In Part I, I argued that the benefits rationale – in terms of the public benefits received by citizens – was an unpersuasive justification for the U.S.’s system of worldwide taxation.
I continue my rant in Part II, examining the practical effects of worldwide taxation on non-resident U.S. citizens. Through a labyrinth of “credits, deductions, exclusions, and non-deductibility,” the Internal Revenue Code treats similarly situated U.S. citizens who live abroad differently.[i] How so? Such persons pay different U.S. taxes depending upon the types and amounts of the taxes imposed by the countries in which they live.[ii]
This disparate treatment in tax liability is inconsistent with the benefits rationale for U.S. worldwide taxation, not to mention the Equal Protection Clause. Why? Because such citizens receive the same benefits of U.S. citizenship, yet pay different U.S. taxes.[iii]
In order to understand this argument, it is necessary to examine the ways in which the U.S. government attempts to blunt the harsh effects of worldwide taxation. It makes three primary concessions: (1) “the foreign tax credit”; (2) “deductions for foreign taxes paid in connection with a U.S. taxpayer’s trade, business, or investment activities;” and (3) the “exclusion under Section 911.”[iv]
Let’s begin with the foreign tax credit. In the income tax setting, the most important accommodation made by the U.S. to mitigate worldwide taxation is the foreign tax credit.[v] It lies at the heart of the system of outbound U.S. taxation.
I want you to put off to the side what you already know about the foreign tax credit so that you can approach this topic with an open mind. The foreign tax credit rests on a simple idea. How simple? Income taxes paid to the U.S. treasury are reduced (i.e., credited) by the amount of income taxes paid by U.S. persons to foreign governments. In so doing, the credit prevents double taxation of the foreign income of U.S. persons.
Let me explain how a credit works. A credit is nothing more than “a dollar-for-dollar reduction of U.S. income tax by the amount of foreign income tax.”[vi] The tax savings from a credit is “the exact amount of the credit itself.”[vii]
Before giving “props” to the U.S. government for passing the foreign tax credit, wait until you hear the rest of the story. Not satisfied with the existing system, in 1921 Congress limited the credit to the amount of U.S. tax attributable to foreign-source income. The credit is available only to the extent that the taxpayer “pays foreign income taxes on foreign-source income at or below the rate at which the U.S. taxes such income.”[viii]
The following two hypotheticals will drive home this point. Each appeared in a brilliant law review article entitled, “Citizenship and Worldwide Taxation: Citizenship as an Administrable Proxy for Domicile,” by Edward Zelinsky.[ix] Let’s assume that the U.S. income tax rate and the foreign country’s income tax rates are identical: each is 30%. Suppose that Adam is a U.S. citizen. Adam owns a condominium in Country X that he rents out.
Suppose that Adam earns $ 100 from renting his condominium in Country X. Adam properly reports his rental income as part of his worldwide income on his U.S. tax return. Thankfully, there are no badges of fraud that might suggest that Adam is engaging in tax “hanky-panky.”
Adam’s income tax liability in Country X, the source jurisdiction, would be $ 30 (30% of $ 100). The U.S. tax on that same income, pre-credit, would also be $ 30 (30% of $ 100). However, instead of paying $ 30 to the U.S. Treasury, Adam can credit the $ 30 he paid to Country X against the tax he would otherwise owe to the U.S.
At the end of the day, Adam would not owe any tax to the U.S. Treasury on his foreign-source rental income. Very simply, the income tax paid to Country X completely offsets Adam’s U.S. foreign-source tax liability. Instead of paying $ 60 in taxes, Adam would pay only $ 30.
Adam’s effective tax rate would be 30 percent, the same as if that income had been earned by a U.S. citizen living in the U.S.
What actually happened here? At a primitive level, the U.S. surrendered the tax it would otherwise have collected from Adam, a U.S. citizen with foreign-source income, to Country X, the foreign country from which the income was derived.
Now let’s add a twist. Suppose that foreign country’s income tax rate is less than the United States’ income tax rate. For example, suppose that Country X’s income tax rate was 20% instead of 30%. Would the result be the same? In that case, Adam would pay $ 20 of tax to Country X.[x] He would “take a credit on his U.S. tax return for that $ 20 income tax payment.”[xi] After subtracting $ 20 from $ 30, Adam would pay “a net tax to the U.S. of $ 10 on his rental income from his condominium.”[xii]
From this example, we can formulate a simple rule: When the foreign income tax rate is “less” than the U.S. rate, “foreign income taxes can be credited in full” and the IRS will collect a balance consisting of “the excess of the U.S. rate over the foreign rate.”[xiii] In the above example, the “excess” collected by the U.S. Treasury was $ 10.
