Japan Foreign Tax Credit from US Taxes

[yokaze]

Say a US Citizen, after filing in Japan and then of course also in the US ends up incurring a tax payment to the IRS, for any combination of income exceeding the US Foreign Earned Income Exclusion limit, income attributed to years past (e.g. vested RSU's grant date), or income from time worked on US soil (e.g. business trip). Is the basic principle of Japan's Foreign Tax Credit for Residents in the Japan-US Tax Treaty essentially to cover this double taxation, and therefore one could just later claim this US tax payment as a deduction on their Japanese taxes?

Now I've also been learning that it's generally in the best interest for a US Citizen to keep any investments based in the US (e.g. mutual funds), as the US tax code essentially treats them as a PFIC, and taxes at a higher rate. However, if any excess tax payments to the US incur on these investments, using the logic above could one not also then claim a tax credit in Japan for them to cover the excess (double?) tax? Or is this what basically makes foreign-domiciled investing as an American more complicated? So, while not impossible, likely just more messy than it's worth?

[TokyoWart]

Say a US Citizen, after filing in Japan and then of course also in the US ends up incurring a tax payment to the IRS, for any combination of income exceeding the US Foreign Earned Income Exclusion limit, income attributed to years past (e.g. vested RSU's grant date), or income from time worked on US soil (e.g. business trip). Is the basic principle of Japan's Foreign Tax Credit for Residents in the Japan-US Tax Treaty essentially to cover this double taxation, and therefore one could just later claim this US tax payment as a deduction on their Japanese taxes?

The principle is to avoid double-taxation but in my experience it doesn't fully do so. Here is what happens:

1. When you complete the Foreign Tax Credit part of your Japanese return (外国税額控除に関する明細書) you will have an entry for dividends from the US and you automatically enter a 10% tax credit for them on part 1 of the worksheet. (You can't enter more or less since its per the treaty, even though actual tax rate ranges from 0-23.8% for those dividends in the US).

2. That gets combined with any US taxes you actually paid for other things (salary, etc.) but the actual amount of foreign tax credit you get to exclude is determined in a section of the form called 所得税の控除限度額の計算. The way that calculation works you can never get a credit for more than the tax you paid, but your actual allowable credit is limited by the overall effective tax rate you are paying in Japan as applied to what is counting as "foreign taxed income" (salary taxed by the US plus dividends taxed by the US, etc.). For instance, if your effective tax rate was 30% in the US but it's only 15% in Japan you wind up only getting a credit for half (15%) of the US taxes you paid.

3. The US dividends you pay taxes on when filing in 2021 are the dividends you received in 2020 and you may be asked to give evidence such as your 1099-div forms to prove that was the amount. However, the salary that is appearing in that form with the actual US tax you paid will be from the prior year (e.g. 2019) because you don't know how much tax you'll pay on it yet. At least, this is how the calculation worked in my case when I was allowed to claim a credit for US taxes paid on salary (if you are a director of a Japanese company you are not allowed to do so.)

Now I've also been learning that it's generally in the best interest for a US Citizen to keep any investments based in the US (e.g. mutual funds), as the US tax code essentially treats them as a PFIC, and taxes at a higher rate. However, if any excess tax payments to the US incur on these investments, using the logic above could one not also then claim a tax credit in Japan for them to cover the excess (double?) tax? Or is this what basically makes foreign-domiciled investing as an American more complicated? So, while not impossible, likely just more messy than it's worth?

Yes, you definitely don't want to hold a mutual fund that is not based in the US (could be a Vanguard international fund, but not a Nomura or Daiwa mutual fund even if it only holds US stocks) because the PFIC handling is complicated and punitive. However, the US taxes you paid on investments is handled as I mentioned above (start with 10% assumed tax payment). I have seen comments here at RetireJapan saying some accountants say the foreign tax credit only applies to stock dividends not mutual funds here in Japan but that is not what my accountant says and I have no interest in challenging that opinion.

Is it worth it? Depends on how much you're getting in US dividends and how your salary is taxed in the US (it of course gets taxed more in the US if you have State tax liability or spend working days in the US). For my return this credit winds up helping offset at least 2 million yen in Japanese taxes each year but that amount is a lot less than what I am actually paying in additional US taxes.

[ichiokuen]

but your actual allowable credit is limited by the overall effective tax rate you are paying in Japan as applied to what is counting as "foreign taxed income" (salary taxed by the US plus dividends taxed by the US, etc.)

