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The following is designed to provide general information for Americans filing U.S. tax returns from Spain. As with all tax and legal issues, seeking tailored advice from qualified counsel is advisable.
As an American citizen, you are required to comply with long-standing U.S. tax policy creating an obligation to continue filing U.S. tax returns, even after a permanent move abroad. With the potential for double taxation to arise, taking advantage of the various tax breaks available in the United States is crucial. To this end, one of the most important tax planning opportunities impacting American expats working abroad is often neglected.
The choice between electing the foreign earned income exclusion or opting instead to claim a foreign tax credit can produce a variety of different outcomes that will continue to influence your tax situation for years after the initial decision is made. While both options may have the ability to reduce your U.S. tax exposure to zero, the nuances of each and the underlying tax planning opportunities will vary. This article will provide an overview of the basic eligibility guidelines for these two important benefits and outline some of the specific scenarios that might lead you to follow one path over the other.
Foreign Earned Income Exclusion
The foreign earned income exclusion allows employees and self-employed individuals to exclude up to $108,700 (2021) of earned income from U.S. tax. To qualify, the following requirements must be satisfied:
- The taxpayer must receive earned income;
- The taxpayer’s tax home must be located outside the United States; and
- The taxpayer must meet either: A) The physical presence test, or B) The bona fide residence test.
Earned Income Requirement
For this purpose, earned income means payments for the performance of personal services. This can come in the form of salaries and wages or other taxable benefits provided through employment. Interest, dividends, capital gains and other investment income are not treated as earned and not eligible to be excluded. Pension distributions, though attributable to services previously performed, are also classified as unearned income.
This is a straightforward determination for freelance service providers or individuals drawing a salary. However, it can become a bit more complicated for partners in a partnership or owners of businesses that require a substantial initial investment. Income will not qualify as earned if capital is a material factor in its production.
Tax Home Requirement
Tax home is defined as the city or general vicinity of the taxpayer’s principal place of business or employment, regardless of the location of his or her residence. An overseas assignment that is less than one year generally will not result in a change of tax home.
Physical Presence Test
The physical presence test is based exclusively on time spent outside the United States. Taxpayers qualify by spending 330 full days in a foreign country during a consecutive twelve-month period. Time spent in international waters or airspace and partial days of presence will not be counted. The 330 days can be spent in any foreign country that is not subject to U.S. travel restrictions. A two-week holiday in Italy would still be counted for purposes of this test for someone living and working in London.
Importantly, the twelve-month period does not need to coincide with the calendar year. This means that partial exclusions can be claimed when a foreign work assignment commences or concludes during a given year. If a partial exclusion is claimed, the maximum exclusion amount for that year will be prorated to account for the days from the other tax year that are used to qualify. A twelve-month period that runs from July 1, 2020 through June 30, 2021, would allow for an exclusion of $54,350 in 2021 (exactly half of the maximum exclusion amount of $108,700).
Bona Fide Residence Test
The bona fide residence test does not require presence in a foreign country for the entire 330-day period. Instead, it obliges the taxpayer to demonstrate considerable, ongoing connections to that country, looking to the nature of in-country housing, whether family members have also made the move, and general personal and economic connections. Meeting the bona fide residence test requires a full calendar year of residency in that country, though short-term trips can be taken to the United States during the qualifying year.
Notably, taxpayers cannot qualify as bona fide residents if they have taken a position that they are nonresidents of that country for tax purposes. For example, someone who is living in Spain on a non-lucrative visa would be limited from using the bona fide residence test if they have taken a position that they are nonresidents of Spain under the U.S.-Spain Income Tax Treaty on account of their considerable connections back stateside.
Waiver of Time Requirements
The time requirements for both tests are only waived if one must leave the country due to war, civil unrest or similar adverse conditions. The IRS publishes a list of the countries where the waiver will be available during any given year. While generally limited, in Rev. Proc. 2020-27, the IRS expanded this list on account of the pandemic to include Americans leaving any foreign country after February 1, 2020. The list of countries covered by the waiver will be published again for the 2021 calendar year sometime during 2022.
