Begin with the End in Mind

If you want to get somewhere, you must know where you’re going. This simple concept is so important that Stephen R. Covey made it the second of his Seven Habits of Highly Effective People. This is especially true when it comes to advocating for the end to American extraterritorial taxation. Several groups have been pushing lately for “RBT” or Residence Based Taxation without clearly defining what they mean by that term. A clear and concise definition is necessary to ensure that the end product (legislation or regulation) achieves all of the desired results.

Under pure RBT the Internal Revenue Code would not claim jurisdiction to tax individuals who live outside the US except to the extent that they have US-source income; citizenship would be irrelevant. Some recent proposals that are being called RBT would not achieve this. These proposals continue US jurisdiction over individuals based on citizenship (citizenship-based taxation or CBT) with a carve out for certain types of non-US income which would be exempt from US taxation. Essentially, they propose an expansion of the current Foreign Earned Income Exclusion that would extend to other types of foreign source income. Significantly, they require continuing compliance in the form of annual certifications. Furthermore, these proposals are not clear about exemptions to various information reporting required under both the Internal Revenue Code and the Bank Secrecy Act. It is essential that Congress and those advocating for change understand the difference between pure RBT and mere reform of the current CBT regime. Given the difficulty of getting Congress to even consider the US tax problems of Americans abroad, it is essential that pure RBT be incorporated in their reforms.

UPDATE: John Richardson and Karen Alpert discuss this post in the following podcast:

What RBT Is

In it’s clearest and simplest form, RBT is the principle that only actual residence confers on a country the right to treat an individual as a tax resident, subject to all of the domestic tax rules including taxation of income sourced outside of the country. Citizenship on its own should not be sufficient to confer jurisdiction to tax (or require disclosure of) non-US source income or assets. An individual should be able to be subject to the full tax code of only one country at a time so that they can take advantage of the tax incentives offered by their country of residence and invest for their future. A non-resident should not have to worry about changes to US domestic tax law that might have adverse consequences to their non-US income or assets. Under RBT, US citizens living outside the United States are not part of the US tax base at all. SEAT co-founder John Richardson has defined RBT clearly in this post on his CitizenshipSolutions website.

RBT is practiced by every other developed country on the planet. It is also practiced by all US states with an income tax.

What RBT Isn’t

Any proposal that requires ongoing US tax compliance, even if it’s much simpler than current compliance requirements, is not RBT. Recent proposals do not follow the principle that the jurisdiction of the tax system should depend on residence, not citizenship. Much of what is being called “RBT” treats US citizens living outside the United States as part of the US tax base, then exempts their non-US income from US taxation. Most of these proposals include annual filing, if only to claim eligibility for the exemption of non-US income. These annual filing requirements effectively concede that non-resident citizens are still part of the US tax base. If there are filing requirements, then future changes in US domestic tax law can have adverse consequences for US citizens abroad. These proposals are not pure RBT. Because these proposals do not take the position that non-residents are outside of the US tax base, they are actually citizenship-based taxation (CBT) with a carveout for certain non-US income. Essentially, they reform CBT to make it work somewhat better.

Why RBT is essential

The current US citizenship-based taxation system has created myriad unintended consequences for Americans who have emigrated to other countries. These have been widely documented. Here are some of the most egregious examples:

Transition Tax and GILTI

When Congress passed the Tax Cuts and Jobs Act (TCJA) in late 2017, it included several provisions that changed the way the US taxes “controlled foreign corporations” (CFCs). Much of the discussion at the time was about the impact of these changes on large multinational corporations. However, the definition of CFC includes any non-US corporation owned by “US Shareholders”, including small corporations owned by US citizens living outside the United States. A dentist in Melbourne, a yoga studio in Toronto, or a small construction company in Paris could all be considered CFCs if they were organized as a corporation and owned by US citizens. Pre-TCJA, running a small business through a corporation was often tax-effective for both US tax and local tax. However, TCJA made no distinction between these businesses and the non-US subsidiaries of Apple, Amazon, or Google. Under the §965 Transition Tax, CFCs were required to pay a one-off US tax on their accumulated earnings since 1986 – even if these earnings had not been distributed to the shareholders and if the corporation did not have the liquid assets to make such a distribution. If not handled carefully, this could easily generate a timing difference between US and local tax which could mean that the foreign tax paid was not available as a foreign tax credit to offset US taxes due. Then, from 2018 forward, TCJA created a new category of income called Global Intangible Low-Taxed Income (GILTI), which was taxable to US shareholders of CFCs even though there may not have been any actual distribution of income. Pure RBT will avoid this type of problem in the future as non-residents will be outside of US tax jurisdiction, and will, therefore, not be treated as US Shareholders. All CBT reform proposals to date have either been silent on the application of CFC rules to US Shareholders living outside the US, or have left the CFC tax and reporting regime in place.

