1. An Overview of U.S. Citizenship-Based Taxation of Individuals
There are two bases on which nations may exercise the jurisdiction to tax: source and political allegiance. 4 Under the heading of source, a nation taxes in rem income or assets located (“sourced”) within its borders regardless of where the owner of such income or assets lives. On a theoretical level, source-based taxation reflects the claim of the nation in which income arises or assets are held that such nation provides the benefits [*1294] within its territory that protect such income or assets. 5 On a pragmatic level, source-based taxation reflects the practical ability of the nation in which income or an asset is located to impose tax before such income or asset is remitted to the owner abroad.
Jurisdiction based on political allegiance is in person am in nature and is premised not on the source of income or assets but upon the political allegiance of the taxpayer who owns such income or assets. Nations other than the United States define political affiliation for tax purposes on the basis of residence and accordingly tax their residents on a worldwide basis without regard to the source of such residents’ incomes or assets and without regard to such residents’ citizenships. Most cognoscenti in this area judge the country of residence as better positioned than the country of source to assess an individual’s overall capacity to pay tax on a progressive basis, since the residence jurisdiction exercises in person am authority over the taxpayer and can require him to aggregate and report her entire income from all sources. Typically, a resident will keep much of her assets and earn much of her income in the country in which she resides. Since the taxpayer lives in that nation, she is most amenable to enforcement action there. By contrast, the source nation lays claim only to the part of a taxpayer’s income arising within the territory of that nation. Insofar as a tax system seeks to tax an individual on her overall ability to pay considering all her sources of income and wealth, residence-based taxation on worldwide income and assets is more compelling than is source-based taxation.
Consider, for example, A, a resident of country X, who owns and rents out a condominium in country Y. As the source country in which the rent arises, Y has an in rem claim to tax on the basis of the services it provides to A’s condominium, located within Y’s borders. On a practical level, Y has the initial ability to tax that rent by, for example, imposing an obligation on A’s tenant to withhold tax from his rent payment and send such withheld tax to Y’s tax department. 6 If necessary, Y can collect unpaid taxes by foreclosing on A’s condominium located within Y’s territory.
[*1295] On the other hand, Y is poorly positioned to assess A’s overall ability to pay if A has income from other countries. Suppose that, in addition to his rental income from Y, A works in and thus has earned income from X where he resides, and has a second, rent-producing condominium in country Z. Under these circumstances, most tax mavens conclude that X, the country in which A resides, has the strongest claim to tax A’s overall income and is in practice best positioned to assess A’s overall ability to pay tax. By virtue of its in personam contact with A, X can best demand and pool information about all of A’s income from X, Y, and Z, 7 and can most effectively enforce its revenue laws against A. Y and Z, in contrast, are capable of assessing only the part of A’s income arising within their respective borders.
For most taxpayers, the jurisdiction of source and the jurisdiction of residence are the same, since such individuals earn and invest their incomes in the same nations in which they reside. On the other hand, when an individual owes political allegiance to one nation but derives income or holds assets in another, both countries have jurisdiction to tax the same item.
Taking a unique position, 8 the United States defines the political allegiance for tax jurisdiction in terms of an individual’s citizenship, regardless of his residence. 9 With a succinctness rare in the tax law, the Treasury Regulations articulate that all U.S. citizens, whether they live within the country or not, are subject to U.S. taxation on their worldwide incomes: “In general,
all citizens of the United States, wherever resident, and all resident alien individuals are liable to the income taxes imposed by the Code whether the income is received from sources within or without the United States.” 10
[*1296] With comparable directness, the Internal Revenue Code extends the reach of the federal estate tax globally to “all [of the decedent’s] property, real or personal, tangible or intangible, wherever situated.” 11 Less elegantly, the Treasury Regulations define a deceased citizen’s gross estate as encompassing his worldwide assets, even if the citizen resided abroad: If a decedent “was a citizen or resident of the United States at the time of his death,” then his gross estate includes “the total value” of his statutorily enumerated interests. 12 Since October 16, 1962, this “total value” has included “real property situated outside the United States.” 13
The regulations under the gift tax similarly indicate that that levy reaches all gratuitous transfers anywhere in the world made by all citizens, regardless of whether such citizens live within or without the United States: “The [gift] tax applies to all transfers by gift of property, wherever situated, by an individual who is a citizen or resident of the United States ….” 14
When it enters into income tax treaties with other nations, the United States preserves its right to tax its citizens, regardless of where such citizens reside or from where they derive their incomes. For example, under Article I(4) of the United States Model Income Tax Convention of November 15, 2006, 15 the United States (as well as the other signatory to the model treaty)
reserves, with minor exceptions, the right to tax the income of its citizens and former citizens as if the treaty had not been entered into, i.e., on a worldwide basis irrespective of the citizen’s residence. So too, in the estate and gift tax context, the United States by treaty preserves its right to tax the assets of its deceased citizens and former citizens, regardless of the location
of those assets or the residence of the deceased citizens. For example, in Article I of the 2004 protocol to the U.S.-French estate tax treaty, 16 the United States reserves the right to tax the estates and gifts of its citizens and former citizens as if there were no treaty between the two nations.