The Foreign Tax Credit
The foreign tax credit offers a dollar-for-dollar offset against U.S. tax for Spanish income tax paid or accrued in that year. The credit can be claimed for tax paid or accrued both on foreign earned income as well as foreign investment income. Value Added Tax and wealth tax would not be classified as income taxes for this purpose.
Tax Credit Baskets
Although the credit is available for all types of taxable income, multiple “baskets” of foreign tax credits have been established to prevent income tax attributable to one type of income from offsetting tax due from another. The two main baskets are the general category, which applies to wages and pensions, and the passive category, which applies to investment income. The Tax Cut and Jobs Act of 2017 created a new basket for “foreign branch” income that may broadly impact the calculations for self-employed individuals. A separate category also exists for foreign tax attributable to U.S. source income for which a credit is available under terms of a U.S. income tax treaty.
Tax Credit Carryovers
Foreign taxes within a given basket that are in excess of the effective U.S. rate on that basket of income can be carried back one tax year and forward ten years. These credit carryovers can produce tremendous tax planning opportunities in later years.
Making the Best Decision Under the Circumstances
With respect to earned income, most American expats living and working in Spain will be eligible for both benefits. However, credits are not available for foreign tax paid on excluded foreign earned income, meaning that both benefits cannot be claimed for the same earnings. The option that makes sense for you will depend on the attributes of your specific tax situation, with the following elements driving the decision-making.
1. You are eligible for refundable tax credits.
The Additional Child Tax Credit is available to American expats and can produce cash payments for tax filers who have not actually remitted any income tax to U.S. Treasury through withholdings or estimated payments. Single Americans earning less than $200,000 and married taxpayers filing jointly earning less than $400,000 will be potentially eligible to receive a refundable tax payment of $1,400 per child below the age of 17 through the 2020 tax year.
The additional child tax credit was further expanded for 2021 with the American Rescue Plan Act (ARPA) of 2021, and the credit amounts may be increased for taxpayers in certain income categories. Those ineligible for the expanded credit will continue to rely on pre-ARPA eligibility guidelines and amounts. Importantly, if you claim the foreign earned income exclusion, you will not qualify for the additional child tax credit, irrespective of whether you meet the other eligibility requirements.
Further complicating this decision, the Recovery Rebate Credit of 2020, another refundable credit designed to administer the 2020 Economic Impact Payments (EIP) to individuals who did not receive the full benefit in the form of advanced checks, applies an income calculation that would not reflect excluded foreign earned income. For higher income taxpayers who did not receive EIP benefits, eligibility for the Recovery Rebate Credit would need to be balanced against loss of additional child tax credit benefits and limitations on claiming and revoking the foreign earned income exclusion year-to-year.
2. You want ease of tax compliance.
If you are working as an employee and your only income source is a Spanish salary below the foreign earned income exclusion threshold, you will have a straightforward tax compliance obligation. Just report your salary in USD, provide some basic information about your employer and your travel dates, and call it a day. For self-filers looking to easily eliminate their annual U.S. tax liability, this will be the path of least resistance. Large U.S. tax companies are beginning to roll out “do-it-yourself” tax preparation products that are tailored to the needs of the American expat community.
3. You receive investment income that is less than the standard deduction threshold for the year or subject to relatively lower rates in Spain.
Tax rates on investment income in Spain will generally be higher than the relative U.S. rate. Nevertheless, the interaction between the foreign earned income exclusion and the standard deduction can shield up to $12,550 (2021) from U.S. tax exposure. For example, if you earn a $100,000 salary, generate $5,000 of U.S. source capital gains and $3,000 in interest from a Spanish bank account, the salary would be exempt by claiming the foreign earned income exclusion and the standard deduction would fully offset the U.S. gains and Spanish. interest income. In this scenario, a small amount of U.S. tax may be due if the foreign tax credit were to be claimed instead.
