Panel. U.S. and Mexican Taxation of Individuals Residing Abroad

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1 Panel U.S. and Mexican Taxation of Individuals Residing Abroad Diana S. Davis, Esq., Of Counsel, Greenberg Traurig, LLP Kenneth Guilfoyle, CPA, Expatriate Services Practice Leader, BDO Seidman, LLP

2 U.S. RESIDENCY AND TAX HOME In general, U.S. citizens and resident aliens are subject to Federal income tax on their worldwide income, from whatever source derived. On the other hand, nonresident aliens are generally subject to tax only on their income from U.S. sources. A "nonresident alien" is an individual who is not a citizen of the United States and who is not a "resident alien" of the United States. Section 7701(b)(1)(A) of the Code defines a "resident alien" as an individual who either (i) is a lawful permanent resident of the United States for immigration law purposes during any part of the calendar year (that is, an individual who holds a "green card") or (ii) meets the "substantial presence test." The substantial presence test consists of a formula that takes into account the number of days that the individual has spent in the U.S. during the relevant year and the two preceding ones.

3 U.S. RESIDENCY AND TAX HOME Article 4, Paragraph 2 of the U.S.-Mexico income tax treaty provides a series of tie-breakers for assigning a single residence to an individual, who is treated as a resident of the U.S and Mexico. The first test is where the individual has a permanent home. If that test is inconclusive because the individual has a permanent home available to him in both States, he will be considered to be a resident of the Contracting State where his personal and economic relations are closer, (i.e., the location of his "center of vital interests ). If that test is also inconclusive, or if he does not have a permanent home available to him in either State, he will be treated as a resident of the Contracting State where he maintains an habitual abode. If he has an habitual abode in both States or in neither of them, he will be treated as a resident of his Contracting State of nationality. In any other case, the competent authorities are instructed to resolve his residence by mutual agreement.

4 U.S. RESIDENCY AND TAX HOME Under the rules of Code Section 911(d), a tax home generally means a substantial residential or business presence in a given place. An individual shall not be treated as having a tax home in a foreign country for any period for which his abode is within the United States. 911(d)(3). An individual s abode is not necessarily in the United States while he is temporarily in the United States. An individual s abode is also not necessarily in the United States merely because he maintains a dwelling in the United States, whether or not his 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 the taxpayer s 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 an individual s abode often will depend on where he maintains his economic, family, and personal ties.

5 U.S. RESIDENCY AND TAX HOME The rules of Code Section 162(a)(2) are applicable for determining the location of a tax home: travel expenses while away from home in the pursuit of a trade or business. Tax home location depends on whether an assignment is temporary or indefinite. A taxpayer who is temporarily absent from his tax home in the United States on business, should be able to deduct his away from home expenses but would not qualify for the foreign earned income exclusion (discussed below). _ If an assignment is for an indefinite period, the new place of employment becomes the taxpayer s tax home, and he should not be able to deduct any of the expenses relating to the general area of this new work assignment. If the new tax home is in a foreign country and certain requirements are satisfied, the taxpayer s earnings may qualify for the foreign earned income exclusion.

6 U.S. RESIDENCY AND TAX HOME TEMPORARY: If the taxpayer s employment away from home in a single location is expected to last, and it does last, for 1 year or less, it is temporary unless facts and circumstances indicate otherwise. If the taxpayer s employment away from home is expected to last for 1 year or less, but at some later date it is expected to last longer than 1 year, it is treated as temporary (in the absence of facts and circumstances indicating otherwise) until such expectation changes. INDEFINITE: If the taxpayer expects the employment to last for more than 1 year. Revenue Ruling provides additional guidance on the rules for determining a tax home (this ruling may be updated from time to time).

7 U.S. RESIDENCY AND TAX HOME CONCLUSIONS Tax Home for purposes of Code Section 7701(b) relating to the definition of Resident Alien and Nonresident Alien. Tax Home has the same meaning that it has for purposes of section 162(a)(2) away from home expenses An individuals Tax Home is considered to be located a the individual s regular or principal place of business. If no regular place of business, either because of nature of business or because not engaged in a trade or business, then Tax Home is the individual's regular place of abode in a real and substantive sense. Treas. Reg. Section (b)-2(c)(1). The Tax Home maintained by the alien individual must be in existence for the entire current year. The Tax Home must be located in the same foreign country for which the individual is claiming to have a closer connection. Treas. Reg. section (b)-2(c)(2).

8 U.S. RESIDENCY AND TAX HOME An Alien Individual seeking to avoid a Tax Home in the US (if qualified under 7701(b)), may establish a closer connection to a foreign country based upon the facts and circumstances. A Closer Connection may be established: Location of permanent home and family Location of personal belongings Location of social, political, cultural or religious organizations Location of where business activities are conducted Location of a driver s license Location of voting Location of residence indicated on forms and documents, e.g. bank accounts Official Forms: such as a W-8

9 EXCLUSIONS UNDER CODE SECTION 911 In lieu of a U.S. foreign tax credit (discussed below), a U.S. taxpayer working abroad could qualify for the U.S. income exclusion rules of section 911 on some or all of his foreign source income. Under Section 911, a U.S. citizen or resident (a qualified individual ) who works in a foreign country for at least 330 days out of a 12-month period can elect to exclude from his U.S. gross income any foreign earned income up to $87,600 per year (computed on a daily basis). In addition, a Qualified Individual can elect to exclude the employerprovided housing costs (i.e., amounts provided by the employer in kind or reimbursed by the employer) in an amount up to 30% of the gross income exclusion.

