updated 11:28 PM CEST, Oct 22, 2021

OPINION: The SEAT approach to residence-based taxation: 'Begin with the end in mind'

Convincing Congress and the Biden Administration of the need for the U.S. to move to a "residence-based" system of taxation is the No. 1 focus of American expatriate advocacy groups around the world right now.

As this and other media organizations have pointed out in recent months, new organizations have been formed to focus on this issue, while existing American advocacy groups have stepped up their efforts as well on the campaign  which calls for the U.S. to join the rest of the world in not basing its taxation of individuals on their citizenship, but rather, on where they live.

One of these new organizations is SEAT (Stop Extraterritorial American Taxation), launched last October  by, among others, Paris-based lawyer and Taxpayer Advocacy Panel member Dr. Laura Snyder; Toronto-based citizenship lawyer and expatriate advocate John Richardson; and Australia-based founder of the Fix the Australia/US Tax Treaty website, Dr. Karen Alpert.

Here, Alpert – who recently retired from a career as an academic at the University of Queensland, in Brisbane – outlines SEAT's philosophical approach to RBT... 

If you want to get somewhere, you need to know where you’re going.

This simple concept is so important that self-help book author Stephen R. Covey made it the second of his 7 Habits of Highly Effective People.

And it's especially true when it comes to advocating for the end to American extraterritorial taxation.

Several groups have been pushing lately for “RBT,” or Residence Based Taxation, without clearly defining what they mean by that term. At SEAT, we believe that a clear and concise definition is necessary from the beginning, in order to ensure that the end product – be it legislation or regulation – achieves all of the desired results.

Under pure RBT, the Internal Revenue Code, as the package of regulations that govern the way Americans are taxed is called, would not claim the right to tax individuals who live outside of the U.S., except to the extent that they had U.S.-source income. An individual's citizenship would be irrelevant.

Some recent proposals that are being called RBT would not achieve this.

Instead, these proposals envision a regime that would see continued U.S. jurisdiction over individuals, based on their U.S. citizenship (in the mode of citizenship-based taxation or CBT, which is what the U.S. currently has – and has had ever since the American Civil War), with a "carve out" for certain types of non-U.S. income, which would be exempt from U.S. taxation.

Essentially, these other versions of RBT would see an expansion of the current Foreign Earned Income Exclusion that would extend to other types of foreign-sourced income.

Significantly, they would still require continuing compliance by the American citizens living abroad in question, in the form of annual certifications.

Furthermore, these proposals are not clear about exemptions to various information reporting required under both the Internal Revenue Code and the Bank Secrecy Act.

At SEAT, we believe it is essential that Congress and those advocating for change understand the differences between pure RBT and such other revampings of the current CBT regime that are also being referred to as RBT, but which are not RBT.

This is because, given the difficulty we face in attempting to get Congress to even consider the U.S. tax problems of Americans abroad, we believe it is essential that pure RBT be incorporated in their reforms, and not one of these "RBT Lites".

What RBT is

In it’s clearest and simplest form, RBT is the principle that only actual residence confers on a country the right to treat an individual as a tax resident, subject to all of the domestic tax rules including taxation of income sourced outside of the country.

Citizenship on its own should not be sufficient to confer jurisdiction to tax (or require disclosure of) non-U.S. source income or assets.

An individual should be able to be subject to the full tax code of just one country at a time, so that they can take advantage of the tax incentives offered by their country of residence, and invest for their future.

A non-resident of the U.S. should not have to worry about changes, for example, to U.S. domestic tax law that might have adverse consequences to their non-U.S. income or assets.

Under pure RBT, U.S. citizens living outside the United States would not be part of the U.S. tax base at all. (This is explained by SEAT co-founder Richardson, in one of his  CitizenshipSolutions website articles.)

A measure of the logic that lies at the root of RBT, which is often pointed out, is the fact that RBT is practiced by every other developed country on the planet. Less well known but also true is the fact that it's also practiced by all U.S. states which have an income tax.

What RBT isn’t

As we at SEAT see it, any proposal that requires ongoing U.S. tax compliance on the part of Americans who live abroad, even if it’s much simpler than current compliance requirements we are currently obliged to meet, is not RBT. Full stop. 

Some of the proposals for fixing the current, dysfunctional U.S. CBT regime that are currently circulating, however, do not follow the principle that the jurisdiction of the tax system should depend exclusively on an individual's residence, without any element of citizenship coming into the equation.

Instead, much of what is being called “RBT” continues the CBT practice of treating U.S. citizens living outside of the United States as part of the U.S. tax base – it then exempts their non-U.S. income from U.S. taxation.

