Citizenship-Based Taxation

Of the many perversities in US tax law, perhaps the most fundamental and notorious is its imposition of tax on the worldwide income of nonresident US citizens. Let’s look briefly at what this means, what the consequences are for US citizens living and working in Canada, and what basis exists in law for citizenship tax.

I. The Structure of Citizenship-Based Taxation

A. US citizens are treated like residents.

Recall that source (of income) and residence (of taxpayer) are the two factors that confer jurisdiction to tax in most countries. For the United States, citizenship is a third factor.[1]For the statutory basis of citizenship tax, see below, Section II.A. We must accordingly tweak the column labels of our two-by-two matrix:

🇺🇸resident or citizennonresident alien[2]“Alien” is an archaic and somewhat alienating term for a person of foreign nationality, which survives mainly in tax and immigration law. Herein I use “nonresident alien” to align with § … Continue reading
domestic source incometaxedtaxed
foreign source income[3]IRC §§ 861–865 characterize the source of income; § 61 includes income “from whatever source derived” except as modified by other provisionstaxednot taxed[4]IRC § 871(b)(2), § 864(c)(4)(A). As always, exceptions apply—in rare cases, even the foreign-source income of a nonresident alien may be subject to US tax on the basis of being “effectively … Continue reading

As a semantic matter, the tax code does not define “resident” as a concept encompassing citizenship. It simply classifies individuals as citizen, resident alien, or nonresident alien, and fails to discriminate, outside of certain limited contexts[5]For example, the “bona fide resident” test for the foreign earned income exclusion, § 911(d)(1)(A)., between resident and nonresident citizens. Thus we do not say that citizens are residents per se; rather that the US imposes world-income taxation on anyone who is citizen or resident.

B. Credits may erase US tax on foreign income.

For US citizens who live and work abroad, US tax liability is reduced—often to zero—by tax benefits available under US law. These are primarily the foreign tax credit[6]IRC § 901 (FTC) and the foreign earned income exclusion[7]IRC § 911 (FEIE).

The FTC is a dollar-for-dollar credit for foreign tax, up to a limit of the US tax otherwise payable on foreign income, calculated by a proportional allocation of tax to income[8]IRC § 904.

The FEIE can, at the taxpayer’s election, and subject to limitations and conditions, reduce US tax where income includes compensation (such as wages) for services performed abroad.

If you live in Canada—or any country with higher taxes than the US—it is usually not advantageous to claim the FEIE, even if eligible. Two factors contribute to this result:

  1. Without FEIE, the US tax on foreign earned income is likely to be fully eliminated by FTC anyway, as Canada’s combined federal and provincial income taxes are significantly higher than the US federal rates.
  2. “Exclusion” is a misnomer; when you take the FEIE, the calculation of US tax begins with tax payable on all income.[9]IRC § 911(f)(1) The FEIE actually increases the effective rate of US tax on any income that is not “excluded”.[10]I leave to a future post the details of the analysis which demonstrates this result, but mention it here to caution the reader against blindly assuming the beneficiality of the FEIE.

C. Foreign credits and tax treaties alleviate double tax on US income.

Where income is from domestic sources, US tax is often creditable under foreign law against the taxpayer’s foreign income tax liability. For example, a US citizen who is a tax resident of Canada will claim the Canadian foreign tax credit if they pay US tax on US-source income.

US tax beyond the tax liability of a hypothetical non–US citizen may also be eliminated by treaty-based foreign tax credit.[11]See e.g. US-Canada treaty Art. XXIV(4-6), providing additional foreign tax credit in the “re-sourced by treaty” category. (A detailed discussion is beyond the scope of this post.)

