The US, along with New Zealand, Luxembourg (residents) and Eritrea, are some of the only countries with the worldwide income tax for their people. Which means as a citizen or legal resident of these countries, the government taxes all your income, both foreign and domestic.
In the US, worldwide taxation dates back almost two centuries. It was established during the American Civil War. Originally called “The Revenue Act,” the government taxed any US person residing abroad at 2%. Those who didn’t want to partake in the war could live wherever they like but still would have to fund the war by paying more tax than mainland residents on their worldwide income. Nowadays, Americans living in foreign countries, putting in a hard day’s work, are obligated to share the American dream through tax on foreign sourced income. All US persons must render unto Caesar no matter where they live.
The US along with many other countries have treaties to resolve international tax issues, when income is sourced in multiple jurisdictions. US tax treaties function as mutual accords to resolve issues involving double taxation. That is, treaties prevent the same income from being taxed by two countries.
In most cases, if you pay tax to a foreign country, you should be allowed to take a foreign tax credit on your US return. You should get a dollar for dollar credit for foreign taxes paid, thus never pay more than the US rate.
For example, if you sell real estate in Colombia, where the capital gains rate is 10%, you pay 10% to Colombia. Then you report the sale to the IRS where the long term capital gains rate is 20% (assuming Trump eliminates Obamacare taxes). You get a credit of 10% for the taxes paid to Colombia and pay 10% to the IRS.
In this article on worldwide income we’ll review common errors and issues in determining US tax on foreign source gains.
First, let’s define income tax treaties, What are they?
Tax treaties are international arrangements under which residents are tax exempt, or taxed at a reduced rate, on certain items of income they receive from sources within foreign country. Tax rates will vary in each country. Under the same arrangements, residents are taxed reciprocally in foreign countries.
In the US, most treaties contain a “savings clause,” preventing US persons (citizens or legal residents) from using certain provisions of a tax treaty trying to avoid taxation on US source income.
Mistake #1: US passport holders receiving income from countries with no tax treaties, are safe from US tax.
“Oh hell no!”
If no provisions cover a particular kind of income by said treaty, or if your country does not have a US tax treaty, US tax rates apply, following the US tax Guide for Aliens. Having a US passport rewards you with obligations to file FBAR (Foreign Bank and Financial Accounts) and pay tax on foreign income no matter where you live.
Mistake # 2 US tax treaties assists you in avoiding double jurisdiction taxes entirely.
Subject to the tax treaty, for US persons, income taxes paid or accrued to the US on foreign income may be credited against the foreign income tax in order to avoid double taxation.
Recapping treaties provide guidelines which mainly reduce tax rates. Treaties with the US allow US persons with receivable foreign income to be entitled to certain credits, deductions, exemptions, and reductions in against foreign income tax. All US persons are taxed on worldwide income regardless of tax treaties. So long as you have a US passport, you pay US taxes.
Double taxation clauses prevent full tax events from occurring in multiple jurisdictions. While US is always pushing full tax on foreign income, the income sourced in the foreign country may be discounted with foreign tax credits or foreign tax exclusion. The following briefly describe these exception to worldwide rule:
Foreign Earned Income Exclusion is limited to excluding up to $102,100 of foreign earned income as of 2017, yearly inflation adjustment applies. Only foreign earned income qualifies for the exclusion, meaning it is not exclusion blanquet for all income. The FEIE doesn’t apply to passive income, capital gains, royalties, dividends and any other type of income that was not earned, and is not foreign source. Other requirements apply.
If you don’t take the FEIE, you can take the Foreign Tax Credit. The foreign tax credit can be claimed when taxes are paid or accrued in a foreign country. The following four tests must be met for any foreign tax to qualify for the credit:
- The tax must be imposed on you
- You must have paid or accrued the tax
- The tax must be the legal and actual foreign tax liability
- The tax must be an income tax (or a tax in lieu of an income tax)
Mistake #3 Americans living abroad are safeguarded by US tax treaties.
Treaty benefits are generally not available to U.S. passport holders living abroad (other than various non discrimination provisions). Arrangements under the treaties cover a range of taxes such as inheritance taxes, value added taxes, income taxes, possession tax etc. If you are living abroad, I suggest you consult with two CPAs, (US and foreign) these will know how to assist you in filings.
Mistake #4 Many of the Federal rules do not apply to the States. If you can be considered a resident of a high tax state, you must consult a local expert.
Not all states of the US honor the provisions set forth in US tax treaties. A ton of the individual states of the US tax income which is sourced in their states. Depending on the state, if you feel like living abroad, you may need to file a non-resident state income tax return. Easiest example is keeping property in the US that generate passive income (such as a rental). Rental income is always US source and taxable in the state where it’s located.
