The United States taxes on the basis of citizenship, or better know as Citizenship-based taxation (CBT). This means it taxes American citizens on their worldwide income regardless where they live. An American citizen living in London, or Toronto, or Tokyo, or Johannesburg, generally must file U.S. tax returns and pay U.S. tax, even if he or she does not live in or travel to the U.S. Taxation is not based on any physical presence test. The source of the income makes no difference either: income exclusively earned and additionally taxed abroad is also subject to U.S. reporting. Moreover, Americans abroad are commonly taxed twice, for example on some types of investment income and certain retirement-savings vehicles. In some cases, where an individual was born in the U.S. to foreign parents on a student or temporary work visa who then returned to their home country, those subject to the tax law and its penalties may not have not been aware of their status as an American birthright citizen. ACA advocates for the adoption of Residence-based taxation (RBT), taxing income based on where it is earned.
Citizenship-based (CBT) versus Residence-based (RBT) Taxation
ACA advocates for the adoption of Residence-based Taxation (RBT) meaning that a US citizen's income would be taxed based on where it is earns. If the income is earned in the United States or in relation to US economic activity, it would continue to be taxed by the United States. Income earned outside of the United States and not in connection to US economic activity would no longer be taxed by the United States.
ACA has done extensive reserach and development for RBT. ACA was the first organization to create a baseline or "vanilla" approach to how taxing US Citizens overseas based on residence might be structured. In order to promote a constructive consideration of the subject, ACA provided a Written Description and a Side-by-Side Comparison indicating the current tax code, often referred to as Citizenship-based taxation or CBT, compared with details of ACA's RBT approach. This baseline approach to RBT was intended to lay out a version that captures the essential elements of residence-based tax treatment and examine and modify these to arrive at an optimal RBT approach, one that meets the needs of the community while addressing the concerns over abuse and potential loopholes. Research work by District Economics Group (DEG), contractor to ACA, to provide an estimate on the cost of switching from CBT to RBT was completed on November 6th, 2017, with another follow-up study completed in early 2022. The DEG study estimates that a revenue neutral budget score for RBT can be arrived at within the 10-year congressional budget widow.
On December 20, 2018, Congressman Holding (Republican-North Carolina), member of the House Ways & Means Committee, introduced legislation transitioning from the current citizenship-based taxation system to a system that provides residence-based taxation for individuals – sometimes referred to as territorial tax for individuals.
Congressman Holding's bill,Tax Fairness for Americans Abroad Act (H.R. 7358) for nonresident US citizens, who make an election to be taxed as a qualified nonresident citizen, would exclude from income, and therefore be exempt from taxation on, their foreign source income. All nonresident US citizens, however, will remain subject to tax on any US source income. ACA worked closely with COngressman Holding's office in their development of the bill
The basic principle of the bill mirrors the thinking behind ACA’s residence-based taxation (RBT) approach, that is, separating foreign-source and US-source income and excluding from US taxation specified foreign-source income earned when a US citizen is a qualified resident abroad. As can be seen in the bill language, the toggle switch determining whether an individual is taxable on US income – and not on foreign income – is residency. A summary outline of the bill can be found here, along with a fuller outline and description provided by ACA here.
ACA’s work on the subject of Residence-based taxation (RBT) was extensively presented to Congressional offices and the tax writing committees and provided these offices with key data on the community of Americans living and working overseas. ACA's knowledge was important to offices working on tax reform for Americans living and working overseas.
CBT is incompatible with the global economy of the 21st century where the tax policy of most industrialized nations is based on residency and not nationality. CBT works against US economic interests in terms of job creation and increasing exports. Throughout its history, ACA has highlighted some of the worst problems that CBT imposes on US citizens overseas with regard to Social Security, Net Investment Income Tax, Functional Currency and Foriegn Pensions.
This is not the worldwide norm. The United States is the outlier in taxation based on citizenship regardless of residency.
