Does America Need Residence-Based Taxation?

Expat Briefing explores ways that US Expats might be able to mitigate their taxes.

In June 2017, Americans for Tax Reform joined US expat groups in calling for Congress to consider residence-based taxation for Americans living abroad. This feature looks at the proposals, and examines why they are considered so important for US expats.

Tax By Citizenship

The United States is one of the few countries on earth (Eritrea is reportedly the other) which taxes its citizens on the basis of nationality rather than residence. In other words, if you were born in the US, or have sufficiently strong ties to be considered an American, the Internal Revenue Service (IRS) has the legal right tax you, no matter where you live, or how long you’ve lived there. And this tax liability will of course be in addition to tax paid in an expat’s country of residence.

Therefore, all US citizens and green card holders must file a tax return (Form 1040) regardless of whether they live abroad. And expats who do owe taxes may have to make estimated tax payments on a quarterly basis.

Fortunately, there are ways in which US expats can mitigate the impact of America’s tax claim on their foreign income and assets.

US taxpayers in higher tax countries can eliminate their US tax liability using the foreign tax credit, which is intended to prevent double taxation when foreign income is taxed by both the US and a foreign country.

US expats also may be able to take advantage of the Foreign Earned Income Exclusion (FEIE). This exclusion entitles US expats to exclude for US income tax purposes a certain amount of foreign earnings that is adjusted annually for inflation. The FEIE thereby reduces the tax liability of US taxpayers working abroad even if they paid no foreign income taxes to another country. In 2017, the FEIE limit is USD102,100.

In addition, US expats can exclude or deduct certain foreign housing amounts. This entitles US citizens who work and live abroad to exclude some or all of the amounts paid for their foreign housing costs when calculating their worldwide income subject to US tax. The housing amount excludable under the US tax code is the total of an individual’s housing expenses for the year less the base housing amount, which is 16 percent of the maximum FEIE amount. However, housing expenses that are eligible to be used in determining the exclusion cannot exceed 30 percent of the maximum FEIE amount, and also cannot exceed an individual’s amount of foreign earned income for the tax year. Furthermore, excludable housing expenses include only reasonable expenses that were actually incurred for housing in a foreign country.

Additional legislation has placed comprehensive reporting requirements on US citizens with income from foreign bank accounts, as well as the financial institutions with which they hold investments.

Each United States person must file a Report of Foreign Bank and Financial Accounts (FBAR), if the person has a financial interest in, or signature authority (or other authority that is comparable to signature authority) over one or more accounts in a foreign country, and the aggregate value of all foreign financial accounts exceeds USD10,000 at any time during the calendar year.

Further reporting obligations have been created by the Foreign Account Tax Compliance Act (FACTA), effective July 1, 2014. Under FATCA, certain US taxpayers holding financial assets outside the United States must also report those assets to the IRS on Form 8938, Statement of Specified Foreign Financial Assets. Reporting thresholds are higher than for the FBAR, the lowest being USD50,000, and vary based on whether a taxpayer files a joint income tax return or lives abroad.

Why The Need For Change?

According to a review of the expat income exclusion rules by the US Government Accountability Office in 2014, the majority – 88 percent – of all tax filings from overseas result in no tax due. And presumably, the 12 percent of US expats who do have to pay taxes are at the wealthy end of the income spectrum.

However, campaigners on US expat issues are argue that this is beside the point. Virtually no other country seeks to effectively double tax its citizens in such a way, and the rules as they stand are complex, difficult to administer, and costly, both for taxpayers and the IRS. What’s more, they are ultimately damaging to US economic interests.

“The current Citizenship-based Taxation (CBT) puts Americans and the US economy at a competitive disadvantage,” says American Citizens Abroad (ACA), an advocacy group for American citizens living and working overseas. “The US tax law discourages US companies from sending Americans abroad to promote US business, creates a major handicap for American entrepreneurs overseas and penalizes Americans working and living abroad.”

