L. C. 1 ha. 1 2 /3: ix: 8 7__ L. 5Q E Government Publications Unit 87-452 E AUG 1 7 3994 Wsmton un‘ - - . CRS REPORT FOR CONGRESS 3; LQui$’n;ve'1g‘té3;';%rarms \ 5' V ‘iv; ‘ x. " 1., ‘gm ~. ,... _ ‘ i " ‘es ;-—.1-’ ;‘~‘.-" {"<..~.‘:ek ! ~17’ 43:‘ ‘? fi‘:fiq I ‘(E N ‘i 1!? ‘i:'=. " '3; ‘?L's’- ‘ r’.'<‘;; ‘ ‘* 2 ;'i«' 1 ‘r3: “:'*.«f "J: 1 37"’? 1 “" ;‘a'=~::_ ',‘,,~‘-u-..‘ _.——\ __w,‘ ,5 5-" 7-‘ ‘P5 =-''.“ ‘‘-’‘3- “=13 "¢'~. ‘'C‘''''’''’‘ ‘'*.'F’“‘':‘-. ’r‘’‘'.-'‘*'. '*:.-.‘=‘ . » -~. —.. 4‘ 7 I’ 9v- _'‘:,.‘f\ «A “A7 “oh re’ aw’ -72- :2; ‘Q FEDERAL TAXATION or I H at A , ~‘~*’» Wk "i.-,o"' .-fie. _.'»'}.f.,,,_,-1 33. "t-Sh _Z;_‘;x\ :17}, "gm 1'." v. :1 ¢ A -,- it r.=' . 1;; * IV 1 E.’ ,5 1 '~‘ ta; L‘ *5-:. H -K 3 ’ my \".r. .1. I S i J. ‘j ‘A. ’L it ‘ta ~ -~ »- .-.\....v .||s .L_z ;; _ ,1 ‘x “ ‘L If a U.S. citizen or resident works in a fore£gniiWV{;W{;fi’Ejgja/yzygyg country, he or she may nonetheless be liable for U.S. A iwfifll Federal income taxes; the United States reserves the right to tax its citizens and residents on their income, regard- less of where the income is earned. However, the U.S. foreign tax credit and a provision known as the foreign earned income exclusion may reduce or eliminate U.S. taxes for at least some Americans who work abroad. by David L. Brumbaugh Analysti11Public Finance Economics Division May 18, 1987 issouri - Columbia Nfllfininufi mumu mm 010-103940489 nivers lllll mini The Congressional Research Service works exclusively for the Congress, conducting research, analyzing legislation, and providing information at the request of committees, Mem- bers, and their staffs. The Service makes such research available, without parti- ‘smi-'biaosi;..ln.ifiany }forms including studies, reports, compila- tions, digests,'and background briefings. Upon request, CRS assists‘ coinifriittees in analyzing legislative proposals and issues, and in assessing the possible effects of these proposals l'and~their alternatives. The Service’s senior specialists and subject analysts are also available for personal consultations in their respective fields of expertise. CRS-iii CONTENTS THE FOREIGN EARNED INCOME EXCLUSION . . . Exclusion or Deduction of Foreign Housing Costs THE FOREIGN TAX CREDIT . . . . . . . . . FILING REQUIREMENTS AND AMERICANS OVERSEAS O FEDERAL TAXATION OF AMERICANS WHO WORK ABROAD If a U.S. person works overseas, he or she may still be liable for U.S. Federal income taxes; the United States asserts the right to tax its citizens and residents regardless of where they earn their income. There are, however, several special U.S. tax rules that make the taxation of income earned abroad different from the treatment of income earned in the United States, and which may reduce or eliminate U.S. taxes for at least some Americans who work overseas. The foreign earned income exclusion, for example, permits people who qualify to exclude some or allcfiftheir foreign earnings from taxable income. ‘Also, the U.S. foreign tax credit allows individuals who pay foreign income taxes to credit the foreign taxes against U.S. taxes they would owe. This report provides a brief summary of the special tax rules that apply to Americans who work abroad. It begins with an explanation of the foreign earned income exclusion, and continues with a discussion of the U.S. foreign tax credit. The report concludes with a description of several special filing situations that may confront U.S. expatriates when they file their tax returns. THE FOREIGN EARNED INCOME EXCLUSION In principle, the United States taxes its citizens and residents on their foreign income. l/ In practice, the foreign earned income exclusion permits expatriates who qualify to reduce (NT completely eliminate their U.S. tax liabilities. Individuals who qualify for the exclusion can exclude up to $70,000 of their foreign earningsihmmmtaxable income; qualifying taxpayers are also permitted to exclude expenditures for foreign housing. The exclusion contained in current law'was originally enacted with the Economic Recovery Tax Act of 1981 (P.L. 97-34), although a similar provision was in effect prior to 1981. The exclusion was designed to reduce the cost to U.S. multinationals of hiring U.S. citizens to work overseas -- a cost that was believed to be high, particularly in countries with relatively high living costs. It was believed that with the ex- clusion's