Oliver Wagner, CPA and John Richardson – January 16, 2022

Americans abroad and the presumption of double taxation

Prologue: For whom the bell tolls …

Whether a US citizen lives in (and is a tax resident of) Mexico and works on a ship in international waters

International waters are not a foreign country. https://t.co/hnhfCddLb1

— John Richardson – lawyer for "U.S. persons" abroad (@ExpatriationLaw) January 15, 2022

Or Whether A US citizen lives in (and is a tax resident of) Holland and is an airline pilot …

OMG imagine if @Ronald77171496 had known that he was a US citizen while he was flying planes across the Atlantic! Read this article which describes the nightmare imposed on "US citizen" airline pilots who have @taxresidency in other countries. (Applies to cruise ship people too!) https://t.co/gW8G30W9Vq

— John Richardson – lawyer for "U.S. persons" abroad (@ExpatriationLaw) January 17, 2022

That US citizen, because and only because of the combination of US citizenship-based taxation coupled with living outside the United States, is likely to be subject to double taxation. The following discussion explains why.

Part A: Introduction – About Citizenship-based Taxation
Part B: How the Internal Revenue Code is designed to mitigate the effects of double taxation in certain circumstances
Part C: Determining what is “foreign source” income
Part D: The problem of international waters …
Part E: The effect of sourcing to the US income earned in international waters by dual tax residents
Part F: Deducting “foreign taxes” paid – although income from international waters may not be foreign, it is still subject to the payment of “foreign taxes”
Part G: Can a US citizen living abroad be saved by a tax treaty? Maybe if he/she lives in Canada****
Part H: Conclusion and the need for “Pure Residence-Based Taxation”

Part A: Introduction – About Citizenship-based Taxation

Whether they live in Mexico, France, Canada, Brazil or even on a yacht, US citizens are taxable on their worldwide income. Worldwide income means income of all kinds, from all sources and wherever earned. US citizens are taxable an ALL income sources. It doesn’t matter whether the income has a source in Mexico, France, Canada, Brazil or even on a yacht. For example, a US citizen living in France who has ONLY French source income is required to treat that income as taxable in the United States. The fact that the income is also taxable in France is irrelevant!

The Internal Revenue Code is based on a presumption of double taxation. The presumption of “double taxation” is reinforced by the “saving clause” in US tax treaties where the treaty partner country agrees that the US retains the right to tax US citizens regardless of the tax treaty. The treaties themselves typically contain a small number of specified exceptions that mitigate against the effects of double taxation in certain narrow circumstances.

Relief from double taxation is available either domestically under the Internal Revenue Code or through provisions in international tax treaties (or possibly both). Each avenue of mitigation will be considered separately.

Part B: How the Internal Revenue Code is designed to mitigate the effects of double taxation in certain circumstances

It is commonly understood that the Internal Revenue Code provides for two distinct mechanisms to mitigate the effects of double taxation.

First – S. 911 – EXCLUDING Foreign Earned Income

US Taxation of Americans Abroad: Does the FEIE (Foreign Earned Income Exclusion Work)? – Sometimes yes and sometimes no https://t.co/jyphB9sz4T

— John Richardson – lawyer for "U.S. persons" abroad (@ExpatriationLaw) January 17, 2022

This is referred to as the FEIE and allows US citizens (and Green Card holders in treaty partner countries) to exclude up to $107,000 USD of “foreign SOURCE” earned income. There are a number of rules and it is more complicated than meets the eye. The key point is that only “foreign SOURCE” “earned” income is eligible for the exclusion. The FEIE exclusion is generally considered to be less advantageous for Americans abroad than using the foreign tax credit rules.

Second – S. 901 – INCLUDING Foreign Earned Income And Paying The US Tax By Taking Credit For Foreign Taxes Paid On Foreign Income

US Taxation of Americans Abroad: Do The Foreign Tax Credit Rules Work? – Sometimes yes and sometimes no https://t.co/HPkGH3st9Q

— John Richardson – lawyer for "U.S. persons" abroad (@ExpatriationLaw) January 17, 2022

This is referred to as the FTC “Foreign Tax Credit Rule”. The foreign tax credit rules continue to evolve in their complexity.

The Internal Revenue Code grants relief from double taxation only with respect to “foreign source” income

Relief from either the FEIE option or the FTC option is dependent on having foreign source income!!

Part C: Determining what is “foreign source” income

The “source rules” are found in § 861 – § 865 of the Internal Revenue Code. § 861 prescribes income sources that are sourced to the United States and over which the US has primary taxing rights. § 862 prescribes income sources that are foreign to the United States where the foreign country has primary taxing rights. § 863 prescribes special rules for determining source including income earned in international waters.