The 2017 Tax Cuts and Jobs Act: Transition Tax and GILTI Regimes
The Tax Cuts and Jobs Act signed into law in 2017 contains a large number of very important, and some quite surprising, provisions affecting US citizens abroad. The TCJA moves the US from a worldwide tax system to a participation exemption system by giving US (that is, domestic) corporations a 100% dividend received deduction for dividends distributed by a controlled foreign corporation (CFC). To transition to that new system, the measure imposes a one-time deemed repatriation tax, payable over 8 years, on unremitted earnings and profits at a rate of 8 percent for illiquid assets and 15.5 percent for cash and cash equivalents. The dividends received deduction is available only to US corporations that are shareholders in a CFC. The deduction is not available to individuals, nor to foreign corporations, which, for example, are owned by US individuals, including individuals living abroad. On the other hand, the repatriation tax applies to everyone, not merely US corporations. Accordingly a US citizen overseas, who is a shareholder in a CFC, might be subject to the repatriation tax. These businesses may be a yoga studio in France, a restaurant in Norway or a consultancy in Thailand. They can be big or small and have probably not been incorporated taking into consideration US tax law. Some of the individual who are subject to the repatriation tax might not have in hand the actual monies needed to pay this tax. ACA made a number of points on the effects of these changes. These are contained in the commentary – TAX REFORM BILL AND AMERICANS ABROAD: WHAT HAPPENED? WHAT'S NEXT? — by Charles M Bruce, ACA’s Legal Counsel and Of Counsel to Bonnard Lawson-Lausanne.
Since passage of the Tax Cuts and Jobs Act in December of 2017, ACA has been consistently advocating to Treasury on the negative fall-out from the Transition Tax on US citizens abroad. Beginning in March of 2018, ACA wrote to Treasury officials requesting relief from certain the reporting requirements of the Transition tax, including an extension in the filing deadline. In April of 2018, Treasury provided some relief giving an extension for the filing deadlines. On June 5th, the Treasury, after pressure by ACA and other advocates, extended the filing deadline further from June, 2018 to June 2019
ACA submitted extensive commentary to the Treasury on its issuance of regulations. ACA advocates for relief for taxpayers residing abroad and asks that the reporting requirements under Section 965 should be modified and that a de minimis rule be applied to exempt small taxpayers resident outside the US. This is the same type of approach that was applied in the case of the filing of Forms 8938 (Statement of Specified Foreign Financial Assets) for FATCA. ACA testified at public hearings on the subject. ACA’s testimony calls for the adoption of a de minimisruling and questions Treasury determination that the transition tax regulations do not impose significant economic impact on taxpayers.
In March of 2019, the US Treasury Department provided updated guidance on GILTI regulations that gives some relief to individual taxpayers, including US citizens overseas. Taking notice of the strong arguments made in 34 sets of comments submitted in response to the proposed regulations, the Treasury Department has modified the regulations. For individuals with businesses that are paying at least modest amounts of foreign taxes (and otherwise are not subject to ‘normal’ Subpart F rules), the use of a Section 962 election will allow the individuals to go back to the old days of only paying tax on income in foreign companies when it is distributed.
Eli S. Noff, Esq. CPA writes about Treasury providing relief to U.S. individual owners of foreign corporations facing the new GILTI regime. Mr. Noff notes in the article that the use of the election under the right circumstances can revert an individual owner of a foreign corporation to the pre-GILTI regime of paying tax on earnings only when they are distributed. Click here for full article. Tax principal Peter Palsen also explains the issues in his piece, “IRS Proposes Additional GILTI High-Tax Relief.” Click here for full article.
ACA continues its advocacy for the Transtion Tax and GILTI regimes that seriously affect small businesses run by US citizens living and working overseas, most recently with two submissions in 2020. ACA writes to Treasury and IRS and Reiterates the need for a De Minimis Ruling for Transition Tax and GILTI and The Torturous Road Leading to TCJA and Its Progeny, the Transition Tax and GILTI. Click here for full article.
Foreign Earned Income Exclusion (FEIE) and Foreign Tax Credits
Foreign Earned Income Exclusion
If you are a U.S. citizen living abroad, you may qualify to exclude your foreign earnings from income up to an amount that is adjusted annually for inflation ($112,000 for 2022). This exclusion is for "earned income" only therefore disability payments, social security income and pensions income do not qualify.
In 2018 the IRS announced a new law that allows US citizens, notably contractors or employees supporting the US Armed Forces in designated combat zones, to qualify for the Foreign Earned Income Exclusion (FEIE). The Bipartisan Budget Act of 2018, changed the tax home requirement for eligible taxpayers, allowing them to claim the FEIE even if their “abode, or home, is in the United States.