D. Despite these mitigations, US citizenship may have a net tax impact.

In many cases, foreign tax credits will fail to fully alleviate the tax cost of being a US citizen. These problems typically arise where income is recognized for US purposes but not subject to foreign tax, including:

  • Investment income inside a Canadian tax-advantaged plan, such as a Tax-Free Savings Account (TFSA), a Registered Education Savings Plan (RESP), or a Registered Disability Savings Plan (RDSP)
  • Capital gain from the sale of a principal residence, which escapes US tax only up to a dollar limit,[12]IRC § 121(b), excluding up to $250000 for single filers or $500000 for joint filers but enjoys an unlimited exemption in Canada[13]Income Tax Act (Canada), s. 40(2)(b)
  • Undistributed income of a passive foreign investment company (PFIC)—such as a Canadian mutual fund or ETF—which the US citizen shareholder has elected to treat as a Qualified Electing Fund (QEF)[14]IRC § 1295

US citizens may also face a net tax cost from the Net Investment Income Tax (NIIT), a 3.8% surtax on the investments of high earners.[15]IRC § 1411 FTC as provided under US law is inapplicable against NIIT, even if income is foreign-source and subject to foreign tax.[16]Reg. § 1.1411-1(e) Some hold the view that tax treaties or social security totalization agreements may grant relief from NIIT, but this is a risky position.[17]See e.g. Kevyn Nightingale, “Americans Living Abroad and the Net Investment Income Tax”, The Tax Adviser (Apr. 1, 2014)

E. US citizenship imposes a substantial compliance and reporting burden.

Even if they pay $0 in US tax at the end of the day, US citizens living abroad are required to:

  • File US income tax returns (Form 1040) every year
  • Share details of their foreign financial assets on Form 8938, and separately on FinCEN Form 114 (the “FBAR”)
  • File Form 8621 for passive foreign investment company (PFIC) holdings—which generally includes foreign mutual funds or ETF’s
  • File Form 3520 and Form 3520-A for foreign trusts—which includes many foreign retirement plans, and may include TFSA’s[18]It is disputed whether a TFSA is a trust within the meaning of Reg. § 301.7701-4; see e.g. Max Reed, “Classification of the Canadian TFSA for US Tax Purposes”, Wolters Kluwer Tax Topics No. 2215 … Continue reading
  • File Form 5471 for any foreign corporation over which they have majority ownership—impacting small business owners and professionals wishing to incorporate in Canada for liability protection

Many of these forms are not supported by consumer-level tax software, and their complexity pushes taxpayers to rely on accountants specializing in cross-border tax, who charge hefty fees to prepare them.

II. The Legal Basis of Citizenship-Based Taxation

A. Citizenship-based taxation is compelled by statute

Perhaps the clearest expression of the US’s citizenship-based tax policy appears in Treasury Regulation § 1.1-1(b), promulgated in 1960:[19]T.D. 6500, 25 FR 11402 (1960), at 11424

“In general, all citizens of the United States, wherever resident, and all resident alien individuals are liable to the income taxes imposed by the Code whether the income is received from sources within or without the United States.”

Some have been misled by Reg. § 1.1-1 into believing that citizenship tax is a regulatory invention. In a recent article titled “A Simple Regulatory Fix for Citizenship Taxation”, authors Richardson, Snyder, and Alpert suggest that by this regulation the Treasury Department has “demonstrated its authority to restrict the meaning of the term ‘individual’ by excluding” nonresident aliens, and thus it could revise the regulation to similarly exclude nonresident citizens.[20]John Richardson, Laura Snyder, and Karen Alpert, “A Simple Regulatory Fix for Citizenship Taxation,” Tax Notes Federal, Vol. 169 (Oct. 12, 2020), p. 275, at 280

This suggestion misunderstands both the regulation and the relevant statutory framework, and drastically overestimates the authority of the Executive Branch.

To be sure, IRC § 1 purports to impose tax on “every” “individual”,[21]IRC § 1(a)(1): “every married individual”; § 1(c): “every individual… who is not a married individual” and if we considered this section myopically, in isolation from the rest of the Code, we might indeed be tempted to think that the reach of “individual” may be circumscribed by administrative rulemaking, or even by the presumption against extraterritoriality: “Absent clearly expressed congressional intent to the contrary, federal laws will be construed to have only domestic application.”[22]RJR Nabisco, Inc. v. European Community, 136 S. Ct. 2090 (2016), at 2100, citing Morrison v. National Australia Bank Ltd., 561 US 247 (2010).

