The article was first published in Global Tax Weekly, issue 154. Below is the full text of the first article in the series on US taxes for US persons living outside the US.
United States Tax Compliance And Planning For US Executives, Entrepreneurs And Investors Living Outside The US – An Overview
by Stephen Flott and Flott & Co.
This is the first article in a series of articles on key US tax compliance and planning issues that should be considered by US executives, entrepreneurs and investors living outside the United States. This first article provides an overview of the US taxation of US citizens and residents (“US Persons”) and briefly discusses certain topics that will be covered in the series.
US Persons1 are subject to tax in the US on their worldwide income, even if they do not live in the US or have any income from source within the US. This is often referred to as Citizen Based Taxation. Only the US and Eritrea, which imposes an annual tax on its citizens who live outside the country, use a Citizen Based Taxation system. The rest of the world taxes based on physical residence. This is generally called Territorial or Residence Based Taxation. Under this system, individuals are only subject to tax in the country in which they physically reside or if they earn income from sources within that country. US Persons who live abroad are typically shocked to learn of their continued US tax filing obligations.
The US has established tax treaties with many countries to reduce the burden of double taxation. Contrary to popular belief, however, these treaties do not change the US taxation of US Persons because all US tax treaties contain a savings clause that, with limited exceptions, states that no provision of the treaty shall be construed to prevent the US from taxing US Persons as if the treaty did not exist. In effect, citizen based taxation requires that tax treaties take this approach.
All income received by US Persons derived from any source is subject to US federal income taxation unless specifically exempted or excluded. “Subject to tax” is not the same as “being taxed”. Thus, US Persons, who are also subject to US federal income tax on income from sources outside the US, are able to claim a tax credit in the US for any foreign tax paid on their income and use that “foreign tax credit” to offset US federal tax on that same income.
There are a number of provisions in the Internal Revenue Code (“IRC”) that deem US Persons to have received income earned by foreign corporations, passive foreign investment companies (“PFIC”), and trusts created by US Persons. These deemed income rules are not typically found in the tax laws of other countries and can create tax planning headaches. For example, if US rules require income to be recognized and US tax to be paid before the same income is recognized in a foreign country, there will be a mismatch between the foreign tax credits available to US Persons to offset US tax, resulting in double taxation of the income.
Despite the existence of citizen based taxation, Section 911 of the IRC allows US Persons who meet certain requirements to exclude from US federal taxation some amount of foreign earned income plus a housing cost amount. The Foreign Earned Income Exclusion (“FEIE”) provided for in Section 911 allows US Persons to exclude the equivalent of USD100,800 from their taxable income for tax year 2015.2 US Persons cannot claim foreign tax credits for any foreign income tax paid on the amount of foreign earned income excluded from US taxation by the FEIE.
US Persons can claim a foreign tax credit for income taxes paid to foreign countries. The purpose of the foreign tax credit is to eliminate double taxation on the same income. The foreign tax credit allows a taxpayer to subtract income taxes paid to other countries from the tentative tax owed to the US Government. Foreign taxes other than income taxes (such as property taxes, excise taxes, payroll taxes, or value-added taxes) cannot be credited against US tax. All foreign income taxes can be credited against US tax, including taxes levied by governments below the national level.
The FEIE is elective. US Persons who can claim the FEIE must decide whether to claim the FEIE or to rely on foreign tax credits. A key factor in determining which option is more advantageous is the amount of US and foreign tax imposed on the foreign earned income. The FEIE only excludes earned income from US income tax. The FEIE does not include income from passive sources, including interest, dividends, capital gains, rents, pension income or social security type payments. Thus, US Persons who work in low-tax jurisdictions will benefit from FEIE as they have little or no foreign tax credits to offset US tax on their earned income. In contrast, those who live in high-tax jurisdictions are generally better off using the foreign tax credit option. At the end of the day, the US will collect any residual US tax on lightly taxed foreign-source income. US Persons in effect pay the higher tax rate whether it is to the country in which they live or derive their income, or to the US.
