updated 2:57 PM CEST, Sep 21, 2023

Opinion: Why it's wrong to insist a U.S. move to residence-based tax regime be 'revenue neutral'

As awareness of the problems associated with the Obama-era law known as the Foreign Account Tax Compliance Act (FATCA) has gradually become more widespread, there's been more discussion about the possibility of the U.S. moving away from its globally-all-but-unique citizenship-based tax regime, to one based on residency.

The proposal has even begun to crop up in discussions with some of the candidates who are hoping to win the Democratic party's nod for president this year. As such discussions have become more frequent, so too has the use of the term "revenue-neutral" – the idea being that the U.S. could move to a residence-based scheme only if it were to mean that the U.S. Treasury would not lose so much as a penny from its coffers in the process.

Here, three regular commentators on U.S. expat tax issues – Toronto-based citizenship lawyer and tax expert John Richardson, Australia-based tax-fairness crusader Karen Alpert, and Paris-based IRS Taxpayer Advocacy Panel overseas representative Laura Snyder – explain why they believe it is unfair to America's estimated 9 million expatriates to insist that such a move only be done in such a way as to spare Homeland taxpayers the potential obligation to make up for any tax revenue shortfall that might result.

While we understand that many American politicians may feel nervous about having to explain to their Homeland voters why the U.S. should move to a residency-based tax regime, even if it might mean that Homeland taxpayers could end up having to pay more in tax themselves, we passionately believe that it's essential all parties to this debate realize that insisting such a move only be permitted if it could be guaranteed to be "revenue neutral" would be gravely immoral and unjust – if, in fact, it could even be done with any degree of accuracy, which we doubt.

This is why.

1. The current system is immoral and unjust on its face.

As even many of those who insist on a "revenue neutral" qualification to any plan to move to residence-based taxation freely admit, Americans living abroad these days are subject to countless unjust burdens with respect to the way they're taxed by the U.S.

Put another way, subjecting persons who do not live in the United States to U.S. income taxation, and thus forcing them to live under two incompatible tax systems, is by definition unfair and unjust.

This is, of course, precisely why so many object to it, and, we would argue, is a contributing factor in driving many American expats to give up their U.S. citizenships, at a rate far greater than citizens of other countries are understood to give up theirs.

Moreover, regardless of the outcome of any determination of revenue neutrality, the current system will remain unjust.

And yet, numerous times in the past, the United States has gone ahead and changed laws, as it sought to address immoral and unjust situations, regardless of their anticipated effects on the nation's coffers. 

Examples include the Married Women’s Property Act, which allowed women to own property and enter into contracts independently of their husbands; the Civil Rights Act, which lifted restrictions on African Americans’ access to public accommodations, such as schools and businesses; and most recently, legalization of same-sex marriages, which allowed same-sex couples to file tax returns as "married filing jointly", which enabled them to benefit from spousal benefits that they couldn't have had if they had to continue to file their tax returns as individuals.

Each of these laws had implications with respect to the U.S.'s total tax revenues, but revenue neutrality was never a condition of their adoption. They were adopted in order to right a wrong, and for that reason, no one dared to mention what the proposed changes might mean in terms of their effect on the nation's tax harvest.  

Evolution of the
concept of citizenship 

Citizenship taxation dates back to the Civil War. At that time – and up until a few decades ago – citizenship was closely tied to domicile. That is, people generally lived in the country where they also happened to be citizens.

Those who emigrated from one country to another in most cases lost their original citizenship, due to widespread prohibitions on dual citizenship.

Today, though, prohibitions on dual citizenship have mostly fallen away, and dual and even triple citizenship is common. 

What's more, citizenship is also no longer tied to domicile.

As a result, many U.S. citizens today are living outside of the United States who have few if any economic ties to the country – and haven't had for years, if not decades, if, indeed, they ever did.

They are domiciled in other countries, often citizens of these countries as well, and they are subject to and pay income taxes in these countries, in which they now live.

Subjecting people who do not live in the United States to U.S. income tax, particularly in the heavy-handed way the U.S. does it, simply does not fit this new reality of citizenship.

As noted above, the way it's done is forcing America's estimated 9 million expats to live under two incompatible tax regimes.

This is why the Democrats Abroad, for example, in its recent interviews of some of the candidates who are vying to be the Democratic Party's choice for president, routinely refers in passing to the “numerous unjust burdens” expats around the world are currently suffering, as a result of the current citizenship-based tax regime.