Likewise, the Foreign Earned Income Exclusion doesn’t apply in some states. For example, California doesn’t have a FEIE. If you’re a CA resident, this state will tax your worldwide income without the FEIE reduction.
Also, if you’re working abroad, and your spouse is living in California, the state will attribute 50% of your income to him or her. So, someone living abroad, qualifying for the FEIE, and earning $100,000 in salary, might pay zero Federal income tax. If they have a spouse in California, they may pay CA tax on $50,000 of that salary.
Mistake #5 International tax treaties are the supreme law of the land
US tax treaties can be overridden by FATCA (Foreign Account Tax Compliance Act). Tax treaties usually specify the same maximum rate of tax that shall be imposed on some types of income. The specific rates proposed by country treaty is subject to FATCA imposing new conditions on the tax rates restricting the treaty benefits. Most tax treaties have the same basis to resolve disputes through negotiation between each country’s tax authority.
Mistake #6 I am a resident to planet earth and I can claim tax freedom. Travelers / aliens have no US residency, and can claim tax credits.
There are all kinds of tax protestor websites and scams out there. Suffice it to say that these are all ridiculous frauds.
Also, even if you don’t have a US green card, you may be considered as a US resident for tax purposes. If you meet the substantial presence test for the calendar year, you are screwed.
To satisfy test, you must be physically present in the United States (U.S.) on at least:
1) 31 days during the current year, and
2) 183 days during the 3 year period that includes the current year and the 2 years immediately before that.
Exceptions to this test do apply:
- Sick days in the US,
- If you were in the US regularly commuting to work from Mexico to Canada,
- Day in the US for less than 24 hours(constant commuting),
- Pro-athlete in the US for charitable purposes,
- Crewmembers of vessels docked in US, and
- Individuals holding certain visas.
Also, only US persons my claim the foreign tax credit against their foreign tax because, in principle, only they are subject to foreign taxes on their worldwide income.
Mistake #7 Getting a US Green Card is a good idea!
The diagrams describes how a US person receives foreign income and US income, versus a non US resident alien would take in that same income.
Solutions offered on the IRS website to pay them less. Yes, these are really the solutions suggested by the Internal Revenue Service!
The IRS offers expatriation as a solution for US persons living abroad. America has seen a substantial amount of renouncement to US citizenships, expatriation. The most famous was Eduardo Saverin, the billionaire co-founder of Facebook Inc, He’s a Brazilian-born expat to the US, and is now a resident of Singapore.
Expatriation is expensive. As of 2013, the U.S. imposed a harsh expatriation tax. For example, for individuals with high net worths of more than $2 million, renouncing U.S. citizenship will cost you 20% on all “accrued” capital gains. That is, you pay tax on all your assets as if they were sold at the time of expatriation.
Charitable contributions in general don’t reduce your foreign source income. However, through charities organized in Mexico, Canada or Israel you can legally apportion contribution against foreign sourced income.
Interest Expense Apportioning
Apportioning interest expense between US and foreign source income, using the asset method, includes home mortgage interest, business interest, investment interest expense, passive activity interest, and partnership interest.
Foreign Earned Income Exclusion
Exclude from earned income up to an amount of $102,100 (2017) of foreign earnings that is adjusted annually for inflation. In addition, you can exclude or deduct certain foreign housing amounts. You may also be entitled to exclude from income the value of meals and lodging provided to you by your employer through Exclusion of Meals and Lodging.
Payments for services conducted in international waters (not a foreign country) and payments in specific combat zones, as designated by an Executive Order from the President, can be excluded.
A qualifying individual may claim the Foreign Earned Income Exclusion on foreign earned self-employment income. The excluded amount will reduce the individual’s regular income tax, but will not reduce the individual’s self-employment tax (which is 15%).
The only way to eliminate self employment tax while qualifying for the FEIE is to run your business through an offshore corporation. For more, see: Step by Step Guide to Taking Your Business Offshore.
Click here for a table listing a variety of personal service income that may fully or partially exempt from US income tax.
Below Are Countries with US Tax Treaties
Certain countries with recent treaties contain an article to avoid treaty shopping. Treaty benefits can be limited to residents that do not meet additional test. The US notices treaty shopping through focusing on the objective characteristics of the party seeking the benefits. Treaty shopping may be considered illegal, but reading public information is okay.
|Countries||Countries that don’t tax foreign income||Countries/cities that don’t tax||Tax free countries with second residency programs||Low tax countries offering second residency|
France** monaco wwi
Union of Soviet Socialist Republics (USSR)
United States Model
Anguilla (low tax)
British Virgin Islands
Turks and Caicos Islands
United Arab Emirates
Turk and Caicos