Eroding The Tax Base Of Other Countries By Imposing Direct U.S. Taxation On Residents Of Those Countries

Eroding The Tax Base Of Other Countries By Imposing Direct U.S. Taxation On Residents Of Those Countries

This is the fourth of a series of posts about international tax reform generally and how FATCA, CRS, citizenship-based taxation, GILTI, etc. work together.

The first three posts were:

US Tax Treaties Should Reflect The 21st Century And Not The World Of 100 Years Ago

The Pandora Papers, FATCA, CRS And How They Have Combined To Create Tax Haven USA

How The World Should Respond To The US FATCA Driven Attack On The Tax Base Of Other Countries

This fourth post continues where the third post – How The World Should Respond To The US FATCA Driven Attack On The Tax Base Of Other Countries – left off. That post described in a general way that FATCA facilitated the US taxation of residents of other countries. The purpose of this post is to give a small number of important examples. To repeat:

The imposition of FATCA on other countries means that …

The United States has effectively expanded its tax base into other countries by claiming residents of other countries as US tax residents. This is a direct attack on and the erosion of the tax base of those other countries.

For some reason this concept is not widely understood. Let’s begin with a a “Q and A”:

Q. What residents of other countries are subject to US worldwide taxation?

A. US citizens and Green Card holders who are subject to US worldwide taxation regardless of where they live in the world. Since the 1967 decision in Afroyim v. Rusk the number of US citizens living outside the United States has dramatically increased. This is true even when they are tax residents of other countries and subject to the tax systems of those other countries.

Q. I understand that they are plenty of tax treaties that prevent double taxation so that people only pay tax in the country where they live?

A. This is another ridiculous myth. The truth is that US tax treaties contain a “saving clause” designed to prevent US citizens from benefiting from many of the provisions of the tax treaty. The “saving clause” says that no matter what the tax treaty says the US can always tax its citizens as if the treaty didn’t exist. Therefore, it’s more accurate to say that the purpose of the tax treaty is NOT to avoid double taxation. The purpose of the tax treaty is to ensure the possibility of double taxation! (Readers might be interested in the comments of the “Steering Committee” of the Australian “Fix The Tax Treaty” blog.)

Q. Okay, but being “subject to US worldwide taxation” doesn’t mean that Americans abroad actually pay US taxes? I thought the FEIE and FTC rules operate so that US citizens living in another country never actually paid tax to the US (if they were paying tax to their country of residence).

A. Neither the FEIE nor the FTC rules protect Americans abroad from US taxation. I invite you to listen to the podcasts included in the appendix to this post to see way. Furthermore, to see why and how the US does not allow FTCs for all kinds of taxes (including VAT taxes) paid in another country see “So, how do Foreign Tax Credits work???” by Dr. Karen Alpert. It is particularly important to understand that even when FTCs apply there is a timing requirement. The non-US tax must be payable at approximately the same time as the US tax is owed. Timing mismatches can result in the denial of the availability of an FTC. There is a timing issue that must be considered! (This is a particular problem of GILTI described below.)

Some examples of how the US tax system imposes direct US taxation on the residents of other countries

There are many examples. For the purpose of this brief post I am going to focus on only two examples. Each example demonstrates how the Internal Revenue Code imposes US taxation on the NON-US source income of residents of other countries and effectively extracts revenue from the non-US country. These are two examples of many!

1. The Obamacare 3.8% NIIT (Net Investment Income Tax)

The basic principle is that the NIIT subjects Americans abroad to a 3.8% surtax on certain investment income. The law is written so that the use of FTCs cannot be used to offset the effect of this tax. Think of it as just a 3.8% tax on investment income which is imposed on the tax residents of other countries!

2. The Section 951A GILTI Tax

The 2017 TCJA contained some very very nasty surprises for US citizens living outside the United States. These surprises included the 965 Transition Tax (which had the effect of literally confiscating the pensions of some Canadian residents) and GILTI which is an ongoing problem.

Q. What is GILTI?

A. GILTI is a US law (IRC 951A) that attributes the earnings of a CFC (“Controlled Foreign Corporation”) to the income of the US shareholder. It is a mechanism to ignore the fact that a corporation is a separate legal entity and treat the income of the corporation as the income of the individual US shareholder. This has the effect of imposing a US tax on the earnings of a non-US corporation that have not been distributed to the shareholder. Significantly this is a way of indirectly taxing the earnings of the non-US corporation. I.e. instead of taxing the corporation directly on its earnings (which is prohibited by most treaties) the US attributes the corporate earnings to the US shareholder and then taxes the shareholder.

Interestingly S. 951A is written in a way that does NOT allow the full of use of foreign tax to offset the US tax. Under the current rules only 80% of the foreign tax paid can be used as a tax credit. In its plain language it is clear that this is an attempt to impose US tax on foreign source income. It is also a clear attempt to do so by not allowing the full use of foreign taxes paid as tax credits.

As emphasized in the above tweet, neither tax academics nor practitioners seem to understand that the biggest victims of GILTI are NOT U.S. Multi-Nationals. The biggest victims are the individuals who live outside the United States and operate small businesses (think dry cleaners, yoga studios, accounting firms, etc.) outside the United States.

Summary: Putting these examples in the context of a US citizen living as a tax resident of another country

The point is that the US is imposing direct US taxation on the non-US source income of people who do NOT live in the United States (and rarely have any connection to the United States). They are being taxed based on “who they are” and not based on their “physical connection” to the United States. Notably, the US is the ONLY major country in world that defines tax residency in terms of “status” (citizenship).

The effect on those other countries is: The US is using “citizenship-based taxation” to extract capital from other countries.

The effect on the impacted individuals living in those countries is devastating and is described in the following two posts:

How To Live Outside The United States In an FBAR and FATCA World

The biggest cost of being a “dual Canada/U.S. tax filer” is the “lost opportunity” available to pure Canadians

Closing thoughts

Today is October 8, 2021. The final discussions about the new international tax rules for corporations are taking place. Pillar 1 and Pillar 2 are the topics of conversation. In the last 24 hours I have seen news reports suggesting that Ireland, Estonia and Hungary (the recalcitrants) are moving toward accepting the minimum tax rules contemplated by Pillar 2.

Pillar 1 and Pillar 2 are introduced in the July 1, 2021 statement from the OECD which included:

GILTI co-existence

It is agreed that Pillar Two will apply a minimum rate on a jurisdictional basis. In that context, consideration will be given to the conditions under which the US GILTI regime will co-exist with the GloBE rules, to ensure a level playing field

Does this mean that international tax reform is simply going to assume that the United States can continue to impose a GILTI surcharge on the rest of the world?

My next post will discuss this issue.

Appendix podcasts explaining why the FEIE and/or FTC rules do NOT result in Americans abroad owing no US tax:

Have a question? Contact John Richardson, Citizenship Solutions.

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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