The rest of the world does not do what the IRS does.
American exceptionalism is a philosophy that refers to the special character of the United States as a uniquely free nation based on democratic ideals and personal liberty. Whether or not you subscribe to this ideology or not, America is at least exceptional in at least one other, if not infamous, manner. In this article, I will discuss just how onerous the US tax compliance burden is overall, and how it specifically burdens the individual with foreign sources of income, the most.
This article is not about tax rates or taxes paid, but rather how US law looks at US taxpayers where ever they may live, where ever they may earn an income. As a Ukrainian attorney with a Master of Laws in taxation, and Director of Tax Compliance at Parent & Parent LLP, I believe I am in a unique perspective to describe to you just how "foreign" the US taxation of foreign income is both to "foreigners" and to US expats with income streams from around the world.
US taxpayers, you are presumed to know everything about US tax law
Taxes affect lives of Americans like nothing else. Right at the hospital when providing information for a baby’s birth certificate, parents are asked to apply for a social security number for their child1. A lifelong tax journey begins with an assignment of this 9-digit number. Kiddie tax, payroll tax, excise tax, sales tax, use tax, property tax, employment tax, income tax, gift tax, generation skipping tax, and, finally, estate tax: a whole life cycle can be described using various names of taxes.
Uncle Sam not only follows you throughout your life. The IRS presumes that everyone’s profession is a tax preparer. Here are some statistics: 6.1 billion hours are spent each year by individuals and businesses to do their taxes and comply with the tax law2. According to the IRS, it takes in average 13 hours for a U.S. taxpayer to prepare a tax return3. Unsurprisingly, 59% of individual taxpayers pay professionals to prepare their tax returns4.
Living in one of the most developed economies of the world, most people in the U.S. are accepted this fate, this tax compliance as a reality. The rest of the world, in the meantime, doesn’t seem to be so obsessed with making the process of tax compliance as punishing. And it doesn’t necessarily mean people are paying less there — it just means the compliance burden is far, far less.
The rest of the world may not even file an income tax return
In some European countries a typical wage employee getting interest/dividend income throughout the year doesn’t even have to file a tax return. Tax withholding is an obligation of employers and banks, not taxpayers. Employee from our example would have to file a tax return only if he had income where no tax was withheld. Most typical examples of such would be rental income or receipt of a gift from a non-relative.
In the US, taxes are also being withheld by employers. However, this withholding has nothing to do with employee’s convenience. All wage employees in the US have to file a tax return to figure out whether their employer withheld too low or too much (to pay on top of the withholding or get its refund respectively). If a taxpayer had interest/dividend income, this income would also have to go on a tax return, with a taxpayer determining a tax bracket for dividends (reduced one for “qualifies and the standard for “non-qualified”).
If you have rental income, the IRS presumes you have increased sophistication
Reporting rental income is a whole different story. IRS is of an opinion, that every American should understand what the word “depreciation” means, and know that appliances he or she buys for a rental property should be depreciated over the years. So you can’t just offset rental income by a price of a new oven you buy. You have to determine what type of an asset for depreciation purposes it is, and expense a certain portion of its price throughout the amount of years applicable to the type of a depreciable property you have determined.
If you don’t have appliances to depreciate, it does not mean that you can forget about researching what is a depreciation. When you decide to sell your rental property, you would have to conclude that your rental property was a “section 1250 property”, calculate depreciation you should have taken in prior years, and determine the amount of capital gains based on it5.
Wouldn’t this sound awkward for a European? Well, maybe not for a person with an accounting background. But even the latter would be surprised to know that in America the one who makes a gift is responsible for taxes, not the one who receives it. And that a “final” tax return is being filed on behalf a dead person within 9 months of his/her death.
US taxation burdens individuals
From a professional standpoint, the reason for all the complexity described above is America’s heavy reliance on individual (as opposed to corporate) taxation. According to the latest statistics from the Organisation for Economic Co-operation and Development (OECD), individual taxes make 37.1% of U.S. tax revenue comparing to OECD countries’ average of 24.1%6. Government regulation of the country’s major revenue source just cannot be straightforward.
However, from a layperson’s view, it sounds like the government is simply delegating its job to its residents. Instead of simplifying things as it is being done in most developed countries, The Federal Government simply wants to see a tax preparer in everyone. Right from the day you are borne and up until 9 months after your death.
US tax compliance is a non-delagable duty; the taxpayer is always primarily responsible
To this point, Uncle Sam is specifically unfriendly towards immigrants/foreign workers coming to the U.S. and, vice-versa, U.S. citizens/green card holders expatriating and leaving the country to live abroad. This is all because they all fall under the category of a “U.S. resident”. In practice, this results in newcomers and expats being taxed on their worldwide (both U.S. and non-U.S.) income. And no matter how much you rely on a tax professional, the IRS still hold a taxpayer ultimately responsible for any errors. Below are some common errors and misconceptions of not just taxpayers, but common mistakes I see US tax professionals make about regarding the taxation of foreign income
Your "foreign" country's definition of income does not matter.
