Since Congress began taxing incomes, American citizens have been unable to escape the reach of Uncle Sam: They must report their income, no matter where they live or where it’s earned. It’s known as a worldwide citizenship-based tax system.
Most other countries, however, have a residence-based system. That means their citizens are only taxed where they live or where their income is earned. The U.S. income of a British expat living in New York, for example, is off limits to Her Majesty’s Treasury.
The Tax Cuts and Jobs Act, passed in December, was supposed to change how the U.S. treats Americans abroad. Instead, it only addressed a similar issue faced by American multinational corporations by allowing their foreign subsidiaries to send home certain profits without paying U.S. taxes on them.
Meanwhile, Congress left U.S. citizens living overseas under the old, punitive system even though, as my research shows, it puts them at a significant disadvantage.
Fortunately, there’s a chance to fix this. The new law included many inadvertent errors and omissions, and lawmakers are working on legislation to fix them. In my view, switching the individual income tax to a residence-based system should be part of any repair effort.
Birth of the income tax
Since first taxing individual incomes during the Civil War, the U.S. has targeted its citizens’ income regardless where they live.
By at least 1914, a year after states ratified the 16th Amendment, which made the income tax constitutional, Americans abroad were complaining of double taxation and renouncing their citizenship as a result.
While current law offers exclusions and credits to prevent double taxation for most Americans, many other provisions are punitive to long-term expats by targeting foreign investments, businesses and retirement savings.
The reporting requirements and incompatibility with local tax laws create significant compliance costs for nonresident Americans that often greatly exceed the amount of U.S. tax they owe, which is zero for most expats.
In 2010, the U.S. further complicated their financial lives by enacting the Foreign Account Tax Compliance Act, which required banks to report to the IRS on all accounts held by U.S. taxpayers.
The act had two consequences: First, many banks closed accounts held by U.S. citizens because the banks were scared of the significant penalties for noncompliance. And second, many people learned for the first time that they were subject to U.S. taxation.
This resulted in a spike in the rate of U.S. citizenship renunciations, from under 800 per year before 2010 to over 5,000 in both 2016 and 2017.
The GOP even included a provision to repeal the act in its 2016 election platform, which also supported moving to a residence-based system of taxation for individuals and a territorial system for corporations.
The main problem with a citizenship-based taxation is that the U.S. is taxing the foreign income of an American or a dual citizen working, living and paying tax in another country, without a dime going through any entity under U.S. jurisdiction.
Currently, the U.S. is the only country – apart from Eritrea – to do this.
In addition, many of the American nonresidents being taxed are “Accidental Americans,” who have few or no ties to the United States but are U.S. citizens due to an accident of birth. Accidental Americans exist because the U.S. grants citizenship broadly, based on both place of birth and parentage.
They have all the tax responsibilities of U.S. citizenship but often don’t even know it.
My own research focuses on tax issues faced by Americans and dual nationals living in Australia.
To illustrate the impact of the U.S. tax system, let’s take the situation of “Kate,” a U.S.-Australia dual citizen living in Sydney. She earns AU$70,000 (US$54,900) per year as a marketing manager at a locally owned company. Fortunately for her, she’s able to exclude this income from U.S. taxation, yet she still must file a 1040 every year and report the AU$20,000 in her local bank account to the Financial Crimes Enforcement Network or face a hefty fine.
Most of Kate’s problems emerge when she tries to take part in a variety of other normal aspects of living somewhere for any significant period of time, from saving for retirement to buying a home. And in general, the exclusions and credits intended to prevent double taxation won’t be sufficient.
For example, Australia has one of the best retirement systems in the world available to all residents, with mandatory employer contributions and low taxes. Withdrawals after age 60 are tax-free in Australia.
Unfortunately, Kate will face lots of complexity and uncertainty when it comes to the U.S. treatment of her Australian retirement savings. If she chooses to contribute more to her retirement fund than her employer, the U.S. could tax some of the income accumulating inside her account, even though she has no access to that income. And when she eventually retires, a portion of her withdrawals will also be subject to U.S. taxation.
Let’s say Kate buys a home. She’ll confront the U.S. taxman again if she eventually wants to sell, depending on fluctuations of the exchange rate between the purchase and sale. If the Australian dollar falls, that will mean the mortgage will be smaller in U.S. dollars, triggering a taxable gain upon repayment. If the Australian dollar appreciates, it increases the likelihood Kate will have to pay U.S. tax on any gain from the sale itself. (The U.S. excludes only the first $250,000.) Either way, Kate will likely lose.
Kate will face similar complexity and potential tax liability if she simply wants to invest in a local mutual fund or start a business in Sydney.
Essentially, every transaction that Kate enters into will be seen as a cross-border transaction by the IRS, even though all parties may be Australian citizens resident in Australia.
Kate’s situation is not unique. A survey of U.S. expats shows that about one-third of respondents were actively considering renouncing their U.S. citizenship, with open-ended responses indicating that tax compliance- and bank-related issues were major factors.
These tax and reporting obligations have cost them the ability to bank and invest, the ability to save for retirement and even jobs, when employers and potential business partners are not willing to allow their accounts to be reported to the IRS.
That’s a shame because overseas Americans are important business, trade and cultural representatives for the U.S.
Now that Congress has recognized the problems of worldwide taxation for U.S. corporations, I hope lawmakers take this opportunity to address the unintended consequences of U.S. tax policy toward American citizens living abroad as well. The likelihood of positive action appears to be growing with increased recognition of this problem.