By Debbie Jennings, National Taxpayers Union Foundation
With less than one month until the presidential election, former President Donald Trump just announced that he would ease the tax burden for Americans abroad.
American citizens living and working abroad have long faced tax challenges that far exceed those of domestically-based taxpayers. The extra tax compliance burdens imposed on Americans abroad are so cumbersome that the National Taxpayer Advocate regularly cites this issue as one of the ten most serious problems encountered by taxpayers annually.
The United States is the only major country to use citizenship-based taxation, levying income taxes on individuals that may not live in nor earn any income in the U.S. This system contrasts with residence-based taxation (RBT), which is used by the rest of the world and operates on the principle that only residents in a country should be subject to its income taxes.
The upcoming election and the expiration of important provisions of the 2017 tax reform provides an opportunity to seriously discuss how to alleviate the burdens of citizenship-based taxation faced by American taxpayers by switching to a RBT system.
Deep Roots In U.S. Tax Code History
The use of citizenship-based taxation in the United States is nearly as old as the federal income tax itself, which was established through the Sixteenth Amendment to the U.S. Constitution and the subsequent Revenue Act of 1913. Citizenship-based taxation was deemed acceptable by the U.S. Supreme Court in the case Cook v. Tate (1924), when a U.S. citizen (Cook) challenged tax on his income that was solely derived in Mexico while he was living in Mexico. In its ruling, the Court stated that:
The basis of the power to tax was not and cannot be made dependent upon the situs of the property in all cases, it being in or out of the United States, nor was not and cannot be made dependent upon the domicile of the citizen, that being in or out of the United States, but upon his relation as citizen to the United States and the relation of the latter to him as citizen.
As the world has developed, nearly every other country has adopted a tax system that is residence-based rather than citizenship-based, leaving Americans as the only nationality aside from Eritreans who are subject to their home country’s taxes while earning income abroad.
Problems with Citizenship-Based Taxation
According to recent estimates, there are at least 5 million Americans living abroad, with some estimating up to 9 million. Some of these taxpayers are “Accidental Americans,” meaning that they have U.S. citizenship due to having American parents, but may have never even been to the country.
For example, former British Prime Minister Boris Johnson, who was born in the U.S. to British parents but moved out of the country when he was five years old, famously reported owing U.S. capital gains tax on the sale of his first home in England, despite not owing British taxes on the sale. Johnson eventually renounced his U.S. citizenship, which is the only way to legally put a stop to U.S. tax liabilities as an American abroad.
Americans abroad often need legal assistance to navigate the U.S. tax code and complex requirements as described below, incurring significant costs. These citizens also face taxation without representation, as many states do not extend voting rights to Americans abroad. Due to being outside of the country, these taxpayers also have virtually no access to IRS services, such as the Volunteer Income Tax Assistance (VITA) and Tax Counseling for the Elderly (TCE) programs.
FATCA Exacerbated these Difficulties
While citizenship-based taxation has long been an injustice to Americans living abroad, the Foreign Account Tax Compliance Act (FATCA) of 2010 made the system immensely more burdensome for these Americans. FATCA requires financial institutions abroad to report information about U.S. citizen account holders to the IRS and likewise imposes reporting requirements on the citizens abroad themselves.
FATCA not only imposes overly burdensome requirements, but also comes with harsh penalties for noncompliance. Foreign financial institutions that fail to report on Americans’ accounts can be subject to a 30 percent withholding fee, causing some foreign banks to deny Americans service for fear of IRS retaliation. Individuals who do not report foreign financial information can face a fine of up to $10,000.
While FATCA was originally intended to target high-income individuals engaging in tax evasion abroad, it is extremely burdensome for any American who resides abroad. Requiring the disclosure of financial information is a step well beyond merely collecting taxes due under a citizenship-based tax system. In addition, FATCA’s requirements can be duplicative of those under the foreign bank account reporting (FBAR) requirements of the Bank Secrecy Act of 1970.
Furthermore, there is evidence to suggest that FATCA is ineffective at achieving its stated goals. The Treasury Inspector General for Tax Administration (TIGTA) has found that FATCA is highly expensive to administer and there has been no cost-benefit analysis of the program. The Senate Finance Committee under Chairman Ron Wyden (D-OR) has also been investigating potential loopholes in the law.
Residence-Based Taxation Would Alleviate these Burdens
While FATCA poses a major problem for Americans abroad, it is important to remember that this law merely exacerbated the issues of an illogical and cumbersome citizenship-based tax system. Moving towards RBT would bring the tax compliance of Americans abroad in line with every other major country in the world.
RBT in its most basic form would tax U.S. citizens based on where their income is earned, thus only levying a tax on U.S.-sourced income. This would involve updating the Internal Revenue Code to account for U.S. residents rather than citizens in certain income tax situations and defining transition rules for those seeking to terminate their U.S. tax residency.
Residence-based systems must first define tax residents, with countries often relying on the “183 day rule” that stipulates that an individual is a tax resident if he spends 183 days or more in the country during the tax year. Many residence-based systems tax residents on their worldwide income, but include certain foreign tax credits to avoid double taxation.
A recent proposal from the group Tax Fairness for Americans Abroad includes several features to transition the U.S. to a residence-based system. This plan would allow citizens abroad to elect to terminate U.S. tax residency while maintaining citizenship, provide relief from burdensome filing requirements, and preserve taxation of U.S.-sourced income. It would also prevent changes of residency from facilitating tax avoidance and would allow for revenue neutrality.
In addition, there are currently several pieces of legislation that have been introduced to deal with tax issues for Americans abroad. These bills would establish a commission to study the issue, exempt individuals from FATCA reporting if they reside in the same country as their foreign financial institution, and create a way for citizens abroad to avoid burdensome filing requirements if they owe no U.S. income tax.
Reform Crucial for Post-Pandemic Workforce
The increase of individual mobility after the COVID-19 pandemic and the upcoming tax reform debate of 2025 present an opportunity to fix problems that are as old as the tax code itself. Shifting the U.S. tax code away from a citizenship-based system toward a residence-based system would sensibly align the country with the rest of the world and ease the immense tax burdens imposed on expats. Several proposals exist, ranging from studying the issue to ending citizenship-based taxation. Americans abroad deserve to finally get relief from Congress.
Debbie Jennings is the Policy Manager at the National Taxpayers Union Foundation.