Most of these proposals include an annual filing requirement, if only to claim eligibility for the exemption of the individual's non-U.S. income from U.S. taxes.

These annual filing requirements effectively concede that non-resident citizens are still part of the U.S. tax base.

Under such a regime, as long as the annual filing requirements remain, then the possibility that future changes in U.S. domestic tax law could have adverse consequences for U.S. citizens abroad would also continue to exist.

These proposals are, obviously, not pure RBT, because they don't begin with the idea that that under no circumstances should there be any flexibility with respect to the idea that non-residents of the U.S. should be considered to be outside of the U.S. tax base.

As explained above, they merely reform CBT, through the use of a "carve out," to make it work somewhat better.

Why RBT is essential

The current U.S. citizenship-based taxation system has created myriad unintended consequences for Americans who have emigrated to other countries. These have been widely documented. Here are some of the most egregious examples:

Transition Tax and GILTI

When Congress passed the Tax Cuts and Jobs Act (TCJA) in late 2017, it included several provisions that changed the way the U.S. taxes “controlled foreign corporations” (CFCs).

Much of the discussion at the time was about the impact that these changes would have on large multinational corporations.

However, the definition of CFC includes any non-US corporation owned by “U.S. shareholders” – including small corporations owned by U.S. citizens living outside of the United States.

A dentist in Melbourne, a yoga instructor with their own studio in Toronto, or a small construction company in Paris, for example, could all be considered CFCs if they were organized as a corporation, and owned by U.S. citizens.

Pre-TCJA, running a small non-U.S. business like these through a corporate structure, if you were an American living overseas, was often tax-effective, from both the U.S. and local tax perspectives.

The Tax Cuts and Jobs Act, though, made made no distinction between small businesses like these, and the non-U.S. subsidiaries of multi-national giants like Apple, Amazon and Google.

Even worse, for such small business owners, under the TCJA's §965 Transition Tax, CFCs were required to pay a one-off U.S. tax on their accumulated earnings dating back as far as 1986 – even if these earnings had not been distributed to the shareholders, and even if the corporation lacked the liquid assets to make such a distribution.

What's more, if not handled carefully, this could easily generate a timing difference between the individual taxpayer's U.S. and local tax reporting, which could mean that the foreign tax paid was not available for them to claim as a foreign tax credit, to offset the U.S. taxes they owed.

Then, from 2018 forward, TCJA created a new category of income called Global Intangible Low-Taxed Income (GILTI), which was taxable to U.S. shareholders of CFCs, even though there may not have been any actual distribution of income.

Pure RBT would avoid this type of problem in the future, as non-residents would be considered to be outside of the U.S. for tax purposes, and would therefore, not be treated as U.S. shareholders.

Interestingly, all the CBT reform proposals to date that we've seen have either been silent on the application of CFC rules to U.S. shareholders living outside of the U.S., or have left the CFC tax and reporting regime in place.

PFICs

Passive Foreign Investment Companies (PFICs, usually pronounced "piff-icks"), as explained in §1297 of the Internal Revenue Code, is the official term given by the U.S. Treasury to such "collective investments" as mutual funds, managed funds, listed investment companies, exchange traded funds, etc.

For such investments held by Americans who live outside of the U.S., the PFIC rules either apply a confiscatory tax rate plus daily compounded interest on the deemed tax deferral, OR they require annual inclusion of unrealized capital gains in U.S. taxable income.

The result is that it is not possible for non-U.S. residents to invest in local markets (and local currency) in the same way that U.S. residents can.

Investment returns are diminished by not allowing “deferral” of capital gains income until a realization event occurs.

Furthermore, the reporting requirements for PFICs are over the top. Incredibly, the IRS estimates that preparation of Form 8621 will take the average taxpayer more than 20 hours, with an additional 17 hours for recordkeeping, and 11 hours to learn about the law.

A separate form is required for each investment – making PFICs are a real boon for the tax compliance industry.

Pure RBT would eliminate PFIC reporting for non-residents, as such individuals would, under the RBT regime, be outside of the US tax system.

Current CBT reform proposals we're familiar with are silent about any change to PFIC reporting requirements, although they would presumably exempt PFICs owned by non-residents from U.S. income tax.

FATCA

The signing into law in March, 2010 of FATCA (Foreign Account Tax Compliance Act), and it’s worldwide implementation over the years between 2012 and 2015 has caused many non-U.S. banks to limit the banking products they allow expat Americans to have access to, even if the expats in question happen to be citizens of the country in which they now live, and therefore wish to maintain their banking and financial accounts.