But statutory interpretation, the Supreme Court reminds us, “is a holistic endeavor. A provision that may seem ambiguous in isolation is often clarified by the remainder of the statutory scheme—because the same terminology is used elsewhere in a context that makes its meaning clear…, or because only one of the permissible meanings produces a substantive effect that is compatible with the rest of the law.”[23]United Sav. Ass’n of Tex. v. Timbers of Inwood Forest Assocs., Ltd., 484 US 365, 371 (1988)

So to understand § 1 we must also have in view the Subpart titled “Nonresident Alien Individuals” which spans §§ 871–879, with particular regard to § 871(b)(2) which, for a nonresident alien, limits tax under § 1 to income “effectively connected” with a US trade or business.[24]Income from US sources which is not “effectively connected” is taxed separately under § 871(a) at a flat 30% rate. For more on this distinction, see my previous post, Effectively Complicated … Continue reading. And we must have in view § 911 (the FEIE), which specifically grants the US citizen who is a “bona fide resident of a foreign country”[25]IRC § 911(d)(1)(A) some limited relief from tax otherwise payable under § 1.

None of these are sensible under a territorial reading of § 1 which renders it inapplicable on its own terms to nonresidents! With a holistic view of the Code, the following are inescapable:

  • “Individual” in § 1 means individuals everywhere.
  • It is § 871(b)(2), and not any regulatory narrowing, which stops US tax from reaching the majority of the planet’s 7 billion inhabitants who have no connections to the US whatsoever. US citizens, of course, are not nonresident aliens,[26]IRC § 7701(b)(1)(B) explicitly excludes citizens from the definition of “nonresident alien” (though the plain meaning doctrine might have sufficed) and thus enjoy no help from § 871.[27]The reader will note that the definition of “United States person” in IRC § 7701(a)(30) has not been mentioned, because it is of no consequence here. It impacts certain reporting obligations, … Continue reading
  • Reg. § 1.1-1(b) does not ipso facto establish or alter the scope of the federal income tax. It merely restates (in more direct language) a result entailed by statute, which Treasury has no authority to upend.

Contra Richardson et al., there is no simple regulatory fix for citizenship tax.

B. Citizenship-based taxation is constitutional

The Supreme Court upheld the power to tax the worldwide income of nonresident citizens nearly 100 years ago in Cook v. Tait.[28]265 US 47 (1924). The plaintiff was a US citizen living in Mexico with property in Mexico, the income from which was subjected to US tax.

Although Mr. Cook brought a constitutional challenge, the Court’s opinion contains scant discussion of the Constitution. Instead, it cites prior comments from United States v. Goelet[29]232 US 293 (1914) which were not dispositive in that case, and the holding of United States v. Bennett[30]232 US 299 (1914) which concerned a tariff on a US resident’s foreign-built yacht. The logic of this reliance has been criticized.[31]Reuven S. Avi-Yonah, “The Case Against Taxing Citizens”, 58 Tax Notes Int’l 389, 391 (May 3, 2010).

But Cook ultimately (and most famously) rested its case on an argument from equitability, upholding citizenship tax on the principle that “government, by its very nature, benefits the citizen and his property wherever found, and therefore has the power to make the benefit complete.”[32]Cook, at 56.

Echoes of this principle appeared later in United States v. Rexach.[33]558 F.2d 37 (1st Cir. 1977). A French woman had lost US citizenship under a provision of the Nationality Act of 1940 which was later struck down as unconstitutional. The First Circuit held that because she “received benefits of citizenship” by traveling on a US passport with the attendant protections of the US government, “the equities favor the imposition of federal income tax liability.”[34]Rexach, at 42.

Under a modern textualist approach, the inquiry into the constitutionality of citizenship tax might begin and end with the words of the Sixteenth Amendment, which confer upon the legislature the power to tax “incomes, from whatever source derived”. Whether the government is deserving or undeserving of the tax revenues collected by exercising the power so conferred is not for the judiciary to decide.

