General Practice, Solo & Small Firm DivisionMagazine
The Long Arm of the IRS
U.S Tax Treatment of Foreign-Source Income
BY Michael E. Zeller and Eric D. Gazin
As everyone knows, there are only two certainties in life, and the more painful one is generally taxes. Whether your client is leading tours in the Australian outback, operating a belly dancing school in Tunisia, or overseeing the Japanese subsidiary of her U.S. employer, if your client is a U.S. taxpayer, the IRS has the right to your client’s tax dollars.
With an increasingly global economy and workforce, taxation on an international level (including, in particular, taxation of foreign-source income) is an issue that lawyers need to address with their clients.
U.S. international income taxation arises under two common fact patterns. First, the IRS assesses an income tax when a foreign individual earns income from U.S. sources. A foreign citizen residing in the United States is not immune to the IRS’s jurisdiction. As long as income contains a sufficient nexus to the United States, anyone can be taxed by the IRS.
The focus of this article, however, is the second fact pattern—the taxation of foreign-source income earned by individual U.S. taxpayers. In contrast with taxation of nonresident aliens for their U.S.-source income, a U.S. taxpayer (as defined below) is subject to a much wider tax net, because nexus to the United States is not required as a precondition to taxation. Solely by virtue of being a U.S. taxpayer, earners are liable for taxes on any kind of income, whether foreign- or U.S.-source.
Taxation of the worldwide income of U.S. taxpayers is the most defining characteristic of U.S. tax policy. The Supreme Court in Cook v. Tait (165 U.S. 42 (1924)) first justified worldwide taxation of U.S. taxpayers. The Court declared that citizens residing abroad are as equally subject to U.S. taxation as those residing here. As a result, foreign-source income is considered gross income under § 61 of the Internal Revenue Code of 1986, as amended (I.R.C.). Foreign-source income is simply added to, and taxed at the same rate as, income derived in the United States.
This policy of worldwide taxation is unique among nations. Most other countries restrict taxation to income derived only from within its territorial borders. Not so in the United States; if you are a U.S. taxpayer, no matter where you are located in the world, the IRS is interested in your income. Those who are not U.S. taxpayers, and thus fall outside the sweep of worldwide taxation, include nonresident aliens and foreign corporations. (This article will only consider individual taxpayers.) It is crucial to determine whether your client is a U.S. taxpayer.
U.S. taxpayers are composed of U.S. citizens and resident aliens. If your client is a U.S. citizen, your work is easy—worldwide income taxation applies. However, determining whether your client is a resident alien is less clear. Aliens are subject to two tests: the Green Card test and the Substantial Presence test.
The Green Card test looks to immigration rules. If your client is a lawful permanent resident, i.e., possesses a "green card," then your client is a resident alien and, therefore, a U.S. taxpayer. Under the Substantial Presence test provided for in I.R.C. § 7701(b)(3), U.S. taxpayer status is accorded where a foreign citizen is present in the United States for (1) at least 31 days during the current calendar year, and (2) at least 183 days over the course of the last three calendar years. If your client meets these circumstances, he or she is a residential alien and is subject to worldwide taxation. Clients not meeting the requirements of either test are subject to U.S. taxation only of U.S.-source income.
U.S.-Source vs. Foreign-Source Income
Determination of whether income is U.S.-source or foreign-source governs whether or not exclusions are available. The source of income is not necessarily determined by where it is paid. For example, if a U.S. employer pays an employee via direct deposit to her U.S. bank account, but she conducts all of her work in Zaire, the income is foreign-source and not U.S.-source. Essentially, the source of the income is the place where work is actually done.
To cite another example, a client who is a U.S. taxpayer working abroad also works in the United States for 11 days during the year. The client has a gross income of $100,000. Because he worked in the United States for 11 days, not all of the income is foreign-source (i.e., tax free). By dividing the number of days worked in the United States by the total number of days worked during the year and multiplying that number by your client’s gross income, you can ascertain what portion of his income is U.S.-source (taxable), and what portion is foreign-source: 11 days worked in United States divided by 240 total days worked during the year multiplied by $100,000 gross income equals $4,583.33 of U.S.-source income.
Determination of Reportable Income
Let’s say that your client, Gretchen Z., a naturalized U.S. citizen, has advised you that she is going to Germany to work for an affiliate company of her U.S.-based employer, and that she will earn $100,000 annually. What do you need to know protect her from running afoul of the IRS?