Our contention, though, is that it's not enough to simply describe the current system as "unjust",  while at the same time stipulating that any efforts to make it "just" be conditioned upon a need to ensure "revenue neutrality" in the process. 

2.  It is not possible to be sure of just how much revenue the United States actually collects from non-resident citizens and green card holders.

Public IRS data lists returns filed from addresses outside of the U.S., but this data includes  returns filed by diplomatic and military personnel, as well as by temporary expats, who would likely be considered U.S. tax residents, even under a residence-based tax regime. 

Therefore, the data necessary to obtain a reliable estimate as to what, exactly, the revenue lost to the U.S. tax base as a result of a move towards a residence-based regime doesn't exist. 

Furthermore, the current taxation of U.S.-source income for nonresident aliens is at a higher tax rate than currently applies to most U.S. citizens. So moving to a residence based tax regime would probably mean that non-U.S.-resident citizens would actually pay more U.S. tax on their U.S. source income.

The exact amount would depend on the relevant tax treaties, and cannot be reliably estimated in advance. But the bottom line is that the revenue that the U.S. would lose by moving to residence-based taxation is the tax collected on the foreign-source income of non-resident citizens – in other words, income that their home countries ("countries of residence") have primary taxing rights to, in the first place.

3. Any determination of revenue neutrality must examine not just an individual's income, but also costs incurred in relation to that income.

This includes not only costs incurred by the IRS, but also by private actors who share responsibility for U.S. tax administration with the IRS.

Costs incurred by the IRS: While the provisions that apply to nonresident citizens are among the most complex in the Internal Revenue Code, the level of support the IRS provides to those taxpayers is much lower than that provided to US residents.

The National Taxpayer Advocate (NTA) has observed on a number of occasions that overseas taxpayers have unique needs: not only are they are confronted with an overwhelming complexity of international tax rules and reporting requirements, but they also face potentially devastating penalties for even inadvertent noncompliance.

It was in this context that in her 2015 report, the NTA detailed a litany of service failures by the IRS with respect to overseas taxpayers. These failings included the closure of IRS attaché offices that had been housed in US consulates, the discontinuance of an email system permitting taxpayers to correspond with the IRS, the lack of availability of toll-free phone numbers for persons calling the IRS from overseas, inadequate postal correspondence, and the lack of training being given to IRS representatives in order to ensure they were able to adequately respond to the queries of overseas taxpayers.

These failures – together with a multitude of others, such as highly-limited foreign language capabilities, and the inability for overseas taxpayers to create an online account with the IRS – remain true today.

As the NTA noted, these service failures constitute serious violations of the Taxpayer Bill of Rights, and more specifically, of the right to be informed, the right to quality service, and the right to a fair and just tax system.

The current system of taxing nonresidents is untenable, even without expending the resources required to remedy these failures  – let alone the resources that would be needed if the U.S. were to begin providing overseas taxpayers with the full support that they require as a result of the complexities they face, and the multitude of languages they speak.

At this time, the IRS simply has neither the resources nor the expertise to effectively administer tax law for residents of other countries whose entire existence – economically and in many cases, linguistically – is “foreign” to the United States.

For these reasons, any analysis of the revenue neutrality of RBT is not complete without accounting for these costs on the part of the IRS – costs that it should incur, but that to date it has failed to. 

Costs incurred by others: It is not just the IRS that incurs costs with respect to tax administration for overseas taxpayers. Overseas taxpayers themselves, as well as foreign financial institutions (FFIs), incur considerable costs in connection with the administration of the United States’ system of worldwide taxation.

This is not an accident. To the contrary, it is a deliberate component of IRS strategy.

In its April 2019 IRS Integrated Modernization Business Plan, the IRS lists its “Strategic Goal 3” as “Collaborate with external partners proactively to improve tax administration.”

A November, 2019 report by the Internal Revenue Service Advisory Council elaborates on what this means:

“IRS’s strategic goal [is] to collaborate with external partners proactively to improve tax administration by incorporating opportunities to leverage and enable as customer service delivery channels trusted members of the tax community.

"Tax practitioners, tax software vendors, financial institutions and payroll providers are aligned with the IRS’s mission to provide quality taxpayer service by helping taxpayers understand and meet their tax obligations.