reduction of costs, the overseas operations of U.S. firmssxndd be better able to compete with foreign businesses. It was also believed l/ The United States taxes individuals who are U.S. residents as well as its citizens on their worldwide income. The rules for deter- nnning whether a person isaaU.S. resident for tax purposes are contained ,in section 7701 of the U.S. Internal Revenue Code. CRS-2 that the exclusion would result in a higher level of Americans working overseas, which in turn would stimulate U.S exports. g] The most recent change in the exclusion was made by the Tax Reform Act of 1986 (P.L. 99-S14). Prior to the Tax Reform Act, the maximum exclusion was $80,000, and was scheduled to increase to $85,000 in 1988, $90,000 in 1989, and $95,000 in 1990. However, the Act reduced the maximum exclusion to a permanent level of $70,000, effective January 1, 1987. In order to qualify for the foreign earned income exc1usion,indiv- iduals must meet several requirements regarding their presence abroad. First, a person must have his or her "tax home" in a foreign country. According to Treasury Department regulations, an individual's tax home is generally the location of the person's principal place of business. _3_/ Second, qualifying individuals must either have their residence sin a foreign country (the so-called "bona fide residence" requirement) or must be physically present in a foreign country for a specified period of time (the "physical presence" test). 3/ To meet the bona fide residence test, a person must have had his or her residence in a foreign country for a period that includes a full tax year. §/ An individual satisfies the physical presence test if they are present in a foreign country for 330 full days of a consecutive twelve-month period. If.a person meets these qualifying tests, he or she can exclude a maximum annual amount of $70,000 from taxable income. However, the amount of the exclusion is reduced if a taxpayer qualifies for the exclu- sion for only part of the tax year. In such cases the exclusion is limited to the fraction of the $70,000 maximum amount that represents the portion of the year for which the person qualifies. Q] 2_/ U.S. Congress. Joint Committee on Taxation. General Explanation of the Economic Recovery Tax Act of 1981.’ Joint Committee Print, 97th Cong., 1st sess. Washington, U.S. Govt. Print. Off., 1981. p. 41-8. Q] U.S. Department of the Treasury. Regulation 1.911-2(b). fl/ Both U.S. citizens and resident aliens can qualify for the ex- clusion under the physical presence test. However, only U.S. citizens can use the bona fide residence test to qualify. §/ For rules on the bonafide residence test, see: U.S. Department of the Treasury. Regulations 1.871-2. For a discussion of how the Foreign Earned Income Exclusion's bonafide residence test compares to the test for U.S. residence, see: Bissell, Thomas St. G. Problems of Green Card Aliens Living Abroad. International Tax Journal. v. 13. Winter, 1987. p. 42. §/ For further details on the requirements for the exclusion and how the size of the exclusion is calculated, see: U.S. Department of the Treasury. Internal Revenue Service. Publication 54: Tax Guide for U.S. Citizens and Resident Aliens Abroad (Reva Nova 86). ‘Washington, U.S. Govt. Print. Off. 1986. 31 p. CRS-3 Even if a person's entire annual income is less than the annual amount calculated in this manner, the entire amount may not qualify for the exclusion. Only income that meets the tax code's definition of "foreign earned income" can be:excluded. lk>qualify, excluded income must first have its source in a foreign country. Generally, this means that the income must be compensation for services rendered in a foreign country. In addition, the income must be "earned" income rather than income from passive (i.e., financial) investment or retirement income. Thus, salaries, wages, and payment for professional services generally qualify for the exclusion, while interest and pension income generally do not. Another important category of income that does not qualify for the exclusion is amounts received from the U.S. Government. Thus, Federal employees cannot use the foreign earned income exclusion unless they receive additional salaries or wages from private sources. The foreign earned income exclusion, finally, is elective; use of the exclusion is optional, and a taxpayer must