With pure RBT, the U.S. no longer would have a U.S. tax claim over non-resident Americans, so FATCA reporting would be limited to actual residents of the U.S.

Proposals to merely reform the existing CBT regime may or may not exempt non-residents from FATCA.

Other changes

American citizens who live outside of the U.S. may not wish to hear this, but they have no choice: As long as they live abroad, they will need to keep up-to-date with any  changes to the U.S. Tax Code that may occur, even though these are rarely publicized:

       *  In the individual tax provisions of TCJA, for example, Congress eliminated the personal exemption, while greatly increasing the standard deduction. This might seem to be a positive change, but there was a little-known (and probably unintended) interaction with the filing requirements set out in §6012 of the U.S. Tax Code, which requires a return from most taxpayers whenever their gross income exceeds the sum of the standard deduction and allowable personal exemptions.

For those with a filing status of Married Filing Separately (MFS), however, a return is required whenever income exceeds the personal exemption.

Now that personal exemptions are zero, this means that anyone using the MFS filing status must file a return, even if their income is zero.

Fortunately, the IRS realized the insanity of requiring returns with zero income, and raised the threshold from zero to US$5.00!

Note that this is neither a trivial nor an inconsequential matter. The requirement to file a tax return would (assuming the thresholds are met) also trigger the requirement to file a Form 8938 ("Statement of Specified Foreign Financial Assets"). 

This form obliges the taxpayer to disclose all of their "foreign" (non-U.S.) financial assets, including assets that they might hold jointly with a non-U.S. citizen spouse  – even if they have as little as US$5 in gross annual income.

       *   In the early 2000s, as official concerns about the financing of criminal enterprises and tax evasion began to increase, Congress significantly increased the penalties for failure to file so-called Foreign Bank Account Reports (FBARs).  Prior to this, few taxpayers were aware of the existence of FBARs, and many were caught out, and hit with eye-watering penalties as a result, particularly after FATCA shone a spotlight on overseas bank accounts held by American citizens.

       *   Meanwhile, in 1997, the U.S. changed the tax treatment of gains on the sale of Americans' principal residence. Until this time, taxpayers could roll any gains they realized as a result of the sale into a new residence, as long as certain conditions were met, without having to pay tax on them.

But under the new rules, any gains would be considered taxable in the year the property sale took place, although an exemption of US$500,000 was provided for on a joint return if, again, certain conditions were met.

The rules were made to apply to taxpayers' principal residences regardless of the location  – so those living in countries such as Canada or Australia, where capital gains on the sale of a principal residence are exempt, were, and continue to be, often caught out.

Those who left the U.S. prior to 1997, meanwhile, may not be familiar with the changed rules.

In short, every time Congress makes even minor changes to the U.S. Internal Revenue Code, there is a possibility that U.S. citizens abroad will be adversely affected – particularly since U.S. lawmakers simply don't routinely consider the impact that such changes might have on non-resident citizens.

As long as non-residents have any ongoing filing requirements, therefore, they will be potentially subject to unintended consequences of changes to the Internal Revenue Code, and thus need to remain informed.

Which we at SEAT believe is wrong. We think individuals ought to be able to emigrate from the U.S. without having to worry about such things, particularly if they've been abroad for decades. 

Implementing 'pure RBT'

One of the main reasons some people oppose RBT in its "pure" form in the U.S. is out of concern that it would enable high-net-worth Americans to easily establish legal residence in low-tax jurisdictions, and by doing this, avoid their U.S. tax obligations completely. This is the reason, some say, that some Washington lawmakers are wary of appearing to endorse Pure RBT, as they are thought to worry that some constituents will think they're on the side of wealthy would-be tax evaders.  

But other countries have had similar concerns, and have found ways to address them.

Some make it difficult (but not impossible) for such individuals to fully end their tax residence, often by using the concept of "domicile" to define residence.

Some apply a departure tax on an individual's appreciated assets at the time when their tax residence is severed.

Some do both. Implementing RBT, then, will require a close look at what constitutes residence and what happens when residence changes.

A good first cut as to how RBT could be written into the Internal Revenue Code may be found in this recent article by my SEAT colleague, Toronto-based lawyer John Richardson.

Residence

While all developed economies practice RBT, there are a variety of ways that residence – and therefore jurisdiction to tax “foreign” income – is determined.

For a summary, see the first section of a recent online panel discussion that included three of SEAT’s founding directors.

Some countries are quite “sticky,” and require some effort on the part of individuals to break their tax residence status.

