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Practical Tax Strategies 2007 Volume 78, Number 01, January 2007 Articles TAX PLANNING OPPORTUNITIES FOR U.S. TAXPAYERS WORKING ABROAD, Practical Tax Strategies, Jan 2007

WORKING ABROAD

TAX PLANNING OPPORTUNITIES FOR U.S. TAXPAYERS WORKING ABROAD

Taxpayers taking long-term foreign assignments need to choose between claiming a tax credit and an exclusion of income for compensation received for their overseas services. Author: SHIRLEY DENNIS-ESCOFFIER, CPA SHIRLEY DENNIS-ESCOFFIER, Ph.D., CPA, is an associate professor of accounting at the University of Miami in Coral Gables, Florida. [pg. 12] The U.S. taxes its citizens and residents on their worldwide income. This means that Americans who work in a foreign country that imposes a tax on income earned in that country will pay that foreign income tax in addition to U.S. tax on their foreign earned income. The Code contains two provisions to minimize this double taxation: (1) The Section 901 foreign tax credit. (2) The Section 911 foreign earned income and housing cost exclusion. Taxpayers are prohibited, however, from claiming a credit for foreign taxes attributable to excluded income. This makes the decision of whether to elect the exclusion one of many important tax planning decisions to be made by Americans working overseas. Recent changes to the foreign earned income and housing cost exclusion have important implications for the tax planning of individuals on foreign assignments. These changes are also important to employers who reimburse their employees for their additional foreign tax costs through tax protection or equalization plans. This article is intended to highlight some of the important tax issues in planning for overseas assignments to those not familiar with this area of taxation.

Brief history of the exclusion

In 1926, Congress enacted an exclusion for the foreign earned income of U.S. citizens to stimulate foreign trade and to place Americans who worked abroad on equal footing with their foreign counterparts. 1 Six years later, Congress realized that the exclusion allowed U.S. government employees, who were not subject to income taxation of the foreign countries in which they were stationed, to completely avoid paying any income tax. This led to the Revenue Act of 1932 incorporating the exception that amounts paid by the United States or agency thereof were not eligible for the foreign earned income exclusion. 2 The Revenue Act of 1942 increased the residency requirement to close a loophole that allowed taxpayers who left the country for only six months to use this provision to avoid taxes. The revised provision allowed only taxpayers who were bona fide residents of a foreign country for an entire tax year to claim the exclusion. 3 [pg. 13] In 1976, reacting to criticism that allowing both the exclusion and the foreign tax credit provided double benefits, Congress mandated

that the foreign tax credit could not be used for any foreign taxes allocated to amounts excluded from gross income. 4 Two years later, the Foreign Earned Income Act of 1978 revised the exclusion-based system by introducing deductions for excess foreign costs for general costs of living, housing, education, and home leave. 5 The general deduction was based on the income of a person paid the salary of a U.S. government employee at step 1 of grade level GS-14, regardless of the taxpayer's actual income. To encourage U.S. citizens to accept positions in hardship areas, a special $5,000 deduction was allowed for individuals working and living in areas designated by the State Department as hardship areas. Employees residing in these hardship areas could elect to claim a $20,000 earned income exclusion instead of the excess living costs and hardship area deductions. During this time, many American businesses experienced difficulty in hiring American employees to work in foreign countries. To encourage employees to accept overseas assignments, many companies agreed to assume their tax burden and included those costs as part of their compensation packages in addition to cost of living and housing allowances. To help these businesses, Congress increased the foreign earned income exclusion to $75,000, in addition to allowing individuals to exclude excess housing expenses, and shortened the foreign physical presence requirement to 330 days in any 12 consecutive months. 6 In 1997, Congress voted to increase the foreign earned income exclusion to $80,000. 7 (More specifically, the exclusion was $72,000 for 1998, $74,000 for 1999, $76,000 for 2000, $78,000 for 2001, and $80,000 for 2002.) This $80,000 amount was scheduled to be indexed for inflation after 2007. In May 2006, Congress passed the Tax Increase Prevention and Reconciliation Act (TIPRA), which accelerated indexing of the exclusion and resulted in a maximum foreign earned income exclusion for 2006 of $82,400. 8 (The inflation-adjusted amount is $85,700 for 2007. 9) However, to pay for the extension of other tax breaks, TIPRA added a new stacking provision so that income not excluded by Section 911 is now taxed at the marginal rates that would apply if the exclusion did not exist, rather than starting at the lowest tax bracket. 10 For example, a single taxpayer with $82,400 of excluded income and $7,000 of taxable income is taxed at the 28% rate that applies to taxable income in the range of $82,400 to $89,400, rather than the 10% rate that applies to the first $7,000 of taxable income. This stacking provision eliminated one of the previous benefits of electing the exclusion and means that most taxpayers now electing the exclusion will have their taxable income taxed at higher rates. TIPRA also changed the computation of the base housing amount and imposed a new cap on excludable housing costs. Prior to TIPRA, housing costs could be excluded to the extent they exceeded 16% of the annual salary (computed on a daily basis) earned at step 1 of a grade level GS-14 U.S. government employee, multiplied by the number of days of foreign residence in the tax year. For 2006, this salary was $77,793, resulting in a 2006 base housing amount that was to have been $12,447 for a taxpayer entitled to the exclusion for the entire year. TIPRA changed the base housing amount to 16% of the foreign earned income exclusion. 11 Thus, for 2006, the new base housing cost is $13,184 ($82,400 16%) or $36.12 per day. Housing costs less than the base amount are subject to U.S. taxation because the base amount represents an estimate of the minimum costs that taxpayers would incur for housing regardless of where they live. Additionally, prior to TIPRA, no upper limit (other than total foreign earned income) was placed on excludable housing costs, as long as the costs were reasonable. Thus, highly compensated individuals could exclude most of their housing benefits. TIPRA added new Section 911(c)(2)(A), which now imposes a cap on the exclusion of excess foreign housing expenses equal to 30% of the foreign earned income exclusion multiplied by the number of days in the tax year that the individual's tax home is in a foreign country. For 2006, the maximum housing exclusion is $11,536. This amount is the excess of the new cap of $24,720 ($82,400 30%) over the $13,184 ($82,400 16%) new base amount for a taxpayer entitled to the exclusion for the entire year. Thus, the total amount that can be excluded from income in 2006 [pg. 14] (unless the taxpayer is an area designated by the IRS as a high-cost location) is $93,936 ($82,400 + $11,536). For 2007, the maximum foreign housing cost exclusion is $11,998 [($85,700 30%) - ($85,700 16%)]. Consequently, the maximum exclusion for 2007 is $97,698 ($85,700 + $11,998). In recognition of the large variation in international housing costs, TIPRA gave the IRS the authority to issue guidance adjusting the 30% cap on the basis of geographic differences in housing costs relative to costs in the U.S. 12 In October 2006, the IRS issued Notice 2006-87, 13 providing a list of high-cost locations where Americans are allowed higher housing cost limits. This list provides welcome relief to Americans working in many high-cost cities, although the limits are not quite as generous as those under pre-TIPRA law.