While the baseline of U.S. tax law is the worldwide taxation of U.S. citizens without regard to their respective residences, this policy is abated in important respects. Indeed, as I shall argue below, 17 these abatements, however meritorious they may be on other grounds, are in practice inconsistent with the traditional tax policy justification of citizenship-based [*1297] taxation, namely, the public benefits stemming from U.S. citizenship, since these abatements result in different nonresident citizens paying significantly different taxes for the same benefits of U.S. citizenship.
In the income tax setting, the most important abatements of the United States’ worldwide taxation of its citizens are the credit for foreign income taxes and the exclusion from gross income of personal service income earned abroad. The income tax credit 18 is among the most discussed provisions of the Internal Revenue Code. 19 The dollar-for-dollar credit is available both to U.S. citizens and to resident aliens to the extent they pay foreign income taxes on foreign-source income at or below the rate at which the United States taxes such income. By using the foreign income tax credit, the United States, as the nation of the taxpayer’s political allegiance, surrenders the tax it would otherwise collect from a citizen or resident with foreign-source income to the foreign-source jurisdiction from which the income is derived.
To see the operation of the foreign income tax credit, suppose a highly simplified example in which A, a U.S. citizen, is in a 30% federal income tax bracket and earns $ 100 from renting his condominium in Country X. If X has no income tax, A, on her federal return, reports this rental income as part of her worldwide income and pays $ 30 of such income to the federal fisc. If,
on the other hand, X also imposes income taxes on A at a 30% bracket, A pays a $ 30 income tax to X, the source jurisdiction, and then credits that $ 30 paid against the tax A would otherwise owe to the United States. The result is no net payment by A to the U.S. Treasury. If, in contrast, X imposes income taxes on A at a 20% bracket, A pays a $ 20 tax to X, takes a credit on her
federal tax return for that $ 20 income tax payment, and thereby pays a net tax to the United States of $ 10 on her rental income from her condominium located in X. 20 The conventional view is that the credit for foreign income taxes prevents double taxation by giving the source jurisdiction the priority to tax. 21
The Code’s credit for foreign income taxes stands in sharp contrast with the Code’s treatment of other foreign taxes. U.S. taxpayers can only deduct for U.S. income tax purposes foreign taxes paid in connection with their [*1298] trade, business, or investment activities. 22 They can also deduct foreign real property taxes unrelated to trade, business, or investment income. 23 All other foreign taxes are neither deductible nor creditable for U.S. income tax purposes. Thus, for example, foreign sales taxes are neither deductible nor creditable for U.S. income tax purposes. 24
If a U.S. taxpayer is subject to the alternative minimum tax (“AMT”), 25 he is subject to yet another set of rules that deny deductibility 26 to all taxes paid to foreign governments except for those constituting expenses of producing income. The AMT also ties the credit for foreign income taxes to the taxpayers’ AMT liability. 27
As I discuss below, 28 the Code’s disparate treatment of different kinds of foreign taxes produces different U.S. tax liabilities for different U.S. citizens depending upon the nature and amount of tax assessed by the nations in which those citizens live and earn their respective incomes. These divergent tax liabilities cannot be squared with the benefits rationale for citizenship-based taxation, since all nonresident U.S. citizens receive the same benefits of U.S. citizenship while paying different U.S. taxes (or sometimes no U.S. taxes) for those benefits.