Hi again TokyoWart,
I had one more question concerning this drama. Your above quoted post, the "foreign earned income" part, do we change that number to yen by the average exchange rate for the year?

Thanks so much!

[TokyoWart]

Your above quoted post, the "foreign earned income" part, do we change that number to yen by the average exchange rate for the year?

So this is about the exchange rate used on the 外国税額控除に関する明細書 form where you report the way the US counted your Japanese income and how much US taxes you paid? I am not sure how my accountant is choosing the exchange rate and it's also confusing because they are really reporting widely different things on that form. For instance, for the Japanese tax return they just prepared for me they are using US dividends as reported on the 2020 1099-DIV forms from my brokerage firms (so dividends received during Jan-Dec 2020) but the other line on foreign income tax paid on earned income is using the US 1040 forms I submitted in 2020 for 2019 (hence a different range of exchange rates from Jan-Dec 2019 or maybe just whenever I paid the taxes when submiting the US return in April of 2020). In any case when I just checked the form now, it looks like they applied an exchange rate of 106.7 yen/dollar for the dividends and automatically applied 10% tax and 107.1 yen/dollar for the other income taxes.

In any case, all of the calculations performed in 所得税及び復興特別所得税の控除限度額の計算 are using yen.

[ichiokuen]

Thank you for your help!

Actually, I am talking about only income earned in the US(in my case capital gains and dividends), not income earned in Japan, because I don't make enough here to be taxed in the US.

I do my dividend dollar-to-yen conversions based on the date I received the dividend, but for the capital gains it would seem logical to apply the average exchange rate for the year, since the gain is based on past purchase price. Or, I wonder, should I use the number I put on my Japanese tax return which reflects the purchase price(which is a bigger number, since the purchases were made when the yen was a lot stronger)?

[TokyoWart]

I do my dividend dollar-to-yen conversions based on the date I received the dividend, but for the capital gains it would seem logical to apply the average exchange rate for the year, since the gain is based on past purchase price. Or, I wonder, should I use the number I put on my Japanese tax return which reflects the purchase price(which is a bigger number, since the purchases were made when the yen was a lot stronger)?

For my Japanese taxes my accountants do not calculate the exchange rate based on every dividend date. I have a very large number of individual positions so this would literally mean hundreds of calculations each year. In fact, the documents they are working from don't even report the individual payment dates because that is not reported to the IRS on the 1099-DIV.

However for capital gains and losses they go back to the acquisition date exchange rate and sales date exchange rates if they are available on the 1099-B (in some cases they are not since purchase date is not necessarily tracked or reported in the US especially for mutual funds and it can be summarized as "VARIOUS" when you use automative dividend reinvestment for stocks). My experience with the Japanese tax authorities is that they do prefer to have that information for stock purchases and sales and this sometimes means that a loss in the US becomes a gain in Japan. For the most part I only sell for tax loss harvesting which is limited to my US mutual funds and ETF's so this almost never enters into calculation of the foreign tax credit on my Japanese tax returns.

If you bought those positions when the yen was stronger I think going back to the exchange rate at time of purchase is actually going to increase your reported gain (i.e. purchase price is a smaller number, not bigger). For instance:

Basis of $1000 when exchange rate was 80 yen/ dollar = 80,000 yen basis
Sale at $1200 when exchange rate was 105 yen/dollar = 126,000 yen sales price
Capital gain of $200 but 46,000 yen which is much larger than ($200) x either of those exchange rates

[ichiokuen]

If you bought those positions when the yen was stronger I think going back to the exchange rate at time of purchase is actually going to increase your reported gain (i.e. purchase price is a smaller number, not bigger).

Yes! This is what really gets my goat! Who is to say how much we bought our yen at?! From the date-of-purchase method my "income" goes up 600,000 yen, whether I actually got that money or not! It's madness.

Yeah, I too usually only sell for tax loss harvesting, but 2020 was a crazy year!

So you sound like a dividend expert(thousands of entries!), is that the best way to go? I'm debating buying more dividend payers or going for growth stocks. Are dividends better for tax purposes in the long run?

[captainspoke]

Review the comments by "stark" in the reddit post mentioned here:

I haven't inquired whether I could sell specific lots in Japan but every time I have sold partial positions here it has been using an average price for the shares acquired and I don't think I've ever been given a choice to do otherwise.

Yep, starkimpossibility's reply on this thread from r/JapanFinance implies using the average price is the only way for Japanese tax purposes.