Expatriate Taxation – Overview

If you are a U.S. citizen or a resident alien of the U.S. and you live abroad, you are still subject to income tax by the United States on your worldwide income, regardless of the source of that income.  Persons in this category, who live and work outside their home country, are sometimes referred to as “Expatriates” or “Expats”.

Additionally, if you are a U.S. citizen or resident alien, the rules for filing income, estate, and gift tax returns, and for paying estimated tax are generally the same whether you are in the U.S. or abroad. For example, generally (for tax year 2013) income tax filing is required after there is income of $10,000 or more for single status, or  $20,000 of income or more for married filing jointly.

Although the U.S., unlike most other countries, taxes the worldwide income of its citizens and residents, there are two primary mechanisms to provide relief from double taxation for those residing and working abroad.  Those relief mechanisms are the Foreign Earned Income and Housing Exclusions/Foreign Housing Deduction and the Foreign Tax Credit.

In certain cases, you may also be entitled to exclude from income the value of meals and lodging provided to you by your employer. Refer to Exclusion of Meals and Lodging in IRS Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.

Foreign Earned Income and Housing Exclusions

The Foreign Earned Income Exclusion is provided for by U.S. Internal Revenue Code Section 911. Pursuant to this code section, a qualifying individual can exclude from income an amount of qualifying foreign earnings up to a maximum that is now adjusted for inflation ($91,400 for 2009, $91,500 for 2010, $92,900 for 2011, $95,100 for 2012, $97,600 for 2013, and $99,200 for 2014). In addition, you can exclude or deduct certain foreign housing amounts.

However, in order to qualify for this exclusion, you must meet at least one of two possible qualifying tests. If neither test can be met, no part of the potential exclusion is available. If a qualifying test is fully met, but only part of a given tax year falls within the qualifying period, a prorated exclusion is allowed.

Qualifying Tests

There are two alternative methods of qualifying for the Exclusion, the Bona fide Residence Test and the Physical Presence Test.

Bona Fide Residence Test

The Bona Fide Residence Test is available only for U.S. Citizens and U.S. Residents from countries that have a tax treaty with the U.S. that contains a non-discrimination clause. This test entails being a bona fide resident (as determined by facts and circumstances), of some foreign country, for at least one full calendar year, (i.e., an entire period from January 1 through December 31 must be covered before the test can ever be met). If such a period has never been covered by foreign residency, the Bona Fide Residence Test would never be met, and the Exclusion would be lost in its entirety (unless the Physical Presence Test were met). There are no exceptions (other than U.S. State Department-certified civil unrest in the particular country) for failure to qualify.

Physical Presence Test

The Physical Presence Test requires being physically present, in some foreign country or countries, for at least 330 full days out of any 12-month period. Conversely stated, the taxpayer cannot be physically present in the U.S., or any U.S. possessions, for more than (any part of) 35 days within the 12-month qualifying period. Again, reasons for U.S. presence, (such as medical emergency), are irrelevant. If the test is not met, the exclusion is lost in its entirety (other than in a case of certified civil unrest in the foreign country).

During any days counted in either of the two tests discussed above, the taxpayer must also have a “foreign tax home” (i.e., simply stated, he cannot be merely on a vacation or a business trip; it typically must be a foreign assignment or other long-term stay).

Excludible Income – The income must be earned income (no dividends, etc), earned during a qualifying period, and not attributable to a year earlier than the immediately preceding calendar year. It must also be earned outside the U.S. Thus, income earned while in the U.S. on business would not qualify.

Foreign Earned Income Exclusion – Tax Home in Foreign Country

To qualify for the foreign earned income exclusion, the foreign housing exclusion, or the foreign housing deduction, your tax home must be in a foreign country all of the qualifying days throughout your period of bona fide residence or physical presence abroad.

Foreign Country

To meet the bona fide residence test or the physical presence test, you must live in or be present in a foreign country. A foreign country usually is any territory (including the air space and territorial waters) under the sovereignty of a government other than that of the United States.