formally elect the provision at the time it is first used. Once made, an election remains in effect for subsequent tax years until it is revoked by choice of the taxpayer. However, if an election has been made and then revoked, the exclusion cannot be elected again for the following five tax years unless approval is obtained from the IRS. Z] Exclusion or Deduction of Foreign Housing Costs Expatriates who meet the residence or physical presence tests for the foreign earned income exclusion can also either exclude or deduct at least part of their foreign housing costs from taxable income. If the housing expenses are employer-provided (i.e., the employee is reim- bursed for the housing or the employer provides housing to the employee, free of charge), qualified costs are excluded from gross income. §f If housing expenses are not employer provided, costs that qualify are deducted from gross inconmu However, both tax deductions and tax exclu- sions reduce taxes in the same way -- the deducted or excluded amount 1/ A taxpayer might find it advantageous not to elect the exclusion if foreign tax credits result in a larger tax saving than the foreign earned income exclusion. For details on the foreign tax credit, see pages 5-7, below. See also: Khokar, Javed A. New Rules Relating to Taxation of Citizens and Resident Aliens Working Abroad. Tax Management International. v. 81. December, 1981. p. 15. Note also that an election must be filed with either a return that is filed on time, with a return amending a return that was filed on time, or within one year of a return's original due date. §/ Absent the foreign housing exclusion, the value of employer provided housing or employer compensation for housing costs would gener- ally be included in a taxpayer's taxable income. CRS-4 is subtracted from gross income. The housing deduction and housing exclusion thus have similar effects on tax liabilities. 9/ The housing exclusion or deduction that can be claimed is equal to the amount by which a taxpayer's qualified housing expenses exceed a base amount specified by the tax code. The base amount is designed to approximate the amount an expatriate would spend on housing in the United States, thereby linking the housing exclusion with the additional cost of obtaining housing overseas. The specific amount is equal to 16 percent of the salary of a Federal employee of the GS-14, step 1 level. As of January 1, 1987, the base amount was $7,109. Qualified housing costs include items such as rent, utilities, and insurance, but do not include taxes or mortgage interest, which are both deductible under separate tax code provisions. Qualified housing costs also do not include the acquisition cost of a house, or amounts spent on furnishings. As with the foreign earned income exclusion, the amount of the housing exclusion or deduction depends on the fraction of a tax year an individual spends abroad. The adjustment is made by increasing or reducing the base amount to reflect the portion of the tax year a person satisfies either the bona fide residence or physical presence test. lQ/ Fknra given amount of housing expenses, the larger the portion of the tax year that is spent abroad, the larger is the base amount, and the smaller is the exclusion. The exclusion or deduction of housing costs can generallylxaclaimed in addition to the foreign earned income exclusion proper; ‘Nonetheless, the tax code contains rules that place a limit on the total amount that can be subtracted from gross income under the foreign earned income exclusion and housing provisions combined. Generally, the amount excluded and/or deducted under the two provisions cannot exceed :3 taxpayer's total foreign earned income, including housing costs. Another way of stating this rule is that the same earnings cannot be subtracted from gross income twice. Suppose, for example, a person is abroad for an entire year, and so qualifies for the maximum $70,000 foreign earned income exclusion. Suppose also, however, the person has only $50,000 of foreign earned income, and spends $10,000 of the amount on foreign housing. The person could elect a $10,000 housing deduction, but income eligible for the earned income exclusion proper would be reduced by $10,000 to $40,000. Alternatively, the person could forego the housing exclusion and exclude 9/ Whether a given amount of housing costs is deducted or excluded may, however, result in different tax savings in some circumstances. See: Renfroe, Diane, Andre P. Fogarasi, and John Venuti. Key Inter- pretive Issues under the Proposed Section 911 Regulations. Tax Notes. September 19, 1983. p. 911. 