Thursday, May 22, 2014

Using tax treaty re-sourcing on US investment for American citizens resident in Spain

If you are living in Spain and your wonderful Beckhamm tax has run out, you will now have to pay Spanish taxes on your worldwide income. If you are lucky to be an American citizen (haha), you have to pay US taxes on your worldwide income.

Normally, you would just apply what you pay in Spain as a foreign tax credit on your US taxes and you’d be done.

However, imagine that you have investments in the US. This is not foreign income from the American perspective, so you can’t apply the taxes you paid in Spain against that. (You can only apply foreign tax credits against foreign income).

You might think you could just use your US taxes as a foreign tax credit in Spain, but that doesn’t work either, since the US/Spain tax treaty doesn’t allow you to get reimbursed for tax by Spain you have to pay just because you are a US citizen.

So what do you do? Turns out there is an escape hatch in the US/Spain tax treaty, which gives the right for the US to tax US source income at a certain rate.

For example, say you made 100 dollars (everything in dollars for the sake of simplicity) in interest in the US. The Spain/US tax treaty says that the US is entitled to $15 of that if they want to.

This $15 can then be applied as a foreign tax credit on your Spanish income. If the Spanish tax rate is 25%, then you would pay $10 in Spain and $15 in the US.

Now comes the fun part. Since the US reserves the right to tax US citizens as if there were no treaty in place, so how do you get credit for the $10 you paid in Spain?

The IRS gives you an out: what you can do is re-source some of your US income and turn it into foreign income. How much can you re-source? Exactly enough for you to get your $10 back. So you divide $10 by your tax rate (36%) and get $27.7. You then re-source $27.7 as Spanish income, on which you get to take up to $10 in foreign tax credits.

Easy, no?

Here’s a spreadsheet for two situations (1) the Spanish tax is lower than the US tax, or (2) the Spanish tax is higher than the US (decoded from this document, page 103):

Line Description How to calculate Low Spanish tax scenario (1) High Spanish tax scenario (2)
1 Total income of this type (gross foreign income on Spanish return)   $100.00 $100.00
2 US/Spain maximum tax treaty rate for this type of income Rate from treaty 15% 15%
3 Maximum tax that the US is entitled to according to the treaty (foreign tax credit on Spanish return) Multiply line 1 by line 2 $15.00 $15.00
4 Spain tax rate Enter Spanish tax rate 25% 40%
5 Spain tax (pre tax credit) Multiple line 1 by line 4 $25.00 $40.00
6 Tax payable in Spain Line 5 - Line 3 $10.00 $25.00
7 US tax rate on citizen Enter your maximum tax bracket 36% 36%
8 US taxes owed as citizen (income on 1040) Multiply line 1 by line 7 $36.00 $36.00
9 US taxes after treaty rate Line 8 - Line 3 $21.00 $21.00
10 Foreign tax credit for re-sourced income (foreign tax paid on 1116, category “certain income re-sourced by treaty” ) Lesser of line 6 and 9 $10.00 $21.00
11 Income re-sourced as foreign income (gross foreign income on 1116, category “certain income re-sourced by treaty”) Divide line 10 by line 7 $27.78 $58.33
12 Taxes payable in US Line 8 - Line 10 $26.00 $15.00
13 Total taxes paid (whichever one is greater) Line 6 plus Line 12 $36.00 $40.00


Anonymous said...

This is great, I got the main concept from the Spain-US treaty, your total taxes are just the greater of what what you would pay on any of the two countries on your worldwide income, but wasn't so sure about how to report it.

Actually, I still haven't had to file a tax return yet, not sure how straight forward this is going to be, if you have some specifics about how to report this on the 1040 I would love to hear it.

Thanks for your blog, please keep posting.

santcugat said...

Thanks! I added some details of where to put it on your return.

You also need to attach a 8833 form, disclosing the paragraph in the treaty you are using to re-source income.

Anonymous said...

thanks a lot, this is very hard to find info, extremely useful for planning my tax strategy for moving to Spain.