The United States is unique among the world’s nations in that it imposes its income tax, gift and estate tax on its citizens regardless of where they live. No matter how long a U.S. citizen has lived outside the country, and even if the individual is also a citizen of another country, he or she is subject to worldwide taxation in the U.S.
Perhaps the most unfair application of worldwide taxation on U.S. citizens is when foreign parents, while on a relatively short term assignment in the U.S., give birth to a child. The parents return home, say to the United Kingdom, when the child is two years old. The child grows up and becomes a productive adult, living his or her entire life in the U.K. That child is considered a U.S. citizen and is required to file U.S. income tax and other informational returns and forms for his or her entire life. At his or her death, the executor is likely obligated to file a U.S. estate tax return.
Because countries around the globe that impose an income tax apply that income tax based on the residency of an individual, a U.S. citizen residing in such a country will be subject to income tax on their worldwide income in the U.S. and in the country of residency. Although the American system does allow for foreign tax credits to reduce or eliminate double taxation on the same income and has entered into income tax treaties with many countries to reduce or eliminate double taxation, an American citizen must report and pay taxes, if appropriate, in both the country of residence and in the U.S.
Furthermore, what would be considered completely normal economic behavior in the U.S. can cause tax and reporting headaches for those living in a foreign country. Purchasing a mutual fund in a foreign country is considered to be a Passive Foreign Investment Company under the U.S. income tax system and is subject to possible unfavorable income taxation and interest charges. Participating in a foreign pension or retirement arrangement will not likely exempt the U.S. citizen from immediate taxation of the income in the retirement plan. Holding and investing in foreign currency will result in foreign currency gains and losses.
If You’re Living Abroad, You Still Have to File
The U.S. has adopted significant extra filing requirements on its taxpayers who have dealings offshore. These disclosure rules assist the Treasury Dept. with collecting tax revenues and prevent deposit of income in foreign structures to defer or avoid paying U.S. income tax. When an American citizen lives in a foreign country, however, all his or her dealings are likely to be offshore. The U.S. citizen living abroad, unlike the typical U.S. citizen living in the States, will have return and reporting requirements that most Americans have never heard of or had to file, making the whole matter rather confusing.
For example, the typical U.S. citizen living abroad might have to file a:
- TD F 90-22.1 foreign bank account report
- Form 8938 Statement of Specified Foreign Financial Assets
- Form 5471, information Return of US Persons With Respect to Certain Foreign Corporations
- Form 8865, return of US Persons With Respect to Certain Foreign Partnerships
- Forms 3520 and 3520A concerning foreign trusts
The penalties for failure to file these additional forms can be severe. For example, the penalty for failure to report contributions to and distributions from a foreign trust is 35% of the amount contributed or distributed from such a trust.
In March 2010, Congress passed the Foreign Account Compliance Act (FACTA), designed to compel foreign financial institutions to report deposits in their institutions by U.S. citizens and U.S. residents. Although the implementation of this statute is just now beginning to take place, most financial institutions throughout the world have begun to identify U.S. depositors. U.S. citizens who have been non-compliant with all of the foreign reporting requirements are in effect being forced to become compliant. The IRS currently has an Offshore Voluntary Disclosure Program to assist in that process.
In light of FACTA and the significant cost and burden of complying with American income tax laws, many U.S. citizens living abroad, especially those with dual citizenship, are electing to expatriate and give up their U.S. citizenship. But American taxation does not end there. The U.S. has an exit tax that applies to certain relatively wealthy U.S. citizens and long term permanent residents who expatriate from the U.S.
While there are many tax and reporting challenges for U.S. citizens living abroad, with some research and counsel from professionals the headache of the process can hopefully give way to an enjoyable overseas experience.
Material discussed is meant to provide general information and should not be acted on without professional advice tailored to your firm's individual needs.