Bill Proposes New Taxation Standard for Americans Abroad

Glen E. Frost, Esq., CPA, CFP®

Mary Lundstedt, Esq.

On December 20, 2018, Congressman George Holding (R-North Carolina) introduced the Tax Fairness for Americans Abroad Act of 2018 (H.R. 7358) (TFAA)—a long-awaited residency-based tax bill with the very real potential to provide the framework necessary to ultimately replace the current US citizenship-based taxation regime. As drafted, TFAA would be applicable to taxable years beginning after the date of enactment of TFAA.[1]

Presently, the U.S. maintains an antiquated approach to taxing its citizens. Contrary to the vast majority of the rest of the world’s standard of taxation, or "residency-based taxation" (RBT)—where a country taxes its nonresidents only on income earned within that country—the U.S. taxes citizens on the basis of citizenship (citizenship-based taxation, or CBT). So, whether a US citizen earns income in the U.S., or while residing abroad, the U.S. requires its citizens to report and pay taxes on their worldwide income. Incredibly, even "accidental Americans"—individuals who may have been born in the U.S., or have a U.S. parent, but never themselves lived in the U.S.—find themselves targets of CBT.

Establishing RBT means that Americans living abroad would experience significant relief from the burdens associated with the current requirement to report and pay taxes on their worldwide income. Under the current system, Americans living abroad experience increased compliance costs and increasingly complex regulations and filing requirements. Unlike their domestic counterparts, Americans abroad file US income tax returns with complex calculations accounting for such things as foreign currency translation and the foreign tax credit. The current system exposes Americans living abroad to high instances of double taxation, the frequent inability to establish foreign banking and investment access, bankruptcy, and even pressure to choose renunciation of US citizenship.

Furthermore, Americans in general would benefit from RBT. With less paperwork for the IRS to produce, receive and process, all Americans could experience a more efficiently run IRS—one that is less administratively backed up and wastes fewer taxpayer dollars on unnecessary work.

Although TFAA, as drafted, would not definitively establish RBT—some Americans abroad will simply not qualify for its benefits—it is a promising step forward. As such, the framework it proposes deserves careful consideration herein.

Tax Fairness for Americans Abroad Act of 2018 (H.R. 7358)

Under the TFAA, a newly proposed Internal Revenue Code (IRC) §911A ("Alternative For Nonresident Citizens Of The United States Living Abroad"), would operate in conjunction with existing IRC §911 and amend existing IRC §7701 to provide an alternative to the current CBT for nonresident US citizens. Accordingly, nonresident US citizens, who are able to elect to be taxed as a "qualified nonresident citizen" (QNC), would be exempt from US taxation on specified foreign-source income while residing abroad. QNCs, however, would remain subject to tax on all US source income.

Qualification

In order to qualify for this alternative, a US citizen must first be considered a "nonresident citizen."[2] The TFAA would amend IRC §7701(b) by adding a section defining a nonresident citizen as being an individual who:

  1. is a U.S. citizen
  2. has a foreign country tax home
  3. is in full compliance with US income tax laws for the 3 previous taxable years, and
  4. either—
    1. shows that he/she has been a bona fide resident of a foreign country or countries for an uninterrupted period which includes an entire taxable year, or
    2. is present in a foreign country or countries during a minimum of 330 full days during such taxable year.[3]

An individual meeting this definition of a nonresident citizen may then elect to be treated as a QNC. The TFAA would define a QNC as a nonresident citizen, with respect to a taxable year, has not made the existing IRC §911 election for such taxable year, and instead makes the election under the newly proposed IRC §911A.[4]

Foreign-Source Income

Again, once qualified as a QNC, the individual may exclude foreign-source income from gross income. Thus, they will be exempt from taxation on their foreign-source income, earned and unearned, as discussed below.

Under the TFAA, foreign-source earned income generally maintains the same meaning as that provided in existing IRC §911, subject to two modifications. First, new IRC §911A(b)(3)(A) would disregard the annual exclusion amount. Second, amounts received would be considered earned income received in the taxable year when the services are performed, rather than the period during which the individual meets the "bona fide foreign residence test" or the "physical presence test."[5]

Per TFAA’s proposed IRC §911(A)(b)(4), foreign unearned income includes all income other than foreign earned income that is sourced outside the US. A limited exception exists with respect only to income from the sale of personal property. According to the new rule, only the portion of gains on personal property attributable to periods during which the individual was a QNC will be excludable.[6]

Filing Considerations

As the bill is written, most QNCs would have dramatically simplified Forms 1040, U.S. Individual Income Tax Return—or no obligation to file one at all, in some cases. Since filing thresholds are derived from gross income, and TFAA would exclude foreign source income from gross income, Americans abroad would simply determine and report their US source income and use the appropriate threshold. In the case where no income tax return is required because an individual lacked the minimum amount of gross income (for 2018, $24,000 for married filing jointly), the individual would still need to make the required election and annual certification that he or she remains in compliance with the eligibility requirements.