4. You have already been claiming the foreign earned income exclusion and will soon move to a low-tax country.
If you have been claiming the exclusion and opt instead to claim the foreign tax credit in a particular year, this is treated as a revocation of the exclusion election. When a revocation occurs, you would be unable to claim the exclusion again for five years without requesting IRS consent in the form of a private letter ruling. If you end up working in a country with lower tax rates than the United States during this window, the inability to claim the exclusion would have serious negative tax consequences. Nevertheless, while the opinion is non-binding, in recently issued Private Letter Ruling 202122001, the Service did consent to a Taxpayer claiming the exclusion after a recent revocation following a change in circumstances that led him to move to a country with tax rates relatively lower than the United States.
5. You may be working in a country with tax rates relatively lower than the U.S. in the future.
Subject to the exclusion revocation issue discussed above, if a possibility exists that you will be relocating to a country with low personal income tax exposure, being able to leverage the prior ten years of excess foreign tax credit carryovers from your time working in Spain can produce a considerable windfall. Foreign tax credits for Spanish tax paid in prior years could be carried over to offset U.S. tax on income earned in a later year in Dubai, Hong-Kong, or as a “non-habitual” tax resident in Portugal.
6. You want to continue funding a U.S. IRA account.
Funding an IRA also requires that you have generated earned income. This means that you either need to opt to claim the foreign tax credit or have generated income in excess of the foreign earned income exclusion threshold if you still wish to participate. Excess contribution taxes would be due on contributions to an IRA in a year that you have excluded all your Spanish earnings from U.S. tax.
7. You are funding a Spanish pension.
While private retirement funds are relatively uncommon in Spain, these can still produce considerable Spanish tax savings when offered by an employer. However, the U.S.-Spain Income Tax Treaty does not offer any U.S. tax protection for Spanish pension contributions and these amounts would be subject to U.S. tax. Moreover, contributions to a foreign pension plan are not eligible to be excluded from U.S. tax through the foreign earned income exclusion. When American taxpayers are maximizing Spanish pension contributions, the foreign tax credit is likely to produce a better outcome, but multiple other details must be considered. The amount of passive and earned income generated during the year as well as the amount of the contribution to the pension would be relevant to this decision-making.
8. You are receiving equity compensation from your employer.
The foreign earned income exclusion is only available for income received less than one year after it was earned. Claiming the foreign tax credit will often be the only way to reduce U.S. tax on the compensation component of stock options and grants or similar deferred compensation arrangements that vest over several years.
9. You are filing taxes as an autonomo in Spain.
For self-employed individuals, the foreign earned income exclusion is applied against gross income with expenses attributable to excluded income being disallowed. For example, if you were to generate $200,000 in revenue, with $100,000 of expenses, although your net income is below the exclusion threshold, you would still be showing taxable income. Furthermore, with the new “foreign branch” basket impacting foreign tax credit calculations and carryovers for self-employed individuals, examining the details of the specific business operations is necessary.
10. You have retained state-level residency back in the U.S.
If you are still filing tax returns at the state level, it will be imperative to first determine whether your state of residency permits its residents to claim one of these benefits. With all states having different rules for handling foreign income, you may need to start the credit v. exclusion analysis with a determination of state tax exposure.
Have You Overlooked this Decision-Making in Prior Years?
Many American expats will often be balancing several of these elements and the better option may not be entirely clear without further analysis. Making a choice that will provide you with the best overall benefit and create the greatest opportunity for future tax planning should ultimately be the goal. Fortunately, if you have not been giving this decision the attention that it deserves, you are permitted to go back up to three years to make changes to your tax return that could potentially produce cash refunds for you. While refundable tax credits cannot be claimed beyond the three-year statute of limitations, certain claims related to the foreign tax credit are granted an extended ten-year window to make corrections to carryover items.
Expat Legal Services Group can help you determine if you have missed out on tax planning opportunities or refundable credits in prior years. It offers flat fee pricing for tax compliance in conjunction with a unique suite of legal services for American expatriates and foreign nationals with financial interests in the United States. Contact Expat Legal Services Group today at info@expatlegal.com or visit the website at expatlegal.com.
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