Cross-Border Tax Notes #3 - What is Foreign Source Income?
For clients with compensation earned from working outside the US, understanding the sourcing rules is key to helping your clients avoid paying taxes – to the extent legally possible – to multiple countries on the same income, avoid US income taxation altogether, or even take advantage of foreign tax credits (FTCs) accrued over multiple prior years working abroad.
What is foreign source income?
“Sourcing” means allocating income to each country according to that country’s domestic tax law.
For example, in the US, most compensation elements (for example, base salary and pre-tax deductions) would be considered as earned during the current calendar year. A bonus would be considered to have been earned during the related period – for example, a bonus for 2022 paid in March 2023 is considered to have been earned during 2022. A bonus for Q3 2022 paid in December 2022 would be considered to have been earned between July-September 2022.
This means that, for most compensation elements besides bonuses, if a client worked 90% outside the US during the calendar year, then 90% of their income would be considered foreign source.
Equity compensation, on the other hand, is considered to have been earned over the period from grant to vest, which means that the foreign source portion is calculated as:
the number of workdays physically spent in foreign countries between grant and vest /
the total number of workdays in all countries between grant and vest
So, if your client Alexandra has RSUs vesting from a grant made four years ago, she spent 120 days last year working in Greece, and works an average of 240 days per year, then 120 / 960, or 12.5%, of that RSU tranche would be considered foreign source.
NB: Some countries – and US states, such as California – consider equity compensation as earned between grant and exercise instead, so it’s important to know the local rules - and this does mean that there is an occasional mismatch between countries, so potentially some double taxation.
NB: To simplify (or complicate) matters, some compensation elements are always considered foreign source, regardless of the portion of time your client physically worked in a foreign country, under Treasury Regulations section 1.861-4(b)(2)(ii)(D), namely: housing, education (typically for minor children), local transportation, tax reimbursements, hazardous or hardship duty pay, and moving expense reimbursements.
Why is it important to calculate foreign source income?
Whether helping your client understand their Foreign Earned Income Exclusion (FEIE) or Foreign Tax Credits, the basis for realizing the benefit of either is foreign income – the portion considered as earned outside to the US.
Foreign Earned Income Exclusion
If someone worked 10% in the US during their foreign assignment, then only 90% of their income would be considered foreign source and could be excluded under FEIE. For example, if their total income was $120,000, then 90% would be $108,000 – and that is the portion they could exclude from US taxation – not the total limit of $120,000 (2023), so they would need to plan to pay taxes on $12,000.
Understandably, this could come as an unwelcome surprise.
Foreign Tax Credits
Similarly, when determining how much of a foreign tax credit a client is eligible for, you must also start from foreign source income, because that is one of the several limitations applied against the foreign tax credit: the portion of foreign source income / total income x US income taxes = maximum foreign tax credit you can claim.
For example, returning to Alexandra’s situation, we determined that 12.5% of her RSU income would be considered foreign source. If that was her total income for the year, and her US tax liability were $10,000, then $10,000 x 12.5%, or $1,250, would be the maximum foreign tax credit she could claim, even if she'd paid $4,000 to Greece.
However, if she'd only paid foreign taxes of $1,000, then that would be her maximum credit.
Unfortunately, if your client is does not in fact have any foreign source income – or has not kept careful records – they won't be eligible for either of these benefits.
This is where you could potentially provide substantial value to your clients.
First of all, even if you don't prepare tax returns, when you're explaining the high level mechanics of either the FEIE or FTCs, it's critical to understand the sourcing rules which could potentially substantially limit your client's ability to benefit from either the FEIE or FTCs, and to emphasize the importance of tracking the locations of their workdays.
Second, if they previously worked abroad and amassed a significant FTC carryforward, then sourcing their equity compensation is a great way to help them continue to benefit from the credit for up to 10 years – as long as they track their annual work days and locations.
It’s not an easy feat – each individual tranche has a separate sourcing schedule (due to different grant and vest dates).
RSUs typically vest over 3-4 years, providing great opportunities to use up accumulated FTCs, and because NQSOs typically allow for up to 10 years to exercise, they provide further opportunities to claim FTCs in later years, and this factor should be considered when putting together a comprehensive strategy for taking advantage of equity awards.
I have one client who’d been on assignment in the UK for several years, and had accumulated a sizable FTC carryforward by the time I started working with him. Over the course of the next four years, I went through an annual exercise of sourcing all elements of his compensation – including 32 tranches of RSUs (two different annual awards vesting quarterly over four-year periods). Over those four years, this exercise helped him claim over $38k of foreign tax credits – saving him exactly that much in US taxes. Unfortunately, he wasn't able to use the full carryforward before it expired, but it was nonetheless a very lucrative exercise for him.
How do I know if my client has foreign source compensation?
--> see Form 2555, line 26
--> see Form 1116, "general category income" (box d checked), line 1
Note: if they claim the Foreign Earned Income Exclusion, this amount will be net of the excluded income.
How do I know if my client has a foreign tax credit carryforward?
--> see Form 1116, "general category income" (box d checked), line 14 (total foreign taxes) minus line 24 (FTC used)
As you can see, understanding foreign source income is the key to unlocking each of the three methods to avoid double taxation, and minimize your client’s global tax liability – the Foreign Earned Income Exclusion, Foreign Tax Credits, and bi-lateral income tax treaties – the latter a topic for another day.
Thanks for reading! If you loved these Notes, you can subscribe here.
If you would like to submit feedback and/or suggestions for future topics, you can do so here.