Understanding current law
To put the proposal for RBT in proper perspective, it is important to understand how U.S. tax law presently applies to Americans abroad.
U.S. taxpayers residing abroad, under the present rules, pay income taxes in the country of residence like any and all residents of that country. The requirement of a nexus between the taxing authority and the place of residence is a universally accepted principle of taxation. (This is readily demonstrable even in the U.S., as it is unimaginable that New York authorities would continue to levy taxes on a former resident of New York now living in California, on the grounds of previous residence in New York.) In addition, Americans abroad are required to file and pay taxes in the United States. On their Form 1040 they can apply the foreign earned income exclusion and housing exclusion if they have income earned overseas. They can also apply foreign tax credits 1 on earned and unearned income up to the level of the U.S. tax liability. Like their domestic counterparts, overseas residents are either taxed at reduced rates on qualified dividend income or exempt from such taxation on qualified dividend income (up to specific income thresholds)4.
The bottom line is that after applying the foreign earned income exclusion and/or foreign tax credits, as well as the tax rules for qualified dividends, most Americans abroad do not owe U.S. taxes. In fact, according to the National Taxpayer Advocate, about 82% of all Americans abroad who filed their 1040 owed no U.S. taxes. Most Americans abroad reside in OECD countries with tax rates higher than U.S. tax rates; the foreign tax credits generated eliminate U.S. taxes on their foreign source income. Not surprisingly, then, tax revenue from Americans abroad, estimated by ACA at $6.3 billion in Exhibit 1, represents only 0.3% of total federal government revenues ($2.17 trillion) collected by the U.S. Treasury in 2011. Were it not for obvious cases of double taxation, the share of U.S. taxes paid by overseas taxpayers would certainly be even lower.
Furthermore, on the basis of recent IRS data and a refined analysis developed in Exhibit No 1, it is highly possible that ACA’s $6.3 billion revenue estimate may be too high and that the likely tax revenues from private American citizens abroad may be in the $3 to $4 billion range, well below the ACA estimate of $6.3 billion.
Foreigners resident overseas (excluding green card holders) are subject to U.S. withholding taxes on most types of U.S. source income, including dividends, rents, royalties, but generally not including interest on bonds and bank accounts. The statutory withholding tax rate is 30%, but it is often reduced by the terms of a double tax treaty, generally to 15% on investment income, sometimes with exemptions for specific items; revenues from private pension funds are generally not subject to U.S. withholding tax. For countries without a treaty with the United States, the entire 30% withholding accrues to the U.S. Treasury.
Foreigners resident overseas with income compensation from independent services performed in the United States are subject to 30 percent withholding on such compensation under section 1441 or, in the case of partnership profits, withholding at rates specified under section 1446. Such income is deemed to be effectively connected with the conduct of a U.S. trade or business (called ECI). Recipients of ECI must submit a Form 1040NR tax return.
Foreigners resident overseas who have no ECI but have passive income subject to withholding are not required to submit a Form 1040NR as long as the proper amount has been withheld on the income including reductions in withholding tax under a tax treaty.
The irony of the present system is that foreigners pay up to 30% withholding taxes on income from their U.S. financial assets; they also pay taxes on their net ECI at graduated rates. On the same revenue flows, however, Americans abroad are not subject to automatic withholding and may not pay tax if they do not file or may not owe any tax due to U.S. tax exemption on dividend income below certain thresholds.
Americans abroad are taxed on the basis of citizenship. Hence, the “saving clause” in U.S. tax treaties denies tax treaty benefits to U.S. citizens and green card holders. The United States does, however, acknowledge the first right of taxation of the country of residence on income earned abroad by allowing a credit for the foreign taxes imposed on foreign source income. It only taxes foreign source income to the extent U.S. taxes exceed the foreign taxes on that income.
For Americans abroad, U.S. tax filing is highly complicated, as foreign currencies must be converted into U.S. dollars and foreign transactions and arrangements must be interpreted according to U.S. tax law. To ensure compliance with U.S. law, overseas tax filers generally engage a tax lawyer or accountant knowledgeable in both local and U.S. tax systems. Such specialists are expensive and in many countries are almost impossible to find. Though most overseas filers owe no U.S. taxes, they end up paying significant compliance fees because of the complexity of the filings and because they receive little help from the IRS, which has significantly reduced its customer service abroad.
Due to CBT, Americans abroad are covered by the Financial Bank Account Reporting (FBAR) and FATCA requirements. The FBAR reporting regime was designed to deal with money launderers, drug barons and arms dealers. The FATCA legislation was primarily aimed at tax evaders resident in the United States. Yet the overwhelming majority of Americans abroad are law abiding and patriotic.