The term “foreign country” includes the seabed and subsoil of those submarine areas adjacent to the territorial waters of a foreign country and over which the foreign country has exclusive rights under international law to explore and exploit the natural resources.

The term “foreign country” does not include U.S. possessions such as Puerto Rico, Guam, the Commonwealth of the Northern Mariana Islands, the U.S. Virgin Islands, or American Samoa. For purposes of the foreign earned income exclusion, the foreign housing exclusion, and the foreign housing deduction, the terms “foreign,” “abroad,” and “overseas” refer to areas outside the United States, American Samoa, Guam, the Commonwealth of the Northern Mariana Islands, Puerto Rico, the U.S. Virgin Islands, and the Antarctic region. The term “foreign country” does not include ships and aircraft traveling in or above international waters. Nor does it include offshore installations which are located outside the territorial waters of any individual nation.

Tax Home

Your tax home is the general area of your main place of business, employment, or post of duty, regardless of where you maintain your family home. Your tax home is the place where you are permanently or indefinitely engaged to work as an employee or self-employed individual. Having a “tax home” in a given location does not necessarily mean that the given location is your residence or domicile for tax purposes.

If you do not have a regular or main place of business because of the nature of your work, your tax home may be the place where you regularly live. If you have neither a regular or main place of business nor a place where you regularly live, you are considered an itinerant and your tax home is wherever you work.

You are not considered to have a tax home in a foreign country for any period in which your abode is in the United States. However, your abode is not necessarily in the United States while you are temporarily in the United States. Your abode is also not necessarily in the United States merely because you maintain a dwelling in the United States, whether or not your spouse or dependents use the dwelling. “Abode” has been variously defined as one’s home, habitation, residence, domicile, or place of dwelling. It does not mean your principal place of business.

“Abode” has been variously defined as one’s home, habitation, residence, domicile, or place of dwelling. It does not mean your principal place of business. “Abode” has a domestic rather than a vocational meaning and does not mean the same as “tax home.” The location of your abode often will depend on where you maintain your economic, family, and personal ties.

Temporary or Indefinite Assignment

The location of your tax home often depends on whether your assignment is temporary or indefinite. If you are temporarily absent from your tax home in the United States on business, you may be able to deduct your away from home expenses (for travel, meals, and lodging) but you would not qualify for the foreign earned income exclusion.

If your new work assignment is for an indefinite period, your new place of employment becomes your tax home, and you would not be able to deduct any of the aforementioned related expenses that you have in the general area of this new work assignment. If your new tax home is in a foreign country and you meet the other requirements, your earnings may qualify for the foreign earned income exclusion.

If you expect your employment away from home in a single location to last, and it does last, for 1 year or less, it is temporary unless facts and circumstances indicate otherwise. If you expect it to last for more than 1 year, it is indefinite. If you expect it to last for 1 year or less, but at some later date you expect it to last longer than 1 year, it is temporary (in the absence of facts and circumstances indicating otherwise) until your expectation changes.

For guidance on how to determine your tax home refer to Revenue Ruling 93-86. This ruling may be updated from time to time.

Changes in the Foreign Earned Income Exclusion

Effective for tax years beginning after 2005, the amount of foreign earned income (and foreign housing costs) excluded from an individual’s gross income will be used for purposes of determining the rate of income tax and alternative minimum tax (AMT) that applies to his or her non-excluded income. The Tax Increase Prevention and Reconciliation Act of 2005 (P.L. 109-222) added a new section 911(f) to the Internal Revenue Code. In essence, an individual’s tax on any foreign earned income above the exclusion amount and on any unearned income is computed as if the foreign earned income exclusion was not claimed. The individual’s tax will be the excess of the tax that would be imposed if his or her taxable income were increased by the amount(s) excluded, and the tax that would be imposed if his or her taxable income were equal to the excluded amount(s). For this purpose, the excluded amount(s) will be reduced by the aggregate amount of any deductions or other exclusions otherwise disallowed. In many cases this will have the effect of increasing an individual’s U.S. federal income tax to an amount greater than it would have been under prior law.

