Digging The Foundation To Build The House Of U.S. Residency Taxation

Digging The Foundation To Build The House Of U.S. Residency Taxation

Prologue

This is the fifth of a series of posts focussing on the need to end US citizenship-based taxation (practised only by the USA) and move to a form of pure residence-based taxation (practised by the rest of the world). The first post was titled “Toward A Definition Of Residence-based Taxation For Americans Abroad“. The second post was titled “Toward A Movement For Residence-based Taxation For Americans Abroad“. The third post was “Toward An Explanation For Why Some Americans Abroad Are Complacent About Citizenship Taxation“. The fourth post explains why some Americans Abroad actually OPPOSE changes to citizenship-based taxation. This fifth post in the series is to begin a discussion of what would be the basic changes (to the existing Internal Revenue Code) that would move the United States toward the world standard of pure residency-based taxation.

It’s about “pure residency-based taxation” and not citizenship-based taxation with a “carve out”

I have previously advocated that the United States should move to to a system of pure residence-based taxation. A system of pure residency-based taxation, means that:

Citizenship is NOT a sufficient condition for tax residency. If citizenship is not a sufficient condition for tax residency, income sourced outside the United States, which is received by people who are not residents of the United States, should not be taxable by the United States.

Note that pure residency-based taxation is NOT citizenship-based taxation with a “carve out” for US citizens living abroad. To put it another way: US citizens, simply because they are US citizens, would NOT be defined as US tax residents and subject to US worldwide taxation. This is different from US citizens being defined as US tax residents, but allowing (like the FEIE) for their foreign income to be excluded from US taxation. Note also that this is a legislative proposal. It is therefore different from our earlier proposal for “A Regulatory Fix To Citizenship Taxation“.

It is my opinion and the opinion of the members of SEAT, that only a system of pure residency-based taxation will solve the many problems of Americans abroad!

How is residency to be determined?

 

Residency is commonly determined in various ways. For example, Canada determines residency based on an objective deeming provision (number of days spent in Canada and through a “facts and circumstances” test described as ordinary residence). Generally, citizenship (if it is a factor at all) is not a significant issue in determining ordinary residence. The Canadian experience is proof that it is possible to have very sticky tax residency without citizenship being an issue.

Purpose of this post:

The purpose of this post is to propose some simple amendments to the Internal Revenue Code which would provide a foundation for the United States to transition from citizenship-based taxation to pure residence-based taxation. The goal is modest. The post is not intended to (I will write a separate post) deal with those who are CURRENTLY US citizens living outside the United States. It is NOT to address all the issues. That said, most of the Internal Revenue Code focuses on the taxation of those who are US tax residents. Little in the Code focuses on the actual definition of US tax residency.

The purpose of this post is begin with the fundamentals and ask:

How could the existing Internal Revenue Code be modified to provide a framework for residency-based taxation? Of course, readers will be left with many questions. But, the proposed foundation would allow for:

1. US citizens to move from the United States and sever tax residency with the United States.

2. US citizens to move from the United States and continue to be treated as tax residents of the United States.

Under either scenario, US citizens would remain US citizens. They would NOT be required to relinquish US citizenship in order to sever tax residency.

Obviously there will be many complications. But, every journey begins with a modest beginning. This is intended to be only a modest beginning. It is to begin digging the foundation to build the house of “residency-based taxation”.

The post is composed of the following parts:

Part A – Residents Are Subject To Worldwide Taxation

Part B – Nonresidents Are Not Subject To Worldwide Taxation

Part C – Definition Of Resident and Nonresident- 7701(b)

Part D – Definitions That Require Change “US Person”, “Relinquishment Of Residency”, etc.

Part E – Relinquishment Of Residence

Part F – Living abroad without relinquishing US residence

Generally, I believe that amendments to a small number of sections of the Internal Revenue Code provide the foundation from which to grow. Note that this proposal solves the problems of the “Retirees Abroad” (they don’t give notice under the new 877(a)(g)) and the problems of accidentals (they were never tax residents in the first place). There would be regulations (like the Canada Revenue Agency folio) for what constitutes residence. In Canada tax residency is defined largely by “ordinary residence” – a concept that is very sticky).

