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.