Tax reform is clearly on the agenda of Congress for 2013. The world has changed significantly since 1986 when the last major tax reform took place. The situation of Americans residing abroad, now subject to a set of tax rules known as citizenship-based taxation (CBT), must be part of the next U.S. tax reform, which is so urgently needed. The problems faced by the community of Americans abroad have been highlighted in the 2011 and 2012 Annual Reports to Congress by the National Taxpayer Advocate, Nina Olson1, as well as her 2013 Objectives Report. The failure of CBT and the need for Residence-Based Taxation (RBT) are thoroughly analyzed in a recent in-depth academic paper by Bernard Schneider, published in the Virginia Tax Review; several other academic and professional studies have also called for the adoption of RBT.2 Current policies are so onerous that increasing numbers of Americans residing abroad are being forced to close down their businesses abroad and/or renounce their U.S. citizenship due to immense pressure from spouses, employers, foreign governments, financial institutions and the undue burdens placed on overseas Americans.
Many of the inconsistencies and inefficiencies inherent in FATCA legislation and IRS policies since 2009 can be traced to the unjustified bundling of Americans abroad and rich tax evaders, domestically resident but with assets hidden abroad, into a single amalgam. In reality, these are two very different subject groups.
Americans abroad are, on the whole, patriotic, honest and hard-working, leading average lives and paying taxes where they reside. A recent study shows that more than half of Americans abroad have lived overseas more than 6 years; the principal reasons for residing overseas are to be with one’s spouse/partner and professional work. 44% of Americans overseas have investments in the U.S., 37% have done business with someone in the United States, 37% donate to U.S. charities and 18% own property in the United States. 39% contribute to U.S. political parties or political action committees (PACs) and 26% remit money back to family in the United States. Most celebrate Thanksgiving, and many Americans abroad send their young children to the United States during summer vacation either to family members or summer camps in the United States to let them experience the American way of life and have an opportunity to enhance their command of English and develop contacts in the United States. Many also encourage their children to attend college and/or graduate school in the United States.
Americans abroad are a vital force for the United States in today’s global economy, yet CBT policies handicap their competitiveness, and by extension, the competitiveness of U.S export capability. The RBT proposal is consistent with the tax policy practiced on individuals by other countries throughout the world.
Reform is all the more important given that the tax revenue collected under the current CBT regime is absolutely insignificant in the U.S. budget – a tiny fraction of one per cent – while the negative consequences of CBT for the economic welfare of the United States and its citizens are huge. Furthermore, RBT should generate more tax revenue for the United States than the current CBT.
ACA proposes that the United States adopt RBT as the default mode of taxation for American citizens and green card holders residing abroad (collectively, “Americans abroad”). As soon as an American established a tax home abroad, he/she would apply to the IRS for a Departure Certificate. Americans abroad would be taxed on the same basis as the U.S. currently taxes non-resident aliens. The U.S. source income of Americans abroad would be taxed through withholding taxes determined by U.S. tax law and U.S. income tax treaties. This would include withholding taxes on all U.S. source unearned income (including dividends, interest, royalties, pensions, rents from U.S. properties, etc.). Income earned in the United States by Americans abroad, income from participations in U.S. partnerships and compensation for self-employment services performed in the United States would be taxed, as the case may be, either by a withholding tax at source or by reporting income on a 1040NR under the same rules that apply to non-resident aliens who have income effectively connected with the United States. Investments in U.S. real estate would remain subject to taxation by the United States.
Under the default mode, as soon as an American establishes a tax home abroad, the citizen would be required apply to the IRS for a Departure Certificate, unless subject to specific exceptions granting the option to remain under CBT. For those applying for the Departure Certificate, the United States would tax income on the basis of CBT only up to the date of granting the Departure Certificate, even if the period of U.S. residence exceeds 183 days in the calendar year. The reason for not delaying the issuance of a Departure Certificate is the need for the American abroad to be able to establish relationships with foreign financial institutions in the country of residence.
RBT can also be defined as an alternative, rather than the default mode of taxation. Americans abroad meeting specified conditions, such as length of residence abroad and choice of country would be able to choose the option to be taxed under RBT. For all overseas Americans who do not opt for RBT, CBT would remain the standard mode of taxation. Those who choose RBT would be subject to the same tax rules mentioned above under the default mode. The application for the Departure Certificate would follow a similar procedure.
Under RBT, members of the U.S. diplomatic service, U.S. military overseas, and citizens residing in tax haven countries would be deemed U.S. tax residents.
Congress may determine that Americans with certain types of temporary overseas mandates, lasting less than two years, remain subject to U.S. taxation as U.S. residents.
Implementation of RBT would necessarily require a transition phase and specific conditions applicable to various segments of the overseas American community. The terms of transition that are proposed take into account the number of years individuals have resided overseas prior to the law becoming effective and their tax filing compliance status prior to enactment of the law. The proposal encourages Americans abroad currently not in compliance to correct the situation in order to be recognized under RBT as a non-resident.
Replacing CBT with RBT has essentially nothing to do with IRS's highly publicized and strenuous efforts to identify and pursue Americans tax evaders. To date the overwhelming majority of those prosecuted for having hidden assets abroad are U.S. residents who would not qualify for RBT. The two issues – the taxation of non-residents and the pursuit of U.S. resident tax evaders – are unrelated.