After posting First Year Abroad, I received the following message on Twitter regarding earned income and foreign pension. And yes, I have to admit that my post was targeted to US Citizens who recently moved overseas to follow a job – in which case the Foreign Earned Income exclusion would reduce their tax liability.

It is important to note, however, that 1) the notion of “earned” income is only important in the context of the Foreign Earned Income exclusion and that 2) the Foreign Tax Credit is a broader mechanism to eliminate dual taxation.

The shortcomings of the Foreign Tax Credit come when the taxpayer’s tax paid to the foreign country doesn’t cover the amount that is due in the US. As seen at The widening gap for the cost of freedom from US citizenship and US tax compliance on the Isaac Brock Society’s website, dual taxation would occur if one receives income that 1) is not “earned” and 2) is not taxed by the foreign country.

Likewise, the Foreign Tax Credit would be inapplicable in jurisdictions without income tax or low rate of income tax. That is also the case of countries which might have a sales tax or other unusual taxes which are not seen by the US as paid “in lieu of income tax”, as is often the case in developing countries.

In Canada, from what I see, the Foreign Tax Credit usually erases US tax due, at least in the “General Category”  (the FTC is broken down in several buckets) – but having Canadian tax free income can indeed cause one to pay US taxes. And that really is my greatest fear when I buy a lottery ticket – if I win the jackpot, the lottery winning will be tax-free in Canada but not in the US meaning that I would have to pay US tax; but so far, luckily, I didn’t have to worry about that – I never won the jackpot. Whew, that was close 😉