I am identifying the building blocks that could define tax residency under a US system of residency-based taxation, with few modifications to the Internal Revenue Code. (These building blocks are generally compatible with the existing Internal Revenue Code.) Once the foundation has been built we would then build our way out. This initial foundation solves the PFIC problem, the CFC problems and most problems related to foreign source income. The FinCEN 114 (FBAR) rules currently reference Internal Revenue Code 7701(b). Therefore, the proposals in this post would solve the FBAR problem.

I will discuss other issues impacting Americans abroad in subsequent posts.

I have included only the sections of the Internal Revenue Code that I consider the foundation of US tax residency. When a word is IN CAPS that means that there has been a change to facilitate a change to pure residence-based taxation.

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Part A – Residents Are Subject To Worldwide Taxation

https://www.law.cornell.edu/uscode/text/26/subtitle-A/chapter-1/subchapter-A/part-I

For Whom The Bell Tolls: 26 U.S. Code § 1 – Tax imposed

(The general principle is that the word “individual” is changed to the word “resident” and that “nonresident alien” is changed to “nonresident”.)

(a) Married RESIDENTS filing joint returns and surviving spouses

There is hereby imposed on the taxable income of—
(1) every married RESIDENT (as defined in section 7703) who makes a single return jointly with his spouse under section 6013, and
(2) every surviving spouse (as defined in section 2(a)),
a tax determined in accordance with the following table …

(b) Heads of households

There is hereby imposed on the taxable income of every head of a household (as defined in section 2(b)) a tax determined in accordance with the following table …

(c) Unmarried RESIDENTS (other than surviving spouses and heads of households)
There is hereby imposed on the taxable income of every individual (other than a surviving spouse as defined in section 2(a) or the head of a household as defined in section 2(b)) who is not a married RESIDENT (as defined in section 7703) a tax determined in accordance with the following table:

(d) Married RESIDENTS filing separate returns

There is hereby imposed on the taxable income of every married RESIDENT (as defined in section 7703) who does not make a single return jointly with his spouse under section 6013, a tax determined in accordance with the following table …

At present the Internal Revenue Code is written so that it imposes worldwide taxation on all individuals (providing a carve out for nonresident aliens). The idea is to convert the word individual to “resident” and to convert “nonresident alien” to “nonresident”. Note that this would also require Treasury to change its regulations in at least two ways:

1. To ensure that “resident” does not include “citizens”; and

2. To include guidelines for the meaning of resident. These guidelines should direct the reader over to the regulations for the new 7701.

(I am generally suggesting using the guidelines for “ordinary residency” which are used by Canada. They are extremely sticky and require a complete break with Canada in order to sever tax residency. For the moment I am not considering the issue of dual residency under a treaty … But, this is an issue that needs to be considered.)

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Part B – Nonresidents Are Not Subject To Worldwide Taxation

Not Everybody Is A Resident – 26 U.S. Code § 2 – Definitions and special rules

(The idea is to change “nonresident alien” to “NONRESIDENT”).

(b) Definition of head of household

(3) Limitations

Notwithstanding paragraph (1), for purposes of this subtitle a taxpayer shall not be considered to be a head of a household—
(A) if at any time during the taxable year he is a NONRESIDENT; or

IRC S. 2 (D) becomes:

(d) NONRESIDENTS
In the case of a NONRESIDENT individual, the taxes imposed by sections 1 and 55 shall apply only as provided by section 871 or 877.

These changes to sections 1 and 2 change the scope of the application from “individual” (which means everybody on the planet) to “resident”. 2(d) provides the exemption to worldwide taxation for nonresidents.

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Part C – Definition Of Resident And Nonresident – 7701(b)

What’s The Difference?

(b) Definition of RESIDENT and NONRESIDENT

(1)In general

For purposes of this Title (other than subtitle B) —

(A) Resident An individual shall be treated as a resident of the United States with respect to any calendar year if (and only if) such individual meets the requirements of clause (i), (ii), (iii) or (iiii):

(i) Ordinary Residence (Note this is modelled on the Canadian rules for ordinary residence and would be flushed out by regulation)

An individual is ordinarily resident in the United States

(ii) Substantial presence test
Such individual meets the substantial presence test of paragraph (3).

