Jackie Bugnion of American Citizens Abroad (ACA) presented the following working paper to tax staff members of U.S. House Ways and Means Committee and the Senate Finance Committee in February 2012.
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For reasons detailed below, ACA proposes two complementary changes to U.S. tax laws as they apply to American citizens and green card holders resident abroad:
1. Eliminate citizenship-based taxation.
2. Collect withholding taxes at source on all U.S. passive income (including dividends, interest, royalties, etc.) of overseas Americans on the same basis as the U.S. currently collects withholding taxes on the revenues generated by U.S. assets, such as shares and bonds, owned by non-resident foreigners.
The ACA proposal would make the United States more competitive in world markets, create jobs at home, simplify taxation for Americans living abroad, alleviate the burden on the IRS, and be revenue neutral (possibly even positive) for the United States.
The United States is the only country that applies citizenship-based taxation in addition to residence-based taxation.1 All other countries besides the United States apply only the concept of residence-based taxation and do not tax their citizens who have established residence outside their borders. The United States applies residence-based taxation to all foreigners resident in the United States, but also taxes United States citizens and green card holders living abroad (hereafter referred to as Americans abroad). This is in spite of the fact that bilateral taxation agreements signed by the U.S. formally acknowledge the preeminent taxation power of the country of residence, even to U.S. citizens residing in the other treaty country.
Citizenship-based taxation is an anomaly in today's global world and has a severe negative impact, not only on Americans living abroad, but on the United States economy overall. Citizenship-based taxation is fundamentally bad law. Legal scholars and tax specialists have recently come out against it for both legal and practical reasons.2 Even the Joint Committee on Taxation has called it into question in its September 2011 report on "U.S. Taxation of Cross-Border Income."3 Citizenship-based taxation should also be viewed as a human rights issue, as it prevents U.S. citizens from being free to work and live worldwide. It is time for the United States to move to residence-based taxation.
Major benefits would accrue to the United States from eliminating citizenship-based taxation. In macro-economic terms, citizenship-based taxation is basically a handicap to the U.S. economy, clearly established by several studies mentioned below. Changing to residence-based taxation would make the United States more competitive in today's world economy, streamline the U.S. tax system, and possibly bring in more revenues than the current expensive and complex system. The following eight points highlight just some of the many benefits to the United States of this change.
- U.S. multinationals would once again hire Americans for overseas posts because they would not have to pay higher tax costs for Americans than for other nationalities. The increased presence of Americans abroad would significantly increase U.S. competitiveness long-term through increased awareness of foreign competition and markets and Americans' normal instinct to favor procuring American made goods and services for sale in the international markets. The need to encourage deployment of Americans overseas for the United States to be competitive cannot be overemphasized, as the tumultuous history of tax legislation on Americans abroad has demonstrated the negative impact of U.S. tax policy on U.S. exports.4
- Small and medium sized U.S. companies would be able to afford to set up foreign sales operations, headed up by knowledgeable U.S. staff. This is crucial for the success of such a new venture because the American overseas manager shares the strategic objectives of the company and has established communication channels and full backing of top management.
- Encouraging U.S. companies to deploy Americans abroad would alleviate U.S. unemployment as citizens could be offered jobs abroad that would otherwise have gone to foreigners.
- U.S. businessmen and entrepreneurs currently working overseas would be much more competitive, being subject only to the taxes in the country of residence, and would be able to enter without discrimination into foreign partnerships or enterprises.
- New domestic jobs and resulting tax revenue from increased exports would compensate many times over any possible "lost" tax revenue from Americans abroad. Every $1 billion of American manufactured goods exports is estimated to generate 7,000 to 10,000 domestic jobs and $150 million in federal tax revenue.5 If citizenship-based taxation were eliminated, the potential increase in U.S. exports would be significant. Every $100 billion of additional exports would generate $15 billion in new federal tax revenue, much more than current tax revenue from Americans abroad.
- The U.S. Treasury would no longer have to pay out certain tax credits to overseas Americans, such as the make work pay tax credit, the child tax credit, and other tax credits that have been legitimately claimed under the current system.
- The IRS would no longer have to process hundreds of thousands, soon to be millions, of tax returns, FBAR forms, and Forms 8938 from Americans living overseas, all of which are highly complex because of different tax systems and currencies involved.
