A Simple Regulatory Fix for Citizenship Taxation

I. Introduction

As Anatole France famously declared: “The law, in its majestic equality, forbids rich and poor alike to sleep under bridges, to beg in the streets, and to steal bread.”¹ He meant that while laws apply to everyone, some people bear the brunt of them more than others. In his example, the poor have many more reasons to sleep under bridges than the rich do, thus it is on the poor that the brunt of such a law falls.

In a similar fashion, the IRC, as interpreted by Treasury regulations, equally penalizes both U.S. residents and U.S. citizens living outside the United States when they own assets outside the United States, save and invest outside the United States, plan for retirement outside the United States, operate small businesses outside the United States, receive pension and welfare benefits outside the United States, engage in financial transactions outside the United States, and even when they complete a U.S. tax return while living outside the United States.² Even though the relevant code provisions apply to everyone alike, the brunt of the provisions falls on those living outside the United States because they have many more reasons to engage in these activities compared with U.S. residents.

U.S. citizens living overseas who are also tax residents of other countries and who earn their living and receive pensions; receive welfare benefits; need to acquire assets, save, invest, and plan for retirement; and need to engage in financial transactions — all while in these other countries — find that their every financial transaction is treated by the IRC as “foreign,” even when these transactions are performed where they call home. They have the impossible task of planning their tax and financial affairs while subject to the tax systems of two countries — the one in which they live, and the United States.

In addition to the compliance burdens imposed by the code, double taxation, and penalty-laden information reporting, compliance with U.S. law often makes it impossible for American expatriates to benefit from the tax planning vehicles offered in their country of residence. In essence, being subject to worldwide taxation by two tax systems often means that Americans living overseas are not able to enjoy the benefits of either system, but are instead subjected to the worst of each.

As damaged as American expatriates are by these laws, they are only the laws’ second biggest victim. The biggest victim is the IRS, which is charged with administering a highly complex tax system on a global basis via U.S. citizens (and green card holders) living overseas. The IRS does not have the skills or resources to do this.³ And given how little Americans overseas actually owe in U.S. taxes,⁴ there is little motivation for the agency to develop the skills or seek the resources necessary to administer the U.S tax system on a global basis either in the near or distant future.

Organizations representing Americans overseas,⁵ many American expatriates acting individually,⁶ and legal scholars⁷ make regular appeals to Congress to change the tax and banking policies that penalize American expatriates so heavily. But for a few exceptions,⁸ their appeals have fallen on deaf ears. While one can only speculate about why this is the case, it is likely caused by a combination of the following factors:

1. The myth of the wealthy American expat: According to this myth, any American who lives outside the United States does so for the principal, if not sole, reason of avoiding taxation. In falling prey to this myth, members of Congress and their staffs are unlikely to develop an understanding of the reality of Americans living overseas, which is that they are just ordinary people seeking to live ordinary lives in the places they live, but are prevented from doing so by the extraterritorial application of U.S. tax and banking policies.⁹

2. Fear that alleviating the tax burden on Americans overseas would be misunderstood by the American public: It is not just members of Congress and their staffs who fall prey to the myth of the wealthy American expat, but also the American public. So even if a member of Congress may not fall prey to the myth and may agree that relief is needed, they may be reluctant to say so out of fear that it would be misunderstood by the majority of their constituents, and more generally by the American public. Because of the strength and the pervasiveness of the myth, a legislator who supports alleviating the tax burdens on Americans overseas could be wrongly — but nevertheless effectively — painted by their political opponents as giving yet more tax breaks to the wealthy.

3. Priority to local constituents: Some members of Congress may perceive the issues faced by Americans living overseas as lower in priority than those faced by U.S. residents. Why, a member of Congress or their staff may ask, should we devote time and resources to solve problems faced by Americans living overseas when we have a multitude of unsolved problems faced by Americans living in the United States? Some might even think — consciously or not — that compared with U.S. residents, Americans living overseas are less worthy of Congressional problem solving because they live overseas. Compounding this problem is the fact that the millions of Americans living overseas cannot vote as a block — they can only vote where they last lived in the United States.¹⁰ This means that their votes are heavily diluted across the entire country.¹¹ This can lead members of Congress to see their overseas constituents as on the fringe. This means, in turn, that they also see the issues of those constituents as fringe issues that do not sufficiently affect their “real” constituents to merit attention. (In this manner, Americans living overseas can be seen as a “discrete and insular” minority that warrants increased protection, in the tradition of Justice Stone’s Carolene Products footnote four.¹²)

4. Yet another myth: According to another common myth, foreign tax credits and the foreign earned income exclusion (FEIE) protect Americans overseas from problems linked to taxation. In fact, nothing could be further from the truth. Because American expatriates live subject to two different tax systems, they are subject to separate and more punitive tax rules compared with both U.S. residents and the other residents of the countries in which they live.¹³ Nevertheless, because many in the tax compliance industry¹⁴ as well as others¹⁵ continue to propagate this myth, many — including members of Congress and their staffs — still believe it. As a result, they do not believe that there is any problem needing to be solved.

