With according to some estimates nine million Americans living abroad subject to US taxation overseas, in this article, we aim to break down what citizenship based taxation is, the implications for American expats, strategies to mitigate double taxation, and some essential considerations for US expat investors.
- What is citizenship-based taxation?
- Other systems: residency and territory-based taxation
- Implications for Americans living abroad
- Mitigating double taxation
- Considerations for expat investors
What is citizenship-based taxation?
Citizenship Based Taxation (CBT) is the type of taxation system employed by the United States. Under CBT, American citizens are taxed on their worldwide income, regardless of where they reside. This means that even if an American citizen lives and earns income abroad, they are still obligated to report and pay taxes to the American government. This unique underpinning of US tax law differentiates the US from the residency-based and territory-based taxation systems used by most other countries.
Other systems: residency and territory-based taxation
In contrast to citizenship-based taxation, many countries utilize residency-based or territory-based taxation systems. Residency-based taxation is a system that taxes individuals based on their residency status within a country, while territory-based taxation taxes individuals based on income earned within the country’s territory. These alternative systems consider an individual’s physical presence or economic activities within the country as the basis for taxation, rather than citizenship alone.
Implications for Americans living abroad
Citizenship Based Taxation (CBT) creates significant challenges for Americans living abroad, as it compels expats to file US taxes every year reporting their global income. This in turn means that CBT can lead to double taxation, where expats face taxation on the same income by both the US and their country of residence. Additional burdens derived from CBT for Americans living abroad include:
The Foreign Account Tax compliance Act (FATCA)
The Foreign Account Tax Compliance Act (FATCA) requires expats with foreign assets with a total value of $200,000 USD or greater at the year’s end, or exceeding $300,000 USD at any time throughout the year to report them on Form 8938.
Foreign Bank Account Report (FBAR)
Additionally, the Foreign Bank Account Report (FBAR) mandates the reporting of foreign financial accounts when expats have a total exceeding $10,000 in their foreign accounts at any point during the year on FinCen Form 114.
Additionally, expats must report ownership stakes in foreign registered corporations and trusts, as well as certain types of investments.
Mitigating double taxation
American expats often face the prospect of double taxation, where their income is taxed by the US and their country of residence. Understandably, this situation can create anxiety among expats. However, there are strategies available to mitigate this tax burden.
Tax treaties
While the US has Tax treaties with numerous countries worldwide, they don’t exempt expats from having to file US taxes. Some treaties can provide certain benefits though, for example relating to retaining the tax benefits of US retirement accounts. It’s important to consult a US tax professional who is familiar with the tax treaty the US has with the country where you reside.
Foreign Earned Income Exclusion (FEIE)
The Foreign Earned Income Exclusion (FEIE) is a provision that allows expats to exclude a certain amount of their foreign earned income from taxation (up to $120,000 in 2023 and $126,500 in 2024) by filing Form 2555 with Form 1040.
The Foreign Tax Credit (FTC)
Similarly, the Foreign Tax Credit (FTC) can be claimed on Form 1116, allowing expats to offset US tax to the same value as foreign taxes they’ve paid.
Totalization agreements
Totalization agreements are a different type of tax treaty intended to mitigate double social security taxation. They stipulate that expats can pay social security taxes to either the US or their country of residence, depending on their length of stay abroad. They also let expats combine contributions they’ve made in both counties to receive social security payments in the country where they retire.
Considerations for expat investors
Investing as a US expat presents another challenge, particularly concerning investing in Passive Foreign Investment Companies (PFICs).
PFICs are pooled foreign investments, typically foreign mutual funds and some pension funds, and they are subject to complex tax reporting and additional taxes. In general, it’s advisable to avoid investing in PFICs.
Seek advice
While navigating citizenship based taxation as an American living abroad may seem daunting, seeking professional advice can provide invaluable guidance to allow you to optimize your tax strategies while ensuring compliance with US tax laws. By leveraging the right strategies and double taxation mitigation, American expats can effectively manage their finances while enjoying their lives abroad.
If you have any questions about financial planning as an American living abroad, get in touch.
This article is for informational purposes only; it is not intended to offer advice or guidance on legal, tax, or investment matters. Such advice can be given only with full understanding of a person’s specific situation.