US citizens and green card holders who plan to accept a foreign work assignment must be aware of US expat tax requirements as well as international tax systems.
Top Expat Tax Tips for Americans planning to accept a foreign assignment
General Concepts of U.S. Taxation Versus Other Countries
All citizens of the United States, green card holders (legal permanent residents) and individuals that meet the Substantial Presence Test (SPT) are considered to be U.S. resident aliens. For those who meet SPT, this is a test whose conditions must be met annually; therefore they are not the main focus for the purpose of this article.
Any U.S. resident alien citizen and green card holder are subject to U.S. federal income taxation on income earned inside of the United States and worldwide. This obligation is based on the calendar year in which the income was earned, and will continue indefinitely regardless of what country the income was earned in, its currency, and the location of the bank in which said earnings are deposited in.
The U.S. income tax reporting period is the same as a calendar year, beginning on January 1st and ending on December 31st. This will not change despite what the tax reporting period may be in the foreign country where the U.S. taxpayer is residing.
For the purpose of U.S. state imposed taxes, the requirements will vary from state to state. There are typically state-specific facts and circumstances, along with tests to determine residency in addition to statutory resident tests. The statutory resident test is usually a combination of the 183 days of presence rule and a permanent residence requirement, the latter of which is state specific, subjective and vague. There are some states which will deem a taxpayer to be a continuing tax resident, even while they are out of the country on a foreign work assignment. This is especially true it the ultimate intent is to return to the state once the foreign work assignment has reached its conclusion (basic domicile definition). If you are in need of more state specific residency issues, you should contact us separately.
The U.S. (and the Philippines) is one of the few countries worldwide that will assess an individual’s tax liability based upon their legal immigration status as either a U.S. citizen or green card holder, not upon their “tax residency”, which is a strictly legal status or concept for tax purposes only. This means that even when a U.S. taxpayer is a resident in a foreign country, they are obligated to pay U.S. income taxes on earnings made worldwide, along with taxation in their chosen country of residence. Other nations use a “tax residency” concept, where the obligation to pay taxes can be severed and is determined by an individual’s specific circumstances. This could include their permanence abroad, personal property and social ties, disposition of their spouse, dependents and dwelling along with having established a tax residency in their new country of residence. Unlike the United States, most other countries will allow their taxpayers to sever their “tax residency” and no longer have an earned income tax filing obligation.
A “tax resident” of a nation is usually defined as a person whose worldwide income is taxable as opposed to “tax non-residents” who are only taxed on income earned inside that nation or sourced to or from it, not any income earned outside of it. A U.S. expatriate –or expat – is a U.S. resident alien living and working outside of the United States.
3 ways to minimize US expat tax liability
For a U.S. expat, there are three ways in with they can avoid double taxation while living abroad and working a foreign assignment:
- The Foreign Earned Income Exclusion (FEIE)
- The Foreign Housing Exclusion (HE) if employed
- The Foreign Housing Deduction (HD) if self-employed
- The Foreign Tax Credit (FTC)
Individual expat taxpayers may not pick and choose which income is excluded. It is either all of the earned income or none.
In the event that a taxpayer ends a foreign assignment and takes on a new one, this will have no affect on either the tax home or BFR or PPT tests. If the taxpayer does move back to the U.S. for a period of time to live and work before taking the second assignment then they could be in danger of forgoing either the tax home test or BFR test and PPT, necessitating that they re-qualify for those tests.
SOFA – North Atlantic Treaty Status of Forces Agreement
SOFA – North Atlantic Treaty Status of Forces Agreement – Employees of a private company that is under contract with any branch of the U.S. armed forces and covered by SOFA, or is a member of a “civilian component” of SOFA, agrees that they are not a resident of the foreign country. As a result of this agreement they many not claim BFR, and must check No on Form 2555 – Part II Question 13(a) and 13(b). This will disqualify them from Bona Fide Residence Test, but PPT may still be used to qualify for the FEIE.
Condition of working for a defense contractor on a foreign assignment
In some instances a condition of employment is for the taxpayer to sign a closing agreement where they waive their right to use the FEIE. This is seen most often when the taxpayer is working for a major defense contractor who has made an agreement with the foreign government and the U.S. Department of Defense. The Department of Defense will in turn alert the IRS that individuals employed by them are not being subjected to local country tax. This puts the taxpayer in a position where they cannot use the FEIE when calculating income.
Schedule C expenses and Foreign Earned Income Exclusion on a foreign assignment
The FEIE, HE and HD exclusions are elective and should not be used if they will trigger income inclusion. This occurs where Schedule C expenses outstrip income and these expenses are added back to actually create income.
Housing Exclusion and Deduction are subject to a Housing Norm
- The Housing Exclusion and Housing Deduction are both subject to a base deduction or what the IRS considers a “housing norm” which for 2015 is $44.19 daily based on a 365 day period or $43.48 for 2014.This would mean that if a taxpayer was abroad for the entirety of the 2015 calendar year, they would first need to deduct $16,128 before any of the Foreign Qualified Housing Costs could count towards the HE or HD.