(iii) First year election
Such individual makes the election provided in paragraph (4).

(iiii) Lawfully admitted for permanent residence
Such individual is a lawful permanent resident of the United States at any time during such calendar year.

(B) Nonresident
An individual is a nonresident if such individual is not a resident of the United States (within the meaning of subparagraph (A)).

(4) First-year election
(A) A NONRESIDENT individual shall be deemed to meet the requirements of this subparagraph if such individual—

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Part D – Definitions That Require Change “US Person”, “Relinquishment Of Residency”, etc.

https://www.law.cornell.edu/uscode/text/26/7701

So, What’s That Supposed To Mean? 26 U.S. Code § 7701 – Definitions

7701(a)(30) and 7701(1)(50)

(30) United States person The term “United States person” means—

(A)
a 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.

(Note that this change solves the CFC problem and the FATCA problem in 1471)

(50)Termination of United States RESIDENCE

(A)In general

An individual shall not cease to be treated as a United States RESIDENT before the date on which the individual’s RESIDENCE is treated as relinquished under section 877A(g)(4).

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Part E – Relinquishment Of Residence

https://www.law.cornell.edu/uscode/text/26/877A

This US Tax Residence Is Too Much For Me!

Expatriation … 877A(g)

(g) Definitions and special rules relating to expatriation

For purposes of this section—
(1) Covered expatriate
(A) In general
The term “covered expatriate” means an expatriate who meets the requirements of subparagraph (A), (B), or (C) of section 877(a)(2).

(B) Exceptions

An individual shall not be treated as meeting the requirements of subparagraph (A) or (B) of section 877(a)(2) if—
(i) DELETE

(ii)
(I) the individual’s relinquishment of United States RESIDENCE occurs before such individual attains age 18½, and
(II) the individual has been a resident of the United States (as so defined) for not more than 10 taxable years before the date of relinquishment.

(C) Covered expatriates also subject to tax as RESIDENTS
In the case of any covered expatriate who is subject to tax as a resident of the United States for any period beginning after the expatriation date, such individual shall not be treated as a covered expatriate during such period for purposes of subsections (d)(1) and (f) and section 2801.

(2) Expatriate
The term “expatriate” means—
(A) any United States RESIDENT who relinquishes his RESIDENCE
(B) EXCEPTION: a lawful permanent resident of the United States (within the meaning of section 7701(b)(6)) is to be treated as an “expatriate” only if he is a “long term resident”.

(3) Expatriation date
The term “expatriation date” means—
(A) the date an expatriate, who is not a lawful permanent resident, relinquishes United States RESIDENCE, or
(B) in the case of a lawful permanent resident, who is a long-term resident of the United States, the date on which the individual ceases to be a lawful permanent resident of the United States (within the meaning of section 7701(b)(6)).

(4) Relinquishment of RESIDENCE

(A) A resident who is not a lawful permanent resident of the United States, shall be treated as relinquishing his United States RESIDENCE on the date that the resident certifies under penalties of perjury, on a form prescribed by the Secretary that he:

(i) no longer meets the “residency requirements”* in S. 7701(b); and
(ii) has established tax residency in another country.

(B) A lawful permanent resident of the United States, who is NOT a “long term” resident, shall be treated as relinquishing his residence on the date that the resident certifies under penalties of perjury, on a form prescribed by the Secretary that he:

(i) no longer meets the “residency requirements” in S. 7701(b); and
(ii) has established tax residency in another country.

(C) The date that a lawful permanent resident, who is a long term resident, meets the requirements of 7701(b)(6).

(5) Long-term resident
The term “long-term resident” has the meaning given to such term by section 877(e)(2).

*(I am generally suggesting using the guidelines for “ordinary residency” which are used by Canada. They are extremely sticky and require a complete break with Canada in order to sever tax residency. For the moment I am not considering the issue of dual residency under a treaty … But, this is an issue that needs to be considered.)