Prior to the passage of this law, these employees, contractors, etc. who maintained an “abode” in the United States, were unable to claim the FEIE. The justification being that their home is in the US and not in a foreign jurisdiction given the temporary, contract or short-term nature of their employment. Although abode is not defined in the IRS code or regulations, it has been defined by various courts as one’s home, habitation, residence, domicile or place of dwelling.
There are a plethora of reason for which a US citizen living overseas who is not supporting the US Armed Forces may continue to maintain an abode in the United States while actually working overseas.
As businesses and commerce have gone global, the ease with which individuals can “pick up and go” to take advantage of employment and financial opportunities has increased. Employees are now more mobile than ever. Some employees may not be able, or may not want, to relocate their home or family during their employment for a number of reasons; safety issues in the country of employment, family member health/disability issues, schooling and educational issues, special needs children, eldercare management, etc.
These reasons and others may require that an employee keep an “abode” or home in the United States to manage their personal and family needs while they are working overseas and paying taxes in a foreign jurisdiction. Forcing a strict adherence to the concept of “abode” puts these individuals at a disadvantage and limits their employment options.
The abode concept is outdated and no longer fits with the way that individuals live and work in the 21st century. The real answer to the complications of tax policy affecting US citizens working overseas is adoption of Residency-based taxation (RBT). It is time for the US Congress to come into the 21st Century not only on the issue of “abode” but also on general tax policy affecting Americans overseas.
Foreign Tax Credits
The US expects foreign countries to tax their income similarly to the US. The US gives taxpayers nine different categories of income to claim foreign tax credits on and limiting each to approximately what the US would’ve taxed. The categories often overlap significantly due to their vagueness and/or the preparer-by-preparer interpretation.
For example, wealth taxes imposed by foreign countries do not qualify as a tax credit, and in some cases it is unclear whether they can be used as an itemized deduction. Certain social taxes used in many European countires also do not qualify. Many foriegn jurisdictions do not use income tax as a primary source of tax revenue, relying on value added taxes (VAT) to raise taxes.
Currency Fluctuation and Phantom Gains
US citizens living overseas must use the US dollar as their functional currency U.S. Code § 985 - Functional currency. Currency fluctuation is virtually impossible for expats to plan around. The volatility in currency exchange rates can cause taxable events for Americans trying to do normal life transactions such as having a credit card or taking on a mortgage to buy a house.
Currency fluctuations are especially problematic for mortgages. Phantom gains on debt forgiveness if the USD appreciates over the term of the mortgage can be virtually impossible for everyday taxpayers to keep track of. Most Americans are not trying to speculate on price changes and most are working in their local jurisdiction currency. To complicate the situation phantom gains are taxable however, phantom loses cannot be taken as a tax credit. U.S. Code § 988 - Treatment of certain foreign currency transactions
For example, if a US citizens overseas buys a house in Europe with a €1 million mortgage while the exchange rate is €1:$1, the expat will also have a $1 million mortgage. If the USD strengthens over time and, over the course of the mortgage, €1 million euros is the same as $900,000, the IRS will say there is $100,000 of debt forgiveness income (the original $1 million minus the $900,000 principal paid). This will result in a large unexpected tax bill at their ordinary tax rate that is not eligible for foreign tax credit relief. Also, had the dollar weakened against the euro, the resulting loss (paying more than $1 million in principal) would not be allowed.
The Affordable Care Act and the Net Investment Income Tax (NIIT)
The Affordable Care Act includes an additional Medicare tax in the form of a 3.8% Net Investment Income Tax (NIIT) on some net investment income of individuals, estates, and trusts that have income above the statutory threshold amounts. Individuals are subject to the NIIT if they have; 1) Net Investment Income and, 2) Modified Adjusted Gross Income (“MAGI”) over certain applicable thresholds. Even if you are exempt from Medicare taxes, you may still be subject to the NIIT.
This new tax leads to double taxation of those US citizens living overseas since foreign tax credits cannot be applied against this tax due to a simple drafting technicality. Additionally, US citizens living overseas have no access to the Affordable Care Act. ACA, Inc. has urged Congress to apply tax fairness and to allow foreign tax credits against the additional Medicare tax: December 2013 ACA, Inc. Press Release
Complete information on the NIIT tax can be found here: http://www.irs.gov/uac/Newsroom/Net-Investment-Income-Tax-FAQs
The Pitfalls of Passive Foreign Investment Companies (PFICs)
PFIC taxes prevent U.S. taxpayers from transferring profits to foreign investment corporations and later claiming the income as a capital gain (while paying the lower capital gains rates) by taxing gains on foreign passive investments at ordinary income tax rates, and charging punitive interest for the time the money was invested.
