What Americans need to know when living abroad
In an ever increasing globalised world, more and more people are finding themselves working outside their home countries. There are estimated to be over 9 million US citizens living outside the United States (according to the US State Department in January 2020). No matter where you work in the world, if you hold a US passport or possess a Resident Alien Card (green card), there are crucial things you need to know when improving your financial wellbeing.
Let’s go through these one by one.
Understand the US Citizenship-based taxation system (CBT)
What do North Korea & The United States have in common? They have a citizenship-based taxation system (CBT) instead of a residency-based taxation system (RBT) like most other countries. This means that wherever you live or work (and even if you have never lived in the USA) you must file US taxes.
Here’s an example to illustrate the difference between both systems:
Residency Based Taxation
First, let’s start with the Residency-based taxation system. Let’s say you are an Irish executive and you get a job working for a company in Dubai and you move your family there. Assuming you do not leave certain situs property behind, like a rental property then your tax reporting and payments to Ireland stop and you now become a tax resident and pay your taxes in the United Arab Emirates.
Citizenship Based Taxation
Secondly, compare that to the Citizenship-based taxation system. Let’s say we have a Taiwanese national who is an independent film producer working in California and because of this she holds a green card. Later she moves to Singapore to work. She decides she does not want to give up her green card because she wants the option to return some day to the United States to work. Well by taking that action, our artist will have to continue to file an annual US tax return.
A CBT system requires that their citizens check in each year and file a tax return to report their worldwide income. They will also obviously be filing tax returns in their host country and paying required taxes there. However, for US persons abroad, if those taxes are less than what would be required in the US, then the likelihood is additional taxes would be due to the United States.
So citizenship based taxation is the root cause of why Americans and green card holders living outside the United States have a complex set of rules to follow. Not only are they required to file an annual US tax return but they must also disclose all non-US bank accounts and financial products held including cash value life insurance policies.
In contrast to residency-based taxation, Americans living abroad with certain income must file US Taxes each year regardless of where they live or work.
2. Understand how FATCA regulation affects your financial life
The United States Foreign Account Tax Compliance Act (FATCA), passed in 2010 requires all financial institutions around the world must provide detailed information about their US clients. This means that financial institutions will be required to investigate their client’s status, send information to the US tax authorities (IRS) and even withhold money when appropriate.
Let’s start with a quick history lesson.
The US tax administration (IRS) has always had tremendous difficulties obtaining satisfactory compliance from US Citizens & Residents Abroad because no US tax forms are issued by foreign entities so no matching is possible. So in the late 90’s, the IRS instituted Qualified Intermediary (QI) agreements. This coerced most foreign financial institutions to sign on and begin to incorporate know-your-client rules. Since almost everyone needs a bank account, it was viewed by the IRS as an effective way to monitor US person’s activities outside the country.
Qualified Intermediary agreements had to be signed by any bank in the world doing business in the US. Banks agreed to provide information about their US clients if and when requested to do so. However, since there was a high degree of coercion, banks resisted as much as possible in being forthcoming with the information. Compliance was very difficult to monitor and enforcement almost impossible.
Swiss banking secrecy took a hit after the introduction of FATCA regulation.
Then in 2007, an event took place that from the IRS’s perspective was ‘’the straw that broke the camel’s back’’. The Swiss bank UBS was found guilty of assisting wealthy US clients in setting up secret accounts and evading taxes. UBS agreed to pay 780 million dollars in fines, interest and restitution but more importantly the bank agreed to turn over the names of 4,450 US account holders. Swiss bank secrecy was delivered a major blow.
The UBS case came about due to a US employee at the bank, Bradley Birkenfeld providing detail information on how UBS promoted tax evasion. More than 33,000 US taxpayers have so far confessed to holding undeclared accounts and over $ 5 billion in back taxes, interest and penalties have been collected. Although convicted on one count of conspiracy and serving 30 months in jail, after his release Mr. Birkenfeld was awarded $ 104,000,000 for his whistleblowing efforts !