For example, Americans working in Hong Kong have a new cap of $114,300, allowing them to exclude up to $101,116 ($114,300 $13,184 base amount) of their housing costs (in addition to excluding up to $82,400 of foreign earned income). The Notice also allows a housing cost exclusion of up to $66,116 for Paris and $58,916 for London. However, some high-cost locations, such as Shanghai, Melbourne, and Dubai, were completely left off the list; this means Americans working in those high-cost locations can exclude no more than $11,536 of their housing costs. The reason for the omission is that Notice 2006-87 provides adjustments only for locations that are listed on the Living Quarters Allowance table for employees of the U.S. Department of State. This State Department table lists only locations where the federal government sends its employees and where U.S. government-leased or -owned housing is not provided. It is possible that future IRS guidance will use a different index that will provide increased housing allowances for more highcost locations.

Qualifying for the exclusion

To qualify for the Section 911 foreign income exclusion and excess housing cost exclusion, an individual must have a tax home in a foreign country and meet either the bona fide foreign resident test or physical presence test.
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The bona fide resident test requires a U.S. citizen to be a bona fide resident of one or more foreign countries for an uninterrupted period of at least one tax year.

The physical presence test requires that a U.S. citizen or resident be physically present in a foreign country (or countries) for 330 full days during a period of 12 consecutive months. Tax advisors should be aware that according to Reg. 1.911-2(g) , the U.S. includes possessions and territories of the U.S. Thus, the term foreign country does not include Puerto Rico, Guam, the Northern Mariana Islands, the Virgin Islands, American Samoa, Wake, and the Midway Islands.

Bona fide resident test. To meet the bona fide resident test, an individual must be a bona fide resident of a foreign country (or countries) for an uninterrupted period that includes an entire tax year (January through December for calendar-year individuals). 14 Whether an individual is a bona fide resident is generally determined by the taxpayer's intentions with regard to the length and nature of the stay. 15 However, Section 911(d)(5) states that an individual is not considered a bona fide resident of a foreign country if the individual claims to that country's authorities that he or she is not a resident and is not subject as a resident to the income tax of that country. The bona fide resident test has been interpreted very narrowly and is sometimes referred to as an assimilation test. The seminal case in this area, Sochurek, 16 provides the following list of factors to consider when deciding if a taxpayer is a bona fide resident of a foreign country: (1) Intention of the taxpayer. (2) Establishment of the taxpayer's home in the foreign country for an indefinite period. (3) Participation in the activities of his or her chosen community on social and cultural levels, identification with the daily lives of the people, and in general, assimilation into the foreign environment. (4) Physical presence in the foreign country consistent with his or her employment. (5) Nature, extent, and reason for temporary absences from his or her temporary foreign home. [pg. 15] (6) Assumption of economic burdens and payment of taxes to the foreign country. (7) Status of resident contrasted to that of transient or sojourner. (8) Treatment accorded the taxpayer's income tax status by his or her employer. (9) Marital status and residence of his or her family. (10) Nature and direction of the taxpayer's employmentwhether his or her assignment abroad could be properly accomplished within a definite or specified time. (11) Good faith in making this trip abroadwhether or not for purposes of tax evasion.