- As U.S. resident aliens are subject to taxation on worldwide income, they are also entitled to deductions on certain worldwide costs such as foreign mortgage interest, real estate taxes and other expenses and losses derived outside of the United States. However, as with what is mentioned above, the ability to deduct foreign unreimbursed employee expenses on Schedule A is not allowed when the FEIE is being used to the extent on income to which the deductions relate are excluded.
- A U.S. taxpayer has the option of using either the accrued basis or paid basis to record their foreign taxes for the purpose of calculating the FTC. As a general rule, the paid basis should be used if the foreign tax cycle is the same as the calendar year like in the U.S., and the accrued basis used when the foreign tax cycle is a fiscal year, not coinciding with the calendar year. The accrued election forces the recognition of the foreign taxes for U.S. tax purposes by looking at the U.S. calendar year in which the foreign fiscal year comes to an end. This avoids the need to calculate the individual withholdings separately or allocate refunds that are received as a result.
Once a taxpayer chooses the accrued method it must be continued to be used indefinitely. It is also considered a riskier approach as it creates a series of mismatched differences in timing of foreign tax to foreign income. It does provide tax relief in the last assignment year abroad, but it may be costly in the first assignment year. There are pros and cons to consider along with foreign tax credit carry back options.
- If the country of residence has a negotiated Totalization or Social Security Agreement with the United States, there could be an opportunity to obtain a retroactive Certificate of Coverage. This is to ensure that the taxpayer can continue to pay into the U.S. or foreign social security system for a specified number of years and receive full benefit for their contributions to social security on earnings made abroad in either the U.S. or the foreign country. Individual taxpayers can visit http://www.ssa.gov/international/ to find out if an agreement does exist in their circumstance.
- A taxpayer who is outside of the United States on April 15th of any tax year will automatically qualify for an extended filing deadline of two months, taking them to June 15th. “Taxpayer Abroad on April 15th” should be written on the top of the extension form 4868.
- Taxpayers who reside outside of the United States are given an automatic six month extension to October 15th. They also have the option of requesting an additional two months, bringing their deadline to file to December 15th.
- There is a statutory three year limit for claiming a refund, yet there is no limitation on the filing of an original claim of FEIE or to amending a filed return where the FEIE is being claimed for the first time. This means that a taxpayer who mistakenly failed to claim the benefits of the FEIE, HE or HD ten years ago or more still have the chance to make the claim.
- Rules under IRC Sec. 121- Sale of Principal Residence state that in the five year window prior to the sale of a principal residence the taxpayer must have owned and used or lived in the home for at least two years for both spouses to qualify for the $250,000 per spouse exclusion of gain. The two year rule for the owned and use test do not have to be the same two years within the five year period prior to the sale of the property.
A temporary absence, even if the home is rented out, is counted as a period of use. This exclusion may only be used once every two years.
If the taxpayer does not meet the two year requirement for both tests they still may qualify if they have one of three accepted “primary reasons”: a change in location of employment, health reasons, or unforeseen circumstances.
For any of these three “primary reasons” the taxpayer would look at a specific primary reason or “safe harbor” and/or individual facts and circumstances for each of the primary reasons. This would include factors such as: close in time, owned and used at time of specific primary reason, primary reason not reasonably anticipated, change or impairment of the financial ability to maintain, and use during ownership.
Safe harbors for the change in location of employment – the focal point of this article and where employment includes new or continuing employment or self-employment – include where the change occurred during the period of ownership and use of the main home. The new place of employment should be at least 50 miles further from the home that was sold then with the former place of employment.
This would then qualify a U.S. expat who moves to a foreign country yet continues to maintain their U.S. place of residence, subsequently renting it out years before selling it after moving abroad, for the change in location of employment as a primary reason.
Where the expat has trouble qualifying is with the two year test for use of the home. If the home is not the taxpayer’s primary residence or the taxpayer does not meet the above tests and they have held the home for more than one year, then the gain will be taxed at the current long term capital gain rate. This is currently 15% and could rise to 20% starting in January of 2013 for taxpayers in the 39.6% tax bracket.
Non-qualified use refers to when the calculation of the gain from the sale or exchange of the principal residence the pro-rata portion of the gain attributable to non-qualified use in tax years 2009 or later, where neither spouse used the property as their main home with certain exceptions will not be able to be excluded under the rules stated above.
There is an exception to the above if any portion of the five year period ending on the date of the sale or exchange after the last date either spouse used the property as a primary residence. Simply stated, if there is any rental use during the five year window before the sale, that rental period is not considered non-qualified use and the gain would not have to be pro-rata apportioned between the qualifying and non-qualifying use.
Do you have more questions about accepting a foreign assignment?
If you have additional questions about US tax issues and foreign assignment, expat tax accountants at Artio Partners provide a wide range of services to Americans working abroad.