TFAA does not explicitly address whether or not information returns will still be required. Without more, the filing requirements remain in place for forms such as: 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations; 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships; 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts; 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner; 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.

Interestingly, however, with regard to one information return, Form 8938, Statement of Specified Foreign Financial Assets, the filing of an election to claim new IRC §911A treatment arguably eliminates the requirement for filing Form 8938. Currently, an individual must file Form 8938 if he or she maintains an interest in a specified foreign financial asset, and the aggregate value of the assets exceeds the applicable reporting thresholds. Note that if an individual is not required to file an income tax return for the tax year, then there is no requirement to file Form 8938, regardless of the value of assets. Since the filing of an election to claim new IRC §911A treatment would, in some cases, eliminate the need to file an income tax return—the requirement to file Form 8938 may also be eliminated.

Note that TFAA does not implement any changes applicable to Foreign Financial Institution reporting under the Foreign Account Tax Compliance Act (FATCA), nor does it eliminate Foreign Bank Account Reports (FBAR) requirements under the Bank Secrecy Act.

Note to Small Business Owners

The Tax Cuts and Jobs Acts of 2017 (TCJA) amended IRC §965 in order for the US to transition to a participation exemption system.[7] The amendment subjects certain foreign corporations to a one-time mandatory repatriation of accumulated, untaxed, post-1986 deferred foreign income. If a corporation is a deferred foreign income corporation (DFIC), then it must increase its subpart F income by the amount of its accumulated, untaxed, post-1986 foreign earnings and profits.[8] A DFIC is any specified foreign corporation with accumulated, untaxed, post-1986 deferred earnings and profits as of the measurement dates—i.e., November 2, 2017, and December 31, 2017.[9] Generally, a US shareholder of a DFIC may expect to be subject to the transition tax—increasing their subpart F income inclusions under IRC §951(a)(1) by their pro rata share.

As drafted, TFAA does not amend the international corporate transition tax. However, since certain pre-effective date foreign earnings must be treated as DFIC subpart F income in the last taxable year beginning before January 1, 2018, such income would apparently be excludable as foreign unearned income.

Conclusion

Although TFAA as drafted would not result in a definitive RBT system, it’s a game-changer with the potential to finally bring relief to Americans abroad. Ultimately, an RBT system would provide significant relief from the burdens our current system imposes on Americans abroad. It would dramatically cut compliance costs and reduce complicated filing requirements. It would also decrease their exposure to high instances of double taxation, and relieve them from the frequent inability to establish foreign banking and investment access, bankruptcy, and even pressure to choose renunciation of US citizenship. Finally, Americans in general would benefit from RBT. With less paperwork for the IRS to produce, receive and process, all Americans could experience a more efficiently run IRS—one that is less administratively backed up and wastes fewer taxpayer dollars on unnecessary work.

For more information, go to the American Citizens Abroad website.

Glen E. Frost, Esq., CPA, CFP®; is Associate Legal Counsel, American Citizens Abroad.

Special thanks to Marylouise Serrato, Executive Director, American Citizens Abroad, Charles Bruce, Legal Counsel, American Citizens Abroad, and Jonathan Lachowitz, Chairman and Financial/Tax Team Director, American Citizens Abroad.


[1] TFAA, new IRC §911A(c).

[2] Note that the TFAA does not apply to IRC §7701(b)(1) resident aliens.

[3] TFAA, new IRC §911A(b), which would add new IRC §7701(b)(C). Note that newly proposed IRC §911A(b) would also add new IRC §7701(b)(D) to exclude Federal employees from the definition of nonresident citizen.

[4] TFAA, new IRC §911A(b)(2).

[5] TFAA, new IRC §911A(b)(3)(B).

[6] TFAA, new IRC §911(A)(b)(4)(B). Presumably personal property is tangible or intangible personal property.

[7] Pub. L. No. 115-97, §14103.

[8] IRC §965(a); Prop. Reg. §1.965-1(b)(1).

[9] IRC §965(d)(1); Prop. Reg. §1.965-1(f)(17)(i).