19/ For details, see: U.S. Department of the Treasury. Internal Revenue Service. Publication 54: Tax.Cuide for U.S. Citizens and Resi- dent Aliens Abroad (Rev. Nov. 86). ‘ CRS-5 the entire $50,000 of foreign income under the foreign earned income exclusion. In either case, the total amount excluded could not exceed the person's total foreign earned income, inclusive of housing expen- ditures. THE FOREIGN TAX CREDIT Another special tax provision that applies to Americans who earn foreign income is the foreign tax credit. The tax code's foreign tax credit rules permit U.S. persons to offset U.S. taxes they would otherwise owe with foreign income taxes they pay. In contrast to the foreign earned income exclusion, a person does not need to be living abroad to claim the foreign tax credit, although the credit is clearly an import- ant provision for U.S. citizens who are working overseas. In general terms, the foreign tax credit is not a tax incentive for U.S. persons to work or invest overseas. Rather, the credit reduces what would otherwise be a tax disincentive to do so -- a disincentive posed by double taxation. The United States asserts the right to tax its residents and citizens on their foreign-source income. At the same, time, foreign nations usually claim the right to tax the income that Americans (and citizens of third countries) earn within their borders. Thus, if the foreign tax credit did not exist, Americans with income from foreign countries would be taxed twice on their foreign-source income: once by a foreign government, and once by the United States. In most cases the double-taxation would result in high tax rates on foreign-source income, and would pose a disincentive for U.S. citizens to invest or work abroad. The foreign tax credit is not without limits. For example, only foreign income taxes can be credited against U.S. taxes. Other types of taxes, such as sales, excise, or property taxes cannot be claimed as foreign tax credits. Also, foreign tax credits can only be used to offset the portion of a person's U.S. tax liability that is attributable to foreign-source income. Foreign tax credits cannot, in other words, be used to offset U.S. taxes due on income a person has earned in the United States. This limitation on the foreign tax credit is calculated by first identi- fying the fraction of worldwide taxable income that is from foreign sources, and then multiplying the total U.S. tax liability (before cre- dits) by the fraction. II/ The tax code applies a single foreign tax credit limitation to a broad range of foreign-source income; a taxpayer combines most types of income and calculates a single limitation that applies to all the foreign taxes paid on the income. There are, however, several types ll/ For additional details on how to calculate the limitation on the foreign tax credit, see: U.S. Department of the Treasury. Internal Revenue Service. Publication 514: Foreign Tax Credit for U.S. Citizens and Resident Aliens (Rev. Nov. 86). Washington” U.S. Govt. Print. Off., 1986. 19 p. CRS-6 of income for which the Internal Revenue Code requires taxpayers to calculate separate limitations. lkmeffect, foreign taxes paid on income subject to one limitation cannot offset U.S. taxes on income subject to a different limitation. Prior to 1987, the types of income that were subject to separate limitations were interest income, oil and gas extraction income, and dividends from special export sales corporations known as Domestic Inter- national Sales Corporations (DISCS) and Foreign Sales Corporations (17303). The Tax Reform Act of 1986, however, increased the types of income subject to separate limitations. The Act expanded the separate limitation for interest to include passive investment income in general, and created new limitations for shipping income, banking income, and dividends from foreign corporations that are not controlled by U.S. stockholders. The Act also created a separate limitation for income subject to a type of levy known as a'Kwithholding tax" that many nations impose on interest and dividend payments to nonresidents. ;g/ The foreign tax