Indeed, these four factors paint a bleak picture for Americans living outside the United States. Getting the attention of Congress, much less its understanding or willingness to act, is a long uphill battle with no promise of success.

Does this mean that American expatriates are condemned to live under crippling policies? Does it mean that Americans overseas must accept that the only way they can live normal lives in the places they live is by renouncing their U.S. citizenship?¹⁶ Citizenship is a human right.¹⁷ Are Americans living overseas — indeed, all Americans — to be deprived of this human right, as well as other human rights such as the right to leave one’s country and return to it,¹⁸ because Congress does not have the bandwidth, the understanding, or the will to act on these issues?

By the same token, does this mean that the IRS is condemned to continue to attempt to administer the highly complex U.S. tax system on a global basis while lacking both the skills and the resources to do so, and with limited tax revenue to show for its efforts? The IRS is repeatedly criticized for failing to adequately enforce the IRC at home.¹⁹ Should it, then, continue to expend its limited resources to enforce the code in other countries on people who are tax residents of those countries?

There is a solution. It lies with Treasury.

There is one simple solution that Treasury could implement that would change the lives of the millions of Americans living around the world. At the same time, it would allow the IRS to focus its limited resources on tax enforcement in the United States.

Section II of this article explains that simple regulatory solution, and Section III explores several alternative actions. While the alternative actions would not have the same broad effect, they would nevertheless relieve significant burdens on both Americans living overseas and the IRS.

II. A Regulatory Solution

As noted, there is a simple regulatory action that Treasury can take to change the lives of millions of Americans living overseas. Following is (1) an explanation of Treasury’s moral authority — indeed, imperative — to take action regarding the taxation of Americans overseas, (2) an explanation of the regulatory action and Treasury’s legal authority to take it, and (3) a description of how this simple action would assist not just Americans living overseas, but also the IRS.

A. Treasury’s Moral Imperative

Section 1 imposes federal income tax on every “individual.” As with all statutory construction, it is important to ascertain what Congress had in mind when extending the income tax base to “individuals.” Tax historians will tell you that since the first income tax was enacted during the Civil War the United States has always taxed on the basis of citizenship.²⁰ But what did that mean?

Cook²¹ is often cited as resolving the constitutional question whether the United States can tax the non-U.S.-source income of nonresident citizens. This Supreme Court decision upholding the taxation of nonresident citizens was handed down at a time — 1924 — when the IRC was far less complex, dual citizenship was uncommon, there was less global mobility, and most people were residents of their country of citizenship.

Cook was a U.S. citizen and resident of Mexico with Mexican-source income. He was not a dual citizen — we know this because, under the Revenue Act of 1921²² and the associated regulations,²³ in becoming a Mexican citizen he would have no longer been taxed by the United States on non-U.S.-source income.

The relevant portion of the regulations from that time states:

An individual born in the United States subject to its jurisdiction, of either citizen or alien parents, who has long since moved to a foreign country and established a domicile there, but who has never been naturalized in or taken an oath of allegiance to that or any other foreign country, is still a citizen of the United States.²⁴

Under the Revenue Act of 1921, a person born in the United States who naturalized or took an oath of allegiance to a foreign country was no longer considered a citizen. This result naturally flowed from the way citizenship was understood in the 19th and early 20th centuries — individuals had a single sovereign, and an oath of allegiance to another sovereign generally meant a loss of the original citizenship.²⁵

The current IRC was originally enacted in 1954,²⁶ just two years after the Immigration and Nationality Act (INA).²⁷ The original regulations under the code defined citizenship for the INA.²⁸ This definition is in the regulations, and not in the statute itself, which doesn’t even mention the word citizen in section 1. Under the INA as it existed in 1954, an individual relinquished U.S. citizenship by performing any one of several expatriating acts including naturalization in a foreign state, serving in the armed forces of a foreign state, voting in a foreign state, or formally renouncing citizenship.²⁹ Loss of citizenship was automatic and not subject to the assent of the individual. So, when the current regulations under section 1 were originally promulgated, citizenship-based taxation was not the Hotel California that now plagues American emigrants — in 1954 you could check out and leave by performing any of several expatriating acts, none of which needed to be documented with the U.S. government to have effect.

