One of the most common tools used by taxpayers living abroad to reduce tax due to the United States is the Foreign Tax Credit (Form 1116). The general concept of the Foreign Tax Credit is simply the idea of not being “double taxed” on the same income. In theory, say someone is living in Israel – for example – and has $20,000 of income in Israel and has already paid mas hachnasa (Israeli income tax) of $5,000 tax on this income. When calculating this income on their U.S. tax return, the taxpayer should be able to reduce any U.S. tax due on this income by the Foreign Tax Credit of what was already paid to Israel.
There are plenty of exceptions to the rules and complex calculations that can be discussed separately and the focus here is to try and understand what foreign tax can be taken for the Foreign Tax Credit.
IRS Publication 514 details the four tests that must all be met for a foreign tax to qualify for the Foreign Tax Credit:
- The tax must be imposed on you
- You must have paid or accrued the tax
- The tax must be the legal and actual foreign tax liability
- The tax must be an income tax (or a tax in lieu of an income tax)
The fourth test – that the tax must be an income tax – can get a bit complicated and is the source of the controversial question in Israel: Can Bituach Leumi be taken as a Foreign Tax Credit?
It is important to note that just because something is called an “income tax” a taxing authority does not mean it is necessarily considered an income tax for the purpose of a Foreign Tax Credit. To be an income tax, it needs to meet both of the following requirements:
- It is a tax. Meaning, you are required to pay it and you get no specific economic benefit from making the payment.
- The predominant character of the tax is that of an income tax in the U.S. sense.
Bituach Leumi (or “national insurance”) is certainly a requirement to pay, but can it be considered to have no specific economic benefit? Generally speaking, you get a specific economic benefit if you receive, or are considered to receive, an economic benefit from the foreign country imposing the tax, assuming that if there is a generally imposed income tax, the economic benefit is not available on substantially the same terms to all persons subject to the income tax. This seems to imply that if the economic benefit is available on substantially the same terms to all persons subject to the tax, there would seem to be no specific economic benefit.
An additional argument in favor of taking Bituach Leumi as a Foreign Tax Credit is because Israel and the United States lack an agreement on national insurance. This usage is sourced in 26CFR1.901-2 (2)(ii)(C), as quoted below, with the caveat as noted in the IRS Publication 514 and quoted below.
(C) Pension, unemployment, and disability fund payments. A foreign levy imposed on individuals to finance retirement, old-age, death, survivor, unemployment, illness, or disability benefits, or for some substantially similar purpose, is not a requirement of compulsory payment in exchange for a specific economic benefit, as long as the amounts required to be paid be the individuals subject to the levy are not computed on a basis reflecting the respective ages, life expediencies or similar characteristics of such individuals.
IRS Publication 514 further states:
No deduction or credit is allowed, however, for social security taxes paid or accrued to a foreign country with which the United States has a social security agreement. For more information about the agreements, see Publication 54
Because the United States does NOT have a social security agreement with Israel, it would seem to imply that the exclusion from Publication 514 would not apply and – assuming Israel Bituach Leumi is not considered to have a specific economic benefit – that it can be taken as a Foreign Tax Credit. That being said, this position is definitely questionable and it has yet to be proven in tax court that the IRS will agree with the argument and consider Bituach Leumi as a Foreign Tax Credit.