(d)Source rules for space and certain ocean activities

(1)In general

Except as provided in regulations, any income derived from a space or ocean activity—

(A)if derived by a United States person, shall be sourced in the United States, and

(B)if derived by a person other than a United States person, shall be sourced outside the United States.

Since income earned by a US citizen in “international waters” is not foreign, it follows that neither the FEIE nor the FTC rules can be used to offset double taxation. In other words, in the absence of treaty relief, income earned by a US citizen in international waters will be subject to taxation by both the United States and any other country of tax residence.

Of course American citizens who live in the United States are subject to tax by ONLY the United States and are not subject to double taxation. Americans citizens living abroad are tax residents of both the United States and their country of actual residence and are subject to double taxation.

Part D: The problem of international waters …

Q. What is meant by the term “international waters”?

A. According to Wikipedia …

“International waters” is not a defined term in international law. It is an informal term, which most often refers to waters beyond the “territorial sea” of any country.[2] In other words, “international waters” is often used as an informal synonym for the more formal term high seas or, in Latin, mare liberum (meaning free sea).

International waters (high seas) do not belong to any state’s jurisdiction, known under the doctrine of ‘mare liberum’. States have the right to fishing, navigation, overflight, laying cables and pipelines, as well as scientific research.

The article goes on to suggest that “international waters” begin approximately 370 km (200 miles) from the shoreline of a country:

The Convention on the High Seas was used as a foundation for the United Nations Convention on the Law of the Sea (UNCLOS), signed in 1982, which recognized exclusive economic zones extending 200 nautical miles (230 mi; 370 km) from the baseline, where coastal States have sovereign rights to the water column and sea floor as well as the natural resources found there.[4]

The claim of tax jurisdiction over international waters (a specific location) – ridiculous

NO country should be able to claim tax jurisdiction over “international waters”. Presumably, no country could justifiably claim that income earned in “international waters” could/should be sourced to any one country.

The claim of tax jurisdiction over individuals who are tax residents – the international standard

All countries may claim tax jurisdiction over their tax residents. Therefore, countries which follow the “residence-based taxation” model would impose taxation on the income earned by their residents in international waters. For example, all Canadian tax residents who earn income in “international waters” are taxable on that income. The US employs “citizenship-based taxation”. Therefore, All US citizens earning income in “international waters” are taxable on that income, etc.

The Internal Revenue Code and international waters

While retaining tax jurisdiction over US tax residents, the US goes one step further and claims tax jurisdiction over income earned in international waters, to the extent that the income is earned by US citizens. Rather than simply presume that income earned in international waters is taxable income to US tax residents (under IRS S. 61 or other sections), the Internal Revenue Code specifically defines income earned in international waters as:

– US source income if earned by “United States persons”*; and

– NOT US source income if earned by a person other than a “United States person”.**

Part E: The effect of sourcing to the US income earned in international waters by dual tax residents

Q. What is the effect of deeming income earned by US citizens in international waters as US source income?

A. The effect is that if a US citizen earns income in international waters that income is NOT foreign source income and therefore cannot be excluded under the 911 FEIE or be treated as foreign under the 901 FTC rules. In other words, US citizens who are tax residents of other countries will get NO RELIEF (under the Internal Revenue Code) from double taxation!

The significance of this was explored in the 2004 case of Francisco, John A. v. Cmsnr IRS, No. 03-1210 (D.C. Cir. 2004)***

US Citizen Airline Pilots And Cruise Ship Employees Living Outside The USA – What percent of the work takes place in “international waters”?

It’s obvious that some work time is spent in “international waters” and some is spent in “non-US AKA foreign countries”.

The income attributable to work in the foreign (“non-US”) country is eligible for either the FEIE or FTC.

The income attributable to “international waters” is NOT eligible for the either the FEIE or FTC rules!

Think of the record keeping and compliance burden!

Part F: Deducting “foreign taxes” paid – although income from international waters may not be foreign, it is still subject to the payment of “foreign taxes”

Internal Revenue Code § 164 allows for the deduction of “foreign taxes” as an itemized deduction.

(a)General rule

Except as otherwise provided in this section, the following taxes shall be allowed as a deduction for the taxable year within which paid or accrued:

(1)State and local, and foreign, real property taxes.
(2)State and local personal property taxes.
(3)State and local, and foreign, income, war profits, and excess profits taxes.

