Citizenship And Worldwide Taxation: Citizenship As An Administrable Proxy For Domicile (Part 4)

1. Implementing Citizenship-Based Taxation

As a final preliminary to evaluating the United States’ citizenship-based taxation of individuals, we must explore the Code’s implementation of such taxation. Recall, in this context, that the Code currently prescribes three different income tax treatments for the foreign taxes paid by U.S. citizens and residents. Foreign income taxes levied against foreign-source income are fully creditable against U.S. income taxes to the extent such foreign taxes are equal to or less than the U.S. taxes assessed against such foreign-source income. 124 All foreign taxes paid in connection with trade, business, and investment activity are deductible for U.S. income tax purposes, as are foreign real property taxes. 125 Other foreign taxes, such as general sales taxes levied by foreign nations, are neither creditable nor deductible. 126 As a result of this disparate treatment of different foreign taxes, otherwise similarly situated U.S. citizens who reside abroad pay different U.S. taxes depending upon the types and amounts of the taxes levied by the countries in which they live and earn their incomes.

To take another simplified example, consider in this context three U.S. citizens, A, B, and C, who reside respectively in countries X, Y, and Z. A, B, and C each has total income of \$ 100, derived totally from sources within the country of her residence. A, B, and C are each in the 30% bracket for U.S. income tax purposes. X finances its government by an income tax assessed at a 30% bracket, while the government of Y levies a property tax and Z uses a general sales tax to pay for their public services. To keep the math simple, let us further suppose that B pays \$ 30 of property tax to Y and that C pays \$ 30 in sales tax to Z.

As a matter of law, A, B, and C, as U.S. citizens, are all subject to U.S. income taxation of their respective worldwide incomes. In practice, however, the Code treats A, B, and C quite differently. At one extreme, A pays no U.S. income tax since her \$ 30 income tax payment to X is totally credited against, and thus eliminates, her federal income tax obligation. At the other end of the spectrum, C pays \$ 30 to the federal fisc on her income of \$ 100 since C receives neither a credit nor a deduction for her \$ 30 sales tax payment to Z. In between is B, who, after deducting her \$ 30 property tax payment to Y, pays \$ 21 of income tax to the federal Treasury. 127

If A or B is subject to the AMT, 128 B loses the deduction for her property tax payments unless these are connected with business or with the [*1314] production of income, while A’s credit for foreign taxes is tied to her AMT liability.

Further complications ensue if a U.S. citizen’s income qualifies for the § 911 exclusion. 129 Suppose, for example, that D and E, both nonresident U.S. citizens, live in the same foreign nation, Q. Let us further assume that both D and E have income of \$ 100 from Q sources, that both of them are in the 30% bracket for U.S. income tax purposes, and that Q finances its government services with a 30% sales tax. However, suppose that, while they are otherwise similarly situated, D’s \$ 100 income stems from employment by a foreign corporation and qualifies for the § 911 exclusion, while E’s income is from investments and thus does not qualify for the § 911 exclusion. In that case, D pays no federal income taxes because of the exclusion, while E pays federal income tax of \$ 30.

(All footnotes will be provided at the end of this multipart series by Edward Zelinsky)

View Part 3

View Part 5

Professor Zelinsky has authored two books “Taxing The Church: Religion, Exemptions, Entanglements And The Constitution” and “The Origins Of The Ownership Society” both available on Amazon. In addition, he has written extensively on the topic of Citizenship Taxation And Defining Residence For Income Tax Purposes.

2 comments on “Citizenship And Worldwide Taxation: Citizenship As An Administrable Proxy For Domicile (Part 4)”

• Edward K. Dwyer,CPA

Have not seen the footnotes yet but have a few observations:
1. Foreign real estate taxes, other than those paid on real property used in a trade or business or incurred in connection with property held for the production of income, are not deductible for years 2018 through 2025. IRC 164(b)(6) as amended by 2017 TCJA.
2. Similarly, foreign sales taxes incurred in connection with a trade or business or in connection with income producing property may still be deducted as ordinary and necessary business expenses. IRC ss 162, 212.
3. Foreign income taxes may still be claimed as an itemized deduction rather than as a credit, but only within the new law’s limit of \$10,000 of taxes as an itemized deduction. IRC 164(b)(6) as amended by the 2017 TCJA.

• What about the long-term expat who has built a financial home where they live. These individuals are truly domiciled outside the US, but retain their citizenship for a wide variety of reasons. If these individuals attempt to comply with the US tax code, they are among the highest taxed individuals on the planet. They face punitive US taxes on their local managed investment funds (PFICs), “repatriation” tax on the retained earnings of their local small corporation, current taxation on their locally tax-deferred retirement savings. The §911 exclusion does not help with any of these. In fact, to file a correct and accurate US tax return, these individuals will pay several times more in tax preparation fees than their similarly situated US-resident counterpart.

These are not rich individuals. The truly wealthy can afford to have someone manage a direct share portfolio that avoids PFICs. The truly wealthy can afford to hire top-notch advisers to help them navigate the minefield of owning a business outside the US. And the truly wealthy do not need tax incentives to save for retirement – they have access to long term investments that are out of reach of the merely middle class.

For middle class US expats (or Accidental Americans), all of these “foreign” provisions in the Internal Revenue Code are extremely costly, both in terms of double taxation and in terms of the compliance costs involved.

Citizenship may have been an administrable proxy for domicile in the 1920s when Cook v Tait was decided. At that time naturalising as a citizen of another country meant you generally lost US citizenship; a woman marrying a national of another country often lost her US citizenship; and children born as dual citizens generally had to choose one country or the other when they became adults. Fast forward nearly a century, and it is not so clear. Dual citizenship, while not encouraged, is allowed and common. Exiting the US tax system under §877A requires a certificate of loss of nationality, not merely a relinquishment of citizenship. The CLN costs US\$2350 – which is beyond the means of many expats. And the tax compliance required to avoid “covered expatriate” status could be financial suicide for someone with PFICs, a small business, or retirement savings.