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Expatriates: IRS Seeking to Close the International Tax Gap
Many American Expatriates (expats) have no doubt been reading about the developments with UBS and the fact that Switzerland will be providing the IRS with information on Americans with Swiss bank accounts. According to Commissioner Doug Shulman, this is only the first step in developing a global information exchange relationship with other countries.
CLOSING THE TAX GAP
Viewing American expatriates and U.S. taxpayers who own foreign businesses and having foreign financial accounts as a means of closing the “tax gap” (the difference between that which is being paid by U.S. taxpayers and what they should be collecting) the IRS is increasing its emphasis on foreign residency compliance (FRC) and has formed a new division within the Office of the Deputy Commissioner (International) for the purpose of scrutinizing U.S. taxpayers residing and investing abroad including international assignees. Not only will they be scrutinizing the taxpayers filing tax returns with foreign and international issues, they will be looking closely at those preparing returns as well looking for mathematical accuracy as well as compliance with tax laws, rules and regulations. Responsibility for international tax compliance has been shifted from Philadelphia, PA (the old Office of International Operations or “OIO” to Austin Texas. Not only have many of the old time experienced international agents retired, but the new culture of IRS personnel in Austin have a significant learning curve ahead of them and are now being faced with processing tax returns filed by experienced international tax professionals as well as inexperienced tax preparers with returns that involve the Section 911 foreign earned income exclusion (FEIE), foreign tax credits (FTC), investment in foreign corporations (CFCs), partnerships and foreign disregarded entities (FDREs), as well as other foreign passive investments. They are processing a huge volume of originally filed tax returns as well as an undetermined substantial number of amended tax returns and returns filed for prior years by Americans seeking to take advantage of the September 23 amnesty deadline. The result will include, but not be limited to, delayed refunds, improper examinations and tax assessments, imposition of penalties and difficulty in achieving penalty abatement due to reasonable cause, denied FEIEs, denied additional extension requests on Form 2350 for those who qualify to defer filing until they qualify for the Section 911 exclusion, complications regarding claiming foreign tax credits (FTCs) both for current years and carrybacks and frozen and delayed refunds (especially relating to foreign tax credits). All refunds greater than $100,000 will be audited by special groups specializing in FRC assigned to IRS offices in Austin, Puerto Rico and certain offices in California regardless of where the taxpayers books and records are maintained.
U.S. MULTINATIONAL EMPLOYERS
Having spent over 30 years of my career dealing with U.S. multinational taxation, including several years with both Big 8 CPA firms and large multinational employers, I see this as a major concern to U.S. multinational businesses as well as the American citizens living, working or investing abroad. Employers who maintain Expatriate Employee Tax Equalization policies instead of Tax Protection policies will find themselves out of pocket significant amount of money while they await the processing of their expat employee tax returns so they can get reimbursed from the tax refund money for payment of foreign taxes that exceeded the employees theoretical tax. Many employers would be advised to consider changing from a program of Tax Protection to Tax Equalization. The principle difference is that with a Tax Equalization policy, the employer holds back an amount from the expat employees wages in a predetermined amount based on what the employee would expect to pay on base compensation had he or she not been assigned abroad and enhancing cash flow in the process. If the employee reasonably expects to be entitled to either the FEIE or a FTC and not owe any U.S. tax on compensation earned overseas, they can legally cease having federal tax withheld from their paychecks and their net pay is virtually unchanged. In addition to paying the expat employee’s foreign income tax, the employer would determine if it was necessary to pay any estimated U.S. income tax on compensation earned in the U.S. while on foreign assignment or to the extent that US tax on qualifying foreign sourced compensation exceeded that which would be covered by either the FEIE or FTC.
U.S. INTERNATIONAL ASSIGNEES
American’s taking foreign assignments should consult with a tax professional competent in areas of FRC prior to taking the assignment and determine if a tax protection or tax assistance agreement is possible to avoid unintended problems. As the task of preparing expatriate income tax returns is more complex now than ever, this is reflected in the cost of obtaining competent tax assistance. Accordingly, part of the employment contract should be for pre-assignment tax planning as well as FRC both as regards to US tax advice and assistance as well as local foreign tax matters. This is advantageous to the employer as it helps avoid embarrassing situations of having employees facing tax problems either in the host country as well as the U.S.
