Tax treaties are formal agreements between countries that help the individual tax authorities communicate, prevent double taxation and fiscal evasion, and assist each other by enforcing their different tax laws. Australia has tax treaties with over 40 countries, including the U.S. While it can seem quite complicated, we’re here to break down some of the basics for you to help you get a better understanding of how the U.S.-Australia Tax Treaty might affect you as an American living in Australia.
The United States remains one of the only countries that enforces its taxation on worldwide income. So, if you are a U.S. citizen or green card holder and your worldwide income exceeds the IRS’s minimum thresholds, you will be required to not only file a U.S. tax return but also pay taxes to the IRS, no matter where in the world you’re residing or where you’re earning that income.
Additionally, if your income is sourced within Australia, you will also need to lodge an Australian tax return and pay tax to the ATO. So, after all this, you might be thinking, well, what will be left over?
This is where the tax treaty comes in handy and why it was designed in the first place. It contains provisions that help Americans living in Australia avoid this exact double taxation situation. The two main solutions are the Foreign Earned Income Exclusion and the Foreign Tax Credit.
There is quite a difference between the income exclusion scheme and tax credits, and one might be more beneficial for your situation than the other. Foreign tax credits work by lowering your income tax directly, which will reduce the tax you might owe. Certain Foreign Tax Credits are refundable, and they can even increase your tax refund if you’re eligible for one.
On the other hand, the Foreign Earned Income Exclusion (FEIE) lowers your taxable income. This option reduces the figure that the IRS will use to calculate your tax, which can lessen or eliminate your tax bill altogether. It allows you to exclude a certain amount of your foreign-earned income from your tax return. For the 2023 financial year, the threshold allows you to exclude up to $120,000 in foreign income through FEIE. So, if you’re a U.S. expat who earned under $120,000 during the financial year in foreign income, you could end up with a $0 tax bill from the IRS.
For Americans living in Australia, claiming Foreign Tax Credits are often the better choice. Because the tax rate is higher in Australia than in the U.S., claiming the FTC will typically eliminate any U.S. tax you might owe. The Foreign Tax Credit route also offers more flexibility than FEIE, and doesn’t have any lock-in requirements or limit your U.S. travel. You’re also able to carry unused tax credits forward and apply them to your next 10 years of tax returns. Even so, it’s always important to consider your unique financial situation and your eligibility for these provisions before choosing one or the other.