The United States is one of the few countries

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1 Expatriate American Tax A Basic Overview for In-House Counsel by Tina Salandra and Bobby Shethia The United States is one of the few countries that impose tax on the worldwide of its citizens and residents after they have established residency abroad. U.S. citizens and residents who live and work in a foreign country are required to file a U.S. tax return that includes foreign earned. The Internal Revenue Code 1 provides key possibilities for reducing or eliminating double taxation, which include: employee are: a tax home in a foreign country and residency. Tax Home in a Foreign Country A taxpayer s tax home is considered to be located near their principal place of employment or business. If they have no regular place of employment due to the nature of their work, then their tax home is their residence. Primary IRS 2 considerations for determining a taxpayer s abode are as follows: Foreign earned exclusion Housing expense exclusion/deduction Foreign tax credits Tax treaty exemptions However, there are twists and turns to applying the expatriate tax provisions. Before applying these provisions, an employee must first meet the requirements for being qualified according to the IRS definition. If they pass this first hurdle, they must then meet the criteria for being a resident of a foreign country. Only after meeting this requirement can they consider using the foreign earned exclusion. The housing deduction can be another minefield that is often misinterpreted. Additionally, there is the foreign tax credit to consider. The following information will provide in-house counsel with the basics for advising global staff on what to expect regarding their tax status as an expatriate American, and how to navigate the details. Qualifying Employees Simply working outside the U.S. does not necessarily qualify an employee as an expatriate. For U.S. federal tax purposes, this is determined by Internal Revenue Code (IRC) Section 911. If employees meet the following qualifications, they may be entitled to certain earned and/or housing expense deductions. The two basic criteria to be considered a qualified Is the taxpayer performing his or her work in the vicinity of the residence and using the residence as their home while working? (They must be lodging/sleeping overnight at that location.)are the taxpayer s living expenses duplicated because his or her work requires he or she to be away from the residence? Are the taxpayer s family members living in their U.S. home or using that residence frequently for lodging? Temporary presence in the United States does not necessarily mean their residence is in the United States. Also, maintaining ownership of a home or apartment in the United States while living and working abroad does not necessarily mean the taxpayer s residence is in the United States. Taxpayers generally are not considered to have an residence in the United States if they can document that their financial, family and other personal ties are to a foreign location. Taxpayers are not considered to have a tax home in a foreign country for any period for which they have a residence in the United States. For example, an employee works in London for four months for an American company that pays for an apartment for her to live in while in London. The employee maintains all aspects of her New York City apartment with the intention of returning to work and live there. The London apartment does not qualify as the employee s tax home. (The determination of tax home under IRC Section 911 is the same as the definition of tax home under ITS Pub Another NEW JERSEY LAWYER October

2 example might involve workers on oil rigs who spend substantial time living on the rig located outside the U.S. They are usually denied IRC Section 911 exclusions because their family and other economic connections remain in their U.S. home. In addition to the 50 U.S. states and the District of Columbia, the definition of the United States for IRC Section 911 purposes also includes Puerto Rico, Northern Mariana Islands, U.S. Virgin Islands, Guam, and American Samoa. Residency There are two tests the IRS uses to determine if an employee is a resident of a foreign country. Under the bona fide residence test taxpayers must have a residence in a foreign country for an uninterrupted period that includes an entire year. Taxpayers may leave the foreign country for brief visits to the United States, but must have a specific intention of returning to the foreign country without unreasonable delay. Facts and circumstances considered by the IRS in determining whether the taxpayer meets the qualification of the bona fide residence test include: intention of the taxpayer to live and work in the foreign country; purpose of the trip (i.e., business not personal); and length of stay in the foreign country. 