The first step is to determine the reportable income, keeping in mind the policy of worldwide taxation. In Gretchen’s case, reportable income includes compensation for services, including fees and commissions; home leave expenses; fringe benefits; allowances for cost of living and housing; plus any taxable moving expenses paid for or reimbursed by her employer. Assuming payment of her income by her U.S. employer (rather than payments made by the German affiliate), her W-2 could report, for example, her gross income of as much as $200,000, because her housing, car, language lessons, etc., were all provided by the employer. These items are included in her gross income under I.R.C. § 61.
The Dilemma of Worldwide Taxation
Worldwide taxation policy presents another problem for Gretchen, because her earnings overseas are potentially subject to double taxation: once by German authorities, in whose territory the income is realized; and once by the U.S. authorities, because Gretchen is a U.S. taxpayer. This problem arises in any tax situation in which one country, in this case the United States, lays claim to the foreign-source income of its citizens, and the other country assesses a tax on income derived from within its own territory. Overlap is inevitable. Governments are aware of double taxation and provide ways to alleviate it. U.S. policies to ameliorate double taxation include I.R.C. § 911 exclusions, the foreign tax credit, and numerous tax treaties.
Section 911 Exclusions from Income
I.R.C. § 911(a) provides a "qualified individual" with a twofold exclusion: one for foreign earned income and one for housing costs. These provisions are aimed primarily at reducing the costs of U.S. companies doing business overseas. Most companies provide expatriated employees a housing allowance in addition to wages and salary (also known as "personal service income"). The exclusions provided for under I.R.C. § 911 help reduce double taxation. Without the exclusion, companies would be forced to "gross up" or inflate employee compensation packages to encourage employees to represent them abroad. However, the additional costs of "grossing up" could place U.S. employers at a serious disadvantage from an overall economic perspective.
The exclusions work by permitting a qualified individual to exclude from gross income any personal service income earned while overseas (earned income). I.R.C. § 911(d)(2)(A) defines "earned income" as "wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered...." The first step toward receiving the exclusion is the classification of the taxpayer as a "qualified individual." Next, he or she must pass one of two tests: (1) prove to the satisfaction of the Treasury Department that he or she is a bona fide resident of the foreign country for one full calendar year, to pass the "bona fide resident" test; or (2) prove that the taxpayer has resided overseas for at least 330 days over any consecutive 12-month period, to pass the "physical presence" test. For each test, the taxpayer must demonstrate that his or her "tax home," where the individual works or lives, is the foreign country.
Amounts excluded from gross income under the foreign earned income and housing cost exclusions are determined differently. The foreign earned income exclusion, once met, allows the taxpayer to exclude $74,000 from gross income. The excludable amount increases each year and will reach a statutory maximum of $80,000 by year 2002; after 2007, the exclusion will increase according to the cost-of-living index.
The housing cost exclusion is calculated according to a formula given in I.R.C. § 911(c)(1). The U.S. taxpayer is permitted to exclude from gross income the amount of fair market rental value of housing provided by the employer, or the amount of the housing allowance that exceeds the base amount determined for that year. The latter figure is determined by multiplying the daily housing cost average (determined by the IRS and set forth in Line 30 of Form 2555) by the number of days within the qualifying tax period. For example, in 1998, the daily rate was $26.42, which provided a base of $9,643 for the full year. Housing costs above this amount are excludable.
If the fair market rental value of Gretchen’s apartment, for example, is $8,000, she would not be able to take the housing cost exclusion. If the fair market rental value is $11,643, she would be able to exclude $2,000 from her gross income (i.e., $11,643 minus $9,643 (the base amount) equals $2,000). The housing cost exclusion is limited to reasonable expenses; not included, for example, are "lavish or extravagant" expenses for maids and gardeners, interest and taxes of the kind deductible under I.R.C. §§ 163 or 164, or any amounts otherwise deductible under I.R.C. § 216(a). There is a final limitation—the combined total amount of both exclusions, foreign earned income and housing cost, cannot exceed the taxpayer’s total earned income for the year.
Gretchen advises you that she has started working in Germany, is living in an apartment on the Alster in Hamburg that costs $24,000 a year, and is driving a car that her employer has provided under her German driver’s license (in Germany, drivers’ licenses are issued for life). She began her position on August 2, 1999.
