Exchange Rate for Foreign Tax Credit – Money & Services

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I was wondering if you could help me with a query.

I live / am domiciled in the UK but hold US Citizenship so need to file US taxes.

I am unsure what exchange rate I should use to convert income/tax in GBP in to USD. Some accountants seem to think using the average rate is okay but I am unsure and want to make sure I get it right. The instructions on the 1116 seem to say to convert taxes at the rate on the date of tax payment but also the IRS website says:

“The Internal Revenue Service has no official exchange rate. Generally, it accepts any posted exchange rate that is used consistently”

For example say I was paid 250,000 GBP in Jun08 when the exchange rate was 2:1, i.e. 500,000 USD.

Then I Paid 100,000 GBP in tax in Dec08 (40% of 250,000) at this time the exchange rate was 1.5 i.e. I paid 150,000 USD

If I convert at the average exchange rate then I have no liability (since I’ve paid 40% in tax – higher than the highest US marginal rate), however if I convert at the payment dates then I will have to pay another 25,000 USD in tax despite already paying 40%!

Is there any way I can avoid this double taxation? It seems somewhat unfair and is not in the essence of the tax treaty.

Common sense would seem to suggest using the average exchange rate consistently for all conversions (since all income/outgoings was in GBP). This seems like a reasonable thing to do but I am unsure.

Thanks for your help

Answer

If you use an “aerage” exchange rate, then that rate MUST be used consistently throughout the return to compute BOTH income levels received and taxed paid, plus iny tax credit computation. You cannot pick-and-choose to use the rate most advantageous to you.

So use EITHER the 1.5 rate consistently or 2:1 rate consistently.

If the average exchange rate is used, be ready to show from where you got that average rate. If it is a generally-accepted source, such as the average foreign exchange rate used by the UK or U.S. governments, then you will have no problem.

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