The Tax Treatment of U.S. Citizens Abroad Is Absurd and Unfair, and Getting Worse

by Veronique de Rugy

The Wall Street Journal has an article by David ​Kuenzi today about the nightmare faced by Americans living abroad trying to comply with the U.S. tax code. America is one of the few countries that taxes its citizens living abroad on their income earned there, which means that expatriates have to file taxes in the country where they live and in the U.S. Most people can claim a credit on their U.S. returns for foreign taxes paid, but this doesn’t generally eliminate the double taxation of part of their non-U.S. income. This whole issue is likely the main reason behind a recent increase in Americans trying to renounce their citizenship. 

But just as important, the cost of compliance and the consequences for failing to comply can be terrible. This is particularly brutal for middle-class American living abroad, and it’s been worsened by the recently passed Foreign Account Tax Compliance Act (FATCA), which is the topic of the WSJ’s piece.  

Fatca requires these institutions to report on the financial holdings of their U.S. clients with the aim of reducing the incidence of off-shore tax evasion by wealthy Americans. Yet officials are less willing to discuss how Fatca worsens the already profoundly unjust tax treatment of millions of middle-class Americans living abroad.

The vast majority of U.S. expatriates living abroad harbor a strong sense of patriotism that includes a willingness shoulder their fair share of the nation’s tax burden. Deep resentment arises, however, when they confront the byzantine complexity of preparing a tax return that includes non-U.S. income and non-U.S. financial accounts. Fatca demands rigorous compliance with arcane rules that the IRS has until now never even attempted to enforced on a widespread basis. For Americans abroad, desperately trying to comply, the outcome to family finances is often disastrous.

Here are some of horror stories reported by the Journal:

In one case, a California school teacher lost her Swiss husband of 30 years to cancer. In the ensuing family trauma, she failed to file a foreign asset disclosure form to report her husband’s Swiss pension. Despite having paid all of her U.S. taxes on time, she is advised by a California law firm to enter the IRS’s Off-Shore Voluntary Disclosure Program. She paid the firm a retainer fee of $124,000 to begin the OVD process and was told to expect penalties of up to $800,000.

In Malaysia, a modest, local family business was thrown into financial turmoil when the authorities discovered that because one of the founder’s daughters, a partial owner of the business through a family trust, married an American and took U.S. citizenship. The entire business was, as a result, subject to complex U.S. accounting and U.S. tax reporting requirements.

In Toronto, an American-born professor made no investments in anything other than bank saving accounts for fear of running afoul of one of the scores of obscure U.S. tax rules regulating investments outside the U.S.

The compliance cost is huge, and so is the tax bill. Here is one example:

An American family living in Germany that buys five or six different German-domiciled mutual funds to create a diversified portfolio is faced with tax complications that almost defy belief. They will have to report each of their six non-U.S. mutual funds on separate forms, every year. The IRS Instruction manual for this Form 8621 estimates that the time needed to prepare the form include “Recordkeeping, 15 hr., 4 min; Learning about the law or the form, 11 hr., 13 min; Preparing and sending the form to the IRS 20 hr., 21 min.”

In other words, the U.S. government expects this family to spend more than 200 hours annually preparing and filing the forms necessary to report their six mutual funds bought from a local German investment advisor. Furthermore, once the filing is made, the tax payers will find their investment gains taxed annually and subject to a tax rate no less than 39.6%, and potentially much higher.

The whole thing is here.

The U.S. should move to a territorial tax system, under which incomes of Americans living in the U.S or abroad would only be taxed by the country where the income is earned. Under that system, you wouldn’t have this outrageous double taxation and you would have no reason to force absurd compliance costs on American expats.