Toward A Definition Of Residence-Based Taxation For Americans Abroad

Toward A Definition Of Residence-Based Taxation For Americans Abroad

Introduction

The discussion of tax reform for Americans abroad is increasing in intensity. Whether through amendments to the Internal Revenue Code or a “Regulatory Fix To Citizenship-based Taxation“, Americans abroad are in desperate need of change. The US tax system as it impacts Americans abroad is forcing renunciations of US citizenship.

The language in the discussion for change reflects a desire (on the part of individuals and organizations) to move from the US system of “citizenship-based taxation” to a system of “residence-based taxation”. Various individuals and groups describe the goal using the language of “residence-based taxation” AKA RBT. It would be a mistake to assume that RBT means the same thing to different people. The purpose of this post is to describe definitions of RBT and and how those definitions may be defined for different individuals or groups.

 

Part I – US Citizenship-based taxation AKA Taxation Of Nonresidents On Worldwide Income

Who Is A Tax Resident (Citizens or Residents) Of The United States vs. What Those Tax Residents Are Taxed On (Worldwide Income)

Whether one is subject to taxation is a question that is different from what income one is taxed on. A surprising number of people confuse citizenship-based taxation (whether) with taxation on worldwide income (what).

What Income Is Taxed – Worldwide Income

1. US citizens and others who are resident in the United States are subject to taxation on their worldwide (whether sourced within or without the United States) income.

2. US citizens living outside the United States are also subject to US taxation on their worldwide income (including income sourced outside the United States). So, a US citizen living in Germany, whose only income is German employment income, is subject to US taxation on that German employment income. (Interestingly, US citizens living outside the United States are subject to a separate and more punitive tax system than US citizens living inside the United States.)

Whether One Is Subject To US Worldwide Taxation

US residents (whether US citizens or not) are subject to US taxation on their worldwide income. But shockingly, US citizens living outside the United States are also subject to US taxation on their worldwide income. To put it another way, US citizens are subject to worldwide taxation based on “who they are” as “opposed to where they are resident“!

Many US citizens live in other countries, are tax residents of those other countries, earn income in those other countries, pay tax to those other countries and are STILL subject to US taxation on their non-US income earned while living in those other countries.

This state of affairs (which some call “citizenship-based taxation”) is such that:

The United States imposes taxation on the non-US income earned by people who are tax residents of other countries and do NOT live in the United States.

The justification that the United States invokes to justify imposing worldwide taxation on individuals is that those unfortunate people are “US citizens”. The vast majority of US citizens are people who acquired US citizenship because they were born in the United States. Some acquired US citizenship because they were born to a US citizen parent(s) outside the United States. US citizenship is primarily the consequence of “circumstances of birth”. In other words, the US claims to right to impose worldwide taxation on people who live outside the United States, based on circumstances of birth. Yes, in 2021 the United States actually imposes worldwide taxation on people with no connection to the United States, except their circumstances of birth.

It’s unjust! It’s inhumane! People do NOT choose the circumstances of their birth!

Part II – Transitioning To Residence-based Taxation – What Does It Mean?

Digging In – Let’s Look More Carefully At How This Works

The US tax code is written in the following way:

It decrees that every individual on the planet (and presumably the galaxy) is subject to US worldwide taxation; and then

States (providing an exception) that nonresident aliens are subject to taxation only on their US source income.

(A US citizen can never be a nonresident alien. Therefore US citizens are included in the group of “individuals” who are subject to US worldwide taxation.)

The Anger (as reflected in the recent SEAT Survey about Americans abroad)

US citizens living outside the United States who are tax paying residents of other countries justifiably feel that their non-US source income should NOT be subject to US taxation. Their champions generally say that the United States should move to a system of “residence-based taxation” AKA RBT. The belief is that this would ensure that the non-US income received by Americans abroad would NOT be subject to US taxation.

The question is: What exactly is meant by RBT? Two possibilities:

Possibility 1. US citizens living outside the United States should not be part of the US tax base at all. The Internal Revenue should be amended to say that ONLY those who are US residents are subject to US worldwide taxation (pure RBT); or

Possibility 2. US citizens living outside the United States continue to be part of the US tax base. But, the Internal Revenue Code should be written to say that the non-US income of US citizens living abroad should be excluded from income taxed by the United States (citizenship-based taxation with a carve out).

There is a VAST difference between these two definitions of RBT. They might look the same to certain people. They might lead to the same outcome for certain people. But, make no mistake they are VERY different.

Possibility 1 – Americans abroad are NOT part of the US tax base to begin with

This possibility is the kind of pure RBT that is the rule in all other countries. It follows the rules in all other countries which is: If you don’t have a physical or economic connection to the United States you are not (except for US source income) subject to the US tax system at all. No filing of tax returns, no reporting, no interference with your financial and retirement planning. No interference with your marriage, etc.

Notice that Possibility 1 is residence-based taxation because those who are NOT US residents are not part of the US tax base to begin with!

Possibility 2 – Americans abroad are part of the US tax base but are allowed to exclude their non-US source income from US worldwide taxation

This is what the 911 Foreign Earned Income Exclusion is about. The FEIE (Form 2555) means that you are always part of the US tax base. If you meet the requirements of the 911 Foreign Earned Income Exclusion that you are permitted to exclude certain non-US income from your US taxable income. This is not an end to citizenship-based taxation, but it does result in some Americans abroad paying less tax to the United States. This is what I call “citizenship-based taxation” with a “carve out”.

Notice that Possibility 2 is a focus on the source of the income (provided the individual has a lack of physical presence in the USA or bona fide residence in other country).

Representative Holding’s 2018 bill was a clear example of Possibility 2 (citizenship-based taxation with a carve out). It was a great step forward. At its core, Representative Holdings bill, was a massive expansion of the FEIE. If enacted it would NOT have resulted in pure RBT (meaning a change to the definition of US tax residency). If passed, the effect of the Holding bill would have been to “normalize” the idea that the non-US income earned by Americans abroad would NOT be subject to US worldwide taxation.

The views of individual Americans abroad

There is (understandably) terrible confusion. The issues are technical and not always easy to understand. My impression is that individuals perceive the current system as tremendously unjust. They seek a just tax system for Americans abroad. That said, they often are not able to articulate exactly what they want. For some examples of how Americans abroad perceive the situation see the following: “Comments From Americans Abroad About The Effects Of FATCA And Citizenship-based Taxation“.

Final thoughts (for now)

This post was written in response to a great deal of discussion in Social media about residence-based taxation. Clearly there is no agreement on what the term even means. Therefore, my main purpose is to (at least) identify some of the issues.

Finally, a “shout out” to all those individuals and organizations who are working hard on this problem. Reversing the US “citizenship-based taxation” AKA extraterritorial tax regime is hard work. All those participating in this difficult journey deserve respect, encouragement and support. That said, the time has come to take a good look at what these proposals really mean.

I invite your comments.

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.

Twitter 

Subscribe to TaxConnections Blog

Enter your email address to subscribe to this blog and receive notifications of new posts by email.