So it was apparent to US legislators that new rules were needed to better assure information sharing. The market collapse of 2008 also put more pressure on governments to find new revenue sources. In 2010, the FATCA amendment was added to the H.I.R.E. (Hiring Incentives to Restore Employment) bill and passed by the US Congress.
History lesson over, how does FATCA work?
To achieve its objective, FATCA requires all FFI’s (Foreign Financial Institution) to provide information to the IRS about their US account holders/investors. An FFI includes any non-US entity who
Is engaged in banking or similar business.
Holds financial assets for the accounts of others as their primary function of their operation.
Is in the business of investing, reinvesting or trading securities, partnership interests or commodities or
Is in engaged in certain insurance related activities.
Americans living abroad are more limited in their options, but can invest and work on their financial future.
The definition of FFI is intentionally broad to encompass both non-US banks and insurance companies but also hedge funds and private equity funds. An FFI must decide to enter into an agreement with the IRS to become a participating FFI or refuse and be classified as a non-participating FFI. During the second half of 2013, the IRS opened their FFI registration system and by June 2014 the first list of PFFI’s was published.
So what does it mean to be classified as a non-participating FFI ? Well, this is where the IRS is pulling out their ‘’velvet glove’’. Any such entity will be subject to a 30% withholding tax on US source payments it receives. Withholdable payments include interest, dividends, rents, royalties, salaries, wages, licensing fees, annuities and any gross proceeds from the sale of US property. It would be extremely difficult to operate as a non-participating FFI considering the size of the US financial markets and that other participating FFI’s would find additional reasons to not deal with them.
The impact of FATCA
Let’s begin by commenting on this US law and how it is requiring implementation in other sovereign countries. This has been one of the most hotly debated aspects of FATCA. How can the US Treasury Department demand financial institutions in other countries to implement and enforce their laws ? The unilateral imposition of FATCA has been seen as an abrasive force by one country to accomplish their goals.
FATCA regulation is contested both in the US and around the world.
Constitutional scholars in various countries have argued that FATCA infringes on privacy rules and basic constitutional rights. US Senator Rand Paul introduced a bill calling for the repeal of FATCA and some Canadian politicians called for their government not to sign on. However, this resistance has been overshadowed by a stronger consensus that governments worldwide agree on the importance of deterring tax evasion. So although FATCA has its faults, the drive to force more transparency in the world financial markets appears resilient and here to stay.
At the G-8 Summit in spring of 2013, David Cameron, the Prime Minister of the United Kingdom and host of the Summit had global tax evasion as a top priority topic on the agenda. Several European countries at the same time expressed their intent to introduce FATCA-like agreements for information sharing to drive transparency.
Now that you know how FATCA works & how it came to be, let’s look at two examples.
Being accidentally American
Americans moving abroad
Being accidentally American
In Canada there are approximately one million people in the country, mostly Canadian citizens who have connections to the United States in one way or another. Some are ‘’accidental Americans’’, those who were born in Canada to parents who were US citizens, some who left the US years ago thinking they automatically renounced their US citizenship when they became Canadian and ‘’border babies’’, children born in the US to Canadian parents who returned soon after birth. In all of these cases, FATCA and US tax filing requirements apply.
Let’s take a look at a hypothetical example of how things can get messy. Meet Bob and Sally Mapplethorpe who reside in Hamilton Ontario. Bob was born in Rochester, New York when his Canadian father worked for Eastman Kodak. The family moved back to Canada soon afterwards and Bob was raised in Canada and attended university in Toronto before marrying Sally and settling in Hamilton. Bob is a successful businessman and Sally teaches at a local college.
One day Bob gets a letter from his local banker. It states that during an audit conducted at the bank (for reasons of FATCA compliance) it was discovered on his Canadian passport that his birthplace was Rochester, New York. The bank determines that this means Bob holds US citizenship and therefore his name will be included on a list that will be made available to the US Department of the Treasury. A week later, Bob receives another letter from the Canadian life insurance company where he owns a number of cash value policies. They too inform him that they recognize him as holding US citizenship and that his name will be kept on a list of US policyholders.