While not all of these factors need to be present for a taxpayer to prove residency, the more evidence that a taxpayer can accumulate, the better. The greater the degree to which a U.S. citizen immerses him or herself in the local culture and severs economic and cultural ties with the U.S., the greater the likelihood he or she will be considered a bona fide foreign resident. The courts have been more lenient than the IRS in interpreting the bona fide resident test. For example in Jones, 17 the Fifth Circuit Court of Appeals ruled that an airline pilot was a bona fide resident of Japan during the period he was assigned by his employer to a Tokyo airport even though his wife resided in Alaska for employment reasons. The Tax Court had originally held that the pilot was not a resident of Japan, and thus, not entitled to the foreign earned income exclusion, because he paid daily rates at a hotel, checking in and out according to his schedule, while he maintained a residence in the U.S. where his family lived. He also had several ties to the U.S. and did not really assimilate into the Japanese community. In reversing the Tax Court, the appellate court noted the right of each spouse to pursue a separate career and stated that an individual should not be denied the exclusion merely because a spouse continues to work in the U.S. The court also noted that he paid Japanese taxes, returned an Alaska dividend check (payable only to Alaska residents) to the state with an explanation that he was no longer an Alaskan resident, and indicated that he intended to live and work in Japan until his retirement. The IRS, however, disagrees with the appellate court's decision and has indicated that it will follow Jones only in the Fifth Circuit. 18 Once a taxpayer has established that he or she is a bona fide resident of a foreign country, this status can be extended to partial tax years. That is, it can extend backward to a prior partial year beginning with the date that the residence actually began and forward to any subsequent partial year ending with the date of return to the U.S. Example. Olga establishes a bona fide residence in Spain beginning on 10/19/06 and continuing through all of 2007. Because Olga is a bona fide resident of Spain for all of 2007, she can also qualify for a partial exclusion for 2006 for the [pg. 16] 74 days that she was a bona fide resident. She can exclude up to $16,706 (74/365 $82,400) of her foreign earned income for 2006. Reg. 1.911-2(c) indicates that a taxpayer's temporary presence in the U.S. for a vacation or business trip does not necessarily prevent him or her from maintaining bona fide resident status if the taxpayer can show that he or she intends to remain in the foreign country indefinitely. Foreign residency also is not considered to be interrupted if residency is established in one foreign country and then, at the termination of that residency, the taxpayer immediately establishes residency in another foreign country. 19 Physical presence test. Whenever significant doubt exists about a taxpayer's ability to satisfy the bona fide foreign resident test, detailed records should be kept to make sure that the 330-day physical presence test can be met. Every full day in a foreign country is counted, and the days do not need to be consecutive. 20 A full day is a continuous period of 24 hours, commencing at midnight and ending the following midnight. Days on which an individual is only partly within a foreign country (such as the day of departure or arrival) are not counted as part of the 330 days because the individual is not in the foreign country for the full day. A series of foreign stays within a 12-month period can be combined to meet the 330-day test. In addition, this rule requires only physical presence in a foreign country. Every day does not need to be a work day; so some of the qualifying 330 days may consist of vacation time in foreign countries. 21 If the taxpayer satisfies the physical presence requirement, but is in the foreign country for less than one full year, the allowable exclusion is computed by dividing the number of qualifying days by the number of days in the tax year and multiplying that fraction by the maximum exclusion. The number of qualifying days can include all days within a period of 12 consecutive months once the individual is physically present and has his or her tax home in a foreign country for 330 full days. The 12-month period should be selected so that it maximizes the number of qualifying days in the tax year. The following example illustrates how to select the 12month period that maximizes the exclusion. 22 Example. Bob is physically present in Switzerland for the 16-month period from 6/1/06 through 9/29/07, except for 15 days in December 2006 when he returns to the U.S. on vacation. To determine the 12-month period for 2006, he counts forward 330 days (not counting the 15 days he is in the U.S.). The 330th day is 5/11/07, so this is the last day of this 12-month period. This 12-month period runs from 5/12/06 through 5/11/07. The number of days during 2006 that fall within this 12-month period is 234 days (5/12/06 12/31/06). Bob's maximum exclusion for 2006 is $52,826, computed by multiplying the fraction 234/365 by $82,400.

Bob determines the maximum number of qualifying days in 2007 by beginning with his last qualifying date in 2007 (September 29) and counting backward 330 days (not counting the 15 vacation days in December). The 330th day is 10/20/06 so this 12-month period runs from 10/20/06 through 10/19/07. The number of days during 2007 that fall within this 12-month period is 292 (1/1/07 - 10/19/07). The inflation-adjusted exclusion amount for 2007 is $85,700, so Bob's maximum 2007 exclusion is $68,560 (292/365 $85,700).

Tax home requirement

Although a taxpayer does not need to demonstrate an intent to remain in a foreign country to meet the 330-day physical presence test, the taxpayer must still show that he or she has established a tax home in a foreign country to qualify for the exclusion. Section 911(d)(3) states that the term tax home has the same meaning for exclusion purposes as it does for Section 162(a)(2) relating to expenses for travel away from home. Although this usually means that an individual's tax home is located at the taxpayer's regular or principal place of business, other factors are considered, such as the extent of an individual's business and family connections with the foreign country as well as the expected length of stay in the foreign country. If the assignment is for an indefinite period, generally expected to last for more than a year, the tax home is likely to be the foreign place of employment. If the assignment is clearly temporary, the taxpayer may not qualify for the foreign earned income exclusion, but may instead be eligible to deduct travel expenses, such as meals and lodging under Section 162(a). [pg. 17] If the individual has no regular or principal place of business, the tax home is at the individual's regular place of abode. 23 Section 911 (d)(3) states that an individual whose abode is in the U.S. cannot satisfy the foreign tax home test. An individual's abode is in the U.S. if his or her economic, family, and personal ties to the U.S. are greater than those to the foreign country. 24 Although it may be more difficult for a taxpayer to show that his or her tax home is in a foreign country when a spouse remains in the U.S., Reg. 1.911-2(b) states that the maintenance of a dwelling in the U.S. by an individual, whether or not the dwelling is used by the individual's spouse and dependents, does not necessarily mean that the individual's abode is in the U.S.

Income eligible for exclusion

Earned income eligible for the exclusion includes wages, salaries, professional fees, and other compensation, such as commissions, bonuses, and incentive premiums paid to induce a move overseas. Earned income may also include any allowances paid for dependents' education costs, housing, home leave, automobiles, other cost-of-living allowances, and any tax reimbursements. Earned income is excludable only if it is foreign source; income is usually sourced according to where the services are performed. Reg. 1.911-3(a) states that the location where the money is received is irrelevant as long as the earned income is from services performed in a foreign country. For a taxpayer involved in a business in which both personal services and capital are material incomeproducing factors, the amount of income considered earned income is limited to 30% of net profits. 25 Capital is considered an income-producing factor if a substantial portion of the gross income of the business is attributable to the use of capital in the business, such as by substantial investment in inventories or equipment. Capital is not considered a material incomeproducing factor if the gross income of the business consists primarily of fees or commissions for personal services performed by an individual who is responsible for the services. For professionals such as accountants, lawyers, or doctors, capital is not considered to be a material income-producing factor, so the entire professional fees amount is considered to be earned income. 26 It is important to note that the foreign earned income exclusion is an exclusion from U.S. income tax only. The taxpayer must usually pay Social Security and Medicare taxes if the employer is American or affiliated with a U.S. employer or if the country in which the individual works has a social security agreement with the U.S. Also, self-employed individuals usually must pay self-employment tax on their income. Certain types of income are not eligible for the earned income exclusion. This includes:
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Interest income. Dividends. Pension income (including Social Security benefits).