IRS VOLUNTARY COMPLIANCE
All Americans with signing authority or financial interest in foreign bank or financial accounts need to familiarize themselves with the requirements for filing Form TDF 90-22.1 by June 30 of each year (reporting signing authority or ownership of foreign financial accounts for the previous year). Presently there is a vast confusion as regards to who will be penalized and many Americans are in fear that by filing they will create a problem. Well if you don’t file you could not only be subject to substantial monetary penalties, you cold face criminal prosecution. Commissioner Shulman announced that anyone who files by September 23, 2009 will be given criminal amnesty and a limit will be set as to any monetary penalties. The same holds true for Americans owning interests in foreign controlled foreign corporations, partnerships and FDREs. After that date you are considered a tax evader and subject to criminal prosecution and substantial monetary penalties amounting to $10,000 per form per year and in the case of foreign financial accounts, up to $250,000 or in extreme cases $500,000.
The Foreign Earned Income Exclusion-Do You Have a Foreign Tax Home?
American expatriates (expats) could be in for some nasty surprises over the coming years. Not only is it more likely than not that someone in Congress will sponsor a bill to repeal the Section 911 foreign earned income exclusion (FEIE) and amend the foreign tax credit (FTC) rules <not to mention the controlled foreign corporation (CFC) laws> the hints from the IRS via a Tax Memorandums concerning contractors in Iraq and Afghanistan and postings to the IRS website all point to the possibility that they are considering a campaign to deny the benefits of the FEIE to Americans who do not totally sever their ties to the U.S. prior to moving abroad. Although this is my personal speculation and maybe I am getting paranoid in my old age but this is what I envision based on the following:
The IRS Section 911 Foreign Earned Income Exclusion (FEIE)
American who have a tax home outside the U.S. can often exclude a significant portion of their foreign sourced income if they qualify under either the bona fide residence test (which includes being a foreign resident for at least an entire calendar year, or 330 out of 365 days physically present outside the U.S. during a consecutive 12 month period.
IRC Section 911 Bonafide Residence Test
So you say, well I was outside the U.S. for an entire calendar year (but returned home to visit my family frequently) after which I returned to my house in the U.S. So shouldn’t I get the FEIE? Not to fast. Even though you were in say Iraq for a year which under Section 162 defined your tax home as being a foreign country (thus denying you travel, meals and lodging), the IRS probably won’t allow you to deduct the FEIE as a bona fide resident. That is because your abode was and still is in the U.S. and Section 911(d)(3) says that even if your tax home is not in the U.S. under 162, because your abode was in the U.S. during that time and therefore could not be in Iraq. Sorry, no Section 911exclusion as a bonafide resident. As you probably did not pay income tax in Iraq you are subject to tax on the full boat here in the U.S.
IRC Section 911 Physical Presence Test and the Concept of Abode
But, you say, what if I never came home during that time and met the 330/365 day rule. Well now it gets complicated. The statutory provision in IRC Section 911(d) merely states that if you have an abode in the U.S. you don’t have a tax home abroad and therefore don’t qualify for the exclusion. But how do you define “abode”? Recently the IRS updated its website to remind U.S. taxpayers of the U.S. abode requirement, although they mention that merely having a house in the U.S. where your family lives does not in itself disqualify you. This is because there is a provision that states that if you maintained a house in the U.S. while your were a bonafide resident of a country where your family would be in a hardship position that you would not be denied status as a bonafide resident.
The statute does not define “abode” and case law defines it as a domestic concept. Further, cited case law has dealt with situations where Taxpayers have been denied treatment as a bonafide resident where they clearly spent much more than 30 days in a 12 month period in the U.S. so the physical presence test was never at issue. In cases such as Lemay vs. the Commissioner the issue was whether the person qualified as a bonafide resident and never addressed the physical presence rule.
So what was the legislative (Congressional) intent of Section 911(d)(3) which stated that you could not have a foreign tax home if you had an abode in the U.S. and where is the IRS likely to be headed with this in the future? The law is vague as are the instructions to Form 2555. Worst yet, there is a technical error in the writing of Regulation 1.911-2 dealing with the issue of “abode”. After dealing with this issue for more than 30 years, it has always been felt by international tax professionals of major CPA and law firms that when Reg 1.911-2 stated that “for the purpose of paragraph (a)(i) of this section, the term tax home……” referring to the definition of a tax home for purposes of Section 162 travel meals and lodging, that a tax home shall not be in a foreign country if there was a place of abode in the U.S. for purposes of the bonafide residence test. Well there is no paragraph (a)(i), there is only a paragraph (a)(1)(i) and a paragraph (a)(2)(i), both which deal with the issue of a bonafide resident, and (a)(2)(i) and (a)(2)(ii) both deal with physical presence. So isn’t it safe to assume that if the Congressional concern was to ensure that someone with a U.S. abode (absent maintaining a U.S. home for family because of hardship reasons) did not claim the bonafide residence rule, which made sense, and as paragraphs (a)(1) and (a)(2) (ii) dealt with physical presence and that the Congressional legislative intent was not to impose this restriction on that sub-section of the Code (dealing with physical presence)?
