The State Department estimates that about nine million US citizens live outside American borders. And in recent years, Congress and the IRS have made their lives a living hell.
One big reason is that the US is one of only two countries that impose the same tax and reporting obligations on citizens living in another country as those living within its territory. The other one is Eritrea, described by Human Rights Watch as a “one-man dictatorship.”
If you’re careful, you can usually avoid paying tax twice on the same income. But income that’s legally tax deferred in, say, a UK pension plan, might not be tax deferred in the US. And you still need to submit two tax returns annually, a time-consuming and expensive task.
Awe-inspiring penalties apply if you innocently slip up. Ray, one of our clients, is a great example. He moved to Canada more than 40 years ago. A few years after he arrived, he acquired Canadian citizenship. When he did so, he thought that he had automatically given up his US citizenship. It’s easy to make that mistake, because the State Department calls acquiring a second citizenship an “expatriating act.” (It is, but only if you confirm your intention to give up your citizenship at a US consulate.) He therefore stopped filing US tax returns.
Eventually, Ray married a Canadian woman and they had a child. Shortly after the child was born, he purchased a Canadian life insurance policy naming his wife and newborn son as beneficiaries.
This innocent act triggered some unpleasant tax consequences back in the US. Unfortunately, in most cases, a non-US life insurance policy isn’t recognized as “life insurance” under the US Tax Code. It’s possible to design a foreign life insurance policy that complies with US tax laws, but most non-US insurance companies don’t bother.
And why should they? After all, the vast majority of the people who buy life insurance in say, France or Germany, don’t need to worry about taxes in the US. And it’s the same in Canada.
What that meant for Ray is that the entire value in the life insurance policy that he built up over 40 years was taxable. So he had $100,000 of unreported income in Canadian dollars that he had never declared to the IRS.
Worse, Ray didn’t realize that a life insurance policy is considered a “foreign account” that must be reported to the IRS. In 2011, the IRS published regulations in the Federal Register extending reporting obligations to foreign life insurance policies with a cash value. That clearly covered Ray’s policy. Since he failed to report it, he faces a penalty of $10,000/year (or more) simply for failing to file a reporting form.
Naturally, the entire time Ray has lived in Canada, he’s paid Canadian taxes, which are considerably higher than taxes in the US. Yet, under US tax rules, he’s treated as if he never left the good ol’ Red, White, and Blue.
Does Ray sound like a tax evader to you?
And don’t forget that the US can revoke the passport of any citizen who owes more than $50,000 in taxes or tax-related penalties. That’s a minor inconvenience to most Americans, since fewer than 50% of US citizens even have a passport. And it’s less of a threat to folks like Ray who already have a second passport.
But a US citizen living abroad on a visa must use their passport regularly to identify themselves. And the visa that gives a foreigner official permission to live in another country is issued only in conjunction with a valid passport. Take away that passport, and unless you have a spare, you can no longer live in that country.
That’s bad enough. But the IRS makes matters worse, courtesy of FATCA, the Foreign Account Tax Compliance Act.
Although you’ve probably heard about FATCA, most Americans haven’t. US residents who don’t invest abroad are unaffected by the law. But if you’re one of the nine million Americans living abroad, FATCA is very bad news indeed.
FATCA demands that every foreign financial institution (FFI) in the world sign and strictly comply with an agreement with the IRS to turn over the account information of its US clients. FFIs that fail to do so are subject to a 30% withholding tax on certain payment from US sources.
FATCA has given the IRS carte blanche to adopt a scorched earth policy with respect to US citizens living abroad. Spurred on by Congress, the agency’s working presumption seems to be that millions of citizens are tax evaders. Indeed, according to Senator Elizabeth Warren (D-MA):
“The US Treasury may be losing more than $100 billion in tax revenues every year as a result of offshore tax havens. I believe measures like FATCA clamp down on overseas tax evasion and help make sure that everyone pays their fair share of taxes.”
It turns out that the $100 billion tax-loss claim is a myth. One of my colleagues tracked down the man who made this claim (at the time, it was merely $70 billion) and asked him on the record how he had arrived at this number. His response? “I guessed.”
Is there any evidence that this guess is anywhere close to accurate? The answer is no, because most US citizens living abroad reside in countries with income tax rates as high as or higher than the US. For instance, at least 660,000 US citizens (like Ray) live in Canada, where the top combined federal and provincial income tax rate can approach 50%. In one province – Newfoundland and Labrador – the top combined rate is 51.3%.
Does Canada sound like a tax haven to you?
FATCA made US clients very unpopular at foreign financial institutions. Since its enactment, many Americans have found it impossible to open legitimate accounts overseas and faced closure of existing ones based on their nationality. Several of our clients found themselves unable to maintain accounts in their adopted countries. Others had mortgages and life insurance policies canceled. One client was told he needed to give up his US citizenship to keep his job.
And now, Congress has again royally screwed Americans living abroad, courtesy of the tax bill it enacted at the end of 2017. The new law is favorable to domestic corporations and lowers individual tax rates significantly. But if you have deferred profits in what the Tax Code refers to as a controlled foreign corporation (CFC), a foreign corporation with more than 50% US ownership, you’re subject to a mandatory one-time repatriation tax of 15.5%. For less liquid assets like real estate, the tax rate is 8%.
The problem is especially acute for US citizens living abroad who use foreign corporations as a savings vehicle and have no intention of repatriating the profits to the US. For instance, many Canadian residents use Canadian CFCs to operate small businesses and set up pension plans. Net profits in these corporations are fully taxable in Canada only when they’re distributed. The repatriation tax effectively confiscates a portion of deferred profits of these corporations, with no provision in Canadian law to offset the tax. Up to 15.5% of the profits are thus subject to double taxation. The only good news is that if you’re affected by this tax, you have eight years to pay it.
With friends like Congress and the IRS, it’s no surprise that tens of thousands of US citizens, especially those already living abroad, have decided their citizenship is more trouble than it's worth. The number of individuals expatriating is increasing rapidly. In 2017 alone, more than 5,000 Americans turned in their passports.
Obviously, the decision to give up US citizenship is a big one. It requires that you acquire a second passport if you don’t already have one. It also requires that you live permanently outside the US, if you don’t already do so. But it’s the only way to permanently and legally disconnect yourself from Congress and the IRS.