Based on these facts, and assuming that Gretchen remains in Germany for a full 330 days (the number of days necessary to pass the physical presence test) within the 12-month period after her arrival, she will be eligible to take both exclusions under § 911 for the period from August 2, 1999, through December 31, 1999. However, she will not be able to take the exclusions on her 1999 tax return if she files on or before April 15, 2000, because at that time she will not yet qualify for the exclusion under either the physical presence test or the bona fide resident test. Therefore, although she has an automatic two-month extension to file her tax return as an expatriate, she will have to submit a regular extension and file her tax return on or after August 1, 2000, to gain these tax benefits.
Alternatively, Gretchen can file a 2350 extension to enable her to satisfy the bona fide resident test, which requires a stay in the foreign country of one full calendar year. In this case, Gretchen would not file her 1999 tax return until after the start of calendar year 2001. Bona fide resident status can be advantageous because it affords the taxpayer more flexibility with regard to return travel to the United States (the number of days are not in issue as they are under the physical presence test). The "tax home" concept applies to both the physical presence test and the bona fide resident test, but it is pivotal under the bona fide resident test. If Gretchen travels to the United States for more than 35 days, but can show that her "tax home" is in the foreign country, and she has previously established bona fide residence in the foreign country, she will still be able to take advantage of the § 911 exclusions.
Once Gretchen has established eligibility for the exclusions under § 911, she can file her 1999 tax return and exclude up to $74,000, on a pro rata basis, of foreign-source income, plus the "housing cost amount" from her gross income. Using our sample figures, Gretchen would be able to exclude up to $30,816.43 for the income exclusion, plus the housing cost amount (calculated as set forth above on a pro rata basis, based on the number of days spent abroad in 1999).
One other option available to Gretchen is simply to file her 1999 return on time, without claiming the exclusion; once she is eligible to benefit from the exclusion under either test, she can file an amended return. Whatever option she chooses, Gretchen will file Form 2555 or Form 2555-EZ with her 1040 filing.
For fiscal year 2000, Gretchen would be able to exclude up to $76,000 of earned income plus the housing cost amount. In year 2000, when Gretchen earns all of her $100,000 annual salary in Germany, she will only be entitled to a $76,000 exclusion. As a result, she will have $24,000 (not taking the "housing amount" exclusion into consideration or any other items that might be included in her gross income) in taxable income. You will want your client to take advantage of other tax-saving alternatives.
The Foreign Tax Credit
The Foreign Tax Credit (FTC) is set forth in I.R.C. §§ 901-908. The FTC is an elective, dollar-for-dollar credit for creditable foreign income taxes "paid or accrued." It is taken on a year-by-year basis but has carry-over provisions that permit the credit to be carried back two years, or carried forward five years.
In general, a foreign tax credit is preferable to a foreign tax deduction. Whereas a credit is taken directly from the bottom line of total tax due, a deduction is an amount merely subtracted from gross income. A deduction, then, is worth only a percentage of its face value, but a credit is worth 100 percent of the amount.
There are limitations to the FTC, however. If the credit is elected, the taxpayer cannot claim deductions for other foreign taxes. What’s the difference? Note that the FTC applies only to "creditable" foreign income taxes. Generally, sales, property, and excise taxes are not creditable. A taxpayer, then, must choose between the FTC for income taxes paid, or a deduction for taxes, income and otherwise. As a practical matter, it is rare that the math would not come out in favor of the FTC. Credits are simply more powerful than deductions.
A second limitation is that the credit must be proportional to actual U.S. income as foreign taxable income is to total worldwide taxable income. Thus, if foreign taxable income is 30 percent of worldwide taxable income, and U.S. tax imposed on a taxpayer equals $25,000, then the maximum amount excludable as FTC is $7,500 (30 percent). More specifically, the I.R.C. distributes the limitation among various "baskets," or categories of income, including passive income, high withholding tax interest, and financial services income. Each basket has its own limitation, based on the same proportion described above.
The golden rule is that the FTC cannot reduce tax on U.S.-source income. Only foreign-source income can be affected by the FTC. After all, the FTC is designed to combat double taxation, although in some cases a limited amount of double taxation remains; the goal of the FTC is not to avoid taxation of U.S.-source income. Therefore, despite having paid foreign taxes, a U.S. taxpayer might not be eligible to make use of all, or a portion, of the available FTC, to guarantee the tax owed on U.S.-source income.