A PFIC is any foreign corporation meeting one of two conditions: 1) 75% or more of its gross income for the taxable year consists of passive income, or 2) 50% or more of the average value of its assets consist of assets that produce, or are held for the production of, passive income.2 Passive income includes dividends, royalties, rents, annuities, capital gains, foreign currency gains, and the like.3 Income derived from active banking activities, insurance, rents from relatives, and export trade is excluded from the definition of passive income for PFICs.4
For the first year, income generated by a PFIC is taxed as ordinary income at the highest marginal rate.5 In subsequent years, increases in distributions from PFICs are penalized as “excess distributions” if the increase exceeds 125% of the average income of the previous three years, or the holding period if less than three years.6 The penalty is the same as the underpayment rate7, which is the Federal short-term rate plus 3 percentage points.8
Taxpayers can avoid PFIC treatment if the company is a qualified electing fund or if the stock is marked to market.9 For the former, the taxpayer must establish fair market value as of the day the company becomes a qualified electing fund and pay the appropriate taxes.10 If a taxpayer does not make this election, the taxpayer remains subject to PFIC rates. A taxpayer may make the qualified electing fund election only if the holding company meets the requirement to determine the ordinary earnings of its net capital gain.11 Mark to market election requires the taxpayer to determine the fair market value of the taxpayer’s holdings annually and pay tax on the gains, with some adjustments for past gains and losses.12
Obviously, investing in Passive Foreign Investment Companies has consequences for the US citizen living overseas. In addition to paying the fees, the taxpayer must fill out Form 8621 to calculate and report those fees, which the IRS itself estimates will take more than 48 hours.13 US citizens living abroad are more likely than those who do not to own foreign accounts. And, they may not even know whether that account qualifies as a PFIC under IRS rules.
Consider an American taxpayer living in Taiwan. If the taxpayer is at all familiar with U.S. tax law, he knows to report income to the IRS. But what about the pension fund set up by his employer, a common event in Taiwan? It is likely the taxpayer knows the balance of the pension account, and just as likely that the taxpayer doesn’t know whether the account qualifies as a passive foreign investment company or, perhaps, a foreign trust. Mutual funds available to owners of foreign accounts face the same problem. As noted earlier, there is a penalty for failure to properly calculate earnings in a PFIC, and the same applies to foreign trusts. In fact, failure to report foreign trust earnings on time results in a penalty of $10,000, or 35% of dividends, whichever is higher, and an additional $10,000 for every 30 days the payment is late after the first 90 days.14
US citizens generally assume that accumulating funds in a retirement account or a mutual fund is a good idea. For taxpayers living overseas, however, that proposition is not a sure thing given the possible tax consequences. At the least, earnings can be reduced by the time spent calculating taxes and by penalties. At worst, the entire fund could be lost to the IRS.15 The complexities, and penalties, presented by tax rules on foreign accounts present special problems for US citizens living abroad, problems that their U.S.-resident counterparts are unlikely to ever confront, especially by accident.
 26 U.S.C.S. § 1297(a).
 26 U.S.C.S. §§ 1297(b), 954(c).
 26 U.S.C.S. § 1297(b).<
 26 U.S.C.S. §§ 1291(a)(1), 1 et. seq.
 26 U.S.C.S. § 1291(b).
 26 U.S.C.S. § 1291(c)(A).
 26 U.S.C.S. §6621.<<
 26 U.S.C.S. § 1291(d).
 26 U.S.C.S. § 1291(d)(2).
 26 U.S.C.S. § 1295(a).
 26 U.S.C.S. § 475.
 26 U.S.C. § 6677(a).
Included in the 2015 highway bill, signed into law on 4 December 2015, was a revenue-raising provision that requires the IRS to revoke or deny the passport of any taxpayer with a seriously deliquent tax debt.