The upshot of the credit coupled with the limitation (if there ever was one), is that the effective tax rate on a U.S. person’s foreign-source income is the higher of the U.S. or the foreign rate.
The second accommodation that the U.S. makes to mitigate the harsh effects of worldwide taxation is deductions for taxes paid to a foreign government.[xiv] Unlike a credit, a deduction is a reduction of taxable income by the amount of a given expense. The tax savings from a deduction is the amount of tax that would otherwise have been imposed on the deducted amount.[xv]
Consider the following example, in which the U.S. and foreign income tax rates are both 30%. For every dollar of foreign-source income, the foreign country would impose a tax of 30 cents.
Let’s first examine the taxpayer’s U.S. tax liability. The U.S. taxes its citizens and residents on their worldwide income, which includes both U.S.-source and foreign-source income. Let’s assume that the taxpayer only has $ 1.00 of foreign-source income. A deduction of the foreign tax would reduce U.S. foreign-source income by 30 cents, leaving 70 cents subject to U.S. tax ($ 1.00 (-) 30 cents). At a thirty-percent rate, U.S. tax would be 21 cents (30% of 70 cents).
For every dollar of foreign-source income, the taxpayer would pay fifty-one cents of tax (30 cents to the foreign government AND 21 cents to the U.S.). The taxpayer would have 49 cents left over after payment of all taxes.
When deducted (as opposed to credited), a payment of 30 cents of income tax to the foreign country reduces U.S. income tax by only 9 cents (30 cents (-) 9 cents = 21 cents).
The taxpayer would end up paying tax – to two different countries – at an overall effective rate of 51 percent.[xvi] For this reason, it’s preferable to credit an amount against taxes than to deduct it from income.[xvii]
An important limitation applies to the deduction of foreign taxes for U.S. income tax purposes. Foreign taxes may only be deducted if they bare some connection to a U.S taxpayer’s trade, business, or investment activities.[xviii] For example, “foreign sales tax is not deductible for U.S. income tax purposes.”[xix] The one exception is for foreign real property taxes.[xx] A U.S. taxpayer can deduct foreign real property taxes even if they have no connection whatsoever to trade, business, or investment income.[xxi]
Finally, the third major concession that the U.S. makes to “tame” the beast of worldwide taxation is the exclusion under Section 911 for “certain nonresident citizens’ personal service income that is earned abroad” and for “housing cost amount(s).”[xxii] With respect to the former, a U.S. citizen who satisfies the nonresidency requirements of 911 “may elect to exclude from his annual gross income up to a certain amount of income … earned abroad from performing personal services, including personal services rendered in connection with self-employment.”[xxiii] For 2013, that amount was $ 97,600.
Nonresident U.S. citizens who satisfy Section 911’s nonresidency requirements may – “in addition to or instead” – be able “to exclude (or deduct) from their gross income some or all of their foreign housing expenses.”[xxiv] The justification for Section 911 is relatively simple: “it facilitates the ability of U.S. citizens to work abroad.”[xxv]
What are the requirements imposed by Section 911? The list might just as well be as long as a child’s Christmas “Wishlist” to Santa. First, the taxpayer must have a “tax home” abroad.[xxvi] And second, the taxpayer must be either (1) “a bona fide resident of a foreign country or countries for an uninterrupted period which includes an entire taxable year”[xxvii] or (b) “during any period of 12 consecutive months [been] present in a foreign country or countries during at least 330 full days in such period.”[xxviii]
How about self-employed U.S. citizens who live abroad? Do they qualify for the Section 911 income tax exclusion? Absent a totalization agreement, the answer is “no.”[xxix] Like the federal income tax, the federal self-employment tax “applies to U.S. citizens on a worldwide basis.”[xxx] Thus, “self-employed U.S. citizens or residents who work abroad must pay federal self-employment tax on their foreign-source earned income,”[xxxi] even if they would otherwise qualify for the Section 911 income tax exclusion.