In addition to the credit for foreign income taxes, the second major modification of the U.S. policy of taxing its citizens’ worldwide incomes is the exclusion under § 911 29 for certain nonresident citizens’ personal service incomes earned abroad and for such nonresident citizens’ “housing cost amount(s).” In 2011, a U.S. citizen 30 satisfying the nonresidence criteria of § 911 may elect to exclude 31 from his annual gross income up to $ 92,900 32 of income earned abroad from performing personal services, 33 including personal services rendered in connection with self-employment. In addition or instead, nonresident U.S. citizens qualifying under § 911 may [*1299] exclude (or deduct) from their gross incomes some or all of their foreign housing expenses. 34
The § 911 exclusion from gross income applies if a U.S. citizen has a “tax home” 35 abroad and either “has been a bona fide resident of a foreign country or countries for an uninterrupted period which includes an entire taxable year” 36 or has “during any period of 12 consecutive months [been] present in a foreign country or countries during at least 330 full days in such
period.” 37 Thus, the § 911 exclusion is only available to nonresident citizens, unlike the foreign tax credit that is available to all U.S. citizens, resident and nonresident, with foreign-source income. Moreover, the § 911 exclusion (unlike the credit) does not depend upon the U.S. citizen’s payment of any income tax to the source jurisdiction. Consequently, income covered by § 911 is often taxed neither by the nation in which it is earned nor by the United States as the jurisdiction of the citizen’s political allegiance. 38
The conventional justification for § 911 is that it facilitates the ability of U.S. citizens to work abroad. However, as we shall see, 39 that argument, whatever its plausibility as a matter of economic policy, is incompatible with the benefits rationale for citizenship-based taxation. In particular, the § 911 exclusion (like the Code’s provisions relative to the crediting, deductibility, and nondeductibility of different foreign taxes) can in practice result in nonresidents who receive the same benefits of U.S. citizenship while paying radically different U.S. taxes.
The § 911 exclusion does not apply 40 for purposes of the tax on self-employment income. 41 As a general rule, the federal self-employment tax, [*1300] like the federal income tax, applies to U.S. citizens on a worldwide basis. 42 Thus, self-employed U.S. citizens who reside abroad and qualify for the § 911 income tax exclusion must pay self-employment tax on their earnings. 43 However, the United States has “totalization” agreements with twenty-four nations. 44 Under these agreements, 45 U.S. citizens or residents who work abroad pay self-employment taxes on their earned income to the countries in which they work rather than to the United States. Consequently, pursuant to the totalization arrangement, these citizens or residents accrue social security benefits from the foreign countries in which they work and to which they pay self-employment taxes, rather than from the United States. 46 Absent such a totalization agreement, self-employed U.S. citizens or residents who work in foreign nations pay federal self-employment tax on their foreign-source earned income. 47
As a general rule, 48 a U.S. citizen or resident employed outside the United States by “an American employer” 49 pays FICA 50 taxes on his salary. This rule is subject to many exceptions. These exceptions include totalization arrangements under which the U.S. citizen-employee pays social security taxes to the foreign nation in which he works and consequently accrues social security benefits under that nation’s system. Another important exception allows certain foreign affiliates of U.S. parents to join the U.S. social security system. 51 In that case, the U.S. citizen employed by such a foreign affiliate pays FICA taxes on his salary. Section 911 does not apply to FICA taxes. 52 Thus, absent an applicable totalization agreement, a [*1301] U.S. citizen employed abroad by a U.S. employer pays FICA taxes on wage income even if that income is excluded from gross income for income tax purposes.
Just as the Code provides a dollar-for-dollar income tax credit for foreign income taxes paid by a U.S. citizen, the Code, subject to certain limits, 53 furnishes a credit against the federal estate tax for “any estate, inheritance, legacy, or succession taxes actually paid to any foreign country in respect of any property situated within such foreign country.” 54 Thus, when a U.S. citizen dies owning property located abroad, U.S. estate taxation is abated on account of foreign death taxes paid on such property. Like the income tax credit for foreign taxes (which is available to both resident and nonresident citizens of the United States), the credit for foreign death taxes applies to the estates of deceased U.S. citizens whether they resided at home or abroad. Also like the foreign income tax credit, the estate tax credit avoids double taxation by ceding primary tax jurisdiction to the source nation in which the deceased citizen owned her assets.