Needless to say, Bob and his wife Sally are very confused and wonder what all this means. Bob decides to give our MDRT member Frank a call to discuss the situation. Frank is caught off guard when asked what all this means. Frank considers himself a Canadian licensed agent who only deals with Canadian clients. He decides to tell Bob and Sally not to worry that this is just a formality and does not have any affect on the plans they have put together.
A few months go by and a letter arrives addressed to Bob from the United States IRS. The letter announces that they have determined Bob to be a US citizen who has not filed past US tax returns or reported accounts at his Canadian bank and life insurance company. The letter goes on to access him $ 245,000 for back taxes owed and another $ 100,000 penalty for his unreported Canadian bank account.
Is this story realistic, could such a thing happen ? Yes, it could but results depend on the facts and circumstances of each case. In this story, Bob only spent a short period of time at birth in the United States and could qualify as an accidental American. Ideally, it would always be better to make a volunteer disclosure versus waiting to get an assessment letter from the IRS. The facts presented do show Bob to have been born in the United States so therefore he is a US citizen until he revokes it. Most likely there would be a fair amount of paperwork in order to expatriate including filing a number of years of past US tax returns and a formal process at the local US Consulate. Penalties may not apply based on these circumstances.
Americans who move abroad
Now let’s change the scenario slightly. Let’s say Bob (American) and Sally (Canadian) meet and marry in the United States where both start their careers. A decade into the marriage they make a decision to move to Sally’s home country and back to Hamilton, Ontario. Bob’s work continues to be successful and profitable and he decides to take Canadian citizenship. He does not give up his US citizenship but in his mind by becoming a Canadian, he no longer is an American.
Bob is becoming so integrated into his Canadian life that he no longer files a US tax return. He files each year and pays his taxes in Canada and comes to learn there are other expatriates from other countries who have immigrated to Canada and they have no more dealings with their home country. Bob feels comfortable that he is doing things right.
Now FATCA is passed and as Canadian financial organisations start to prepare for it, the same series of letters go out. Bob approaches a local financial advisor Frank who he has come to view as his trusted advisor. Frank still has no clue as to what is going on and instead of trying to learn more or advise them to seek expert legal advise on this matter, he tells them that the letters from the bank and insurance company were just procedural and nothing more would come of it. A few months later the IRS letter arrives and the assessment and the size of the penalties nearly knock him off his feet.
In this second scenario, the problem is more serious. The IRS has found him and he never took steps to come forward first with a volunteer disclosure. So to recap; Bob has not filed annual US tax returns and also not filed required foreign bank account reports (FBAR) disclosing his Canadian bank account and Canadian cash value life insurance policies. Plus there is an additional ticking time bomb in the fact that he owned some Canadian registered mutual fund investments.
So how does this situation get repaired ? The first thing Bob thinks about doing is marching down to the US Consulate in Toronto and turning in his US passport. Of course it is not that simple because in order to expatriate you must first be up to date with your US tax filing requirements. So he seeks the help of a US CPA and they begin to file past returns. They start with going back 6 years. Bob learns that all along there was a foreign earned income exclusion he could have claimed to wipe out some or most of the tax but unfortunately if you do not file a return you cannot claim the exclusion (currently $ 97,600 in tax year 2013). So then the CPA proceeds in applying foreign tax credits since Bob in fact paid higher taxes in Canada then what he would have had to pay in the United States.
Even if we assume the filing of past tax returns works there still remains a much more serious problem. Bob not only did not file past returns but he also did not complete mandatory FBAR’s to disclose all foreign bank and other financial accounts. If the total aggregated sum of those accounts exceeded $ 10,000 at any time during a calendar year, all those accounts must be reported on the form and submitted before June 30th of the following year. The IRS takes this matter very seriously since it involves the possibilities of money laundering and terrorist activities. This is reflected by the severe penalties for non-compliance. Non-willful violations expose the taxpayer to fines as high as $ 10,000 for each year they fail to report. However, willful violations are generally the greater of $ 100,000 or 50% of the maximum amount held in all non-US accounts during the year. To give an example of what that means; assuming the taxpayer held $ 250,000 in all non-US accounts for the past 4 years, the penalty would amount to $ 500,000 !