Amounts paid by the U.S. or one of its agencies to an employee. Amounts received more than one tax year after the tax year in which the services are performed. 27

U.S. government employees. The justification for denying a foreign earned income exclusion to government employees, including diplomats and members of the U.S. armed forces, is that they are typically exempt from tax by a host country. For this purpose, U.S. government employees includes those working at armed forces post exchanges, officers' and enlisted personnel clubs, embassy commissaries, and similar personnel paid from nonappropriated funds. This denial of exclusion does not apply, however, to amounts paid by the U.S. or a U.S. agency to individuals who are not employees of the U.S. or a U.S. agency. Also, foreign-source income earned by military or civilian employees or their spouses from sources other than the U.S. government may be eligible for the foreign earned income exclusion. Members of the armed forces are entitled to many other tax benefits, such as exclusions for combat zone pay, living allowances, moving allowances, travel allowances, family allowances, in-kind military benefits, and other payments. 28 Bonuses. If an individual receives a bonus that is attributable to services performed in more than one tax year or to services performed both in the U.S. and a foreign country, it is necessary to allocate the bonus to the [pg. 18] related services when computing the exclusion. Regs. 1.911-3(d) and (e) provide that income is attributed to the tax year in which it is earned even if received in another tax year. This means that when computing the exclusion, bonuses and reimbursements are usually attributed to the tax year in which the related services are performed, not to the year of payment. Additionally, under Section 911(b)(1) (B)(iv), a deferred payment (such as a bonus) qualifies for the exclusion only if it is received by the close of the tax year following the year in which it was earned. Deferred compensation received after this point does not qualify for the exclusion. Reg. 1.911-3(e)(4) indicates that bonuses are generally attributable to all of the services that give rise to them on the basis of facts and circumstances. Unless linked to specific services, a bonus is usually divided by the number of months in the period in which the services were rendered and multiplied by the number of months falling into each tax year. Example. In 2004, Bill's employer offered to pay him a $108,000 bonus at the completion of three years of work in Brazil. Bill began work in Brazil on 7/1/04 and worked there during all of 2005 and 2006. He returns to the U.S. on 7/1/07. The company pays Bill the $108,000 bonus in July 2007. For purposes of computing the exclusion, Bill's bonus is considered to be attributable to his entire three years of foreign service, at the rate of $3,000 for each of the 36 months he worked in Brazil. If Bill earned a $72,000 salary for 2006, he can exclude $10,400 ($82,400 maximum exclusion - $72,000 salary) of the $36,000 bonus attributable to 2006. Because the exclusion does not apply to amounts paid after the close of the tax year following the year in which services are rendered, the portion of Bill's bonus attributable to 2004 and 2005 cannot be excluded. This example shows that taxpayers need to consider carefully the timing of bonus payments. To the extent the taxpayer will earn less than the maximum exclusion, bonus payments should be accelerated. In addition, to the extent possible, bonuses should be clearly linked to services performed abroad, such as awarding the bonus on the basis of foreign productivity. 29 Housing costs. Housing (and meals) provided to employees living in employer-provided foreign camps for the employer's convenience are excluded from gross income under Section 119. Many U.S. employers also reimburse their American employees for the additional costs to maintain the same standard of living they enjoyed in the U.S. Personal housing costs are usually not deductible, and if they are paid or reimbursed by an employer, they must be included in taxable income. Section 911, however, allows a qualifying individual to exclude housing costs paid or reimbursed by an employer in excess of a base amount ($13,184 for 2006). Eligible housing costs include any reasonable expenses paid or incurred for foreign housing for the taxpayer, his or her spouse, and dependents during the part of the year the taxpayer qualifies for the Section 911 benefits. Housing costs include rent and other related expenses, such as utilities (other than telephone charges), insurance, furniture rental, and parking, but do not include interest or real estate taxes. 30 Although a self-employed individual is not eligible to exclude housing expenses, he or she can elect to deduct these expenses in computing adjusted gross income. 31 The sum of the foreign earned income exclusion, the housing cost exclusion, and the housing cost deduction (for self-employed individuals) cannot exceed the individual's foreign earned income for the tax year. 32 An individual who elects both the housing cost

exclusion and the foreign earned income exclusion must take the housing exclusion first. 33 An individual who claims the housing cost exclusion must claim the full housing exclusion up to the extent allowable. If an individual has no foreign earned income for the year, he or she cannot deduct any housing expenses for the year, but can carry any unused housing expenses forward one year. [pg. 19] These housing expenses can be deducted in that next year subject to the foreign earned income limit, but only after first using the housing expenses incurred in that year. 34

PLANNING TIP
Prior to 2006, the housing exclusion had no maximum dollar limit other than total foreign earned income, effectively allowing highly compensated individuals to exclude most of their housing costs (as long as the housing was not considered lavish or extravagant). Since TIPRA imposed a new cap on excludable housing costs, taxpayers need to pay close attention to the locations listed by the IRS in Notice 2006-87 and any pronouncements that update this list in future years. Taxpayers who live just outside the city limits of one of these high-cost locations may wish to consider moving just within the city limits. For example, a taxpayer living just outside of Paris, may wish to move just inside the Paris city limits to increase his or her maximum housing exclusion for 2006 from $11,536 for outside Paris to $66,116 in Paris.