PFICs

Passive Foreign Investment Companies (PFICs) are defined in §1297 of the Internal Revenue Code. Many collective investments (mutual funds, managed funds, listed investment companies, exchange traded funds, etc.) are treated as PFICs by US tax professionals. The PFIC rules either apply a confiscatory tax rate plus daily compounded interest on the deemed tax deferral OR require annual inclusion of unrealized capital gains in US taxable income. The result is that it is not possible for non-US residents to invest in local markets (and local currency) in the same way that US residents can. Investment returns are diminished by not allowing “deferral” of capital gains income until a realization event occurs. Furthermore, the reporting requirements for PFICs are over the top. The IRS estimates that preparation of Form 8621 will take over 20 hours, with an additional 17 hours for recordkeeping and 11 hours to learn about the law. A separate form is required for each investment, so PFICs are a real boon for the tax compliance industry. Pure RBT will eliminate PFIC reporting for non-residents as they will be outside of the US tax system. Current CBT reform proposals are silent about any change to PFIC reporting requirements, although they would presumably exempt PFICs owned by nonresidents from US income tax.

FATCA

The passage of FATCA in 2010 and it’s worldwide implementation in 2012-2015 has caused many non-US banks to limit the banking products available to US citizens, even those who are also citizens of the country where they live and bank. With pure RBT, the US no longer claims tax jurisdiction over non-residents, so FATCA reporting would be limited to actual residents of the US. CBT reform may or may not exempt non-residents from the effects of FATCA.

Other Changes

Americans living overseas must keep up with changes to the US tax code that are rarely publicized outside of the US:

  • In the individual tax provisions of TCJA Congress eliminated the personal exemption while greatly increasing the standard deduction. This might seem to be a positive change, but there was a little known (and probably unintended) interaction with the filing requirements set out in §6012 which requires a return from most taxpayers when gross income exceeds the sum of the standard deduction and allowable personal exemptions. For those with a filing status of Married Filing Separate (MFS), however, a return is required whenever income exceeds the personal exemption. Now that personal exemptions are zero, this means that anyone using the MFS filing status must file a return even if their income is zero. Fortunately, the IRS realized the insanity of requiring returns with zero income and raised the threshold from zero to $5.00!

    Note that this is neither a trivial nor an inconsequential matter. The requirement to file a tax return would (assuming the thresholds are met) also trigger the requirement to file Form 8938. Form 8938 is a form which requires the disclosure of foreign financial assets, including assets that may be jointly held with a non-US citizen spouse). To put it simply the requirement to file a return with as little as $5 of gross income could result in the transmission of information about jointly held assets to the IRS.
  • In the early 2000s Congress increased the penalties for failure to file FBAR (reporting foreign bank accounts). Prior to the penalty increase, many taxpayers were unfamiliar with this requirement. Those who weren’t following US tax news were often still unfamiliar with the FBAR requirement until their foreign bank started informing them of their US tax obligations due to FATCA.
  • In 1997 the US changed the tax treatment of gains on the sale of a principal residence. Under the prior rules, taxpayers could roll gains into a new residence under certain conditions, otherwise the entire gain was taxable. Under the new rules, gain is taxable in the year of sale with an exemption of $500,000 on a joint return if certain conditions are met. These rules apply to principal residence regardless of location, so those living in countries such as Canada or Australia where capital gains on the sale of a principal residence are exempt are often caught out. And those who left the US prior to 1997 may not be familiar with the new rules.

In short, every time Congress changes the Internal Revenue Code there is the possibility that US citizens abroad will be adversely affected because Congress does not consider the impact of US tax rules on non-resident citizens. As long as non-residents have any ongoing filing requirement, they will be potentially subject to unintended consequences of changes to the Internal Revenue Code.