4 Generally, taxpayers must relocate for an extensive (i.e., usually more than one year) or indefinite period of time and establish a home for their immediate family to qualify as bona fide residents of a foreign country. Taxpayers who relocate abroad to work on a particular project for a specified or limited stay are not usually considered to have met the test, even if they work in the foreign country for more than a year. Bona fide residence is not always the same as domicile. A domicile is a permanent home to which the taxpayers intend to return. It is possible to be both a bona fide resident in a foreign country and simultaneously be domiciled in the United States. States tax agencies may aggressively try to use the concept of domicile to determine state residency status to impose state taxes on expatriate Americans who do not live or work in the state. Note that in most states, merely owning real estate does not solely determine residency or domicile in that state. Qualification as a bona fide resident is determined by completing IRS Form 2555 or Form 2555-EZ with a U.S. tax return. However, only U.S. residents (individuals holding a current resident alien visa or green card), who are also nationals of a foreign country with which the United States has an tax treaty, may qualify for the bona fide residence test. For example, an Italian national, who has an H1-B visa, and is then sent by his American employer to live and work in Argentina cannot use the bona fide residence test because Argentina does not have a tax treaty with the United States and the employee is not a U.S. citizen. 5 A physical presence test requires the taxpayer to be physically present in a foreign country or countries for 330 days in a consecutive 12-month period. It is an alternative for the expatriate American employee to qualify as a resident of a foreign county if they don t qualify under the bona fide residence test. Days in the foreign country must be full 24-hour days. Partial days do not count. Days of arrival and departure from the United States count as a day spent in the U.S. Time spent in international waters (i.e., traveling via cruise ship) does not count toward the 330- day physical presence test requirement. However, days spent in a foreign country for any purpose, including vacation, family obligations and hospital stay, do count toward the 330-day requirement. IRS rules for determining the 12- month period include: 1. The 12-month period begins any day of any month, and ends the day before the same calendar day 12 months later (i.e., April 15, 2011 April 14, 2012). 2. Any 12-month period can be used for the 330-day requirement, but the period must be made up of consecutive months (January December, April March, September August, etc.). 3. The first day of the 12-month period does not have to be the taxpayer s first full day in a foreign country, and the same is true for the last day of the 12-month period. The taxpayer may choose the 12-month period that results in the greatest exclusion. 4. The taxpayer s 12-month periods can overlap one another. For example, an employee arrives in Brazil to live and work on June 1, As of May 31, 2011, she has fulfilled the 12 consecutive months of residency in Brazil. For year 2011, her 12-month period can be January December 2011, even though it overlaps her prior 12- month period ended May 31, In the year of arrival in the foreign country establishing residency, the taxpayer may claim partial earned exclusion on a pro-rata basis by filing an amended tax return after meeting the qualification of the physical presence test. Employees who otherwise meet the aforementioned qualifications for residency in a foreign country are not treated as bona fide residents or physically present if there is a U.S. travel restriction for that country in effect. It is recommended counsel check with the U.S. Department of State website for the most current travel-restricted countries. Foreign Earned Income Exclusion Once an employee qualifies as a resident of a foreign county, he or she can exclude up to $91,500 of earned per year while living and working abroad. 34 NEW JERSEY LAWYER October