A sticky definition of residence, such as domicile, is one way to ensure that it is more difficult for wealthy people to “game the system.”

But even for countries with sticky tax residence regimes and RBT, it is still possible for citizens to sever their tax residence without renouncing citizenship.

If the U.S. were to move to RBT, it is quite likely that Congress would want to add something like "domicile," or perhaps the “ordinarily resident” concept used by Canada and Australia, to the definition of "residence in §7701(b) of the tax code.

"Day-counting" rules, such as the current "substantial presence" test, are good for quickly catching people who move in to the country. More subjective tests, such as "domicile" and "ordinarily resident" are good for keeping people in the system until they clearly establish residence elsewhere. Many countries use both.

Loss of Residence

Many countries are concerned about the potential loss of their tax base when wealthy individuals relocate to other jurisdictions. 

And given international norms on sourcing capital gains, unrealized gains on personal property, including investments, at the time of a wealthy individual's departure, are often taxed only by the destination jurisdiction.

Under CBT, the U.S. "exit tax" (§877A) imposes tax on certain unrealized gains when a person is giving up their U.S. tax jurisdiction (e.g., when citizenship is renounced).

The main problem with the U.S.  exit tax is not that it exists, but the point at which the tax is measured and levied.

Because the U.S. claims tax jurisdiction over non-resident citizens, the current exit tax is often levied years, or even decades, after the individual left the U.S., and the assets covered therefore end up including assets accumulated, earned, and taxed in the destination country.

Other countries, including both Canada and Australia, have departure taxes. But the difference is that these countries measure and levy the tax at the time the tax residence is severed.

Therefore, these departure taxes capture gains accrued while the person is actually resident in the country.

Pure RBT is not inconsistent with a departure tax. In Part E of a recent John Richardson post,  in which he describes how Pure RBT might work, he proposes that §877A be amended to be triggered at the point of the loss of U.S. tax residence, rather than at the point of loss of citizenship. 

Furthermore, requiring notice on severing of tax residency gives those who prefer the current system the option to remain in that system – all they need to do is to keep filing tax returns as residents, while not giving notice of loss of U.S. tax residence.

Again, we've seen that the recent proposals to reform rather than replace CBT have tended to either not address how §877A might change, or they've proposed such new revenue-raisers as a new departure tax, while leaving §877A intact to apply again on loss of citizenship, were that eventually to happen.

Transition rules

As with any major change to the tax system, a move to RBT would require there to be a new set of regulations to deal with those individuals who are already resident overseas at the time it takes place.

Many of these non-resident U.S. citizens, of course, such as the "accidental Americans," should never have been in the U.S. tax base in the first place. Others left the U.S. years or decades ago and have set up their financial lives without any consideration having been given to the U.S. tax rules.

To expect these individuals to pay anything to “exit” the U.S. tax base is, we believe, absurd.

Pure RBT should let non-residents be non-residents. There should be no requirement to first come into U.S. tax compliance, or to pay an exit tax.

Conclusion

Getting the attention of Congress to address the U.S. tax problems of non-resident citizens was never going to be easy. Our votes are spread across all 50 U.S. states, so individual members of Congress barely notice us.

This is one reason that we think it's important that this this reform to the U.S. tax system be done right the first time and why, therefore, we stress the need to begin, and carry on our campaign for RBT, with "the end in mind."

Pure RBT recognizes that non-residents should not be considered to fall under the U.S.'s tax jurisdiction.

Non-U.S. resident Americans' non-U.S. assets and income are properly outside of the U.S. tax base, and once an individual is no longer resident on U.S. soil, no further U.S. tax compliance should be required.

At SEAT, we believe that only pure RBT will address the U.S. tax problems faced by all individuals living outside of the U.S., including U.S. emigrants and accidental Americans – allowing them to invest, bank, and arrange their financial affairs under the tax laws of the country in which they live, and no other.

That is, pure RBT is the only solution that solves the problems of all individuals and groups impacted.

CBT reform that falls short of this goal will mean that U.S. emigrants would be looking over their shoulders at the IRS, and U.S. tax law changes, for the rest of their lives.
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Karen Alpert lower resDr. Karen Alpert, pictured left, is a former U.S. citizen who now lives in Brisbane, Australia, where she recently retired from her career as a finance lecturer at the University of Queensland, and where she continues to work as a tax expert, and as a passionate advocate for tax fairness. She oversees a blog entitled FixtheTaxTreaty.org.

To read and download her 2018 paper, "Investing with One Hand Tied Behind Your Back – An Australian Perspective on United States Tax Rules for Non-Resident Citizens", click here.