The FEIE eliminates US tax on the qualifying amount of foreign earned income in high-tax foreign jurisdictions. The foreign tax credit will also achieve this result since the higher foreign taxes are sufficient to fully offset the US tax on the foreign earned income. Also, under the foreign tax credit option, excess foreign taxes paid above the amount required to offset the US tax on the foreign earned income can be carried back one year and forward for ten years. There are also certain refundable tax credits that are based on earned income that the US Person typically will not be eligible for if the FEIE is elected, whereas the US Person who instead uses the foreign tax credit will be able to claim these credits. Many US Persons residing abroad, despite paying no US tax for the year, qualify for these refundable tax credits and receive a refund from the US Government. One could look at it as being paid to file the US tax return.
There are also other planning considerations in deciding between electing the FEIE or using foreign tax credits. For US Persons with both foreign source income and US source income, the FEIE could be used under the right circumstances to reduce their adjusted gross income below the standard/itemize deduction and personal/dependency exemption amounts to remove any US tax liability on their US source income. In other circumstances, using the foreign tax credit option is more beneficial, typically in higher-tax foreign jurisdictions, where US Persons have both US source income and foreign source income. The choice between electing the FEIE and relying on foreign tax credits is not always obvious. The best option depends on many different factors.
Another non-tax filing requirement that is often overlooked is the foreign bank account report (“FBAR”), the non-filing of which can carry substantial penalties. US Persons are required to file an FBAR if they have financial accounts located outside the US and the total on deposit in all such financial accounts at any time during a calendar year exceeds the equivalent of USD10,000. For purposes of the FBAR, a financial account includes, but is not limited to, a securities, brokerage, savings, demand, checking, deposit, time deposit, or other account maintained at a financial institution. A financial account also includes a commodity futures or options account, an insurance policy with a cash value, an annuity with a cash value, and shares in a mutual fund. A foreign financial account is a financial account that is located outside the US. Thus, financial accounts held within the US are not reported on the FBAR.
The FBAR is really nothing more than a report of financial accounts located outside the US detailing the name of the financial institution, the address, account number, and the maximum balance of each foreign financial account for each year. The FBAR is an informational filing, not an income tax filing. For the mobile US executive or investor, the FBAR filing is important because failure to comply with the filing requirement carries large penalties.
The penalty for nonwillful failure to file is an amount not to exceed USD10,000 per account per year. US Persons who willfully fail to file the FBAR are subject to a penalty equal to the greater of USD100,000 or 50 percent of the balance in each unreported account at the time of the violation. Willful violations may also be subject to criminal penalties. As should be apparent, it is important that US Persons timely file their FBAR every year.
The individual compliance filing requirement under the Foreign Account Tax Compliance Act (“FATCA”) is similar to, but slightly different from, the FBAR filing requirement. There is a corresponding obligation for foreign financial institutions under FATCA, receiving a lot of press as of recently, which requires foreign financial institutions to report in one way or another to the IRS the account information of US Persons held at the foreign financial institution. The foreign financial institution reporting requirements make US Persons’ compliance with both the FBAR and FATCA filing requirements more significant, as now the IRS will be supplied with the information about the accounts to impose penalties for noncompliance.
US Persons comply with FATCA by reporting their specified foreign financial assets on Form 8938, which is submitted with their US income tax return. There are a number of FATCA filing thresholds depending on the residence of the US Person and his or her filing status. These will be detailed in a later article in this series. Specified foreign financial assets include financial accounts maintained by a foreign financial institution and other foreign financial assets held for investment if they are not held at a financial institution. Other foreign financial assets include stocks or securities issued by a foreign person, any interest in a foreign entity, and any financial instrument or contract that has a foreign person issuer or counterparty. While the penalties for failure to file Form 8938 are not as severe as the FBAR penalties, the penalties are still significant, so US Persons with Form 8938 filing obligations will want to ensure they are in compliance with their filing obligation.
