Based on the current US tax laws for expats, many taxpayers (mainly those in high tax countries) may be better off if they “revoke” one of the main benefits for expats, the Foreign Earned Income and Housing Exclusions.
Some background – the Foreign Earned Income and Housing Exclusions are not “optional”. If you don’t want to claim the Foreign Earned Income and/or Housing Exclusions (after you have once claimed them on a prior tax return), you need to “revoke” them by attaching a statement to your tax return (see IRC Sec. 911(e)(2) for those of you who like to read the Internal Revenue Code).
Why the change now? The Tax Increase Prevention and Reconciliation Act of 2005 (ironically) changed (by increasing) the way expats calculate the US tax on “non-excluded” income. Prior to the 2006 tax year, expats would deduct the exclusions and then calculate the tax on the remaining income, so you got to use the lowest marginal tax rates. As of 2006, you need to add back the exclusions before calculating tax, which means you generally “start” at a much higher marginal tax rate (the IRS calls this the “stacking rule”).
Since Foreign Tax Credits are calculated based on average tax rates, but the income gets taxed at the higher “marginal” tax rates, you “lose out” when calculating you foreign tax credits if you use the exclusion (and have sufficient foreign tax credits).
For example, a taxpayer in the Netherlands (without the 30% ruling) earning $200K might pay $75K in Dutch income tax. If they use the exclusion, their US tax would be (roughly) based on $200K – $80K = $120K (less deductions and exemptions). Let’s say the “marginal” US tax rate is 30%, or $36K of tax before credits. The tax after credits would be zero and the Foreign Tax Credit Carryover would be $9K ($75K Dutch tax paid less $30K allocated to excluded income less $36K used as a Foreign Tax Credit).
If the taxpayer did not claim the exclusion, the Dutch tax would remain the same, but the US tax would be based on $200K. In this case the “average” tax rate might be (again very roughly) around 25%, or $50K (this is lower than the first example because you get to use the lower tax brackets to calculate the average rate). After applying Foreign Tax Credits, the US tax would still be zero, but the Foreign Tax Credit Carryover would now be $25K ($75K less the $50K used as a Foreign Tax Credit).
Since “excess” tax credits carry over for 10 years, the taxpayer would be leaving $16K “on the table” by taking the exclusion (since the tax due in both cases is zero, but the carryover with the exclusion was $9K and without it was $25K). In the event the taxpayer then moved back to the US (and continued to have foreign travel days), or to a no tax country such as Dubai, or a very low tax country such as many in Asia, they may have missed out on a huge benefit by unnecessarily using foreign tax credits.
Sound complicated? It is. It turns out this decision is very complex for many taxpayers, not least because you need to know what you are doing for the next several years, because if you do choose to revoke the exclusion, you cannot claim it again until the sixth taxable year after the exclusion was revoked.
Note: If you have the “30% ruling” in the Netherlands, it probably doesn’t make sense to revoke, but it doesn’t hurt to do a quick analysis just in case (we currently do this analysis for all of our clients).