Tax Guide for Expatriates and Foreign Nationals
This is a short tax guide on expat tax that covers taxation of expatriates and foreign nationals. This is a specialized field of tax, and an entire textbook could be written about the topic.
The US tax code imposes taxes on worldwide income of all US persons. IRC § 7701(a)(30)(A) defines a US person as a US Citizen or resident. A resident is able to claim the same deductions and personal exemptions as a US citizen.
A non-resident is only taxed on income from US sources and foreign-sourced income that is connected with US trade or business.
What is a Resident?
A resident for US tax purposes is a foreign national who meets one of following tests:
1. Lawful permanent resident test: An individual who holds a green card is considered a resident for tax purposes for the period of time that he was a lawful permanent resident
2. Substantial presence test: An individual that spends at least 31 days during the current calendar year; and the sum of the total number of US presence days in the current year, plus 1/3 of the total US presence days in the preceding year, plus 1/6 of the US days during the second preceding year equals or exceeds 183 days.
As an expatriate working in a foreign country, you may be subject to income tax in both the US and your host country. In order to alleviate double-taxation, the US tax code offers two primary forms of relief – Foreign Earned Income Exclusion and Foreign Tax Credits. There may be an applicable tax treaty between the US and your host country for additional tax relief.
Foreign Earned Income Exclusion
An individual who qualifies for the benefits under IRC § 911 may exclude a portion of foreign earned income and elect to deduct a portion of foreign housing costs incurred. There are implications of claiming both the Foreign Earned Income Exclusion and Foreign Tax Credits, as will be discussed further below.
A taxpayer is a “qualified individual” to claim the benefits of section 911 if:
1. His tax home is in a foreign country; and
2. He meets one of two tests:
a. Bona fide resident test: taxpayer is a US citizen and a bona fide resident of a foreign country for an uninterrupted year that includes an entire tax year; or
b. Physical presence test: taxpayer is a US citizen or US resident alien who is physically present in the foreign country (or countries) for a total of at least 330 days in any 12 consecutive months.
An individual’s tax home is considered to be the location of his regular or principal place of business. Or if he does not have a regular or principal place of business, then his regular place of abode.
Foreign Tax Credit
IRC § 901 allows a US Citizen or resident to claim a credit for foreign income taxes paid or accrued against US tax liability. There is also an option to elect a deduction rather than a credit, but there very few situations where doing so would be more beneficial than a credit.
Most foreign taxes qualify under this section as long as the person is legally liable for the tax under foreign law; for example, property taxes, capital gains tax, wage tax, PAYE tax, etc.
Foreign Earned Income Exclusion (FEIE) vs. Foreign Tax Credits (FTC)
A taxpayer may not claim a credit or deduction for foreign taxes paid or accrued on foreign earned income that was excluded from US gross income under IRC 911. If you qualify for both the FEIE and FTC, it is generally more beneficial to claim both unless you are in a high tax country such as the UK, Netherlands, Norway, China, and other countries where marginal tax rates are higher. It is best to do a calculation using both FEIE and FTC, and FTC alone during your first year abroad to determine which is more beneficial.
Taxation of foreign nationals (i.e., not US Citizen or green card holder) in the US depends first on whether that person is considered a US resident as discussed earlier.
A nonresident who becomes a resident during the tax year files a dual status return. In addition, there are options for nonresidents to elect to be treated as US residents under 7701(b)(4), 6013(g), and 6013(h). These elections won’t be discussed here for the sake of simplicity.
A US resident is taxed on worldwide income. This means that any foreign income, including wages, investment income, rental income, and business income earned abroad must be reported on the US tax return. Income such as gain on the sale of a foreign property is included, even if it may not be taxable in your home country. Foreign tax credits and tax treaties are available to alleviate some of the effects of double taxation.
A non-resident taxpayer is subject to two tax regimes – one for US source income not effectively connected with a US trade or business, which is taxed at 30% on the gross amount; and the second for net income that is effectively connected with a US trade or business which is taxed at a graduated rate.
US Source Income Not Effectively Connected to a US Trade or Business
A non-resident is taxed on US source income. Here are some general statutory rules:
1. Interest income is sourced based on the residence of the debtor
2. Dividends are based on the residence of the distributing corporation
3. Compensation for services are based on the place of performance
There are also a variety of non-statutory rules that cover severance, pension distributions, alimony, insurance recovery, scholarships, partnership income, and more. And of course, there are numerous exceptions, and exceptions to exceptions, as is with most of the tax code.
US Source Income Effectively Connected to a US Trade or Business
Business income effectively connected to a US trade or business includes:
1. Compensation for personal services performed in the US
2. Profits from the operation of a business in the US
3. Income of a partner from a partnership engaged in a US trade or business
4. Income from real property operated as a business
5. Income from real property held for investment if election is made
6. Income from sale or disposition of US real property interests
7. Income from the sale of business-related capital assets
8. Capital income derived from assets or activities of a US trade or business
Note that trading in stock, securities, or commodities in the US for one’s own account does not constitute engaging in a trade or business.
Again, this was a short summary of an extensive area of taxation. Many important topics were left out such as:
Tax treaties, including dependent personal services
No lapse and boomerang rules
Closer connection exception to the substantial presence test
Departure/arrival year rules
Taxation of dual status individuals
Scale down and stacking rules
FTC paid/accrued methods
Issues specific to foreign properties, such as repayment of mortgage and currency exchange gain/loss
Passive Foreign Investment Companies
Foreign business entities
And many exceptions to the general rules discussed here