The IRS defines a seriously delinquent tax debt as a tax liability of an amount greater than $50,000, and for which the taxpayer has exhausted all administrative appeal rights. That amount includes penalties and interest in addition to the taxes. The statutory $50,000 amount is adjusted annually for inflation and is currently $52,000.
Taxes can be collected without imposition of undue and unwarranted hardship for traveling US citizen and for those living overseas. For reasons grounded in principle, law, and equity, ACA strongly opposes the notion of revoking passports for the purpose of collecting tax debts.
Americans Abroad Caucus Co-Chairs Maloney (D-NY) and Mulvaney (R-SC) along with their colleagues wrote to the Secretary of State Kerry in April of 2016 advising him of the serious issues with regard to the passport revocation provision as it applies to Americans living and working overseas. See Caucus letter here.
ACA has been on the forefront of this issue bringing it to the attention of the legislature and the Americans Abroad Caucus. ACA has continued to highlight to the Congress the serious negative impact such legislation could have on Americans living overseas: ACA letter to Congress and Final ACA position paper on passport revocation.
ACA is concerned over this provision given the increase in individuals coming into compliance from overseas, the lengthy mail delivery and communication time between the IRS and overseas tax filers, the risk of error in filing from overseas and the lack of clear regulatory guidance on how the process for the final determination of those whose passports will be revoked. ACA also believes that a general policy of revoking US citizen's passports for tax delinquency in unfair.
On October 16, 2019, the IRS reversed its temporary suspension of passport certification for revocation/denial for taxpayers with open National Taxpayer Advocate Services (TAS) cases. The reversal is based on the IRS belief that excluding cases for certification solely on the basis that the taxpayer is seeking TAS intervention and assistance could permit “won’t pay” taxpayers to circumvent the intent of the law—allowing them to continue to hold or renew a passport even with a debt in excess of $52,000.
Prior to this reversal, Acting TAS Advocate, Bridget Roberts, had blogged the good news that the IRS had agreed to temporarily: (1) exclude from passport certification those cases with TAS involvement, and (2) reverse certifications for TAS taxpayers who were certified prior to engaging TAS. She emphasized that “TAS has long advocated for the IRS to exclude from certification taxpayers who came to TAS and were actively working with us prior to being certified.” Significantly, Roberts highlighted that certain groups of taxpayers may have been so desperate to avoid passport certification that they were unduly pressured into agreeing to unrealistic payment plans, perhaps based on incorrect liability determinations. Specifically, Roberts identified the following taxpayers working with TAS as particularly susceptible to this:
- taxpayers who did not believe that they owed a liability and were working with TAS to challenge a substitute for return;
- those seeking penalty abatement based on reasonable cause; and
- those pursing an audit reconsideration.
ACA maintains that loss or denial of a US passport for US citizens overseas holds serious and unparalleled consequences compared to those faced by US citizens living in the United States. An ACA Freedom of Information Act request has revealed that of the over 260,000 cases reported for potential passport revocation, approximately 1,850 represent individuals who are overseas residents. A US passport for these US citizens may be the only official US document conclusively proving US citizenship.
For those US citizens overseas working in high-risk countries and danger zones, a US passport may be their only proof to the US Embassy or Consulate in circumstances necessitating urgent assistance. Also, a US passport is the underpinning document for many Americans to hold “work permits” and “right of residency” in many foreign countries. Without such a document, many would be unable to work or maintain their livelihoods if their US passports were revoked or denied.
ACA supports the US government efforts to track down and prosecute real tax evaders; however, US citizens who are attempting to come into compliance given the new bank account reporting forms, or those who may have been assessed erroneously calculated tax debts should not find themselves coerced into paying onerous and potentially bankrupting amounts just to keep their passports when they are not engaged in active tax evasion.
US Small Businesses Overseas
Information to come.
The Child Tax Credit and the Earned Income Credit
The enhanced Child Tax Credit, passed in the American Rescue Plan legislation of 2021,and the Earned Income Credit require that those eligible to receive them live at least six month during the year in the United States. This excludes many Americans overseas who may qualify for the tax benefits. Independent studies show
that Americans overseas are similar demographically to Americans living in the United States and that those in need of the Child Tax Credit and the Earned Income Credit face the same issues overseas as domestic Americans. ACA has written to the tax writing committee to have them investigate why Americans overseas were left out of this important legislation aca-ctc-letter-211006.pdf (americansabroad.org)