Although not perfect, this may be helpful to certain individuals. This provision converts “foreign taxes” into a deduction for US tax purposes. The following IRS commentary is helpful:

Choice Applies to All Qualified Foreign Taxes
As a general rule, you must choose to take either a credit or a deduction for all qualified foreign taxes.

If you choose to take a credit for qualified foreign taxes, you must take the credit for all of them. You cannot deduct any of them. Conversely, if you choose to deduct qualified foreign taxes, you must deduct all of them. You cannot take a credit for any of them.

Why Choose the Credit?
The foreign tax credit is intended to relieve you of the double tax burden when your foreign source income is taxed by both the United States and the foreign country.

The foreign tax credit can only reduce U.S. taxes on foreign source income; it cannot reduce U.S. taxes on U.S. source income.

It is generally better to take a credit for qualified foreign taxes than to deduct them as an itemized deduction. This is because:

A credit reduces your actual U.S. income tax on a dollar-for-dollar basis, while a deduction reduces only your income subject to tax;
You can choose to take the foreign tax credit even if you do not itemize your deductions. You then are allowed the standard deduction in addition to the credit; and
If you choose to take the foreign tax credit, and the taxes paid or accrued exceed the credit limit for the tax year, you may be able to carry over or carry back the excess to another tax year.

https://www.irs.gov/individuals/international-taxpayers/foreign-tax-credit-choosing-to-take-credit-or-deduction

In summary:

While a foreign tax credit is not possible to offset the tax arising from US-sourced income, another benefit is available.

While of much limited use, an alternative is to claim the foreign tax as an itemized deduction. This will only reduce taxable income by the amount of taxes paid. But in a case such as this in which the US sees the income as US-sourced and the foreign country sees it as foreign-sourced, the taking the foreign tax credit as an itemized deduction might be the only option.

Part G: Can a US citizen living abroad be saved by a tax treaty? Maybe if he/she lives in Canada****

It’s clear that the Internal Revenue Code does NOT offer relief from double taxation. Might a tax treaty provide relief? The answer appears to depend on the treaty. Most treaties do NOT. But, the Canada/US tax treaty may offer relief. Note specifically Paragraph 4 of Article XXIV of the Canada/US tax treaty:

4. Where a United States citizen is a resident of Canada, the following rules shall apply:

(a) Canada shall allow a deduction from the Canadian tax in respect of income tax paid or accrued to the United States in respect of profits, income or gains which arise (within the meaning of paragraph 3) in the United States, except that such deduction need not exceed the amount of the tax that would be paid to the United States if the resident were not a United States citizen; and
(b) for the purposes of computing the United States tax, the United States shall allow as a credit against United States tax the income tax paid or accrued to Canada after the deduction referred to in subparagraph (a). The credit so allowed shall not reduce that portion of the United States tax that is deductible from Canadian tax in accordance with subparagraph (a).

How this treaty provision works …

The way it works is that the Canadian tax authorities will only grant a foreign tax credit for taxes paid to the US to the extent that the taxpayer would have been liable for those had he not been a US citizen.

In this instance, since the income would not have been US-source had the taxpayer not been a US citizen, no foreign tax credit would have been afforded on the Canadian side.

The US-Canada tax treaty (in a clause that is not typically found in other tax treaties) provides that in such an instance, the US will provide a foreign tax credit on that income that would otherwise not be eligible for the foreign tax credit because it was treated as US-sourced income.

Part H: Conclusion and the need for “Pure Residence-Based Taxation”

It is obvious that the combination of US citizenship-based taxation and the sourcing to the United States of income earned in International waters creates double taxation for Americans abroad. In this case it is particularly pernicious because the Internal Revenue Code does not allow for the application of either the 901 FTC rules or the 911 FEIE rules.

Interestingly the sourcing of income earned in international waters to the United States means that the problem of double taxation can be solved ONLY if Americans abroad cease to be tax residents of the United States. Amendments to the FEIE or the FTC rules will not solve this problem.

_______________________________________________________________________

Appendices:

*Note that “United States person” is defined in 7701(a)(30) as follows:

(30)United States person

The term “United States person” means—

(A)a citizen or resident of the United States,
(B)a domestic partnership,
(C)a domestic corporation,
(D)any estate (other than a foreign estate, within the meaning of paragraph (31)), and
(E)any trust if—
(i)a court within the United States is able to exercise primary supervision over the administration of the trust, and
(ii)one or more United States persons have the authority to control all substantial decisions of the trust.

