As is the case with minor children living in the U.S., minor children living abroad may have U.S. tax filing obligations for investment income, such as bank interest, dividends, mutual fund income, or capital gains derived either in the U.S. or abroad. However, minor children living abroad have an additional complication of perhaps owing foreign income tax on the same income.
To mitigate double taxation, U.S. tax rules allow a Foreign Tax Credit (FTC), which generally provides a credit for income taxes paid to a foreign country. However, the issue becomes more complicated when the child lives in a country where the child does not bear the tax liability of his or her own income but rather is included in the parent’s tax return under local tax rules.
Foreign Tax Credit Challenges for Children Living Abroad
For example, in India, a minor child’s investment income is included with the parent’s taxable income. In fact, in India, there doesn’t appear to be a widely accepted avenue for a minor child to file a tax return separately, even if the child wanted to do so. The income must be included with the parent’s tax return, and the Indian tax liability belongs to the parents, not the child. On the other hand, the U.S. may still treat the child as a separate taxpayer under its own rules. While an option may exist to report a child’s income on a parent’s tax return (Form 8814), however, in that case, the liability is separately calculated and added to total tax, indicating that is separate and above from what the parent will owe.
When Foreign Tax Credit Rules Don’t Align
As a result, there may be a mismatch: the foreign tax liability is that of the parent while the U.S. tax liability is that of the child.
For foreign tax credit purposes, credits can only be claimed on taxes paid for which an individual is legally liable for the foreign tax under foreign law. If the child were considered the taxpayer under foreign law, an allocation could perhaps be made between the parent and the child. However, this holding will be dependent on the local tax law.
This mismatch creates practical challenges for families and tax professionals.
Planning Around Foreign Tax Credit Pitfalls
Prior to making gifts to a minor child, the tax implications of doing so in the U.S. and under local law should be strongly considered. A few of the planning alternatives to consider will include: (1) making gifts to a U.S. non-grantor trust for the benefit of the child; and (2) considering the nature of investments made with the gifted funds (i.e. interest, dividends, long term appreciation, Section 529 plans, etc.) in order to seek alignment between U.S. and local tax law (i.e. invest in assets for capital appreciation during the years of minority to minimize U.S. tax).
Key Takeaway
In an increasingly connected world, families often assume that paying tax in one country should automatically prevent double taxation elsewhere. But when countries follow different rules for taxing children and parents, even relatively simple investment income can create unexpected complications. There is no one-size-fits-all solution to such a problem. Please contact your WG tax advisor to discuss further.