So, how did we get to the current situation in which record numbers of American emigrants³⁰ are eager to pay the State Department $2,350 and undertake significant compliance costs to extinguish their U.S. citizenship?

Since the 1950s, an increasing number of countries have become tolerant of dual citizenship.³¹ In the United States, this was in large part in response to the Supreme Court decision in Afroyim,³² which held that Congress could not legislate loss of citizenship. Instead, the Court held, each citizen has “a constitutional right to remain a citizen . . . unless he voluntarily relinquishes that citizenship.”³³ As a result of this holding, most of the acts listed in the INA that normally would be expatriating would have that effect only if performed with the intent of losing U.S. citizenship. In other words, Afroyim — decided on the basis of nationality and not tax law — had the effect of increasing the number of U.S. citizens. Those persons who, before Afroyim, would have relinquished U.S. citizenship instead remained U.S. citizens. This was the case even though they had performed the kinds of expatriating acts that Treasury regulations had previously deemed sufficient for the loss of U.S. tax residency.

While Afroyim addressed citizenship only in the context of the INA, its expansion of citizenship has had profound implications for a country that taxes all citizens, wherever resident, on their worldwide income. Further, with the expansion of dual citizenship, U.S. citizenship no longer means sole allegiance to the United States, further diluting the rationale for taxing nonresident citizens, especially those who are citizens of other countries.

Does the IRC need to follow the INA to determine who is a citizen for tax purposes? No. As will be discussed, there is no section 1 statutory reference to tie citizenship for tax purposes to U.S. nationality law. It is Treasury that made the election — by regulation — to tie tax residency to U.S. nationality laws. It is Treasury that has not yet taken into account drastically altered nationality laws and their effect on tax residency. And it is Treasury that has thereby not yet amended the relevant regulation.

Further, the tax rules already deviate from the INA when it comes to defining who is a citizen. Consider the rules for terminating U.S. citizenship for tax purposes under sections 7701(a)(50) and 877A(g)(4). Under the INA,³⁴ the voluntary performance of an expatriating act with intent to lose U.S. citizenship does not require notice to the government for citizenship to be relinquished. However, section 877A(g)(4)(B) provides that citizenship is not relinquished for tax purposes until the Department of State is notified of that expatriating act. Based on this provision, several commentators have noted that “tax-citizenship” is not the same as citizenship under U.S. nationality law.³⁵

This is where the simplicity of our proposal lies: Treasury has not just the moral authority, but also the moral imperative, to rein in the mission creep of citizenship-based taxation. Treasury also has the legal authority to do so in the manner we explain.

B. Treasury’s Legal Authority

As noted, section 1 imposes federal income tax on every “individual.”

The term “individual” is broad. Conceivably, it refers to every human being in the world. Regulatory clarification is obviously necessary.

Reg. section 1.1-1(a)(1) provides some clarification: This regulation — not statute — explains that “individual” is restricted to “citizen or resident.”

In adopting this — again, regulatory — definition of the term “individual,” Treasury is demonstrating its authority not just to define the term, but also to restrict its meaning. Treasury has further demonstrated its authority to restrict the meaning of the term “individual” by excluding from the definition — and thereby excluding from federal income taxation — persons who are “nationals” but not citizens and who reside outside the United States.³⁶

Treasury also has the authority to modify reg. section 1.1-1 to exclude from the meaning of the terms “individual” or “citizen” persons who meet specific conditions. These conditions include (1) not living in the United States; (2) living in another country; and (3) being tax resident in another other country. That is, in the same manner as it has done for “nationals,” Treasury also has the authority to exclude persons living overseas, who meet specified other conditions, from federal taxation on their worldwide income.

This can be done in various ways.

To begin, Treasury can create by regulation a new category of persons who, for the purposes of federal income taxation, are neither “citizens” nor “nonresident aliens.” This new category can be called “qualified nonresidents.” Qualified nonresidents would not be subject to U.S. taxation on non-U.S.-source income. Qualified nonresidents would be subject to all U.S. taxation on U.S.-source income, including capital gains on U.S.-source property.

The creation of this category of persons for the purposes of federal income tax would have no effect on the retention of U.S. citizenship for nationality purposes. Further, when a person becomes a qualified nonresident, they would not be subject to the section 877A expatriation tax, nor to any other tax by reason of assuming the status of qualified nonresident. (Although, because the section 877A expatriation tax rules would remain in effect if the individual relinquished U.S. citizenship for nationality purposes, regulatory changes should be adopted to ensure that the growth in assets during the period when the individual was a qualified nonresident would not be subject to that tax.)

Who would count as qualified nonresidents? Those who meet two conditions:

Condition No. 1 — Foreign residency: The person must meet the foreign residency test set forth in section 911(d)(1)(A) (for the FEIE) that (1) the person’s tax home is in a foreign country, and (2) he has been a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year.