Mobile US investors will need to be alert to the special tax and reporting rules for owning interests in entities located outside the US. Entities formed outside the US with US Persons as owners will be classified as corporations, partnerships, or disregarded entities for US tax purposes. For most entities formed outside the US, US investors will be able to elect the entity’s US tax classification. If no election is made, the default rules provided in the IRC and Treasury Regulations will determine the entity’s tax classification. Certain foreign entities are classified by Treasury Regulations as per se corporations and no election can be made to change that classification. The opportunity to elect the tax classification of a foreign entity provides US investors with many important initial tax planning considerations as there can be complications with changing the initial entity classification after the first year of US tax reporting.
There are also special tax reporting rules for certain types of foreign corporations which will be discussed in greater detail later in this series. For example, if US Persons own more than 50 percent of the equity in a foreign company, it will be considered a controlled foreign corporation (“CFC”) for purposes of US taxation. CFCs are subject to special tax rules that must be taken into account when US Persons file their tax returns.
Also, under certain circumstances, a foreign corporation might be classified for US tax purposes as a passive foreign investment corporation (“PFIC”) which has adverse tax consequences for US Persons. For example, foreign mutual funds are taxed as PFICs
in the US. The adverse tax consequences including the cost of tax compliance associated with a PFIC often makes investing in foreign mutual funds prohibitive for US Persons. Unfortunately, since foreign mutual funds are routine investments in other countries as they are in the US, US Persons are often surprised to learn of the adverse consequences of their foreign mutual fund investments.
Since foreign companies are generally not required to file US tax returns, where a US Person’s interest exceeds certain levels or other tests are met, that person is required to file special information returns to essentially provide the information that would be contained in a US corporate or partnership tax return. The burden of providing the information is shifted to the US Person under these circumstances.
Another important tax issue for US Persons, particularly executives working overseas, is the status of foreign deferred compensation or retirement plans. The IRC does not include special rules for taxation of foreign retirement or deferred compensation plans. It has provisions covering qualifying US retirement plans (e.g., 401ks, IRAs, etc.). For example, to qualify for tax deferral benefits, the plans must be held in US based accounts and meet
specific reporting and other requirements. Equivalent retirement accounts in other countries are not tax deferred in the US because they do not qualify under the IRC rules. Very few US tax treaties cover retirement plans. Canada and the UK are two that do. A tax deferred retirement plan in most foreign countries is not likely to be tax deferred in the US. Thus, it is not uncommon for US Persons employed abroad to be currently taxable in the US on their and their employers’ contributions to their foreign retirement plans even though they are tax deferred where they live.
An associated issue, often overlooked unfortunately, is that a foreign retirement plan may be classified under IRC rules as a foreign trust. If it is, in addition to the unfavorable tax treatment in the US, there is a trust reporting obligation. We will cover this issue in greater detail later in this series. If a US Person expects to be overseas only for a limited period, the best option if it is possible is to continue to contribute to a US retirement plan, with the caveat that once the US Person becomes a resident of the foreign country where he or she works, he or she may face a mirror tax issue in the foreign country with his or her US retirement plan.
The IRC makes the lives of US Persons living abroad, particularly executives, entrepreneurs and investors, much more interesting than their compatriots living in the States and their tax compliance challenges significantly more complex. This series will address the various tax compliance challenges and planning opportunities.
1The term “US Person” as used in these articles includes only US citizens. It should be noted that legal permanent residents (LPRs) and non-citizens who spend more than 183 days in the US during a tax year are US Persons for tax purposes. LPRs cease to be US Persons when they abandon their status. Non-citizens cease to be US Persons as soon as they spend fewer than 183 days in the US during a tax year. The calculation of days present in the US for purposes of determining the substantial presence test includes 1/6 of the days spent in the two years prior to the current tax year, 1/3 of the days spent in the year prior to the current tax year, and all of the days spent in the US during the current tax year. Effectively, non-citizens should not spent more than 122 days a year in the US during any consecutive three year period to avoid being a US Person for US tax purposes.
2The amount of the permitted exclusion has been indexed for inflation since 2005.