Dual-career couples
When both spouses work abroad, Reg. 1.911-5(a) states that each spouse qualifies separately for the foreign earned income exclusion, and the exclusion limit applies separately to each spouse. Example. Oscar and Maria, husband and wife, both become bona fide residents of Italy and work in Italy for 300 days in 2006 and all of 2007. In 2006, Oscar has $70,000 of foreign earned income, and Maria has $60,000 of foreign earned income. The maximum income that either one can exclude for 2006 is $67,726 (300/365 $82,400). Therefore, Oscar can exclude only $67,726 of his foreign earned income, while Maria can exclude all $60,000 of her foreign earned income. Maria's unused exclusion cannot offset any of Oscar's income in excess of his own exclusion. Spouses who live together and file a joint return may compute their housing cost exclusion either jointly or separately. If they file separate returns, they must compute their housing exclusion separately. If they compute their housing exclusion separately, they may allocate their housing expenses to either of them or between them, but each exclusion is reduced by the base amount. 35 If they live together and compute their housing amount jointly, only one spouse can claim the housing cost exclusion or deduction. If, however, the spouses have different periods of foreign residence and the spouse with the shorter period claims the exclusion, only the expenses incurred in that shorter period may be claimed as housing expenses. 36 Where both spouses work abroad but do not live together, each may exclude a housing cost amount if they have different tax homes that are not within a reasonable commuting distance of each other. In this situation, whether they file separately or jointly, the housing cost exclusion or deduction must be determined separately for each spouse. 37

Effect of exclusion on deductions

Section 911(d)(6) prohibits a double tax benefit by disallowing any deductions allocated to excluded foreign earned income. The following formula is used to calculate the nondeductible expenses: Exclusion for foreign earned income and housing ------------------------------------------------Qualifying earned income x Deductions definitely related to qualifying earned income

Under Reg. 1.911-6(a), certain deductions are considered unrelated to any specific item of gross income and, therefore, are always deductible. These include alimony payments, qualified retirement contributions, real estate taxes and mortgage interest on a personal residence, medical expenses, charitable contributions, and personal exemptions. For purposes of these rules, a housing deduction is

not treated as allocated to excluded income. Expenses that are typically disallowed under this provision are unreimbursed employee business expenses and deductible moving expenses incurred in moving to the foreign country. If an employee has reimbursed business expenses and has adequately accounted for them to his or her employer, the amount received up to the actual expenses is not included in earned income and is not allocated to the excluded earned income. 38 If the expenses exceed the reimbursement, excess expenses must be allocated between excluded and nonexcluded income. Example. During 2006, Ken is a bona fide resident of Germany for the entire year. He was paid a salary of $105,000 and he paid $6,000 for expenses related to his employment. He fully accounted for his expenses to his employer and was reimbursed for $4,000 of these expenses. The $4,000 Ken received is not treated as earned income, and $4,000 of the expenses is not deductible. Of the $2,000 excess expenses, $1,570 is allocated to the excluded income computed as follows: $82,400 / $105,000 $2,000 = $1,570 Ken can deduct $430 ($2,000 - $1,570) as a miscellaneous itemized deduction. If an employee does not account for expenses to the employer, such as when an employee receives an expense allowance, the expense allowance is included in earned income and expenses must be allocated between excluded and nonexcluded income. Example. During 2006, Jillian is a bona fide resident of Australia for the entire year. She receives a salary of $100,000 and an expense [pg. 20] allowance of $1,000 per month. She paid $7,000 for business expenses and did not account to her employer for these amounts. Jillian has earned income of $112,000 of which $82,400 was excluded. Her nondeductible expenses are $5,150 ($82,400 / $112,000 $7,000), reducing her deductible expenses to $1,850 ($7,000 - $5,150). Moving expenses. Employer reimbursements for allowable moving expenses (the cost of moving household goods, as well as transportation and lodging expenses incurred in traveling to the new residence) for the employee and family members are usually excluded from the employee's gross income. The unreimbursed portion of allowable moving expenses is deductible as an above-theline deduction in arriving at adjusted gross income. For foreign moves, reasonable costs of storing household goods while the taxpayer's tax home is outside the U.S. also qualify as moving expenses. 39 Reg. 1.911-3(e)(5) provides a special sourcing rule for moving expense reimbursements that are included in the taxpayer's gross income. Taxable reimbursements for expenses incurred in moving from the U.S. to a foreign country are foreign-source income. However, taxable reimbursements for expenses incurred in moving from a foreign country to the U.S. are U.S.-source income, unless prior to the move to the foreign country there is a written agreement that the individual will be reimbursed for those moving expenses regardless of whether the individual continues to work for the employer on return to the U.S. Therefore, an employee may wish to request such as agreement. If a moving expense deduction is allocated to foreign earned income, the deduction is considered to be attributable to services performed in the year of the move only if the individual meets the requirements to qualify for the foreign earned income exclusion for a period that includes at least 120 days in the year of the move. If, however, the individual does not qualify for at least 120 days, the deduction must be attributable to services performed in two years. The moving expense is connected with the year of the move and the succeeding tax year if the move is to a foreign country (or the prior year if the move is back to the U.S.). 40 When an individual's moving expense deduction is attributable to services performed in two years, the taxpayer may use Form 2350 or a comparable form to apply for an extension of time for filing a tax return until after the end of the second year. 41 Storage expenses are attributable to the year in which the expenses are incurred. Moving expenses that are allocated to excluded income cannot be deducted, so this 120-day rule limits the deductible moving expenses. Example. Ed accepted a position in Uruguay in late 2006. He qualified as a bona fide resident of Uruguay for the last 45 days of 2006 and all of 2007. In 2006, Ed's employer paid him $6,000 for allowable moving expenses, fully reimbursing him (under a nonaccountable plan) for his move from the U.S. to Uruguay. The reimbursement was included in his income. Ed's only other foreign income consisted of $15,000 for wages earned in 2006 after his move to Uruguay and $85,700 for wages earned in Uruguay for 2007. Because Ed did not