- And, of course, Americans abroad would not only be freed from the unjust burden of double tax reporting and double taxation but would also enjoy expanded job opportunities overseas and the possibility to invest in local investment vehicles in the country of residence such as ETFs, life insurance policies, mutual funds and real estate investment vehicles, now out of reach due to the burdensome U.S. filing for PFICs (passive foreign investment corporations). They would also be relieved of foreign currency risks when purchasing a home.
Eliminating citizenship-based taxation would streamline the U.S. tax code substantially and increase U.S. competitiveness. A complete cost/benefit analysis requires Congressional initiative to command a GAO study, a Congressional budget study, or a Joint Committee on Taxation study. The last studies were realized more than 30 years ago. The President's Export Council report in 19796 and the GAO 1981 study7 both concluded that employing Americans abroad can increase exports and that U.S. tax policy, then as well as now, was discouraging the employment of U.S. citizens overseas.
ACA Alternative Proposal
Currently U.S. citizens residing abroad first pay taxes to the country of residence. They do have a potential tax liability to the U.S. of 15 percent tax on U.S. source dividends, but only if the amount reaches the taxing threshold in their tax declaration. In fact, after applying the FEIE and foreign tax credits, most Americans abroad do not owe U.S. taxes, even if some of their income is U.S. source income.
Most types of U.S. source income received by a foreign person resident overseas are subject to U.S. tax of 30 percent. A reduced rate, including exemption, may apply if there is a tax treaty between the foreign person's country of residence and the United States. If a non-resident alien owns U.S. stock, the U.S. dividend-paying corporation, through the withholding agent, deducts and transfers to the U.S. Treasury a withholding tax generally equal to 30 percent of the dividend paid. For those countries with which the United States has income tax treaties, normally half can be claimed back by the non-resident alien; if full identity of the beneficial owner is known to the withholding agent, the reduced treaty withholding can be immediately applied.8 For countries with which the United States does not have a tax treaty, the entire 30 percent withholding accrues to the U.S. Treasury. Hence foreigners are paying a 30 percent U.S. tax on all U.S. source income through a withholding regime, whereas most Americans residing abroad do not. Americans living abroad pay 15 percent to the United States on U.S. dividends only when such income is above certain thresholds and when foreign tax credits are insufficent to cancel the U.S. tax liability.
ACA proposes taxing overseas residents, both American citizens and green card holders, the same way that the United States taxes non-resident aliens having U.S. source income.
In practical terms, the withholding tax system is in place, as it already operates for non-resident aliens, and it can easily distinguish nationality and residency differences. Little cost of implementation is involved and once it is operative, it provides automatic tax revenues to the United States.
ACA estimates that taxing U.S. persons residing overseas through withholding tax on U.S. source income would compensate for tax revenue lost by eliminating citizenship-based taxation on U.S. persons abroad, making this proposal tax neutral at worst, and positive at best. Most significant, compliance among Americans abroad will automatically jump from the current low level to 100 percent. There will be increased predictability and certainty in tax collection. Tax revenue on U.S. source income would go to the United States instead of to foreign governments. IRS administrative costs would be reduced in a major way. Equally important, withholding on passive income would affect primarily wealthy individuals who have large portfolios of securities or other sources of passive income, thereby responding to a key concern of Congress that wealthy citizens should not have particular tax advantages from residing overseas.
Implementation of the ACA Proposal
To implement ACA's proposal defined above, namely to eliminate citizenship-based taxation and to apply a withholding tax on U.S source income to U.S. persons residing overseas comparable to the U.S. withholding tax on foreigners, the following considerations should be written into the U.S. tax code:
1) As soon as a U.S. person establishes residency abroad and informs the IRS of the new status, the taxing regime applicable would change. Those already residing overseas would announce to the IRS their status. Overseas residents will be required to file annually a one page declaration to the IRS attesting to their overseas resident status with their name, address, social security number and a listing of all U.S. citizens in the household. This form is to be stamped and countersigned by the fiscal authorities of the country of residence attesting that the U.S. person is subject to taxation in the country of residence.
2) Regarding passive income from U.S. source, Americans abroad will be treated the same way that foreigners are presently treated. The 30 percent U.S withholding tax will generally apply to U.S. source revenue and existing reduced treaty tax rates would extend to U.S. persons residing overseas. Withholding on U.S. source pension payments would remain minimal as is already the case under U.S. double taxation treaties, so as not to penalize modest income of retirees living overseas. There should be no withholding on U.S. social security payments, because under the Windfall Elimination Provision (WEP), the Social Security Administration already substantially reduces social security payments to individuals who also receive a foreign pension.