Condition No. 2 — Tax residency: The person must be a “tax resident” of a foreign country while meeting the foreign residency test. For this purpose, tax residency is determined under the laws of the country in question.³⁷ Foreign residency is determined under U.S. law (more specifically, under condition 1 above).

Annex 1 contains our proposed text for the relevant modification to reg. section 1.1-1.

C. Simple Act — Profound Effects

This simple regulatory action would resolve a multitude of problems faced by Americans living overseas. It would allow them to live as ordinary people, like the other ordinary people, in the places where they live. It would allow them to save, invest, plan for retirement and retire, hold title to family assets, create and operate businesses, and benefit from public welfare in the same manner as the other residents of the places where they live. It would free Americans overseas from the heavy burden of completing annual U.S. tax returns — documentation so complex that many require expensive professional assistance — all to demonstrate that no U.S. tax is owed. It would obviate any need for annual — and duplicative — reporting of their local bank accounts to Treasury.³⁸

Perhaps less obviously, but no less profoundly, this simple regulatory action would also resolve a multitude of problems faced by the IRS. Reg. section 1.1-1 shoulders the IRS with the responsibility of administering a tax system on a global basis. This responsibility is unprecedented; no other country in the world expects anything comparable from its agency for tax administration.³⁹

This responsibility is also enormous: Administering a tax system on a global basis presents several obstacles that cannot be addressed without considerable resources. Today the IRS is required to divert its limited resources from the national administration of the U.S. tax system to find solutions to those obstacles, thus far with little success. The simple regulatory action proposed here would allow the IRS to consolidate its resources to more effectively administer a national tax system.

Set forth here are just some of the obstacles the IRS faces in its attempts to administer a global tax system. To effectively do so — as well as comply with the Taxpayer Bill of Rights — the IRS must develop secure and affordable means to provide overseas taxpayers with:

• access to in-person assistance from the IRS;

• access to fully functioning IRS online accounts;

• a facility for toll-free international calls to the IRS;

• IRS personnel adequately trained to respond to the special queries and issues of overseas taxpayers, able to speak the wide range of languages spoken by overseas taxpayers, and available 24 hours a day to cover all the time zones in which overseas taxpayers live;

• forms, publications, and other communications fully developed in each of a wide range of languages spoken by overseas taxpayers;

• rules and publications to clearly explain the U.S. tax implications of different forms of income, savings and retirement plans, financial instruments, and business entities that are common in other countries;

• a system for reliable and timely delivery of postal mail to overseas taxpayers;

• a facility for effecting deposits to overseas taxpayers’ foreign bank accounts and a facility to accept deposits from overseas taxpayers’ foreign bank accounts without incurring a transfer fee; and

• IRS examiners adequately trained to audit the complex returns of overseas taxpayers.

Today the IRS does not provide any of these essential services to overseas taxpayers. Annex 2 contains a more detailed discussion of these services, the obstacles they present to the IRS, and how the IRS’s failure to provide these services represents multiple egregious violations of the Taxpayer Bill of Rights.⁴⁰

Further, a 2018 report of the Treasury Inspector General for Tax Administration concludes that the IRS is not equipped to enforce the Foreign Account Tax Compliance Act.⁴¹ By obviating the need for duplicative annual reporting of their local bank accounts by persons living overseas, the solution proposed here would relieve the IRS of much of the burden of FATCA enforcement.

In essence, this simple solution would save U.S. citizenship — it would allow Americans living overseas to remain U.S. citizens. At the same time, it would relieve the IRS of the enormous and unprecedented burden of administering a tax system on a global basis, thereby allowing the agency to better concentrate its limited resources on a more effective national administration.

III. Additional Regulatory Relief

As an alternative to the solution proposed in Section II, Treasury could take the following regulatory actions. These actions would not by any means have the same wide-reaching effect, but, taken together, they would relieve significant burdens on both Americans living overseas and the IRS.

A. Duplicative Financial Filings

Problem: Americans living overseas are subject to complex as well as duplicative financial informational filings. More specifically, each year they are required to comply with both the foreign bank account reporting standards and FATCA. Both of these reporting requirements relate to financial accounts that U.S. persons hold outside the United States. While most Americans living inside the United States have little reason to hold financial accounts outside the United States,⁴² Americans living outside the United States have every reason to hold them in the places where they live. They are indispensable for carrying out the most basic elements of modern life, such as receiving salaries and pensions, paying bills, and for saving and investment.