meet the bona fide residence test for at least 120 days during 2006 (the year of the move), the moving expenses must be allocated to services he performed in both 2006 and 2007. His total foreign earned income for both years is $106,700 ($15,000 wages for 2006 + $85,700 wages for 2007 + $6,000 moving expense reimbursement). Over these two years, Ed can exclude a total of $95,859, consisting of the $85,700 full exclusion for 2007 and a $10,159 ($82,400 45/365) partial-year exclusion for 2006. Of the $6,000 moving expenses, $5,390 ($95,859 / $106,700 $6,000) are disallowed because they relate to excluded income. Ed can deduct only $610 ($6,000 - $5,390) of his moving expenses. Indirect expenses, such as pre-move house-hunting trips, are not deductible. The employee will usually have taxable compensation income if the employer reimburses or pays directly for these or other nonqualifying relocation costs. However, if these expenses can be properly classified as reimbursable business travel expenses, they may be excludable.

How to claim the exclusion

U.S. citizens and residents living abroad are required to file a tax return. A return must be filed even if all of their income is excluded as foreign earned income. The foreign earned income and housing cost exclusion elections are made separately on Form 2555. A taxpayer may use Form 2555-EZ if:
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The housing exclusion or deduction is not claimed.

[pg. 22]
q

Total foreign earned income is no more than the maximum earned income exclusion. The taxpayer has no self-employment income for the year. The taxpayer did not have any business or moving expenses for the year.

If a husband and wife each qualify for the exclusion, each must file a separate form. Once made, an election remains in effect for all subsequent years unless the taxpayer revokes it. Once revoked, the election cannot be made for the next five years without IRS approval. 42 To exclude foreign earned income, the Section 911 qualifying period must have been completed at the time the return is filed. To alleviate this hardship, an individual who is working overseas may obtain an extension beyond the customary six months by filing extension application Form 2350. Taxpayers who expect to file Form 2555 can use Form 673 to notify their employers not to withhold income tax on their wages that will qualify for the exclusion.

Credit for foreign taxes

Under Sections 164 and 901, taxpayers are entitled to claim either a deduction or credit for income taxes paid to a foreign country. The credit will usually result in a greater tax savings than the deduction because it is a dollar-for-dollar reduction of U.S. income taxes. To the extent that foreign income has been excluded from U.S. taxation, the foreign taxes paid on that income do not qualify for deduction or credit. This means that if all foreign income is excluded, the taxpayer cannot claim any foreign tax credit. The portion of foreign taxes that is allocated to excluded earned income is determined by multiplying the foreign tax by a fraction:
q

The numerator of the fraction equals excluded earned income, less deductible expenses related to excluded earned income. The denominator of the fraction is the earned income, less deductible expenses allocated to earned income.

Any deductions allocated to foreign-source income reduce the allowable foreign taxes available for the credit. Mortgage interest, real estate taxes, medical expenses, charitable contributions, and alimony payments are apportioned to foreign-source income based on the ratio of foreign-source gross income to total gross income. Thus, an individual with significant itemized deductions may get more benefit from those deductions to the extent the exclusion is claimed. An individual who plans to claim the foreign tax credit may wish to shift the deductions into years that the taxable foreign income is lower in order to increase the tax benefit of the deductions. Example. Lisa is a cash-method U.S. citizen living and working in a foreign country. Her total foreign earned income is $120,000 of which she excludes $93,936 under the foreign earned income and housing exclusions. She paid $30,000 in foreign income taxes and

$20,000 for unreimbursed business expenses. Of this $20,000 business expense amount, $15,656 ($20,000 $93,936/$120,000) is considered allocated to excluded income. She will not be able to claim a credit for $23,484 of her $30,000 in taxes computed as follows: ($93,936 - $15,656) / ($120,000 - $20,000) $30,000 taxes paid = $23,484 Lisa can claim a credit for no more than $6,516 ($30,000 - $23,484) of her foreign taxes. Foreign tax credits are subject to an additional limitation. Section 904(a) states that a U.S. citizen or resident is allowed to credit foreign income taxes against the U.S. income tax liability, but not in excess of the U.S. tax otherwise due on foreign-source income. Foreign-source taxable income is foreign-source gross income reduced by deductions allocated to that income. The same sourcing rules previously discussed apply. Generally, the limitation is determined by multiplying the U.S. tax on worldwide income by the ratio of the individual's foreign taxable income to his or her worldwide taxable income. This effectively means that the tax paid is the higher of the U.S. or the foreign tax.