To illustrate how the FTC actually works, let’s look at Gretchen’s tax return for 2000 (using a different set of figures than those discussed above). Gretchen’s gross income in 2000 is $200,000. Of the 240 days that she worked during that year, 60 of them were in the United States. Therefore, she has $50,000 of U.S.-source and $150,000 of German-source income. Because she is a bona fide resident of Germany, Germany will tax her on the full $200,000 (assuming she has no deductions or exclusions in Germany); assuming a 50 percent income tax in Germany, she will pay $100,000 in German taxes.
On her U.S. tax return, she will be able to exclude $76,000 under I.R.C. § 911, and perhaps an additional $14,000 for housing and other exclusions, for a total exclusion of $90,000. This leaves Gretchen with an adjusted gross income (AGI) of $110,000. From her AGI, Gretchen is allowed to take her standard deductions and exemptions, which total approximately $10,000. Now Gretchen has $100,000 of taxable income in the United States. Assuming a 30 percent tax in the United States, her U.S. tax liability is $30,000. But she has already paid $100,000 in taxes in Germany. Does she get a $100,000 FTC? No, she does not, because otherwise she would be getting a double benefit going well beyond the intent of avoiding double taxation.
Gretchen next must determine the available and allowable FTC. To determine the available FTC, divide the amount of foreign-source income excluded ($90,000) by the amount of total foreign-source income ($150,000), and multiply the result by the amount of foreign tax paid ($100,000). This leaves Gretchen with an available FTC of $60,000 ($90,000 divided by $150,000, and then multiplied by $100,000). Unfortunately, however, Gretchen will not be able to use all of the FTC to eliminate her tax liability in the United States. The amount that she will be allowed to take as a credit in the current year is determined by dividing the amount of foreign-source income remaining after the exclusion ($60,000) by the amount of U.S. taxable income ($100,000) and multiplying that by the amount of tax owed in the U.S. ($30,000). Gretchen will be able to take an FTC of $18,000 ([$60,000 divided by $100,000] multiplied by $30,000) and will be liable for $12,000 in U.S. taxes. Of the $60,000 available FTC, she will have $42,000 worth of FTC that she can carry forward or back as described above.
Income Tax Treaties
In addition to the I.R.C. § 911 exclusions, the United States has entered into a number of treaties to avoid double taxation. The treaties have several goals. First, most guarantee that taxpayers of one country will not be subjected to more severe tax treatment than taxpayers of the other country. Such guarantees are called nondiscrimination provisions. Second, the treaties contain mechanisms for disputes, which provide established methods to resolve issues concerning the tax priority of each country. Finally, the treaties seek to avoid double taxation. As opposed to I.R.C. § 911 exclusions and the FTC, treaty provisions represent accommodations between countries and allocate taxing rights between opposing sides. Their function is not to give breaks to certain individuals but, in effect, to divide the taxing spoils.
Tax treaties typically regulate tax policies in a number of areas, defined by types of income represented. Common areas include dividends, royalties, interest, and capital gains. In Gretchen’s case, the Income Tax Treaty between Germany and the United States, which took effect on August 21, 1991, allocates tax for all of these. In the case of royalties and interest, the resident country (Germany) has the sole right to tax. The same is true with respect to dividends, except that the source country has a limited right to withhold, equaling 15 percent for individual recipients.
The treaty also regulates the personal service income of employees. Per Article 15 of the treaty, both countries have the right to tax Gretchen’s wages and salaries. However, Germany loses the right to this income if (1) Gretchen is present in Germany fewer than 184 days during the year; (2) her employer is not a resident of Germany; and (3) her remuneration is not actually borne by a "permanent establishment" (i.e., an office or branch located in Germany).
Since, under the existing fact pattern, Gretchen passes both the physical presence test and the bona fide resident test, effectively establishing her tax home in Germany, Germany retains its right to tax the income. The treaty, in Article 23, protects against double taxation another way, by allowing both countries to implement a foreign tax credit with respect to income sourced in the other country. Thus, Gretchen can take an FTC for any German income, subject to the limitations described above. In addition to the credit, Germany goes one step further and provides an outright exclusion for any income that is taxed by the United States as U.S.-source income. CL
Michael E. Zeller and Eric D. Gazin are associates in the International Business Group of Moore & Van Allen, PLLC in Charlotte, North Carolina, and can be reached at www.mvalaw.com. The authors would like to express their appreciation to Keith Butcher of Moore & Van Allen, PLLC, and K. Felix Mwamba of PriceWaterhouseCoopers, for their assistance in the preparation of this article.