Both FBAR and FATCA require Americans living overseas to annually report detailed information about the accounts they hold in the places they live, including the name and address of the financial institution, type of account, account number, and the maximum balance of the account during the year. Even though the substance of the disclosures is essentially the same, these are two different reporting requirements that must be fulfilled using two different forms (FinCEN Form 114 and Form 8938, respectively) which are submitted to two different agencies within the same Treasury Department. One requires a greater variety of accounts to be reported than the other, and the reporting requirement for each is triggered by a different threshold. Perhaps most importantly, each is subject to its own separate draconian penalties for failure to file.⁴³

FATCA also poses a problem for the IRS. The 2018 TIGTA report noted earlier observes that even though the IRS has spent nearly $380 million, it is still not in a position to enforce FATCA.⁴⁴ The report explains that this is because the IRS has not established the processes needed to ensure compliance. For example, the IRS has no processes in place to inform taxpayers on how to correctly complete Form 8938, to address submission errors or incomplete filings, to match data across different forms to verify correctness, or to initiate compliance efforts with nonfilers.⁴⁵ The end result, the report confirms, is that even though the IRS has expended considerable resources on FATCA compliance, it has little to show for its efforts.⁴⁶

Solution: This problem of both complexity and duplication requires a two-pronged solution:

1. Americans living overseas should be exempted from the requirement to submit FBARs (FinCEN Form 114) as well as from the requirement to submit FATCA forms (Form 8938) regarding accounts that are local to them (that is, accounts in their country of residence). The ostensible purpose of FBAR is to combat money laundering,⁴⁷ and the ostensible purpose of FATCA is to combat tax evasion.⁴⁸ As noted above, financial accounts held in the place where one lives are necessary for day-to-day life; they are not vehicles for either money laundering or tax evasion.

2. To the extent that an obligation to report any non-U.S. accounts remains in place, the obligation should be consolidated into one form, triggered by one threshold, submitted to one governmental agency, and subject to one set of reasonable penalties for failure to comply.⁴⁹

Authority: Section 7805 grants Treasury the general authority to prescribe “all needful rules and regulations for the enforcement” of the IRC.⁵⁰ In addition to this general regulatory authority, section 6038D(h) grants Treasury specific authority to prescribe regulations regarding foreign financial asset reporting, including “appropriate exemptions,” such as when the secretary determines that disclosure under section 6038D would be “duplicative of other disclosures.” Finally, the Bank Secrecy Act grants the secretary the authority to exempt classes of persons from the FBAR rules.⁵¹

There is precedent for this form of regulatory relief. Treasury has already used its authority under section 6038D(h) in two important ways: (1) to establish the amounts that trigger the FATCA reporting requirement for Americans living overseas ($200,000 for individuals and $400,000 for joint filers),⁵² and (2) to exempt U.S. persons who are nonresident aliens from FATCA reporting.⁵³

In 2011 Treasury considered exempting Americans living overseas from FBAR requirements but decided against it, stating that “FinCEN does not believe that an exemption is appropriate simply because a United States person chooses to live outside of the United States.”⁵⁴ This justification ignores the existence of persons who were born in the United States to two non-U.S. citizen parents and who, while still children, left the United States with their families to return to their parents’ home country.⁵⁵ It also ignores the existence of persons who were born and have lived all their lives outside the United States and are U.S. citizens by virtue of the U.S. citizenship of a parent. It cannot be said that anyone belonging to these two categories of persons “chooses” to live outside the United States. Indeed, the application of FBAR rules to those persons is another example of the profound implications of Afroyim’s expansion of citizenship. At the same time, that Treasury’s justification ignores the existence of those persons highlights the fundamental problem of tying citizenship for tax purposes to U.S. nationality law.⁵⁶

For Americans of all categories, the justification Treasury offered in 2011 makes a mockery of the right to move from one country to another. The importance of this right is underscored by the fact that it is enshrined in not one, not two, not three, but four international human rights instruments.⁵⁷ Restrictions may be placed on this right only for the purposes of protecting national security, public order, public health or morals, or the rights and freedoms of others.⁵⁸ Today FBAR — as well as FATCA — operate as fiscal restraints on the right to move from one country to another; neither FBAR nor FATCA can be justified on any of the permissible grounds for restrictions.