credit has an additional restriction that applies to taxpayers who use the foreign earned inconm exclusion: foreign taxes are not creditable if they are paid on income a taxpayer excludes under either the earned income exclusion or under the housing exclusion. FILING REQUIREMENTS AND AMERICANS OVERSEAS In general, filing requirements for U.S. citizens and residents who work overseas are the same as the rules that apply to taxpayers who stay in the United States. Nonetheless, expatriates may find them- selves in circumstances that change filing requirements from those they would face in the United States. For example, like all U.S. individuals, those who work abroad must pay at least 90 percent of their estimated tax liability for a given year in installments over the course of the year. U.S. employers are required to withhold taxes from their employee's salaries; this with- holding of tax generally meets the estimated tax requirements for indiv- iduals who work in the U.S. and for U.S. persons who work abroad for U.S. employers. But foreign employers are generally not required to withhold U.S. taxes from the salaries of their U.S. employees. Thus, expatriates may themselves be required to make estimated tax payments to the U.S. Government. l§/ l§/ For a detailed description of the foreign tax credit changes, see: U.S. Congress. Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986. Joint Committee Print, 100th Cong., 1st Sess. Washington, U.S. Govt. Print. Off., 1987. p. 873-915. ;§/ Estimated tax payments are made in four installments that are generally due on April 15, June 15, and September 15 of the tax year for which they are made, and on January 15 of the succeeding year. One- quarter of the required annual payment must be made on or before each deadline. CRS-7 Like other U.S. taxpayers, individuals who work abroad are not required to file tax returns if they earn less than a certain minimum amount of gross income. 13/ But at the same time, as described above, U.S. expatriates may qualify to exclude up to $70,000 from taxable income. The amount expatriates exclude under this provision must nonetheless be included when they calculate whether they'have sufficient grossixuxme to require a tax return. Expatriates, in other words, are required to file U.S. tax returns even iftflmzforeign earned income exclusion completely eliminates their U.S. tax liability. The foreign tax credit similarly does not change filing requirements for expatriates. Expatriates must file a tax return in order to claim the credit. Thus, a return is required even if a person's foreign taxes completely offset U.S. taxes. Finally, the Tax Reform Act of 1986 (P.L. 99-514) requires that individuals who apply for a U.S. passport or for legal residence in the United States (i.e., for a "green card") must at the same time file a so-called "information" return with the IRS. The return provides the IRS with the individual's taxpayer identification number, information on any foreign residence, and whether the green card applicant has been required to file a tax return in the past. The information return will be required with passport or green card applications filed after December 31, 1987. The Tax Reform Act's requirement for an information return grew out of congressional concern about tax compliance by U.S. persons who are living abroad. Testimony at congressional hearings suggested their is a relatively high rate of noncompliance with tax laws among Americans living abroad. The new information returns are designed to assist the IRS in collecting taxes from expatriates by providing the agency with additional information about Americans living overseas. However, the return is also designed to ensure that U.S. persons who depart the country are aware that they may still be liable for U.S. taxes and must still file tax returns while they are overseas. 12/ 1fl/ The threshold varies, depending on an individual's filing status. For example, single individuals who are under 65 do not have to file if their income is less than $3,560; a married couple need not file if their joint income is less than $5,830. 1§/ U.S. Congress. Senate. Committee on Finance. Tax Reform Act of 1986. Report to Accompany H.R. 3838. S. Rpt. No. 99-313. 99th Cong., 2d sess. Washington. U.S. Govt. Print. Off, 1986. p. 389-91. 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