_____________________________________________________________________________________

** A close look at Internal Revenue Code 863(d) reveals …

(d)Source rules for space and certain ocean activities

(1)In general

Except as provided in regulations, any income derived from a space or ocean activity—

(A)if derived by a United States person, shall be sourced in the United States, and
(B)if derived by a person other than a United States person, shall be sourced outside the United States.

(2)Space or ocean activity

For purposes of paragraph (1)—

(A)In general

The term “space or ocean activity” means—

(i)any activity conducted in space, and
(ii)any activity conducted on or under water not within the jurisdiction (as recognized by the United States) of a foreign country, possession of the United States, or the United States.

Such term includes any activity conducted in Antarctica.

(B)Exception for certain activities

The term “space or ocean activity” shall not include—

(i)any activity giving rise to transportation income (as defined in section 863(c)),
(ii)any activity giving rise to international communications income (as defined in subsection (e)(2)), and
(iii)any activity with respect to mines, oil and gas wells, or other natural deposits to the extent within the United States or any foreign country or possession of the United States (as defined in section 638).

For purposes of applying section 638, the jurisdiction of any foreign country shall not include any jurisdiction not recognized by the United States.

___________________________________________________________________

*** For a lucid judicial decision exploring the consequences of income being earned in “international waters” and therefore becoming US source income see Francisco, John A. v. Cmsnr IRS, No. 03-1210 (D.C. Cir. 2004)

https://cases.justia.com/federal/appellate-courts/cadc/03-1210/03-1210a-2011-03-24.pdf?ts=1411132061

II. ANALYSIS

As is, we think, evident from the discussion above, the question before us is straightforward. So is its resolution.

Section 863(d)(1)(A) provides: ‘‘Income derived from a[n] ocean activity’’ as defined therein shall, for a ‘‘United States person TTT be sourced in the United States.’’ Section 7701(a)(30)(A) of the Code defines a ‘‘United States person’’ as including ‘‘a citizen or resident of the United States.’’ The parties agree that Francisco is a citizen of the United States.

His residence in the specified possession is immaterial to the statutory definition of a United States person, which would include him as a citizen even if he lived in a foreign country. The international waters in which he fished during the tax years fit precisely the statutory description of ‘‘water not within the TTT jurisdiction TTT of a foreign country, possession of the United States, or the United States.’’ § 863(d)(2)(A)(ii). Therefore, the Tax Court properly held § 863(d) to be the section governing Francisco’s tax liability.

Francisco argues that the waters within which he fished are not governed by § 863(d). He claims that for purposes of the Tax Code, those waters should be considered as being within the jurisdiction of a possession of the United States.

He bases that argument on the American Samoa Code, the governing law of the possession, which adopts a so-called ‘‘mirror image tax code.’’ Under a mirror-image code, the possession’s statute adopts the United States Internal Revenue Code but replaces ‘‘the United States,’’ where necessary, with ‘‘American Samoa.’’ Thus, the possession, like the United States, taxes worldwide the income derived from ocean sources of its taxable ‘‘persons.’’ From this, taxpayer reasons that the international waters upon which he fished were within the ‘‘tax jurisdiction’’ of the United States’ possession and therefore outside the reach of § 863. We have little trouble rejecting this argument.

______________________________________________________________________________

**** Article XXIV – Canada/US Tax Treaty

Article XXIV
Elimination of Double Taxation
1. In the case of the United States, subject to the provisions of paragraphs 4, 5 and 6, double taxation shall be avoided as follows: In accordance with the provisions and subject to the limitations of the law of the United States (as it may be amended from time to time without changing the general principle hereof), the United States shall allow to a citizen or resident of the United States, or to a company electing to be treated as a domestic corporation, as a credit against the United States tax on income the appropriate amount of income tax paid or accrued to Canada; and, in the case of a company which is a resident of the United States owning at least 10 per cent of the voting stock of a company which is a resident of Canada from which it receives dividends in any taxable year, the United States shall allow as a credit against the United States tax on income the appropriate amount of income tax paid or accrued to Canada by that company with respect to the profits out of which such dividends are paid.