B. Trust Reporting

Problem: Many Americans living overseas save for retirement using tax-deferred vehicles offered — and sometimes required — by their country of residence. One example is Australia’s superannuation, a retirement scheme to which all Australian employers are required to contribute on behalf of each of their employees. Like many foreign retirement plans, a superannuation account can take different forms; some forms are considered to qualify as “foreign trusts” under section 7701(a)(31)(B). As a result of this qualification, Americans overseas are required to comply with confusing and burdensome informational filing obligations to the IRS, subject to steep penalties for even inadvertent mistakes.⁵⁹

These obligations are so confusing that even professional tax practitioners get them wrong. This was evidenced in 2019, when thousands of Americans living overseas received IRS penalty notices of $10,000 for late filing of Substitute Form 3520-A, a purely informational form pertaining to a foreign trust. Many of the overseas taxpayers who received this penalty notice had engaged the services of a professional tax practitioner.⁶⁰

It is because of this kind of risk (among others) that many Americans overseas minimize or altogether avoid participation in the retirement schemes offered in their countries of residence.⁶¹ This limits their ability to plan for retirement and the resources available to them when they do retire.

And it is not just overseas taxpayers and their advisers who are confused by the rules pertaining to foreign trusts. IRS personnel are also confused. This is evidenced not just by the multitude of penalty notices that were sent in connection with Substitute Form 3520-A, but also by the IRS’s later acknowledgement that the notices were sent in error and by the launch of an investigation by the IRS Office of Associate Chief Counsel (International) into why they had been sent.⁶² The IRS expended these resources for purely informational forms — that is, forms that do not generate tax revenue.

Solution: The IRS has already attempted to solve this problem with Rev. Proc. 2020-17, 2020-12 IRB 539. Unfortunately, this solution is incomplete. By placing limits on allowable contributions and the time and purpose of withdrawals, the IRS is attempting to export U.S. law to other countries. Other countries do not define their tax-advantaged retirement schemes based on limits in U.S. law, and Americans living overseas have no control over the laws of the country they live in. Common retirement plans in several jurisdictions do not meet the restrictive requirements of Rev. Proc. 2020-17.⁶³

In the context of FATCA, Treasury has already done the work to formulate a reporting exemption for foreign retirement accounts: Model 1 intergovernmental agreements for FATCA specify that some kinds of retirement planning accounts are excluded from FATCA reporting. The same accounts that are excluded from FATCA reporting under Model 1 IGAs⁶⁴ should also be excluded from Form 3520 reporting under Rev. Proc. 2020-17.

Authority: In addition to the general regulatory authority granted to Treasury under section 7805,⁶⁵ section6048(d)(4) authorizes the secretary to suspend or modify foreign trust reporting if there is no significant tax interest in obtaining information about the trust. For foreign retirement accounts held by nonresidents of the United States, the secretary has implicitly determined, in the context of FATCA, that reporting of these accounts held in Model 1 IGA jurisdictions does not significantly compromise the tax collection and disclosure interests of the United States.

C. Mutual Funds

Problem: The passive foreign investment company rules in sections 1291-1298 are among the most complex in the IRC. These investments must be reported annually on Form 8621, which is four pages long and must be completed separately for each investment.⁶⁶ When PFIC shares are sold, the computations can require many pages of supporting statements, adding to the compliance burden for taxpayers and also to the processing burden for the IRS.

The PFIC rules entered the IRC as part of the Tax Reform Act of 1986 ⁶⁷ to prevent the deferral of income by investing in foreign investment companies that were not required to distribute currently realized income and capital gains.⁶⁸ In 1985 less than 15 percent of U.S. households invested in mutual funds. That proportion grew rapidly to about 45 percent by 2000, where it has remained for the past 20 years.⁶⁹ There are many reasons for this growth, including an increased availability of mutual fund products, a reduction in management fees, and an increased reliance on private savings to fund retirement.

These factors also apply to Americans living overseas. The United States is not the only country with a developed mutual fund market. At the end of 2019, U.S.-domiciled funds accounted for only 8 percent of the 122,528 regulated investment funds available globally and 47 percent of the $54.9 trillion invested in regulated funds.⁷⁰ In countries such as Canada and Australia, these funds are required to distribute current income to investors, much like U.S. funds. These funds that are commonly available to retail investors are not the same type of foreign investment companies that Congress was targeting with TRA 1986.

However, most mutual funds outside the United States are considered by many tax preparers to be PFICs and subject to the PFIC regime, which, at best, taxes unrealized gains currently, and, at worst, subjects the investment to the highest U.S. marginal tax rate and complex daily compounded interest charges on the “deferral” of U.S. tax as well as highly complex U.S. reporting requirements (Form 8621).

As a result, many Americans living overseas avoid participating in any kind of savings or investment scheme that might be deemed a PFIC. This means that they are unable to benefit from many tax-advantaged savings and investment schemes that other residents of the countries where they live are able to benefit from. Examples include the United Kingdom’s Individual Savings Account (ISA)⁷¹ and France’s Assurance Vie.⁷²

Solution: Modern regulated mutual funds that are generally available to retail investors are not designed for tax deferral; they are not the foreign investment funds that Congress was targeting in 1986. Given the importance of mutual funds to the financial planning of those with insufficient wealth to diversify a direct share portfolio, Treasury should limit the applicability of the PFIC rules to exclude managed investment vehicles available to retail investors in jurisdictions in which current income and gains are required to be distributed to the investor. Treasury can do this by expanding the list of exemptions from the requirement to file Form 8621 in reg. section 1.1298-1(c).