Back in The Day's When...
In fact, back when I started in the 1970s, most U.S. expatriates were executives or international management trainees (and sometimes technicians working on special projects) of major corporations who were taking 2-3 year (sometimes more) assignments overseas working at U.S. branches or foreign subsidiaries of their U.S. employers. As they would first qualify under the (at that time) 17/18 month rule for physical presence, they would then be bonafide residents of the foreign country for the remaining time during the assignment. If they were married they usually brought their families with them and lived in U.S. communities and the children went to U.S. schools. To avoid complications with the bonafide residence test we would advise them to either sell or rent out their U.S. homes, give up their U.S. drivers licenses and in essence give up ties to the U.S. and establish ties to their foreign communities. Of course there was and still is a requirement that if a resident of a foreign country one must always pay local taxes legally assessed by their foreign host country. In situations where the U.S. expatriate did not sever ties with their U.S. “abode” it was rare for a major CPA firm to claim a Section 911 FEIE based on bonafide residence and always used the physical presence test, again taking the position that any U.S. ties would prevent claiming bonafide residence status but not physical presence.
Today a shrinking global economy has brought many more Americans abroad in search of employment and business opportunities. I suspect that the IRS is positioning to confront not only contractors in Iraq and Afghanistan but all American expatiates with a denial of Section 911 physical presence benefits for those who would otherwise have qualified for the 330/365 day test on the grounds that they continued to maintain an abode in the U.S. (especially if they were married and rented or owned a home), kept their state drivers license, voted in U.S. elections and eventually returned to the U.S. after their assignment was completed. Until Congress favorably intervenes by clarifying the statute, or the Administration requires that the Secretary of the Treasury instruct the IRS to clarify and correct the regulations, or sufficient case law that is not disqualified as precedent pursuant to IRC Section 7463(b) clearly addresses the issue of “abode” as it pertains to persons otherwise qualifying under the physical presence test defense and other civilian contractors returning from Iraq and Afghanistan will face the same tax problem of uncertainty.
The IRS Memo mentioned above discussed extensively the concept of “abode” and that if a person has an abode in the U.S. they do not have a tax home in a foreign country and therefore are not entitled to claim the FEIE if they have an abode in the U.S. leading one to conclude that if they had a place in the U.S., a U.S. driver’s license, etc. this would deny them the benefits of the FEIE under the physical presence test as well as the bonafide residence test. I predict that AM2009-003 is the first step toward a campaign to deny FEIE benefits for U.S. persons who would otherwise have a tax home in a foreign country and qualify under the physical presence test.
Although based on my decades of experience dealing with U.S. taxation of American expatriates and reading through historical documents pertaining to the Congressional intent of the Section 911 FEIE, I am convinced that the provision of 911(d)(3) is intended to prevent abuses as regards those claiming to be a bonafide resident while spending half of their time in the U.S. and avoid paying U.S. tax and that the writers of the Regulation intended to write paragraph (a)(1)(i) < and not (a)(i) as it is written in Reg. 1.911-2> which dealt with a foreign bonafide residence, my prediction is that we will see numerous taxpayers claiming the physical presence tax benefits of IRC 911(d)(1)(b) being arbitrarily and possibly capriciously denied the tax benefit and face with the burden of defending their position. My advice is to consult with a qualified tax professional in advance and be certain that you have a “tax return filing position” before you file in order to avoid substantial penalties; however always remember that the law states that a U.S. citizen is responsible for paying only that amount of tax that is legally due pursuant to the law.
PLEASE NOTE: BASED ON RECENT INFORMATION GAINED BY READING FORUM POSTINGS BY CERTAIN "AMERICANS" LIVING ABROAD WITH NO INTENTION OF RETURNING, I HAVE NOW CONCLUDED THAT THERE ARE MANY MORE FORMER AMERICANS WHO STILL RETAIN THEIR U.S. CITIZENSHIP WHO REFUSE TO FILE U.S. TAX RETURNS. BASED ON STATEMENTS FROM IRS COMMISSIONER SHULMAN, MY GUESS IS THAT THEY ARE IN FOR A BIG-UNPLEASANT SURPRISE. added December 15,2009.
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