3 The term earned includes: Employee wages and salaries Professional fees Other compensation for personal services, such as: housing, car allowance, moving expenses, personal travel reimbursement, etc. Self-employment/independent contractor Certain fringe benefits related to employment abroad, paid by an employer on behalf of an employee, included in earned are: Housing expenses paid by the employer Education expenses of the employee s spouse or dependents Local transportation, for the employee and/or their family members, including vehicles provided for personal use Moving expenses reimbursements The foreign earned exclusion is limited to the lesser of total earned or $91,500 (if, including the aforementioned fringe benefits, exceeds $91,500). Employees cannot claim any deductions or credits related to excluded. Therefore, a foreign tax credit cannot be claimed for foreign taxes paid on excluded. Also, deductible IRA contributions cannot be based on excluded, only taxable earned. Housing Expenses: Exclusion or Deduction One of the more frequent questions asked by Americans working abroad is whether their housing expenses are deductible. There are two types of housing expenses: 1) those paid by the employer, and 2) those paid by the employee directly. Employer-paid housing expenses are included in. The employee can choose to exclude fringe benefits as part of the earned exclusion of up to Salary $ 100,000 Housing paid by employer 20,000 Total 120,000 Income exclusion (91,500) Housing paid by employee (30,000) Less deductible floor 14,640 Housing deduction (15,360) Total of exclusion + housing deduction $91,500, combined wages and employerpaid housing expenses. If the employee pays for his or her own housing expenses directly, the maximum deduction is different for each foreign country. For example, in Abu Dhabi the maximum housing deduction is $49,687, while in Bangalore the deduction is limited to $28,450. A list of limits on housing expenses can be found in the instructions to IRS Form However, the IRS has set a deductible of $14,640, which must be subtracted from employee-paid housing expenses in order to arrive at the allowable deduction. The table above serves as an illustration: In this example, an expatriate American is working in Abu Dhabi earning $100,000 in salary and $20,000 in housing expenses paid for by her employer. Plus she spends another $30,000 on housing expenses on her own. Foreign Tax Credit For those who do not qualify for the foreign earned exclusion, or who have earned far higher than the exclusion amount, the foreign tax credit provision is intended to prevent double taxation. This credit is applied against U.S. federal taxes, but is not a refundable credit. Therefore, if the foreign tax paid exceeds U.S. federal tax, the balance of the foreign tax credit will carry forward to a future year when there is U.S. tax to be offset. (106,860) Taxable compensation $13,140 Important rules for applying the foreign tax credits are as follows: 1. An employee can take credit for foreign taxes paid or accrued in a tax year. 2. If there is a tax treaty between the U.S. and the foreign country that the employee is working in, the provisions of the tax treaty will take precedence over the IRS Code. In some countries the employee may not get the full amount of the tax paid as a credit. 3. Foreign tax credits are also eligible for taxpayers who take the foreign earned exclusion. For example, a U.S. citizen who works and lives in Norway earned $800,000. The first $91,500 can be excluded. Norway deducted $300,000 as withholding tax from her paycheck. She can take a foreign tax credit for the Norwegian tax that relates to the remainder of her foreign earned. 4. A foreign tax credit may also be applied to foreign tax paid on unearned or passive foreign (i.e., dividends, interest, rent, limited partnerships, etc). Beware that unearned foreign cannot be excluded from total. Foreign Nationals Working in the U.S. The following is a summary of the various U.S. visa categories and the tax implications of each category. H1-B: NEW JERSEY LAWYER October

4 Status U.S. Tax Residency Requirements U.S.Tax Status U.S.Tax Ramifications Foreign Earned Income H1-B, L-1, permanent resident/ green card holder More than 31 days in a calendar year or Resident Must include worldwide Exclusion only if host country has a tax treaty with the U.S. H1-B, L-1, permanent resident/ green card holder Less than 31 days in a calendar year or Non-resident Only U.S. reported AOS (adjustment of status, those who have applied for a green card and are working in the U.S. on an EAD) More than 31 days in a calendar year or calendar Resident Must include worldwide Exclusion only if host country has a tax treaty AOS (adjustment of status, those who have applied for a green card and are working in the U.S. on an EAD) Less than 31 days in a calendar year or Non-resident Only U.S. reported temporary specialty professional worker holding a minimum of a bachelor s degree or the equivalent; L-1: temporary intracompany transferee executive, manager, or specialized knowledge professional; U.S. permanent resident: Adjustment of status applicant who is awaiting the permanent residence card; and, employment authorization document (EAD) holder. Importantly, a foreign national is considered to have dual-status in the first year they are working in the U.S. on a temporary visa. As a dual-status taxpayer, they are only required to report U.S.