3) As a corollary, the new law will supersede or eliminate the "savings clause" written in the current income tax treaties, to ensure that U.S. citizens resident abroad are treated the same way that the citizens of the foreign countries are treated.
4) Overseas residents who have their own businesses overseas will no longer be required to file tax Form 5471 or Form 8865. Nor will these entrepreneurs be required to pay U.S. Social Security and Medicare taxes.
5) Americans abroad will not be required to file Form 1040 and all other forms related to overseas investments listed in footnote 9.9
6) Real estate in the United States owned by overseas residents will remain subject to U.S. taxes on revenue and capital gains, in accordance with general international tax practice and U.S. federal and state tax policy.
7) Any active income earned in the United States by Americans resident abroad will require filing Form 1040NR, the form used by non-resident foreigners who are engaged in trade or business in the United States or who earn income from U.S. sources. Deferred compensation earned by executives while in the United States and paid-out after retirement abroad should also be reported on Form 1040NR. Distributions from U.S. retirement accounts to Americans who have not been an overseas resident for five consecutive years would require reporting on 1040NR.
8) Americans resident overseas will be exempted from all reporting requirements of the FBAR (Form TD F 90-22.1) and FATCA (Form 8938). Foreign financial institutions (FFI) will not have the obligation to report to the IRS on financial accounts owned by Americans and green card holders living in the country where the FFI is located. A copy of the overseas resident declaration under Number 1 above will provide foreign businesses and banks with proof of local residence of the U.S. person whose information need not be reported to the IRS.
9) The FATCA reporting requirement that a non-listed foreign corporation or foreign partnership report to the IRS instances of U.S. ownership of 10 percent will not apply to overseas residents. This FATCA provision is very detrimental to American entrepreneurs, domestic or overseas. Most foreigners do not want their business to be reporting to the IRS for any reason whatsoever. The door is then shut for Americans to participate in many profitable international ventures.
10) Americans abroad will remain subject to U.S. estate taxes during the first 20 years of residence overseas, but on a sliding scale. The applicable estate tax rate would decline by 5 percent every year of residence abroad, reaching 0 percent in the 20th year. During the period when U.S. estate taxation remains applicable, it should follow the estate tax rules for American citizens, not the U.S. estate rules applicable to non-resident foreigners who are taxed at the maximum U.S. estate tax rate on all U.S. assets exceeding only $60,000.10 Incidentally, the United States should eliminate this estate tax claim on foreigners, as it has a serious negative impact on foreign investment in the United States.
11) Adopting this proposal requires starting with a clean slate. The IRS will settle all claims outstanding against Americans and green card holders already residing abroad for tax liabilities and will nullify all claims for penalties relating to non-filing of Form TD F 90-22.1 (FBAR) and Form 8938 (FATCA).
12) Adopting this proposal will significantly reduce the threat of identity theft surrounding all of the information currently required in an overseas taxpayer's tax return: Social Security number, birthdate, bank account numbers, bank addresses, highest maximum balance, personal investments, home address, signature, etc. These requirements are the identity theft criminal's dream come true, all relevant information for one person in one convenient package.
Eliminating citizenship-based taxation and simultaneously introducing U.S. withholding tax on U.S. source income of Americans and green card holders resident overseas would be economically advantageous for the United States.
It would most likely be tax neutral or positive and would lead to major tax simplification and efficiencies for the IRS.
It would also enhance U.S. competitiveness in a spectacular way.
It would align the United States with international norms of taxation.
And it would greatly improve the relationship between Americans abroad and their home country which they dearly love.
1 With the one exception of Eritrea. Ironically, the United States joined in Resolution 2023 of the Security Council of the United Nations on December 5, 2011, condemning Eritrea for imposing a "Diaspora tax" on its citizens residing overseas. Of course, citizenship-based taxation is nothing more than a tax on the American diaspora under a different name.
2 Paula N. Singer, "Tax Reform for Americans Abroad," Tax Notes Int'l, May 25, 2009, p. 673, Doc 2009-8923, or 2009 WTD 102-14. Reuven S. Avi Yonah, The Case Against Taxing Citizens, Public Law And Legal Theory Working Paper Series, Working paper No. 190, Mar. 2010, Empirical Legal Studies Center Working Paper No. 10-009, available at http://www.law.umich.edu/centersandprograms/elsc/abstracts/pages/papers.aspx.