Additionally, since 2011 a separate FATCA Form 8938 must be filed with the income tax return reporting all foreign financial assets. These include all the accounts listed on the FBAR plus other financial assets not held in an account such as closely held corporation stocks, loans extended by the taxpayer, rental agreements and stock options. Not filing that form carries a potential additional penalty of $10,000 per year.
3. Know your options on how to improve your financial wellbeing
What you must do:
File all required tax forms & reporting requirements
PFIC’s should be avoided (in most cases)
What you can do:
Know the rules & seek advice before investing
Expatriation
American and green card holders residing outside the United States are beginning to realize that not understanding the rules is not going to protect them from a system being put in place that is designed to shine a spot light on their financial planning. If mistakes are being made they need to be addressed right away.
In 2009, the IRS established a series of Offshore Voluntary Disclosure Programs. This was done to encourage US taxpayers to come forward and disclose their non-US accounts in exchange for reduced penalties and avoid criminal prosecution. The program required taxpayers to file (or amend) income tax returns going back eight years disclosing any undeclared income and pay tax and penalties. Important to note, the taxpayer needed to submit a request to participate in the OVDP. This needs to be done before the IRS finds out about them or receives their name from the non-US financial institution. Along with the past tax returns, they must also file past FBAR forms.
PFIC’s
The story of Bob & Sally referred to a “ticking time bomb” with the fact that Bob had owned some Canadian mutual funds (i.e. mutual funds that are not registered in the United States). Why is this a major additional problem ? The reason is that the IRS has a special tax regime in how they handle investments that are classified as a PFIC (Passive Foreign Investment Company). A PFIC is defined as any non-US entity with 50% or more of its assets being passive and or 75% of its income being passive. Generally, all non-US investment funds that are formed as entities are PFIC’s. So a mutual fund investment, a variable or interest sensitive cash value life insurance policy not issued from the United States would qualify for PFIC status.
When PFIC legislation came into effect in 1986 it was trying to address the unfair tax advantages non-US investment funds had over US mutual funds. A non-US fund had the ability to roll up the gains in the fund until shares were sold. Contrast that to a US fund which must distribute each year its capital gains, interest and dividends and reports those figures on a 1099 tax form in order to maintain their tax transparency and avoid a two tier taxation for their investors (tax on corporate profits then tax on dividends distributed). 1099’s are also issued for various transactions taking place on life and annuity products. This allows the IRS to match up what has taken place against what the taxpayer is declaring on their return. Since matching is not possible with non-US products, the PFIC regime was put in place in 1986.
The end result is that the longer you hold on to a PFIC investment and the better it does, the worse off the investor would be. It is possible that over a 20 year holding period with a double digit annual investment return could wipe out the entire investment after these tax rules are applied. It would also require a sizable amount of additional paperwork that would need to be included on the US tax return increasing the complexity and cost of reporting. To top it all off, PFIC’s do not benefit from a step up in basis which may leave heirs of a US citizen holding these investments with a very unpleasant surprise.
Expatriation
The combination of citizenship based taxation, FBAR’s and PFIC’s have caused many Americans abroad to take pause and consider whether holding US citizenship is still the best thing for them to do. For some long time residents abroad with little or no further connections to the US and those accidental Americans, it could very well be the right time to give up their US citizenship (expatriation).
For high net worth individuals, however, a quick trip to the local US Consulate and turning in your passport is not going to relinquish one from the situation. This is the same for long time green card holders. They cannot just turn in their card or let it expire as the means to get out of the system. Since 1966 there have been expatriation tax rules under IRS Section 877.
FATCA regulation might scare many Americans living abroad, however being compliant is not an overwhelmingly difficult task.