Authority: In addition to the general regulatory authority granted to Treasury under section 7805,⁷³ section 1298(f) grants Treasury specific authority to determine who is subject to PFIC reporting obligations. Further, section 1298(g) grants Treasury the authority to prescribe regulations appropriate to carry out the purposes of the PFIC rules more generally.

D. Burdensome Business Filings

Problem: Americans living overseas who operate businesses in the countries where they live — businesses like dry cleaners, yoga studios, and doctor’s offices — are subject to complex U.S. informational filing requirements. This includes, notably, Form 5471 for non-U.S. corporations and Form 8865 for non-U.S. partnerships. Few are able to complete these forms without expensive professional assistance. The Tax Cuts and Jobs Act⁷⁴ dramatically exacerbated the problem. The burden and expense of the forms, coupled with the difficulty of understanding the requirements, lead many Americans living overseas to forgo plans to operate a business in the places where they live. It also resulted in the exclusion of Americans from entrepreneurial opportunities in the places where they live because their potential partners do not want to expose the business to U.S. filing requirements or to the resulting increased operating costs. For those Americans who do operate businesses overseas, the necessity to comply with complex and expensive U.S. filing obligations makes their businesses less competitive in relation to other businesses that are not operated by Americans and not subjected to the same burdens.⁷⁵

Although we would not expect a public complaint from the IRS, it is clear that monitoring compliance by individual shareholders who live outside the United States and carry on business through local corporations requires special expertise — expertise with a steep learning curve. Most in the tax compliance industry⁷⁶ struggle with issues relating to controlled foreign corporations (subpart F);⁷⁷ there is no reason to expect IRS examiners to be more capable.⁷⁸

Solution: For U.S. taxpayers who meet section 911 residency requirements (that is, who would be eligible for the FEIE), amend the operative regulations under sections 6031-6039 to exempt those taxpayers from the requirement to file forms 5471, 8865, and others for any business they carry out in their country of residence. The exemption should encompass all those businesses, but at a minimum small businesses that are operated by Americans living overseas as their primary source of income.

Authority: In addition to the general regulatory authority granted to Treasury under section 7805,⁷⁹ section 6038(a)(1) grants Treasury specific authority to determine what information regarding foreign business entities U.S. persons are required to provide. Also, section 6046(b) grants Treasury the specific authority to determine the information to be contained in any tax return pertaining to a foreign corporation.

Further, there is precedent for Treasury providing this kind of regulatory relief: Reg. section 1.6038-2(j)(2)(ii) allows for U.S. persons who are nonresident aliens to file the foreign corporation’s audited foreign corporate tax return in lieu of Form 5471.⁸⁰

Finally, Treasury should be inspired by the Regulatory Flexibility Act in alleviating the filing burdens to which small businesses are subject.⁸¹

E. Transition Tax and GILTI

Problem: The TCJA dealt a double whammy to Americans living overseas who operate businesses in the countries in which they live. To begin with, it imposed a retroactive tax on American individuals based on the retained earnings of their companies — the transition or repatriation tax. Further, it imposed, again on American individuals, the global intangible low-taxed income regime — an ongoing tax based on the company’s income.⁸² Both of these taxes have proven to be crippling for Americans living overseas who operate businesses in the countries in which they live.

The transition tax resulted in a significant erosion in the value of companies. Further, because the transition tax was not based on any taxable event that would generate a tax credit in the business owner’s country of residence, it forced many to accept double taxation. The effects were especially disastrous in countries like Canada, where local laws have given incentives to small business owners to retain earnings in their companies as a way to fund retirement.⁸³ U.S. citizens operating small businesses in Canada found themselves required to liquidate large portions of their retirement savings — in amounts ranging from $200,000 to $4 million — in order to pay the transition tax.⁸⁴

GILTI makes it more expensive for Americans living overseas to operate a business in the countries where they live on an ongoing basis. It is yet another expense, in addition to those already discussed, that they must face but, again, not one that their local competitors face. Further, laws like GILTI and the transition tax make Americans living overseas even more undesirable as business partners, resulting in their exclusion from entrepreneurial and other business opportunities.⁸⁵

The need to address the problems created by laws like the TCJA has become more urgent in light of former Vice President and Democratic presidential nominee Joe Biden’s recent proposal for a new “offshoring tax penalty,” a “minimum tax on foreign earnings,” and the “elimination of offshore tax loopholes.”⁸⁶ If those proposals are successful, careful attention will be required to make sure that they do not have equally if not greater adverse effects for Americans living and operating small businesses overseas than the TCJA did. If so, in all likelihood it will hammer the final nail in the coffin of any possibility for Americans living overseas to operate their own businesses.