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Part F – Living abroad without relinquishing US residence

https://www.law.cornell.edu/uscode/text/26/911

The Expat Lifestyle

26 U.S. Code § 911 – Residents of the United States living abroad

(a) Exclusion from gross income

At the election of a qualified individual (made separately with respect to paragraphs (1) and (2)), there shall be excluded from the gross income of such individual, and exempt from taxation under this subtitle, for any taxable year—
(1) the foreign earned income of such individual, and
(2) the housing cost amount of such individual.
(b) Foreign earned income
(1) Definition
For purposes of this section—
(A) In general
The term “foreign earned income” with respect to any individual means the amount received by such individual from sources within a foreign country or countries which constitute earned income attributable to services performed by such individual during the period described in subparagraph (A) or (B) of subsection (d)(1), whichever is applicable.

(B) Certain amounts not included in foreign earned income
The foreign earned income for an individual shall not include amounts—
(i) received as a pension or annuity,
(ii) paid by the United States or an agency thereof to an employee of the United States or an agency thereof,
(iii) included in gross income by reason of section 402(b) (relating to taxability of beneficiary of nonexempt trust) or section 403(c) (relating to taxability of beneficiary under a nonqualified annuity), or
(iv) received after the close of the taxable year following the taxable year in which the services to which the amounts are attributable are performed.

“Qualified Individual”

qualified individual

(1) Qualified individual The term “qualified individual” means an individual whose tax home is in a foreign country and who is— (A) a RESIDENT of the United States and establishes to the satisfaction of the Secretary that he has been a bona fide resident of a foreign country or countries for an uninterrupted period which includes an entire taxable year, or (B) a RESIDENT of the United States and who, during any period of 12 consecutive months, is present in a foreign country or countries during at least 330 full days in such period.

That’s take 1 – The end for now …

Notice that this proposal solves the basic problems of retirees abroad and others who are in favor of retaining the current system of citizenship-based taxation (they can always be treated as US tax residents if they don’t sever tax residency). It also solves the problems of accidentals (they were never US tax residents to begin with).

I repeat: this post is intended to be only a modest beginning. I will be interested in the inevitable comments. Once the foundation has been established it will be easier to build the walls, the roof and the rest of the house. But without this foundation nothing is possible.

John Richardson – Follow me on Twitter @Expatriationlaw

*Appendix – Excerpt Canada Revenue Agency Folio Defining “ordinary residence” in Canada.

Meaning of ordinarily resident

1.6 In determining the residence status of an individual for purposes of the Act, it is also necessary to consider subsection 250(3), which provides that, in the Act, a reference to a person resident in Canada includes a person who is ordinarily resident in Canada. In Thomson, Estey J. held that, “one is “ordinarily resident” in the place where in the settled routine of his life he regularly, normally or customarily lives”.

1.7 In the same decision, Rand J. stated that the expression ordinarily resident means, “residence in the course of the customary mode of life of the person concerned, and it is contrasted with special or occasional or casual residence. The general mode of life is, therefore, relevant to a question of its application.” Justice Rand also went on to say that, “ordinary residence can best be appreciated by considering its antithesis, occasional or casual or deviatory residence. The latter would seem clearly to be not only temporary in time and exceptional in circumstances, but also accompanied by a sense of transitoriness and of return.” The meaning given to the expressions resident and ordinarily resident as stated by the Supreme Court of Canada in Thomson, have generally been accepted by the Courts.

1.8 To determine residence status, all of the relevant facts in each case must be considered, including residential ties with Canada and length of time, object, intention and continuity with respect to stays in Canada and abroad

Have a question? Contact John Richardson, Citizenship Solutions.

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The Reality of U.S. Citizenship Abroad

My name is John Richardson. I am a Toronto based lawyer – member of the Bar of Ontario. This means that, any counselling session you have with me will be governed by the rules of “lawyer client” privilege. This means that:

“What’s said in my office, stays in my office.”

The U.S. imposes complex rules and life restrictions on its citizens wherever they live. These restrictions are becoming more and more difficult for those U.S. citizens who choose to live outside the United States.

FATCA is the mechanism to enforce those “complex rules and life restrictions” on Americans abroad. As a result, many U.S. citizens abroad are renouncing their U.S. citizenship. Although this is very sad. It is also the reality.

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