3 Joint Committee on Taxation, Sept. 6, 2011 (JCX-42-11), prepared for the Public Hearing before the Senate Committee on Finance of Sept. 8, 2011, "Present Law and Issues in U.S. Taxation of Cross-Border Income," p. 93, available at http://www.jct.gov/publications.html?func=startdown&id=4355. The statement of the Joint Committee on Taxation is:
Treatment of individuals
Although most commentary on the issues of worldwide and territorial bases of taxing jurisdiction have focused on competitiveness of U.S. companies in comparison to foreign owned companies subject to territorial systems, a shift to a territorial system could also include provisions related to the treatment of individual taxpayers. Such reform would constitute a significant departure from long-standing policies, although it would have the effect of aligning the U.S. basis of taxation more closely with that of its trading partners.
The U.S. has consistently defended its assertion of worldwide jurisdiction with respect to its citizens and residents, both in the structure of the Code and in the terms of various bilateral and multilateral agreements. To the extent the U.S. has ceded such authority in practice, it reflects acceptance of international norms in favor of relief from double taxation and the policy favoring the facilitation of employment of U.S. citizens or residents abroad.
If the broad assertion of taxing jurisdiction is to be conceded in favor of expanding territorial taxation to individuals, the scope of any such expansion should be considered. For example, the exclusion could apply only to earned income by increasing or removing caps on the foreign earned income exclusion and making the exclusion available to Federal employees. The treatment of unearned income may require revisions to the rules for determining source of such income, and create a need for new rules to establish status as a nonresident citizen. Such rules in turn would require anti-abuse provisions, possibly modeled on rules governing tax-motivated expatriation.
4 Brief history: In 1962 Congress enacted and President John F. Kennedy signed the Tax Act of 1962 which for the very first time subjected U.S. citizens residing outside of the U.S. to U.S. income tax, even though citizenship-based taxation had been recognized by the U.S. many years before. Because of concern that such taxation not destroy the willingness of U.S. citizens to relocate abroad to perform the vital function of selling job-creating American exports, this 1962 legislation included a $35,000 Foreign Earned Income Exclusion (FEIE), which at that time amply covered the compensation paid to practically all U.S. citizens, including top management executives, deployed abroad. The object of this legislation was to tax the income of the few very wealthy U.S. citizens who were presumed to have moved abroad for the purpose of escaping higher U.S. tax rates. With the inclusion of this FEIE, American citizens, including those in top management positions, continued to accept overseas assignments. U.S. exports and the manufacturing jobs they created continued to grow while the U.S. balance of trade continued to be positive, as it had been every year since 1876.
However late in 1976 Congress enacted and President Gerald R. Ford signed the Tax Reform Act of 1976, which massively increased the U.S. taxation of Americans abroad, making it retroactive to January 1, 1976. The FEIE was reduced to the first $15,000 "off the bottom" at the lowest marginal tax rate, with all income above that amount taxed at the marginal rate that would apply had there been no FEIE. A parallel tax court decision at about that same time ruled that reimbursements of out-of-pocket expenses for tuition for dependent children English language education, excess cost of living, excess cost of housing, obligatory home leave, security guards in dangerous areas, and such that were the direct and inescapable result of being deployed abroad were classified as taxable income along with all "in-kind" employer supplied meals and housing in remote areas where nothing else was available. These reimbursements and in-kind income items remained tax free to US diplomatic personnel and other Federal Government employee abroad, but were defined as taxable income to private citizens.
The effect on U.S. citizens living and working abroad was an absolute disaster. Hundreds of thousands came home because they could not survive. Congressional hearings revealed that U.S. contractors, who were number one in winning highly competitive bids over foreign competitor companies for foreign project engineering and construction projects, were hit with skyrocketing costs for their U.S. citizen personnel. These were labor intensive projects, where the professional expertise of U.S. citizens was a key qualifying factor in the award of these contracts. As a direct result of this Tax Act these companies, in sworn testimony confirmed by a GAO on-site task force, suddenly had employees whose U.S. tax obligation now exceeded their salaries; leaving them with less than zero on which to live. That was the end of U.S. dominance of that market as well as a significant loss in U.S. goods exports since the foreign companies whose labor costs were consequently lower replaced U.S. sources with products from their own countries. In 1975 the U.S. recorded its largest trade surplus in its entire history. But with the collapse of U.S. competitiveness in bidding on foreign engineering and construction projects and the return to the U.S. of hundreds of thousands of other expats that had always ensured a U.S. trade surplus, U.S. citizens and firms abruptly abandoned formerly profitable markets that had been had been rendered unprofitable by this tax legislation.