"Each mission and business partner can serve dozens, hundreds, thousands or millions of taxpayers.“

At first glance this might sound innocuous. But scratch the surface, and you’ll realize that the IRS is announcing, in no uncertain terms, its intention to rely even more heavily than it already does on such individuals and entities as tax practitioners, tax software vendors and financial institutions, to carry out tax administration on behalf of the United States.

In other words, the IRS – a public agency – is planning to rely even more heavily than it already does upon these tax practitioners, tax software vendors, and financial institutions – i.e., the private sector – to carry out what is in fact a public service that it is responsible for.

And while the IRS is funded by public tax dollars, tax practitioners, tax software vendors, and similar financial institutions are instead funded by private customer (taxpayer) fees.

For example, as reported in a major Democrats Abroad report published last year, 55% of the non-resident tax filers surveyed said they engage the support of a professional tax preparer when filing their annual tax returns; of these, 61% reported incurring an average tax filing preparation cost of more than US$500 – at least twice what U.S.-based Americans spend on average.

In fact, professional fees of upwards of US$2,000 and more each year for the preparation of an overseas tax return is common.

Equally if not more significant is this: according to a survey of Americans living overseas published in October, 2019, 41% of the survey’s 602 participants reported paying significant fees to a professional tax preparer, even though they end up owing nothing in U.S. taxes.

This statistic alone shines a bright light not only on the high cost of tax administration placed squarely on the shoulders of overseas taxpayers, but also on the fact that this cost is being incurred by expat Americans without any corresponding revenue gain whatsoever for the U.S. Treasury.

As regards FFIs, meanwhile, it is not just IRS policy but also federal law that requires them to engage in tax administration on behalf of the United States.

More specifically, FATCA obliges FFIs to develop and implement complex procedures in order to be able to identify among all of their account-holders those who are “suspected US persons.”

Their failure to do so is subject to very steep penalties: a withholding tax of 30% on all their U.S.-source income.

FFIs have incurred, and continue to incur, substantial costs in administering FATCA. While no one has performed a comprehensive study of these costs, there is information available: the Spanish bank Banco Bilbao Vizcaya Argentaria estimated that compliance costs could range from US$8.5m for a local entity to US$850m for a global one.

The unwillingness of companies seeking to offer competitively-priced financial products outside the U.S. to American expat clients is one frequently-seen measure of the unwillingness of FFIs to take on the added costs. 

The British government, meanwhile, has estimated the aggregate initial costs to UK financial institutions at US$1.1bn to US$1.9bn, with a continuing cost of US$60m to US$100m a year.

More globally, KPMG and Deloitte have estimated that more than 250,000 FFIs are affected by FATCA, with costs for some of the larger ones reaching more than US$200m.

Overseas taxpayers and FFIs incur these costs because of IRS policy to “collaborate” with tax practitioners, tax software vendors, and financial institutions for the purpose of tax administration and because of federal law (FATCA). That is, extensive costs for the purpose of US tax administration are incurred not only by the public sector (the IRS) but also by private actors.

A complete and honest examination of the revenue neutrality of RBT, therefore, must take into account these considerable tax administration costs that the current system places squarely on the shoulders not of the IRS, but those of FFIs and overseas taxpayers themselves.

What  a 'non-revenue neutral' determination
would mean: Enter Taxpayer Bill of Rights 

If it were determined that RBT could not be adopted because it was not revenue neutral, then the Taxpayer Bill of Rights would require that the IRS at once set about spending the resources necessary to provide the same level of service to international taxpayers as it is currently provided to domestic taxpayers.

Because it is entirely inconsistent and a complete contradiction of logic, on the one hand, to defend the current system as revenue positive to the United States but yet, on the other hand, to continue to provide insufficient resources for the IRS to properly support its overseas taxpayers.

Either there is a revenue surplus from the taxation of persons outside the United States, or there isn’t. And if there is, then it is incumbent on the IRS to fully support overseas taxpayers.

Otherwise, the determination of revenue neutrality was a farce, and its outcome will serve to perpetuate continued violations of the Taxpayer Bill of Rights.

Again, we applaud DA’s efforts to reach out to the Democratic presidential candidates, to ask them about issues relevant to Americans living overseas. It is a very important initiative.

However, for the reasons explained above, we strongly recommend that DA remove from its communications any suggestion that a demonstration of revenue neutrality should be required in order for the United States to adopt a system of residence-based taxation.

Karen Alpert, Laura Snyder and John Richardson