There are differences between the Section 911 exclusion and the foreign tax credit that at first blush are not so obvious. First, the Section 911 exclusion is “only available to nonresident citizens.”[xxxii] The foreign tax credit, on the other hand, “is available to all U.S. citizens”[xxxiii] – resident and nonresident alike – so long as they have “foreign-source income.”[xxxiv]
Second, unlike the foreign tax credit, the Section 911 exclusion “does not depend upon a U.S. citizen’s payment of any income tax to the source jurisdiction.[xxxv]The practical consequence of this is that “income covered by Section 911”[xxxvi]is rarely, if ever, “taxed … by the nation in which it is earned [or] by the U.S.”[xxxvii]
With this background, you should find it easier to understand my argument. Let’s take the following example, taken from Mr. Zelinsky’s article entitled, “Citizenship and Worldwide Taxation: Citizenship as an Administrable Proxy for Domicile.”
Abe, Brian, and Carol are U.S. citizens who reside in three different countries. Abe lives in Country X. Brian lives in Country Y. And Carol lives in Country Z.
Abe, Brian, and Carol each has total income of $ 100, derived from sources within their particular country of residence.[xxxviii] They are each in a 30% income tax bracket in the United States.[xxxix]
Country X imposes an “income tax at the rate of 30%,” while Country Y levies a “property tax,” and Country Z imposes a “general sales tax.”[xl]
For purposes of keeping this example as straightforward as possible, suppose that Brian pays “$ 30 of property tax to Country Y” and Carol pays “$ 30 in sales tax to Country Z.”[xli]
As a matter of U.S. law, Abe, Brian, and Carol must pay U.S. income tax on their respective worldwide incomes.[xlii] Practically speaking, however, the Internal Revenue Code treats Abe, Brian, and Carol “differently.”[xliii]
Let’s analyze this hypo as if it was a swinging pendulum in a grandfather clock. At one extreme is Abe.[xliv] Abe pays no U.S. income tax whatsoever.[xlv] Why? Because Abe paid $ 30 of foreign tax to Country X, which is credited against the $ 30 of tax he would otherwise have had to pay to the U.S.[xlvi] Thus, his $ 30 income tax payment to Country X completely offsets his federal income tax obligation to the U.S.[xlvii]
At the other extreme is Carol. Carol pays $ 30 in sales tax to Country Z on $ 100 of income, receiving “neither a credit nor a deduction” by the U.S. government.[xlviii]
In the center is Brian.[xlix] After deducting his $ 30 property tax payment to Country Y, he “pays $ 21 of income tax to the U.S. Treasury.”[l] No doubt Abe is the taxpayer who is in the most desirable position vis-à-vis his U.S. income tax obligations.
You might criticize this example on the grounds that it manufactured a scenario that was bound to lead to divergent tax liabilities. After all, all three taxpayers lived in different countries, and variances are to be expected. Surely, this disparity wouldn’t exist if all three lived in the same country. Or would it?
Let’s explore that by examining a hypo involving two U.S. citizens who reside in the same foreign country. Because we’re feeling a little bold, not to mention daring, let’s inject the Section 911 exclusion into the mix.
Suppose that Debra and Edward are both U.S. citizens who live in the same foreign country, Country M. Assume the following additional facts:
- Both Debra and Edward have income of $ 100, derived from sources within Country M;[li]
- Both Debra and Edward are in a “30% bracket for U.S. income tax purposes;”[lii] and
- Country M imposes a 30% sales tax.[liii]
While they share all of the above in common, there is one difference – their income is not derived from the same source. Debra works for a foreign corporation in Country M.[liv] Because her income is derived from her employment, Debra is eligible for the Section 911 exclusion.[lv]
If the justification for worldwide taxation under the benefits rationale is woefully inadequate, then why do we continue to indulge in this fiction? In my opinion, if you scratch below the surface, you’ll find that the single-most influential factor in the majority’s decision comes down to one word: enforceability. While this word was not uttered once in the Cook v. Tait opinion, the fact remains that there are hints throughout that the majority was well aware of the popular belief – even back then – that residence-based taxation on worldwide income was the most efficient system to administer, and thus enforce.
Thus, I’d argue that the Court’s justification for validating worldwide taxation in Cook v. Tait has more to do with “ability to pay considerations” than it does with “benefits of citizenship.”
