The issue of allocating income and taxes paid abroad on the US tax return is simple yet non intuitive. We are often asked to explain this issue to clients and decided to write a stand-alone article describing the various cases you might encounter. We will use UK as an example - but same concept applies to any country around the world.
As far as the IRS is concerned, both income earned and taxes paid / withheld are considered to have happened on the ACTUAL DATE of the cash flow (ie money hitting or leaving your bank account).
It does not matter whether the cash flow refers to salary associated with a previoius year or whether tax was levied on income you had earned in the the preceeding year.
For the purpose of the foreign tax credit calculation, the IRS takes into account taxes paid or withheld during the CALENDAR YEAR – regardless of whether tax was levied on income earned in the same or previous year.
So, $10,000 tax paid on January 2014 should be reported in the Tax Questionnaire for the 2014 tax year.
Both earnings and tax withheld are reported based on the calendar year. Allocation is made based on your paystubs – the total amount of wages earned from January through December and the total amount of tax withheld from January through December.
Income tax paid on self-employment income is the amount actually paid during the tax year to the resident country tax authorities on income from self-employment.
Income may be earned the same year or in the previous year. The timing of the actual tax payment determines the year where it is reported.
If you utilized foreign tax credit then the amount of refund should be deducted from the foreign tax reported for credit in the prior year. In some cases it may require amendment of the prior year returns, in other cases it can be avoided.
If you did not utilize foreign tax credit in the year for which you received foreign tax refund - do nothing. No need to report it to the IRS.
On your 2014 return you only report 20% actually withheld.
When you file your 2015 return you report additional 20% paid during 2015.
There are two options of handling additional tax paid.
Executive Summary: We recommend that we prepare the return for you before the deadline. We would use:
1. Actual income you earned during last calendar year.
2. Actual taxes you paid during last calendar year (regardless whether it was tax bill for the prior year or automatic withdrawals during the tax year).
Then once we see what your actual situation is (vis-a-vis you owing tax or getting a refund), we will advise on the best course of how to proceed. If need be, we could then wait for your local tax return to be prepared and incorporate it in the filing.
Below we describe the 4 alternative ways this can be handled (all dates assume current calendar year is 2015 and you are filing the 2014 tax year return).
I.J. Zemelman, EA is the founder of Taxes for Expats