Although the credits for foreign income and death taxes and the § 911 exclusion abate the federal taxation of U.S. citizens, other provisions of the Code point in the opposite direction and extend citizenship-based taxation to include certain former citizens even though they are currently nonresident aliens. For specified former citizens who expatriated before June 17, 2008, § 877 establishes, for federal income tax purposes, a ten-year transition period following such expatriation. During such period, a former citizen may be taxed as if he were still a U.S. citizen, 55 i.e., on his worldwide income, or may be taxed under special rules which treat as U.S.-source income certain items which nonresident aliens generally do not report as U.S.-source income.56
In 2008, Congress amended the Code to replace the ten-year transition period of § 877 with immediate income taxation of certain expatriating citizens’ unrealized appreciation. In particular, for a “covered expatriate” 57 who relinquishes U.S. citizenship on or after June 17, 2008, new Code [*1302] § 877A imposes the obligation upon expatriation to pay immediate income tax on the unrealized appreciation of many of the former citizen’s assets. 58 In the alternative, the former citizen who is a “covered expatriate” can defer such tax if she provides to the IRS security which it deems adequate to ensure that tax will actually be paid on the disposition of the former citizen’s assets. 59
In the estate tax context, Code § 2107 provides a special rule if a former citizen dies within the ten-year transition period established in § 877. In particular, during such transition period, the gross estate of a deceased former resident covered by § 877 includes the value of a foreign corporation’s stock to the extent that the deceased former citizen had a significant interest in such corporation and the corporation owns assets located in the United States.
In 2008, at the same time that Congress decreed that expatriation will cause the immediate income taxation of a “covered expatriate[‘s]” unrealized appreciation, Congress augmented the estate taxes due on the death of such an expatriate. In particular, new Code § 2801 requires a U.S. citizen or resident receiving property on account of the death of a “covered expatriate” to pay an estate tax on such property unless the deceased expatriate’s estate pays tax on such property.
Section 2801 also applies to gifts received by U.S. citizens and residents from “covered expatriate(s)” by requiring such citizens and residents to pay taxes on such gifts. In addition, former citizens still covered by the ten-year transition period of § 877 owe U.S. gift taxes on gifts made within that transition period of certain U.S. and foreign securities, which other noncitizens can transfer free of U.S. gift taxes. 60
For example, if A, a French citizen with no ties to the United States, gives shares of Microsoft to his children who are also French citizens, no U.S. gift tax is levied on this transfer, even though the gifted shares are of a U.S. corporation. If, however, the French citizen is a former U.S. citizen who makes his gift to his French offspring during the ten-year transition period established in § 877, he owes gift tax on the transfer. If the former U.S. citizen is a “covered expatriate” and his children receiving Microsoft shares are themselves U.S. citizens or residents, these donee-children owe U.S. gift taxes by virtue of new § 2801.
It has long been established that the U.S. Constitution permits the federal government’s worldwide taxation of nonresident U.S. citizens. In Cook v. Tait, 61 the taxpayer was a U.S. citizen who was domiciled in Mexico and who derived his income from property located in Mexico. In upholding [*1303] the income tax assessed by the federal government, the Supreme Court distinguished between the taxing authority of the various states of the Union, “limited by” their respective “borders,” and the taxing authority of the federal government, subject to “no such limitation.” 62 In sustaining the federal income taxation of a nonresident citizen’s Mexican-source income, the Court emphasized “that government by its very nature benefits the citizen and his property wherever found.” 63
Although Cook provides constitutional underpinning for the federal government’s citizenship-based taxation, as we shall see, 64 the benefits rationale of that decision proves unpersuasive, both in theory and as implemented by the provisions of the Internal Revenue Code that tax different U.S. citizens different amounts for the same benefits of U.S. citizenship.
(Footnotes will be provided at the end of this multipart series.)
Citizenship And Worldwide Taxation: Citizenship As An Administrable Proxy For Domicile – Part 2 is a continuation of Professor Edward Zelinsky’s publication on Citizenship And Worldwide Taxation.