-based on their tax return. There are important tax considerations for U.S. employers who hire foreign nationals on temporary work visas (i.e., H1-B or L-1). For example, in 2010, an Indian citizen working in the U.S. on an L-1 visa in New York traveled abroad 20 days each month. He also received a salary from the Indian parent company for the 20 days a month he spends overseeing production in New Delhi. As an L- 1, who spends more than 31 days in the U.S., his tax status is that of a U.S. resident; consequently, he has to add his salary from the Indian parent company on his U.S. tax return. However, he does not qualify for foreign earned exclusion because: a) he does not meet the bona fide resident test, which requires a minimum of 330 days outside the U.S (he has only 120 days abroad), and b) he fails the physical presence test, which requires that he live at the foreign location for at least 12 consecutive months, because his tenure in India started only in July How does he avoid double taxation? He can take an extension for 2010, (allowed for six months) and file his return by Dec. 15, 2011, by which time he would have completed his physical presence test in India (i.e, 12 consecutive months living abroad from July 1, 2010, to June 30, 2010). Otherwise, he can take the foreign tax credit for tax paid to India. Social Security Totalization Agreements Totalization agreements were created by the United States government in cooperation with countries, that have government-sponsored retirement benefits similar to Social Security in the U.S. The purpose of the totalization agreement is to avoid double payment into two country s retirement benefit programs. However, the employee cannot choose which country s retirement system in which to contribute. Totalization agreements usually require the employee to contribute to the country in which they work. Beyond avoiding double taxation, the agreement also allows for a continuity of vesting in a retirement benefit program, so there is no break in the accrual of Social Security to the tax payer while working abroad. The agreements are reciprocal, in that they cover both expatriate Americans working abroad and foreign nationals working in the U.S on visas. A U.S.-based company doing business in a foreign country is required to withhold the employee Social Security tax from their foreign-based U.S. citizens or residents. In addition, the U.S.- based employer is required to pay the employer portion of Social Security tax, and remit both portions to the IRS as required in the U.S. Non-U.S.-based companies employing U.S. citizens and 36 NEW JERSEY LAWYER October

5 residents are not required to withhold or remit Social Security tax. 6 Tax Treaties The United States currently has tax treaties with more than 60 countries. 7 Country-specific treaty provisions may usurp the general rules found in IRC Section 911; therefore, it is important to review and understand the treaty provisions for the country(s) where global staff members work and reside. Tax treaties reduce the U.S. taxes of residents of foreign countries; therefore, tax treaty provisions are important when hiring a foreign national to work in a U.S.-based company. With certain exceptions, they do not reduce the U.S. taxes of U.S. citizens and residents. U.S. citizens and residents are subject to tax on their worldwide. However, a tax treaty may exempt the U.S. citizen or resident from certain taxes normally imposed by the foreign country in which they work and reside. Generally, treaties only apply to federal taxes. Most treaty provisions that exempt or reduce tax, do not apply to Social Security taxes or state taxes. Social Security taxes are addressed in a separate totalization agreement. Foreign Bank Account Reporting (FBAR) Chances are employees working abroad have opened bank accounts in the foreign country they are working and living in. It is, therefore, likely they are subject to annual foreign bank account reporting (FBAR) requirements. In general, any U.S. citizen or resident who, at any time during a calendar year, has a signature authority or interest in a foreign bank or securities account(s) and the aggregate value is $10,000 or more, is subject to FBAR, and must file Form TD F by June 30 for the prior calendar year. 8 FBAR is required whether the person lives within the United States or abroad. Therefore, the FBAR also applies to foreign nationals working in the U.S. on a visa with resident alien status. Endnotes 1. Section (IRC) Treas. Reg. Section (b). 3. Section 162(a)(2). 4. IRC Section Rev. Rul , C.B IRC Section 312(1). 7. IRS Publication 901, U.S. Tax Treaties. 8. IRS Notice and s Announcement Tina Salandra, CPA, is Numerical LLC s principal, and has over 20 of experience in tax, accounting, and business services. Bobby Shethia, M.B.A. E.A., is Numerical s senior accounting manager and has 12 of accounting experience working with small businesses with an international workforce. NEW JERSEY LAWYER October