“CBT is very complex and costly to administer for both the taxpayers and the IRS. Tax filing from abroad is significantly more costly than domestic tax filing, even when no tax is due. CBT is grossly unfair as Americans abroad can pay taxes twice on the same income due not only to inherent incompatibilities between US and foreign tax rules but also to US legislation that imposes double taxation.”

Furthermore, largely because of FATCA, foreign financial institutions have come to view American clients as financial pariahs, which are more hassle than they are worth from a tax compliance point of view. This has led to reports of swathes of US expats being denied basic financial services in their host countries.

So what’s the answer? According to Americans for Tax Reform, residence-based taxation (RBT) is.

In support of residence-based taxation, ATR recently submitted a statement to a congressional hearing entitled, “Increasing US Competitiveness and Preventing American Jobs from Moving Overseas,” urging the committee to ensure that residence-based taxation is implemented in the final tax reform legislation.

“Implementing residence-based taxation will reduces compliance burdens associated with hiring Americans so that US citizens working overseas are hired on a more level playing field and thereby increase job opportunities for Americans,” ATR said. “Moving to residence-based taxation has the added effect of diminishing the need for the IRS to act as a global police force. Because citizens residing abroad would (in most cases) no longer need to worry about paying US taxes, this reform could reduce the size and scope of the IRS international division, allowing the agency to be streamlined.”

ATR wants RBT to be included in comprehensive US tax reform legislation, which is currently being debated in Congress.

Unsurprisingly, ACA agrees, and in December 2016, it set out a detailed description of its proposal for the enactment of residency-based taxation. The ACA said that as part of a general tax reform package, an election should be provided to citizens who are long-term nonresident citizens to be taxed as nonresident aliens if they meet certain conditions – for example, a minimum three-year period of residence abroad.

According to ACA, the Republican victory in last year’s elections means that Congress and the Administration are now more sympathetic to the plight of US expats than before. Indeed, it has pointed out that the House Republican Blueprint for tax reform “opens the door for this important change.”

“Residency-based taxation for individuals is a relatively straightforward exercise and does not risk ‘muddying the water’ for changes regarding corporate international taxation. There are no obvious roadblocks to undertaking this step,” said ACA Global Foundation Chairman Charles Bruce.

As for FATCA and the US expat banking lock-out, campaigners are urging the IRS to allow a “same-country” exception whereby taxpayers’ financial accounts in foreign home states where they are “bona fide” residents should be excluded from FATCA reporting. Only accounts in a country other than an American taxpayer’s country of residence should be subject to information reporting, they say.

However, critics of FATCA say that the law tramples all over US citizens’ constitutional rights, is extra-territorial, damages the US investment environment and shouldn’t have been passed in the first place. They state that repealing it would be the far better option, and given that doing so would allow Republicans to tear up another of President Obama’s signature reforms, this possibility is by no means off the table.

Ultimately, the final determinant will likely be cost. Will Congress view any revenue lost from switching to residence-based taxation or repealing FATCA a price worth paying? Doubtless, most of the 8m-strong US expat community certainly hope so. But if not, then it probably wouldn’t be the first time they felt ignored by the own Government.

The Nuclear Option For US Expats

In the absence of residence-based taxation, US expats do have another path open to them to escape America’s tax net. But it’s one that the vast majority of US citizens would undoubtedly take with an extremely heavy heart – renounce their citizenship. Nevertheless, record numbers of people are choosing to take this nuclear option; according to Treasury Department statistics published in the Federal Register, 5,411 US taxpayers gave up their passports or their green cards in 2016 – over 26 percent more than the previous record of 4,279 set in 2015.

Although the evidence is only circumstantial, many campaigners on US expat welfare issues say that it surely can’t be a coincidence that the citizenship renunciations have spiked at a time when US expat tax reporting obligations have snowballed thanks largely to FBAR and FATCA. So perhaps the time for Congress to reexamine these matter is long overdue.