Foreign Tax Credit versus Foreign Earned Income Exclusion Under the New Law

Abstract

This paper deals with the recent new law concerning foreign earned income exclusion and foreign housing cost allowance exclusion. It points out that the former is $95,100 in 2012, while the latter has a certain limit depending on the location in the world. Nevertheless, both exclusions do not give rise to the reduction of marginal tax rate. Instead, a taxpayer’s tax bracket is determined as if no exclusions were taken. This new tax rule has far-reaching consequences on a U.S. expatriate’s foreign tax credit and tax liability. This paper demonstrates many examples. It also investigates the problem of foreign qualified dividend in determining foreign tax credit. This paper further develops many tax planning strategies for foreign tax credit. The decision depends on whether a foreign country has high or low income and tax rate.

Keywords: Foreign tax credit, foreign earned income exclusion, foreign housing cost allowance, foreign-source income, worldwide income, qualified dividend, rate differential portion, active income, passive income