2. In the case of Canada, subject to the provisions of paragraphs 4, 5 and 6, double taxation shall be avoided as follows:
(a) subject to the provisions of the law of Canada regarding the deduction from tax payable in Canada of tax paid in a territory outside Canada and to any subsequent modification of those provisions (which shall not affect the general principle hereof)
(i) income tax paid or accrued to the United States on profits, income or gains arising in the United States, and
(ii) in the case of an individual, any social security taxes paid to the United States (other than taxes relating to unemployment insurance benefits) by the individual on such profits, income or gains
shall be deducted from any Canadian tax payable in respect of such profits, income or gains;
(b) subject to the existing provisions of the law of Canada regarding the taxation of income from a foreign affiliate and to any subsequent modification of those provisions – which shall not affect the general principle hereof – for the purpose of computing Canadian tax, a company which is a resident of Canada shall be allowed to deduct in computing its taxable income any dividend received by it out of the exempt surplus of a foreign affiliate which is a resident of the United States; and
(c) notwithstanding the provisions of subparagraph (a), where Canada imposes a tax on gains from the alienation of property that, but for the provisions of paragraph 5 of Article XIII (Gains), would not be taxable in Canada, income tax paid or accrued to the United States on such gains shall be deducted from any Canadian tax payable in respect of such gains.
3. For the purposes of this Article:
(a) profits, income or gains (other than gains to which paragraph 5 of Article XIII (Gains) applies) of a resident of a Contracting State which may be taxed in the other Contracting State in accordance with the Convention (without regard to paragraph 2 of Article XXIX (Miscellaneous Rules)) shall be deemed to arise in that other State; and
(b) profits, income or gains of a resident of a Contracting State which may not be taxed in the other Contracting State in accordance with the Convention (without regard to paragraph 2 of Article XXIX (Miscellaneous Rules)) or to which paragraph 5 of Article XIII (Gains) applies shall be deemed to arise in the first-mentioned State.
4. Where a United States citizen is a resident of Canada, the following rules shall apply:
(a) Canada shall allow a deduction from the Canadian tax in respect of income tax paid or accrued to the United States in respect of profits, income or gains which arise (within the meaning of paragraph 3) in the United States, except that such deduction need not exceed the amount of the tax that would be paid to the United States if the resident were not a United States citizen; and
(b) for the purposes of computing the United States tax, the United States shall allow as a credit against United States tax the income tax paid or accrued to Canada after the deduction referred to in subparagraph (a). The credit so allowed shall not reduce that portion of the United States tax that is deductible from Canadian tax in accordance with subparagraph (a).
5. Notwithstanding the provisions of paragraph 4, where a United States citizen is a resident of Canada, the following rules shall apply in respect of the items of income referred to in Article X (Dividends), XI (Interest) or XII (Royalties) that arise (within the meaning of paragraph 3) in the United States and that would be subject to United States tax if the resident of Canada were not a citizen of the United States, as long as the law in force in Canada allows a deduction in computing income for the portion of any foreign tax paid in respect of such items which exceeds 15 per cent of the amount thereof:
(a) the deduction so allowed in Canada shall not be reduced by any credit or deduction for income tax paid or accrued to Canada allowed in computing the United States tax on such items;
(b) Canada shall allow a deduction from Canadian tax on such items in respect of income tax paid or accrued to the United States on such items, except that such deduction need not exceed the amount of the tax that would be paid on such items to the United States if the resident of Canada were not a United States citizen; and
(c) for the purposes of computing the United States tax on such items, the United States shall allow as a credit against United States tax the income tax paid or accrued to Canada after the deduction referred to in subparagraph (b). The credit so allowed shall reduce only that portion of the United States tax on such items which exceeds the amount of tax that would be paid to the United States on such items if the resident of Canada were not a United States citizen.
6. Where a United States citizen is a resident of Canada, items of income referred to in paragraph 4 or 5 shall, notwithstanding the provisions of paragraph 3, be deemed to arise in Canada to the extent necessary to avoid the double taxation of such income under paragraph 4(b) or paragraph 5(c).

7. For the purposes of this Article, any reference to “income tax paid or accrued” to a Contracting State shall include Canadian tax and United States tax, as the case may be, and taxes of general application which are paid or accrued to a political subdivision or local authority of that State, which are not imposed by that political subdivision or local authority in a manner inconsistent with the provisions of the Convention and which are substantially similar to the Canadian tax or United States tax, as the case may be.

8. Where a resident of a Contracting State owns capital which, in accordance with the provisions of the Convention, may be taxed in the other Contracting State, the first-mentioned State shall allow as a deduction from the tax on the capital of that resident an amount equal to the capital tax paid in that other State. The deduction shall not, however, exceed that part of the capital tax, as computed before the deduction is given, which is attributable to the capital which may be taxed in that other State.

9. The provisions of this Article relating to the source of profits, income or gains shall not apply for the purpose of determining a credit against United States tax for any foreign taxes other than income taxes paid or accrued to Canada.

10. Where in accordance with any provision of the Convention income derived or capital owned by a resident of a Contracting State is exempt from tax in that State, such State may nevertheless, in calculating the amount of tax on other income or capital, take into account the exempted income or capital.