) before deciding.

They also are eligible for many of the same exemptions, deductions and credits they would be eligible for living in the United States, including such things as deductions for moving expenses and exemptions for dependents. One added bonus for Americans working abroad is that they also can deduct the cost of storage for their belongings left behind in the U.S. while they’re working abroad.

Whether or not an expatriate owes taxes for Social Security and Medicare also depends on the country in which he is working. All workers are generally subject to paying these taxes, regardless of where they work, unless the U.S. government has signed a formal agreement with the government of the country in which the individual is working. Usually, these agreements provide that the individual will only have to pay Social Security-type taxes to one country, and they specify which country will eventually pay the individual’s benefits. If no such agreement is in effect for the country the expat is working in, he may end up paying taxes to both the U.S. and the foreign government.

Taxes of Your Host Country

Americans working abroad will most likely also be taxed in the foreign country in which they are residing, as most countries impose an income tax on individuals living or working there. So that their workers are not penalized from a tax standpoint by foreign assignment, however, many employers have adopted tax equalization policies.

Under these policies, an employer usually ensures that the employee will pay the same amount of tax while on foreign assignment as she would have in the United States. As an example: You pay your company income taxes (through withholding on your compensation) on the income you would have earned had you stayed in the United States and your company pays all of the U.S. and foreign income taxes that you actually owe during your foreign assignment.

Once you have filed your tax return, your employer performs a tax equalization calculation to determine a final tax settlement, which is the amount owed to or from the employer.

“While tax law is offering fewer incentives for deploying workers on overseas assignments, the global economy may be incentive enough for both companies and employees to recognize the value in overseas assignments,” said Luscombe.

Filing Your U.S. Tax Return

Most U.S. citizens living abroad get a two-month extension to file their returns (June 16), but, if they owe, interest charges start adding up on any taxes due beginning on April 15. This applies to U.S. citizens or residents who both have their tax home and abode outside of the United States or Puerto Rico on the regular due date.

Taxpayers working abroad must also report their income in U.S. dollars, even if they receive all or part of their income, or pay all or part of their expenses, in foreign currency. For 2007, taxpayers eligible to exclude any of their foreign earned income or housing expenses under the rules discussed above, usually must file Form 2555, Foreign Earned Income, with their regular Form 1040, unless they have an income of $85,700 or less and are eligible to file the simplified Form 2555-EZ. One of these forms must be filed even if all of their foreign income is excluded and they don’t owe any tax. Additionally, once a taxpayer has elected either or both the foreign earned income or housing exclusions, it remains in effect until revoked.

“Tax issues as they relate to expatriates are extremely complicated, and you would probably be best advised to seek the assistance of a tax advisor before you accept or leave on your overseas assignment,” notes Luscombe. “There is, however, also a range of assistance available from the IRS as tax time approaches.”

The IRS offers services to help taxpayers while outside the U.S. complete and file timely and correct tax returns. During the filing period (January to mid-June), they can get the necessary federal tax forms and publications from U.S. embassies and consulates. The IRS has full-time permanent staff in four U.S. embassy and consulate locations in Frankfurt, London, Paris and Puerto Rico that can provide tax forms and publications; answer federal income tax questions; help with problems; and assist with the preparation of current and prior year tax returns. IRS trained volunteers are also available at some embassies and consulates. The IRS also makes available a special kit for overseas filers, Package 1040-7, containing special forms with instructions and Publication 54.

About CCH, a Wolters Kluwer business

CCH, a Wolters Kluwer business (CCHGroup.com) is a leading provider of tax, accounting and audit information, software and services. It has served tax, accounting and business professionals and their clients since 1913. Among its market-leading products are The ProSystem fx® Office, CorpSystem™, CCH® Tax Research NetWork™, Accounting Research Manager® and the U.S. Master Tax Guide®. CCH is based in Riverwoods, Ill.

Wolters Kluwer is a leading global information services and publishing company. The company provides products and services for professionals in the health, tax, accounting, corporate, financial services, legal and regulatory sectors. Wolters Kluwer has 2006 annual revenues of €3.4 billion, employs approximately 18,450 people worldwide and maintains operations across Europe, North America, and Asia Pacific. Wolters Kluwer is headquartered in Amsterdam, the Netherlands. Its shares are quoted on the Euronext Amsterdam (WKL) and are included in the AEX and Euronext 100 indices. For more information, visit www.wolterskluwer.com.

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