Electing exclusion vs. credit

A key factor in deciding whether to elect the Section 911 exclusion or the foreign tax credit is the foreign tax rate on the foreign earned income as compared to the U.S. tax rate. In a country with a low tax rate (or no income tax), taxpayers will usually benefit by electing the Section 911 exclusion. However, in foreign countries whose rates are higher than those of the U.S., taxpayers are usually better off claiming the foreign tax credit instead of the exclusion. Low-tax foreign jurisdiction. Electing the Section 911 exclusion completely eliminates U.S. income tax on the eligible foreign earned income and allows an individual who works in [pg. 23] a low-tax foreign jurisdiction to benefit from the lower foreign tax rates. If the individual instead elected to claim the foreign tax credit, he or she would pay U.S. tax to the extent that the income is taxed at a higher rate, so the individual would receive no benefit from working in a country with a low tax rate. Example. Gary, a U.S. citizen, lived and worked in a foreign country for all of 2006. Gary is single and claims the standard deduction. During 2006, Gary had $80,000 of foreign earned income and paid $8,000 of foreign income taxes. If Gary does not elect the foreign earned income exclusion, his U.S. taxable income would be $71,550 ($80,000 less the $5,150 standard deduction and $3,300 personal exemption), and his U.S. tax would be $6,445 ($14,445 tax less the $8,000 foreign tax credit). If Gary elects the foreign earned income exclusion, his U.S. taxable income and tax would be zero. Therefore, the exclusion results in a tax savings of $6,445, as compared with the credit. An individual who elects the Section 911 exclusion can still take a credit for foreign taxes paid on foreign earned income in excess of the maximum exclusion. High-tax foreign jurisdiction. The benefits of electing the foreign tax credit are greater when an individual works in a country with higher tax rates than those of the U.S. Not only do the higher [pg. 24] foreign taxes offset the U.S. tax on the foreign earned income, but the excess foreign taxes can be carried back one year and forward ten years to offset foreign income in those other years. Example. The same facts as in the previous example, except that Gary paid $24,000 of foreign income taxes on his $80,000 of foreign earned income. If Gary elects the exclusion, his U.S. taxable income and tax would be zero. If Gary does not elect the exclusion, his taxable income would be $14,445. The foreign tax credit limitation would limit the credit to $14,445, and Gary's net U.S. income tax would be zero. The difference from the previous example is that Gary now has a foreign tax credit carryover of $9,555 ($24,000 foreign tax - $14,445 credit), which would not be available if he elected the exclusion. When an individual moves from a low-tax foreign country to one with a higher tax rate, the taxpayer may wish to revoke the election for

the foreign earned income exclusion so that the maximum foreign tax credit can be claimed. If the individual moves back to a country with a low tax rate, he or she can request permission from the IRS to re-elect the exclusion. 43 Although taxpayers can carry excess foreign taxes back one year and forward ten years, an individual usually cannot obtain much benefit from a carryback unless he or she had significant overseas travel before taking the foreign assignment. Thus, most taxpayers look for ways to use the excess credits in future years.

PLANNING TIP
The foreign tax credit carryover that can be used in a particular year is determined by the limitation for that year. Years in which the taxpayer has foreign-source income but is subject to little or no foreign tax, such as years in which the individual makes extended business trips or exercises stock options, may provide opportunities to use foreign tax credit carryforwards. Taxpayers making extended foreign business trips should determine if any of their compensation (including bonuses) can be considered attributable to the time they spend on those trips. Compensation is considered foreign-source to the extent services are performed overseas. Reg. 1.861-4(v)(1) requires that an allocation be made according to the relative number of days worked in the U.S. and in a foreign country (or countries). It is, therefore, important for individuals with foreign tax credit carryforwards to keep an accurate record of the number of days they spend working overseas along with the total number of days worked during the year. For this purpose, weekends and vacation days are usually ignored. Example. Linda has a foreign tax credit carryforward to 2006 of $3,000. She lives and works in the U.S. throughout 2006, except for a six-week foreign business trip. Linda was not subject to any foreign income taxes in 2006 because her overseas assignment was brief. (A typical tax treaty provides that physical presence for a short period exempts that compensation income from foreign income tax.) Linda received a salary of $70,000 for the 250 days she worked during 2006, including the 30 days spent working overseas. Linda is single and claims the standard deduction, resulting in taxable income of $61,550 ($70,000 less her $5,150 standard deduction and $3,300 personal exemption) and a U.S. income tax of $11,945 before taking the foreign tax credit. Because 12% (30/250) of Linda's taxable income is foreign-source earned income, she can use $1,433 (12% of $11,945) of her foreign tax credit carryforward to reduce her tax liability to $10,512 ($11,945 - $1,433). If stock options were granted before or during the time the individual was working overseas, it may be possible to use foreign tax credit carryforwards to offset part of the U.S. tax on income from the exercise of that option. Reg. 1.911-3(e)(4) specifies that the foreignsource portion of the income is based on the number of months worked abroad divided by the number of months from the grant date to the exercise date. Example. Helen was granted a stock option on 1/1/06. Helen worked in Germany for all of 2006 and worked in the U.S. for all of 2007. Helen exercised the option on 3/31/07 and recognized $20,000 of income. Thus, $16,000 ($20,000 12 months / 15 months) of Helen's option income will be considered foreign-source income. Taxpayers can claim the foreign tax credit by using Form 1116. When a husband and wife file a joint return, they compute the foreign tax credit based on the total taxes incurred by both spouses and using their aggregate taxable income (Regs. 1.901-1(e) and 1.904-1 (e)). As long as the couple continues to file joint tax returns, foreign-source income of either spouse can be offset by their foreign tax credit carryforward.

Employer tax reimbursement plans

Many employers offer their employees who work overseas tax reimbursement plans. These plans are designed so that the tax the employees pay does not exceed what they would have paid in tax if they were still living in the U.S. The two most common methods to accomplish this are tax protection and tax equalization plans.
q

A tax protection plan reimburses an individual for any U.S. or foreign taxes paid in excess of what he or she would have paid in U.S. tax if the individual had remained in the U.S. If the combined actual taxes are lower, the employee realizes a benefit from the foreign assignment because the individual pays only the actual U.S. and foreign taxes; the employee keeps any tax savings. Thus, under a tax protection plan, an employee may be able to realize a significant tax savings by moving to a low-tax country. From an employer's perspective, the disadvantage of this type of plan is that the employer bears an extra tax cost from sending employees to high-tax areas, and employees still have an economic incentive for preferring to accept assignments in low-tax

countries.
q

Under a tax equalization plan, an American employee working overseas has the same net tax liability he or she would have paid if the employee had remained in the U.S. This is achieved by reducing the employee's salary by the hypothetical U.S. tax, and then reimbursing the employee for the actual U.S. and foreign taxes on the covered income. Under this plan, the employer pays any excess tax but also keeps any tax benefit from having employees in low-tax countries. This helps to offset the tax costs of having employees in high-tax countries and also prevents employees from preferring one foreign assignment over another merely due to tax differences.