10 EXCLUSIONS UNDER CODE SECTION 911 To the extent that the individual s foreign housing costs are attributable to amounts not provided by the individual s employer, the Qualified Individual is allowed to deduct such amount (subject to a limit) in computing adjusted gross income. The Qualified Individual s gross income exclusion, housing cost exclusion, and the housing cost deduction in any taxable year cannot exceed the individual s foreign earned income for the year.

11 FOREIGN TAX CREDIT The purpose of the foreign tax credit is to avoid double taxation. The U.S. allows its taxpayers a foreign tax credit only for taxes paid on income that is, under U.S. tax principles, considered to be foreign source income. The credit is limited to the same proportion of the U.S. taxpayer s U.S. tax liability (35%) as his foreign income is of his worldwide income as follows: Net Foreign Income Net Worldwide Income X U.S. Income Tax Liability

12 FOREIGN TAX CREDIT A U.S. foreign tax credit for foreign taxes paid on income that qualifies as capital gains will be limited to the U.S. rate applicable to capital gains (15%) as follows: 15% / 35% = 42.86% 42.86% x 35% ordinary tax rate = 15% tax rate equivalent Thus, only approximately 42.86% of the capital gains would be included in Net Foreign Income and Net Worldwide Income for purposes of calculating of the foreign tax credit limitation. This rule has the effect of limiting the value of foreign tax credits granted by the U.S. for foreign taxes paid on capital gains to the 15% U.S. rate. U.S. tax rules permit the taxpayer to claim the credit for foreign income taxes paid or accrued regardless of the taxpayer s method of accounting. The foreign tax credit is claimed with the annual tax return (IRS Form 1040 for individuals) together with IRS Form 1116 which must contain certain information and calculations.

13 FOREIGN TAX CREDIT A taxpayer claiming accrued foreign taxes generally must post a bond with the IRS. The IRS can re-determine the foreign tax credit claimed by the U.S. taxpayer and the taxpayer s U.S. tax liability must be re-calculated for the year in which the credit was claimed. If the foreign re-determination is caused solely by foreign currency fluctuation and is lower in amount than the lesser of $10,000 or 2% of the foreign tax liability initially accrued, the U.S. taxpayer can make the relevant adjustment for the year of the re-determination. In claiming a foreign tax credit, the U.S. taxpayer also must look into Article 24 ( Relief From Double Taxation ) of the U.S.-Mexico income tax treaty.

14 SOCIAL SECURITY For purposes of the Federal Insurance Contributions Act ( FICA ), all wages derived from employment (including benefits), unless specifically exempted, are subject to tax. FICA is composed of two elements (i) old-age, survivor and disability insurance, which funds retirement and disability benefits, and (ii) hospital insurance which funds medical benefits. Employees who work in a foreign country might be relieved for contributing to the U.S. social security system if the U.S. has a social security totalization agreement in effect with the employer s country. Totalization Agreements eliminate dual social security coverage by including rules that assign a worker s coverage to the country where the worker has a greater economic attachment.

15 SOCIAL SECURITY Under the Territoriality Rule, an employee who would otherwise be covered by both the U.S. and a foreign system remains subject exclusively to the coverage laws of the country in which the employee is working. However, under the Detached-Worker Rule, a person who is temporarily transferred to work for the same employer in another country remains covered only by the country from which he or she has been sent. On June 29, 2004, Mexico and the U.S. signed a social security agreement which is not in force. In lieu of a social security treaty, the internal laws of the country where the taxpayer is working (i.e., Mexico) might provide relief from contributing to two social security systems. This is a Mexican tax issue that should be addressed with Mexican tax counsel.

16 U.S. REPORTING REQUIREMENTS OF U.S. CITIZENS AND RESIDENTS LIVING ABROAD A U.S. citizen who is a tax resident of another jurisdiction (i.e., Mexico) would still be required to file IRS Form 1040 ( U.S. Individual Income Tax return ) by April 15 th of each year, regardless of whether he is required to file an income tax return in another country. A U.S. taxpayer residing abroad is given an automatic two month extension to file his U.S. income tax return. A U.S. citizen who claims a foreign tax credit should file IRS Form 1116 together with his annual income tax return. U.S. taxpayers with an interest in a foreign financial account are required to file a Report of Foreign Bank & Financial Accounts ( FBAR ) on Form TD F on an annual basis. Penalties for failure to comply with this reporting requirement could be significant.

17 U.S. REPORTING REQUIREMENTS OF U.S. CITIZENS AND RESIDENTS LIVING ABROAD U.S. taxpayers who are owners of stock in controlled foreign corporations ( CFCs ) must file IRS Form 5471 on an annual basis. U.S. taxpayers with an interest in a foreign partnership are required to file IRS Form 8865 ( Return of U.S. Persons with respect to Certain Foreign Partnerships ) on an annual basis. U.S. taxpayers who are direct or indirect owners of a foreign disregarded entity are required to file, on an annual basis, IRS Form 8858 ( Information return of U.S. Persons With respect to Foreign Disregarded Entities ).