A simple comparison of a worldwide system of taxation to a source-based system of taxation reveals why the former is easier to administer than the latter. As a preliminary matter, at the heart of this is the deep-rooted belief held by tax scholars that the country of residence is better suited than the country of source to measure an individual’s overall ability to pay tax.[lx]
How so? By virtue of the “person’s presence in his country of residence,” that country is in the best position “to measure and tax an individual’s overall ability to pay tax.”[lxi] For example, the nation of residence is usually the country in which the taxpayer “works, earns at least some of her investment income, and maintains some (if not all) of her assets.”[lxii] Thus, it can require the taxpayer to “aggregate and report her worldwide income from all sources”[lxiii] and enforce any judgments against the taxpayer for any liability arising from that income and assets.[lxiv]
By contrast, the source nation only has a claim to tax that part of a taxpayer’s income arising within its borders.[lxv] Because taxing systems must consider a person’s “overall ability to pay”[lxvi] – which necessarily requires itemizing “all of a person’s sources of income and wealth”[lxvii] – residence-based taxation is more advantageous than source-based taxation.
Consider one final example, which again comes from the creative genius of Mr. Zelinsky. Alan is a businessman who is a resident of Country X.[lxviii] He works for a company in Country X. Alan also owns property in two foreign countries: Country Y and Country Z, respectively.[lxix] He owns a condominium in Country Y, which he rents out during the year.[lxx] Alan owns a second condominium in Country Z, which he also rents out.[lxxi]
As the source countries in which the rent arises, Country Y and Country Z have the right to tax the rental incomes generated by Alan’s condominiums, since they are located within their respective borders.[lxxii] For example, Countries Y and Z can tax that rent by forcing Alan’s tenant in each country to withhold tax from his rent payments, and send it to Country Y and Country Z’s respective treasuries.[lxxiii]
While this might appear to be adequate, the problem is that Country Y and Country Z can only assess “that part of Alan’s income that arose within their respective borders (i.e., rental income).”[lxxiv] Thus, while Country Y can foreclose on Alan’s condominium located within Country Y if Alan defaults, consider what would happen if the foreclosure sale fell short of covering Alan’s Country Y tax deficiency. Could Country Y impose a lien for the balance of that deficiency on Alan’s second condominium in Country Z?
Alan’s Country Z condominium is unlikely to become encumbered by a Country Y lien for the balance of the deficiency. Why? Very simply, Country Y knows nothing about Alan’s Country Z condominium.
On the other hand, Country X, as the country in which Alan lives, “has the strongest claim to tax Alan’s overall income” because it is best positioned “to assess [his] overall ability to pay tax.”[lxxv]For example, Country X can demand information about all of Alan’s income from sources within Country X, Country Y, and Country Z.[lxxvi] Armed with this information, Country X can then enforce its tax laws against Alan.[lxxvii]
Now you know the rest of the story, namely the true justification for the United States’ system of worldwide taxation.
[i] Citizenship and Worldwide Taxation: Citizenship as an Administrable Proxy for Domicile, Edward Zelinski, Iowa Law Review, 2011, p. 1292.
[ii] Id. at p. 1298.
[iii] Id. at p. 1297.
[iv] Id. at pp. 1297-99.
[v] Id. at p. 1297.
[vi] International Taxation, Joseph Isenbergh, Second Edition, Foundation Press, 2005.
[vii] Id., supra, Note (vi).
[viii] Id., supra, Note (i), at p. 1297.
[xiii] Id., supra, Note (vi).
[xiv] Id., supra, Note (i), at p. 1297.
[xv] Id., supra, Note (vi).
[xviii] I.R.C. Section 164(a).
[xix] Id., supra, Note (i) at p. 1298.
[xxiv] Id. at 1298-99.
[xxv] Id. at 1299.
[xxvi] Section 911(d)(1), (3).
[xxvii] Section 911(d)(1)(A).
[xxviii] Section 911(d)(1)(B).
[xxix] Id., supra, Note (i), at p. 1300.
[xxx] Id. at 1299-1300.
[xxxi] Id. at 1300.
[xxxii] Id. at 1299.
[xxxviii] Id. at 1313.
[li] Id. at 1314.
[lx] Id. at 1294.
[lxii] Id. at 1323.
[lxiii] Id. at 1294.
[lxiv] Id. at 1323.
[lxv] Id. at 1294.
[lxix] id. at 1295.
[lxx] Id. at 1294.
[lxxi] Id. at 1295.
[lxxii] Id. at 1294.
[lxxiv] Id. at 1295.