While worldwide taxation for U.S. residents is a fact that now, more US taxpayers are aware of, thanks to IRS’s Offshore Voluntary Disclosure Programs (OVDP), and FATCA8, there is something that majority of taxpayers do not take into account. It is the fact that the IRS doesn’t really care what your financial asset is according to the laws of your foreign country. The IRS looks at the whole world of foreign financial assets through the Internal Revenue Code (hereinafter – the Code) and its definitions. For example, if your income is tax-free bond in India, that does not mean it is tax-free for to the IRS.
US taxation of Foreign Certificates of Deposit
Do you have a certificate of deposit abroad and are waiting to tax the interest it will have produced in the year of the certificate’s maturity? Don’t forget that according to the U.S. rules, interest income is being taxed on a year-by-year accrual basis. This means that a portion of the interest income you are expecting to get in the future would go onto a U.S. tax return every year you hold the certificate. So, technically, every year you would have to pay taxes on income that you haven’t yet received. If your foreign bank doesn’t provide information on the amount of an accrued interest, that does not mean that you are relieved from including it on your tax return. Again, the Code has its own set of rules, that don’t take into account foreign accounting principles or laws. It is, basically, presumed that you would be able to do all the necessary accrual calculations on your own.
US Taxation of Foreign Retirement Plans
Do you have a foreign retirement plan? The IRS treats most of those as foreign trusts, which require Form 3520 to be filed by April 15th and Form 3520-A to be filed by March 15th (did you know there is a tax deadline that is even earlier than April 15th?). According to the IRS instructions to both of these forms, preparing them would take around 10 hours. The forms are not attached to your tax return, but instead are sent to a separate IRS office. And, by the way, when completing the forms you would have to prepare a balance sheet for your pension plan. Well, as said before, the US government presumes you to be a tax preparer.
US Taxation of Foreign Life Insurance Plans
Do you have a foreign life insurance plan? Most likely, it does not fall under the IRS’s definition of a life insurance. Thus, according to the IRS, you are supposed to read Sec. 7702 of the Code and understand such terms as “net surrender value” and “mortality charge”. You will need to understand those terms to compute income generated by the policy when filing a U.S. tax return. And, again, it won’t matter if your foreign life insurance provider is not able to help you with the numbers relevant for U.S. purposes only. Also, don’t forget excise taxes; You likely need to file and pay on Form 720 four times a year 1% of premiums paid to your foreign life insurer.
US Taxation of Foreign Mutual Funds
Are you making investments into foreign mutual funds, called in the Code as Passive Foreign Investment Companies (PFICs)? Be prepared to spend days on preparing your U.S. tax return. The latter should most likely have form 8621 attached to it, which takes more than 20 hours to prepare (according to the IRS itself). If you have multiple mutual investments, multiple this time by the amount of mutual funds you have an ownership in.
US Taxation of Capital Gains of Foreign persons
This is best explained with a simple example. Suppose in 1980 you invest in a British stock of a petroleum company . You paid £100,000 for the stock. In 2010, you become a US person for tax purposes, at which point in time the stock was worth £1,000,000. In 2014, you go to sell this stock, and its value went up a little but after brokerage fees, the net amount paid to you is £1,000,000. So now, what is your capital gain for US tax purposes? You will not like my answer. Would you believe the IRS will claim your gain is £900,000? Yes, the IRS is convinced that it is entitled to capital gains that occurred prior to you were under the US taxing jurisdiction. There are some very unique work-arounds to this, but this is why many competent attorneys will advise foreign taxpayers to quickly sell all their assets and buy them back immediately before becoming a "US person." Do you see how monumentally unfair this is? If a taxpayer does not get the proper advice, they could have, in the above example a tax bill of $300,000 in 2014, or if they got proper advice, they would owe the IRS nothing. Again, the federal government presumes you should know.
Compliance with the US Taxation of Foreign Income is dangerously difficult
There are plenty of other examples to share, and we didn't even address the issues of Foreign Partnerships or Corporations which are other, huge burdens.
There is only one conclusion that may be drawn out of this: the government sees a tax preparer in every individual, no matter what a person’s profession is. Remember, even when you hire an accountant to prepare your tax return, you are still the one declaring under penalties of perjury that you “examined return and accompanying schedules and statements, and to the best of knowledge and belief, they are true, correct and complete”. When foreign income is concerned, either for the expat, the Visa holder, resident alien, or the dual citizen, the stakes are incredibly high and the compliance work is incredibly onerous. And there does not appear to be any political relief in sight. If you need assistance, contact us. We can help.