Solution: Treasury should entirely exempt Americans living overseas from both the transition tax and GILTI. Because the transition tax was a one-time tax and not ongoing, in order for that exemption to have meaning, it should be retroactive. While this may not make whole those who have paid the tax, it would help to repair the damages they have suffered.

If Treasury does not provide for a total exemption, then it should adopt de minimis amounts below, which the taxes do not apply.

Treasury should remain vigilant in the event that any new taxes or penalties for the operation of businesses outside the United States are adopted, to be sure they do not again result in punishing Americans living and operating small businesses overseas.

Authority: Since the adoption of the TCJA, Treasury has repeatedly taken the initiative to exercise regulatory authority for subpart F — including GILTI — rules. With the GILTI regulations Treasury has already exercised its regulatory authority to protect small business owners, including Americans living overseas, in two ways:

1. by interpreting section 962 to allow individuals to benefit from the section 250 deduction, thus lowering the amount of GILTI income; and

2. by interpreting the subpart F rules to mean that foreign income subject to a rate of foreign taxation at a rate of 90 percent⁸⁷ or more by the source country will not be considered to be GILTI income.⁸⁸

These precedents demonstrate that Treasury also has the authority to implement our proposed solution.

IV. Conclusion

Most articles like this conclude with a caveat that the solutions proposed are not panaceas. This article proposes a solution that actually would be a panacea. Modifying reg. section 1.1-1 to exclude Americans living overseas from the definition of the terms “individual” or “citizen” would change the lives of those millions of Americans. Further, it would enable the IRS to stop diverting resources to the ineffective administration of a global tax system⁸⁹ and to employ those resources to more effectively administer a national one.

In the alternative, Treasury could take a series of other, more prompt regulatory actions. Their cumulative effect would not be panacean, but would still relieve significant burdens on both Americans living overseas and the IRS.

As important as these regulatory changes are, they will not be the end of the road for Americans overseas. In order that they may have the option to retain U.S. citizenship, tax justice is required. As easily as a Treasury regulation can be adopted by one administration, it can just as easily be reversed by another. Therefore, as important as the role of Treasury is in bringing immediate relief to Americans living overseas, this problem screams for Congressional action.

Annex 1

Proposed Modification to Treasury Regulation Section 1.1-1

We propose that after reg. section 1.1-1(c) there be added a reg. section 1.1-1(d)⁹⁰ as follows:

(d) “Qualified Nonresident” — When a U.S. citizen for nationality purposes may elect to not be a U.S. citizen for tax purposes and become a “qualified nonresident”:

Any U.S. citizen who meets the following conditions for two consecutive years may elect to be treated as a noncitizen for purposes of the Code when that person:

• meets the conditions in section 911(d)(1)(A) of the code as a qualified individual for two consecutive years (foreign residence test); and

• while meeting the test in section 911(d)(1)(A) of the code, is a “tax resident” of a country outside the United States for those same two years.

An individual meeting those conditions will be considered to be a “qualified nonresident.” Qualified nonresidents will continue to be U.S. citizens for immigration and nationality purposes and will be treated as U.S. citizens for the purposes of taxation on U.S.-source income, including capital gains realized on the sale of U.S. property.

Annex 2

The Impossible Job of the IRS

Following is a list of just some of the essential services that the IRS does not provide to overseas taxpayers, together with a brief description of the obstacles each presents to the IRS.

The failure to provide these essential services to overseas taxpayers constitutes multiple violations of the Taxpayer Bill of Rights — violations that are both patent and egregious. Notably, these failures violate (1) the right to be informed, including the right to know what to do to comply with tax laws and the right to clear explanations; (2) the right to quality service, including the right to receive prompt service and to receive clear and easily understandable communications from the IRS; (3) the right to pay no more than the correct amount of tax, including the right to pay only the amount of tax legally due; and (4) the right to a fair and just tax system, including the right to expect the tax system to consider facts and circumstances that might affect taxpayers’ underlying liabilities and ability to provide information timely.⁹¹

These failures demonstrate that the IRS does not treat overseas taxpayers on an equitable basis with U.S. residents; indeed, the opposite is true — they are treated in a manner that is manifestly discriminatory.⁹²

The failure to provide these essential services demonstrates that the IRS has neither the skills nor the resources to administer the U.S. tax system on a global basis: