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Citizenship-based taxation and related reporting requirements: Problems and proposed solution

This article discusses the problems with citizenship-based taxation, specifically in the United States, and proposes a solution to replace it with residential taxation. It also explores the requirements to report foreign assets and recent IRS enforcement programs.

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Citizenship-based taxation and related reporting requirements: Problems and proposed solution

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  1. Citizenship-based taxation and related reporting requirements: Problems and proposed solution October 18, 2012

  2. Outline • Taxation systems for individuals • Citizenship-based taxation • US taxation of foreign income • Requirements to report foreign assets • Recent IRS enforcement programs • Foreign Account Tax Compliance Act (FATCA) • Effects • Proposal

  3. Taxation systems for individuals No income tax (23) Territorial (34) Residential (185) Citizenship-based (2)

  4. Citizenship-based taxation • Presently, only two countries tax the foreign income of nonresident citizens: Eritrea and the United States • Mexico, the Soviet Union, the Philippines, Vietnam and Myanmar previously used citizenship-based taxation but all eventually abolished it • Eritrea: • Highly authoritarian government, accused of various violations of human rights, most militarized country in the world • Levies a 2% tax on net income of nonresident citizens • Diaspora tax condemned by United Nations Security Council Resolution 2023, and successfully prohibited in Canada • United States: • Taxes citizens, regardless of where they reside, in the same manner as residents

  5. US taxation of foreign income • Arguably the most complex part of the Internal Revenue Code for individuals • IRS forms 1116, 2555, 3520, 5471, 6251, 8621, 8891, 8938 • Rarely supported by tax professionals or software • The IRS has admitted that Americans abroad are the group that needs the most assistance with tax return preparation, and the one that has the least access to it • Due to the credit for the usually higher taxes already paid to their countries of residence, 91% of Americans living abroad do not owe tax to the US, but still must file all forms • Taxes collected from Americans abroad amount to less than 0.2% of federal tax revenue

  6. Requirements to report foreign assets • Regardless of tax due, all US citizens and residents must file reports of foreign assets, but most do not • Report of Foreign Bank Accounts (FBAR) • IRS form 3520 (foreign trusts, gifts and inheritance) • IRS form 8938 (foreign financial accounts) • Enormous penalties for noncompliance, disproportional to any tax due • FBAR: 50% of the value of the bank account • IRS form 3520: 35% of the value of the trust, 25% of the value of the gift or inheritance • Account balances, trusts, foreign gifts and foreign inheritances are not taxable • Americans abroad need local bank accounts for mundane activities like earning salaries and paying bills • Immigrants often retain the bank accounts they already had before immigrating to the US

  7. Recent IRS enforcement programs • Offshore Voluntary Disclosure Program (OVDP) of 2009 • Offshore Voluntary Disclosure Initiative (OVDI) of 2011 • 2011 program extended indefinitely • Misleading information about possible penalties outside the program • Misleading promises of reduced penalties for voluntary disclosure • Severely criticized by the National Taxpayer Advocate of the IRS, Nina Olson, in her periodic reports to Congress

  8. Foreign Account Tax Compliance Act (FATCA) • FATCA is an extraterritorial US law that asks every financial institution in the world to report to the IRS on accounts of US citizens or residents, or face withholding of payments from the US • Included as an amendment to the unrelated Hiring Incentives to Restore Employment (HIRE) Act of 2010 • Congress passed FATCA amendment without deliberation • The international financial community has been severely complaining about FATCA • Implementation will cost much more than any possible additional tax revenue to the US • Many foreign banks have decided to avoid FATCA altogether by closing accounts of Americans abroad • Americans are now pariahs in the financial world

  9. Effects • On Americans abroad • Negative sentiment toward the US • Loss of availability of financial services • Divorce from foreign spouse • Renunciation of US citizenship: increased by a factor of 7.8 from 2008 to 2011 • Emotional stress and despair • On immigrants • Abandonment of green cards and return to country of origin • More emotional stress and despair • Reduced immigration and naturalization by wealthy individuals • On the US economy • Lack of representatives of American companies in other countries to promote US exports • Lower exports and fewer job opportunities

  10. Proposal • Replace citizenship-based taxation with residential taxation, in line with the rest of the world • Residential taxation is still worldwide taxation, but only for residents of the country, regardless of citizenship • Simplify reporting of foreign income and assets • Eliminate overburdening or repetitive filing requirements: IRS forms 3520, 5471, 8621, FBAR and FATCA • Eliminate penalties unrelated to tax due

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