Although the objectives of tax protection and equalization plans are similar, a tax equalization plan is usually considered less costly for the employer. Any amounts excluded under Section 911 reduce the cost of protection or equalization plans to employers because the company does not have to reimburse the employee for U.S. tax on those amounts. Many businesses view Section 911 as a tax subsidy for the cost of sending an employee overseas. Companies with tax protection or equalization plans may have to pay additional taxes due to the TIPRA changes, which means the new law will hurt American businesses as well as American expatriates not covered by employer-provided tax protection plans. The change to a stacking system, which taxes income not subject to the exclusion at the higher marginal tax bracket, increases the U.S. tax, as does imposing a new upper limit on the excess housing cost exclusion. An employer that uses or is considering adopting a tax protection plan because it is simpler to administer, may wish to reassess the costs and benefits of changing to a tax equalization plan.

Tax treaties
The U.S. has income tax treaties with many countries. Although no two treaties are exactly [pg. 25] alike, they generally provide tax exemptions to residents of one treaty country on short-term assignments to the other country. If an American employer maintains its employee on the U.S. payroll, physical presence in the other treaty country for a short period usually exempts that personal service income from foreign income tax. A typical treaty allows no more than 183 days presence in a year. Thus, an assignment for the last 183 days in one year and the first 183 days in the next year may comply with the typical treaty. Some treaties, however, use a shorter period of time and others have monetary limits. Treaties also frequently exempt teachers and students from foreign income tax. Thus, it is important to know the specific provisions of the treaty for any country where the taxpayer plans to conduct business.

Conclusion
Changes made by TIPRA affect tax planning for overseas assignments, particularly regarding the housing cost exclusion. Individuals may be able to minimize the impact of taxes on compensation received from their foreign assignments with some advance planning. Employers also need to consider their expatriate compensation packages in light of the significant changes made by TIPRA. This article is not intended to be all-inclusive, but to highlight some of the tax complexities and opportunities provided by foreign assignments, and to create an awareness of issues that should be addressed before taxpayers begin their assignments abroad.

H.Rep't. No. 356, 69th Cong., 1st Sess. 33 (1926), reprinted in 1939-1 (Part 2) CB 361.
2

H. Rep't No. 1492, 72d Cong., 1st Sess. 15 (1932), reprinted in 1939-1 (Part 2) CB 539.
3

S. Rep't. No. 1631, 77th Cong., 2d Sess. 50 (1942), reprinted in 1942-2 CB 372.
4

H. Rep't. No. 658, 94th Cong., 1st Sess. 200 (1975).

5

The Foreign Earned Income Act of 1978 was enacted as sections 201-210 of the Tax Treatment Extension Act of 1977, P. L. 95-615,

92 Stat. 3097 (1978).

6

Economic Recovery Tax Act of 1981, P.L. 97-34, 111(a), 95 Stat. 172, 190.
7

Taxpayer Relief Act of 1997, P.L. 105-34, 111 Stat. 788, 988 (1997).
8

Tax Increase Prevention and Reconciliation Act of 2005, P.L. 109-222 (5/17/06).
9

Rev. Proc. 2006-53, 2006-48 IRB 996.

10

Section 911(f).
11

Section 911(c)(1)(B).
12

Section 911(c)(2)(B).
13

2006-43 IRB 766.

14

Section 911(d)(1)(A).
15

Reg. 1.911-2(c) and 1.871-2(b).

16

9 AFTR 2d 883, 300 F2d 34, 62-1 USTC 9293 (CA-7, 1962), rev'g 36 TC 131 (1961).
17

67 AFTR 2d 91-795, 927 F2d 849, 91-1 USTC 50174 (CA-5, 1991), rev'g TC Memo 1989-616, PH TCM 89616, 58 CCH TCM 689 .
18

Action on Decision 1991-014.

19

See Carpenter , 34 AFTR 2d 74-5080, 495 F2d 175, 74-1 USTC 9473 (CA-5, 1974), rev'g 30 AFTR 2d 72-5590, 348 F Supp 179, 722 USTC 9711 (D.C. Tex., 1972), for the test to determine if a bona fide foreign residence is maintained when a move from one foreign country to another (or from one job in a foreign country to another job in that same country) is interrupted by a trip to the U.S.
20

Reg. 1.911-2(d)(2).
21

Rev. Rul. 57-590, 1957-2 CB 458.

22

Based on example in IRS Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad for 2005 Returns, page. 19.
23

Rev. Rul. 73-529, 1973-2 CB 37 .

24

Wilson, TC Memo 1991-491, 62 CCH TCM 900, TCM 91491 .

25

Section 911(d)(2)(B).
26

Reg. 1.119-3(b)(3).
27

Section 911(b)(1)(B).
28

See IRS Publication 3, Armed Forces' Tax Guide.

29

See Reg. 1.911-3(e)(4)(ii), Example 2.

30

Reg. 1.911-4(b)(1).
31

Section 911(c)(4)(A).
32

Section 911(d)(7).
33

Reg. 1.911-4(d)(1).
34

Section 911(c)(4)(C).
35

Reg. 1.911-5(a)(3)(i).
36

Id.
37

Reg. 1.911-5(a)(3)(ii).
38

Rev. Proc. 64-48, 1964-2 CB 993.

39

Section 217(h)(1).
40

Reg. 1.911-3(e)(5).
41

Reg. 1.911-7(c)(2).
42

Section 911(e); Reg. 1.911-7.

43

Reg. 1.911-7(b)(2).
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