The unanticipated negative consequences of this legislation were of such magnitude that more than one year after its effective date Congress retroactively postponed the effective date from January 1, 1976 to January 1, 1977. But the damage had already been done and with no idea what Congress would ultimately do, neither U.S. companies nor U.S. citizens were willing to go back abroad to address these markets in the blind hope that Congress would somehow "make things right." Ever since 1976 the U.S. has never again recorded a positive trade balance, and the cumulative foreign trade deficit, which began that year, now exceeds $8 trillion and continues to increase at an average of $1.9 billion per day.
Congress once again adopted the FEIE concept in 1981, but over the years the amount of the FEIE became a political football and did not keep up with inflation or economic reality. In 2006, Congress passed the Tax Income Prevention and Reconciliation Act (TIPRA), which prolonged the Bush tax cuts and introduced compensatory revenue raising measures aimed at Americans abroad. It introduced the stacking measure, which basically eliminates much of the double tax relief of the FEIE, and limited the housing exclusion.
5 This number is based on recent ratios of federal tax revenue as a proportion of GDP, i.e. 15 percent. Source: http://www.taxpolicycenter.org/taxfacts/displayafact.cfm?Docid=200.
6 President's Export Council, "Task Force to Study the Tax Treatment of Americans Working Overseas," Dec. 10, 1979, stated:
Americans working overseas are essential to a viable export program. An increase in the number of Americans assigned abroad can increase our exports, reduce the negative balance of payments, enhance our country's image, and raise employment in the U.S. Recognizing that it is in the best interest of our nation to encourage Americans to work overseas, the Task Force recommends the adoption of tax policies that are comparable to those of major competing industrial nations, none of which now tax citizens who meet overseas residency tests.
7 GAO, "American Employment Abroad Discouraged by U.S. Income Tax Laws" (ID-81-29), 1981, stated:
The competitiveness of U.S. exports in the world market has become a major national concern because of the deficit in the U.S. balance of trade that developed in the 1970s and its implications for real income and employment in the United States. This problem has the focus of major initiatives to improve Government export promotion programs and to identify and correct Government disincentives to exports. To adequately promote and service U.S. products and operations in foreign countries, U.S. companies employ a large force of U.S. citizens abroad. There is widespread concern that tax provisions contained in the Foreign Earned Income Act of 1978 are proving a disincentive to employment of U.S. citizens abroad, and, therefore, adversely affecting exports. A GAO survey of a group of major U.S. companies having substantial operations abroad revealed that U.S. taxes were an important factor in reducing the number of Americans employed overseas.
8 A full list of the reduced treaty tax rates by country and by type of income can be found in IRS Publication 515, starting on p. 39.
9 IRS and Treasury forms no longer needed to be filed by bona fide overseas residents:
- 1040 including all schedules;
- 1041, U.S. Income Tax Return for Estates and Trusts;
- 3520, Annual return to Report Transaction with Foreign Trusts and Receipt of Certain Foreign Gifts (except in the case of death of a bona fide resident overseas, in which case the return must be filed);
- 3520-A Annual Information Return of a Foreign Trust with a U.S. Owner;
- 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations;
- 8520-A, Annual Information Return of Foreign Trust with a U.S. Owner;
- 8621, Return by a Shareholder of a Passive Foreign Investment Company or a Qualified Electing Fund;
- 8865, Return of U.S. Persons with Respect to Certain Foreign Partnerships;
- 8891, Beneficiaries of Certain Canadian Registered Retirement Plans;
- 8814, Parent's Election to Report Child's Interest and Dividends (if your dependent child is also a bona fide overseas resident);
- 8938, Statement of Specified Foreign Financial Assets (FATCA); and
- TD F 90-22.1, Report of Foreign Bank and Financial Accounts (FBAR), filed with the Department of the Treasury.
This list is indicative, not exhaustive.
10 IFC Section 2103 taxes estates of non-resident foreigners at the maximum U.S. estate tax if the total amount of U.S. investments (real property or securities) exceeds $60,000. This extension of U.S. law to estates of foreigners is discouraging foreign investment in the United States. Congress should consider repealing this law which works against the interests of the nation.
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