Individuals ought to be able to emigrate from the US and not be afraid of the IRS or US tax rules for the rest of their lives.

Implementing Pure RBT

One of the main objections raised to pure RBT in the US is the fear that high net worth individuals will establish residence in tax havens and avoid taxation completely. Other countries deal with this issue in different ways. Some make it difficult (but not impossible) to break tax residence, often by using the concept of domicile to define residence. Some apply a departure tax on appreciated assets when tax residence is severed. Some do both. Implementing RBT, then, will require a close look at what constitutes residence and what happens when residence changes. A good first cut as to how RBT could be written into the Internal Revenue Code is in this post by John Richardson.

Residence

While all developed economies practice RBT, there are a variety of ways that residence, and therefore jurisdiction to tax “foreign” income, is determined. For a summary, see the first section of the recent online panel discussion that included three of SEAT’s founding directors. Some countries are quite “sticky” and require some effort to break tax residence. A sticky definition of residence, such as domicile, is one way to ensure that it is more difficult to “game the system.” But even for countries with sticky tax residence, it is possible to sever tax residence without renouncing citizenship. If the US were to move to RBT, it is quite likely that Congress would want to add something like domicile or the “ordinarily resident” concept used by Canada and Australia to the definition of residence in §7701(b). Day-counting rules such as the current substantial presence test are good for quickly catching people who move in to the country. More subjective tests such as domicile and ordinarily resident are good for keeping people in the system until they clearly establish residence elsewhere. Many countries use both.

Loss of Residence

Many countries are concerned about the potential loss of tax base when wealthy individuals move away from their jurisdiction. Given international norms on sourcing capital gains, unrealized gains on personal property (including investments) at the time of departure are often taxed only by the destination jurisdiction. Under CBT, the US Exit Tax (§877A) imposes tax on certain unrealized gains when US tax jurisdiction is lost (e.g., when citizenship is renounced). The main problem with the US Exit Tax is not that it exists, but the point at which the tax is measured and levied. Because the US claims tax jurisdiction over non-resident citizens, the current Exit tax is often levied years or decades after the individual left the US, and the assets covered include assets accumulated, earned, and taxed in the destination country. Other countries, including both Canada and Australia, have departure taxes. The difference is that these taxes are levied and measured at the time tax residence is severed. Therefore these departure taxes capture gains accrued while actually resident in the country. Pure RBT is not inconsistent with a departure tax. In Part E of John Richardson’s recent post describing how Pure RBT might work, he proposes that §877A be amended to be triggered on loss of US tax residence rather than loss of citizenship. Furthermore, requiring notice on severing of tax residency gives those who prefer the current system the option to remain in that system – all they need to do is to keep filing as residents while not giving notice of loss of US tax residence. The recent CBT reform proposals have either been silent on how §877A might change, or they have proposed a new departure tax while leaving §877A intact to apply again on loss of citizenship.

Transition Rules

As with any major change to the tax system, there will need to be transition rules to deal with those individuals who are already resident overseas. Many of these non-resident US citizens, such as the Accidental Americans, should never have been in the US tax base in the first place. Others left the US years or decades ago and have set up their financial lives without any consideration of US tax rules. To expect these individuals to pay anything to “exit” the US tax base is absurd. Pure RBT should let non-residents be non-residents. There should be no requirement to first come into US tax compliance, or to pay an exit tax.

Conclusion

Getting the attention of Congress to address the US tax problems of non-resident citizens is not easy. It’s important the this reform to the US tax system be done right the first time. This is why it is very important to be clear about what the goal is. Pure RBT recognizes that non-residents are not under US tax jurisdiction; their non-US assets and income are properly outside of the US tax base, and once residence is properly severed no further US tax compliance is required. Only pure RBT will address the US tax problems faced by all individuals living outside the US, including US emigrants and Accidental Americans, allowing them to invest, bank, and arrange their financial affairs under the tax laws of a single country – the country where they live. That is, pure RBT is the ONLY solution that solves the problems of ALL individuals and groups impacted. CBT reform that falls short of this goal will mean that US emigrants would be looking over their shoulders at the IRS and US tax law changes for the rest of their lives.

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