The combination of U.S. tax compliance in addition to foreign tax compliance, FBAR and FATCA Form 8938 filing requirements and the negative impact of FATCA on access to foreign financial institutions makes life for Americans residing overseas extremely difficult and creates tremendous stress.
Americans abroad can be penalized by double taxation, despite the application of foreign tax credits, due to genuine differences between tax systems.
Americans abroad are subject to discriminatory taxation of phantom income and capital gains related solely to fluctuation in the exchange rate between their local currency and the U.S. dollar.
Americans abroad face the burden of double tax reporting to their country of residence and to the United States.
U.S. business people employed by a U.S. corporation and self-employed entrepreneurs working overseas must contribute to U.S. Social Security and Medicare in addition to contributions to equivalent foreign social systems.
- Americans abroad must report their foreign financial assets twice to the U.S. Government, once on the FBAR required under the Bank Secrecy Act and secondly on Form 8938 created under FATCA.
Americans abroad who have not been in compliance with U.S. tax filing and want to correct the situation risk losing their life savings, even if they owe no U.S. taxes, because of the excessively high penalties in the law related to FBAR and Form 8938 non-filing and the application of punitive penalties under the IRS voluntary disclosure programs.
Americans abroad have become pariahs in the international world of finance; foreign banks do not want them as clients because of FATCA legislation and foreign businesses do not want to deal with Americans. Bank accounts of Americans abroad are being forcibly closed, mortgages are being denied, securities have to be parked in expensive SEC registered ghettos, and Americans are excluded from joint bank accounts with foreign spouses (at least a third of Americans abroad are married to foreigners).
Americans abroad are subject to unfair, disadvantageous fiscal treatment of retirement and savings vehicles that happen to be held outside the United States. American entrepreneurs are excluded from joint-ventures with foreigners because of FATCA and managers are being limited to careers below signature authority level or excluded from specific jobs because of FBAR.
Americans abroad are exposed to a high risk of identity theft as an overseas taxpayer’s tax return includes highly confidential, extensive personal details of assets as well as income and personal identification. With the current sharp increase in identity theft at the IRS and in financial markets worldwide, this is a major concern to Americans abroad. This identity theft risk increases and other personal risks are created by the Intergovernmental Agreements (IGA) under FATCA legislation being negotiated between the U.S. Treasury and foreign governments whereby information on American financial accounts abroad would transit through foreign governments to IRS.
Americans abroad are denied access to cost efficient investment vehicles in their country of residence that most Americans consider a given right. Investment in local Exchange Trade Funds, Mutual Funds and other investment vehicles in the country of residence is barred by the burdensome U.S. rules governing Passive Foreign Investment Corporations (PFIC) and SEC rules denying Americans the right to invest in certain foreign securities that are not registered with the SEC, for instance, bond issues. Yet it is normal that Americans abroad should be able to make investments in the country in which they reside.
As clearly established as far back as 1981 by the Government Accountability Office and 1979 by the Presidents Export Council, CBT negatively impacts not only Americans working and living abroad, but also the United States domestic economy and the competitiveness of U.S. businesses in the international marketplace.
CBT is an anomaly and is fundamentally bad tax law. Legal scholars and tax specialists have argued against it for both theoretical and practical reasons. Several academic papers have made the point quite explicitly: it is difficult to enforce and leads to unfair double taxation. It is contrary to the fundamental principle that taxation is justified by services provided; overseas residents receive few, if any, services from the U.S. government. The Joint Committee on Taxation questioned citizenship-based taxation in the report dated September 2011, “U.S. Taxation of Cross-Border Income”.
CBT is also a human rights issue, as it unduly punishes U.S. citizens working and living worldwide. With the exception of Eritrea, a tiny African country with a GDP less than a sixth that of Vermont, the United States is the only country to apply citizenship-based taxation. Ironically, the United States condemned Eritrea in December 2011 at the United Nations for its citizenship-based taxation (the so-called diaspora tax).
Moving to RBT would be an immense relief for Americans abroad because it would mean lower expenses and lesser risks - financial or otherwise – and their savings would not be onerously taxed compared to Americans living in the United States. Equally important, shifting to RBT provides an incentive for and a fair way to allow non-compliant Americans abroad to enter into compliance, presuming that the IRS develops an appropriate compliance program.
Foreign tax credits can be applied against earned income to the extent not allocable to excluded income. ↩