Foreign Tax Credit

Another mechanism for the prevention of double taxation is the foreign tax credit, provided for in IRC Sec. 901. Calculation of this credit may be very complex, but, in basic terms, it allows a credit against the U.S. tax allocable to a particular category of foreign source income.

There is a limitation calculation designed to ensure that the credit will never offset any U.S. tax allocable to U.S. source income. IRC. Sec. 904.

When the Foreign Earned Income Exclusion has been elected, the foreign taxes potentially available for foreign tax credit are disallowed in direct proportion to the percentage of Foreign Earned Income that is excluded. That is, if 85% of the total Foreign Earned Income is excluded, then 85% of the foreign taxes paid on that income for that year would be disallowed and unavailable for credit against U.S. tax.

Equalization, Tax Protection, And Gross-Ups

Companies that assign employees abroad may take a variety of positions with respect to assignment-related expense reimbursements and tax reimbursements.

A company may be willing to reimburse only moving expenses, leaving any further expense/tax burden to the employee, i.e., treating the employee as a “local hire.” Of course, very few employees would be willing to relocate on such terms. Such cases usually involve an employee’s independent desire to relocate abroad, perhaps due to a pre-existing marriage to a national of the particular country.

A step toward further involvement in assisting the relocated employee is “tax protection.” This entails an agreement to reimburse expenses for the employee, coupled with a guarantee to protect the employee from any resulting additional taxes.

Under such an arrangement, effectively administered, the employee is protected from any additional tax cost, and indeed could end up significantly better off from a tax standpoint than if he had remained working in his home country. In certain cases, where tax windfalls could depend upon the country of assignment, the selection of country assignments could create dissension within the company’s International Assignee population. A more comprehensive approach to limiting the tax impact of International Assignments is “Tax Equalization.” This type of program not only protects employees from additional tax, but also prevents instances of tax windfall. It is designed to ensure a situation where foreign assignments become “tax neutral,” thus making no country more tax desirable than the next.

A well designed Tax Equalization Policy tends to promote greater consistency of treatment, and thereby greater fairness amongst all the transferred employees. Under such a program a hypothetical tax is calculated for the employee, which is designed to represent what that employee’s tax obligation would have been had the employee remained and worked in his home country.

An amount designed to meet this obligation is hypothetically withheld from the employee and retained by the company. At the time the actual tax return is completed in the following year, the hypothetical tax calculation is prepared, and either the employee must pay a further amount to the company to discharge his hypothetical tax obligation, or he receives a refund of overpaid hypothetical tax.

The company is responsible for payment of all actual taxes, U.S. and foreign, and in return, retains the benefit of exclusions, deductions, and credits directly related to the foreign assignment. Thus, they do not show up on the hypothetical tax calculation.

Tax Gross

Ups Under any of the aforementioned approaches, where the company has provided a benefit, or reimbursed an expense of the employee (except where specifically excepted by the Code, as with certain moving expenses), taxable compensation income is created. When the Company is responsible for the corresponding tax generated, payment of that obligation will in turn produce a taxable reimbursement with its own tax obligation, (i.e., “tax on tax”).

Ultimately, such tax escalation is finalized through a “pyramid gross-up”, which is a calculation that determines the amount of tax necessary to fully cover all the additional taxes to be incurred due to reimbursements in that year.

Tax reimbursement costs can be enormous, accelerating further costs to the Company, and in many cases pushing the total reimbursement into a higher tax bracket. Consequently, the tax gross-up should be done in the final year, and not on an ongoing basis. In many cases, tax that might be incurred on expense reimbursements can be avoided, by taking advantage of the Foreign Earned Income Exclusion or offsetting foreign tax credit.

Where such tax cannot be currently offset, it can at least be deferred until the following year, to the time of return preparation, and when the equalization is prepared, the tax obligations settled, and the transaction closed.