US Expat Tax Transition Proposal Needs Finessing to Meet the Mark – Bloomberg Tax

A plan to transition the US from a citizen-based taxation system to a residence-based system like in most other countries would be good for US citizens abroad and the US itself. While the proposal is a step in the right direction, it doesn’t go far enough.

The proposed Residence Based Taxation of Americans Abroad Act would only transition the US to a residency-based taxation system for income taxes and not gift and estate taxes. It would only apply to US citizens and not permanent residents (green card holders) living abroad. A comprehensive solution must include income taxes, gift and estate taxes, and apply to green card holders.

US citizens abroad could elect to be treated as nonresidents for US income tax purposes if certain criteria are met. Like other nonresidents, they only would have to pay US income taxes on US source income. They also could benefit from US tax treaties with their countries of residence, something not available to them now.

Non-resident US citizens would be freed from compliance with the US’ complex international tax rules and international information reporting requirements, as well as the cost of compliance and compliance risks. And the US would be relieved from the cost of administering and enforcing its tax rules against a population that pays little or no tax.

As most people in the tax world know, the US taxes its citizens on their worldwide income regardless of their residency. The US is one of only two countries that does this, the other being Eritrea.

Prior to the Foreign Account Tax Compliance Act, few US citizens abroad complied with their tax obligations because many were unaware of them. There was rampant noncompliance in filing tax returns, paying taxes, and filing Reports of Foreign Bank and Financial Accounts, or FBARs.

When FATCA took effect in 2010, panic among US citizens abroad set in, and there was a mad rush to get compliant. Most US citizens living abroad weren’t trying to evade their taxes but were simply unaware of their US tax obligations. Recognizing this, the IRS opened various amnesty programs to help US taxpayers whose noncompliance was non-willful become compliant.

The citizenship-based taxation system severely harms citizens abroad, who often must pay tax on income paid in to foreign retirement accounts as well as on the income earned within them—even when not subject to tax in their country of residence. They’re also subject to punitive taxes on certain investments, such as in foreign mutual funds.

The situation is even worse for US citizens abroad who own and operate businesses through foreign corporations, most of whom must pay US taxes on the profits of their foreign corporation regardless of whether they receive a dividend. They’re forced to comply with rules that are intended for large multinational corporations, not small business owners.

Further, US citizens living abroad usually can’t benefit from tax treaties between their countries of residence and the US due to the savings clause contained in most US tax treaties. The savings clause essentially says the US reserves the right to tax its citizens as if the treaty didn’t exist. The proposal would deactivate the savings clause of applicable US tax treaties, giving citizens abroad who elected to be treated as nonresidents access to them.

US citizens living abroad are subject to complicated and burdensome reporting obligations. They must report their foreign financial accounts—such as bank accounts, brokerage accounts, retirement accounts, annuities, and certain life insurance—ownership in certain foreign entities, and certain foreign trusts.

The taxation and reporting burden for US citizens abroad is so complex that they need a specialized tax professional to navigate it. Such professionals are expensive and often cost-prohibitive for the average US citizen abroad.

This has created the unfortunate side effect of the emergence of low-cost US international tax “experts.” Many of these self-proclaimed experts are better at marketing than tax. Being unable to afford competent US international tax professionals has left many US citizens abroad with no choice but to hire low-cost tax professionals, most of whom can’t provide accurate tax advice or preparation.

This conundrum has left many US citizens abroad vulnerable to additional taxes, penalties, and interest in the event of an audit.

FATCA’s primary purpose was to curb supposed massive offshore tax evasion. But the biggest impact has been on ordinary US citizens abroad. FATCA has been a failure, as evidenced by the actual revenue it has raised compared with projections.

The current proposal is a good start that would certainly be welcomed by citizens abroad. However, it doesn’t go far enough. To truly transition to a residency-based tax system, comprehensive change is needed that includes green card holders and encompasses estate and gift taxes in addition to income taxes. It also should be simple for citizens abroad to be treated as nonresidents—the current proposal’s election rules seem complex and likely will be difficult to comply with.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Jimmy Sexton is founder and CEO of Esquire Group and chairman of the International Business Structuring Association (Middle East Chapter).

Write for Us: Author Guidelines