C. Citizenship-based taxation is legitimately imposed under international law

Broadly recognized norms of public international law cabin the application of US law on the global stage. But under those norms, a person’s nationality is a sufficient connection to subject them to the prescriptive jurisdiction of a sovereign state.[35]Alex Mills, “Rethinking Jurisdiction in International Law”, British Yearbook of Int’l Law, Vol. 84, Issue 1 (2014), pp. 187-239, note 30 (p. 196) and surrounding text So there is no basis in international law to assert that the United States has exceeded its authority by taxing its nonresident citizens, or that US tax laws are somehow without force for them.

Professor Allison Christians argues a different view, namely that “the residence and source principles are so widely understood as the foundations of income taxation…, they may constitute customary international law.”[36]Allison Christians, “A Global Perspective on Citizenship-Based Taxation”, 38 Michigan Journal of Int’l Law 193 (2017), at 226

But the mere fact that states widely utilize the residence-and-source model does not entail that they do so “out of a sense of legal obligation”.[37]Christians, note 131 (p. 227), characterizing “customary international law”; cf. Restatement (Third) of the Foreign Relations Law of the United States (American Law Institute 1987), § 102(2). Christians offers no support for the latter—in fact the many arguments advanced in favor of residence-based taxation undercut the assumption that states view it as compulsory, by lending plausibility to the competing theory that they have freely chosen it as the superior policy.

Canada, for its part, has not intimated that the US is acting unlawfully by taxing US citizens in Canada. It signed an intergovernmental agreement for Canadian financial institutions to collect information about US persons,[38]Agreement Between the Government of the United States of America and the Government of Canada to Improve International Tax Compliance through Enhanced Exchange of Information under the Convention … Continue reading and in Deegan v. Canada (Attorney General)[39]2019 FC 960 (CanLII), [2020] 1 FCR 411 (pending appeal) its Federal Court upheld the agreement against a challenge of unlawful discrimination, finding that “the Charter does not require Canada to assist persons resident in this country in avoiding their obligations under duly-enacted laws of another democratic state, nor does it require this country to shelter those living in Canada from the reach of foreign laws.”[40]Deegan, para. 430

III. The Ongoing Debate and Concluding Remarks

The merits and drawbacks of citizenship tax are the subject of extensive and ongoing discussion in scholarly literature.

Professor Michael Kirsch writes cogently in favor,[41]Michael S. Kirsch, “Citizens Abroad and Social Cohesion at Home: Refocusing a Cross-Border Tax Policy Debate”, 36 Virgina Tax Review 205 (2017) and worries that a repeal of citizenship tax may “undermine the cohesion of American society, creating the perception that some citizens are exempt from a fundamental obligation of citizenship”.[42]Kirsch, at 248

Professor Ruth Mason writes cogently against,[43]Ruth Mason, “Citizenship Taxation”, 89 Southern California Law Review 169 (2016) concluding that citizenship tax “increases complexity for nonresident taxpayers, is impossible to enforce, and does not serve anti-abuse goals better than would less restrictive alternative regimes.”[44]Mason, at 238

Meanwhile, advocacy groups like American Citizens Abroad continue to pressure Congress to adopt residence-based taxation, but it appears there is little political appetite for it. The Tax Fairness for Americans Abroad Act[45]H.R. 7358 (115th Congress) (2018), which would have been a step in this direction, failed to move past the House.

On this blog, I eschew advocacy, but aim to dispel confusion (and confused arguments). I have attempted here to give a basic picture of the substantive provisions of citizenship-based taxation, and an adequate accounting of the nonresident US citizen’s legal duty to comply with it.

A separate discussion may be had about the enforcement of citizenship tax, whether the resources of the IRS are up to the task, or if, practically speaking, “it is possible that citizenship-based taxation remains a paper tiger for many nonresident U.S. Persons.”[46]Christians, note 61 (p. 208) (Did you notice I have not once mentioned FATCA?) But this belongs to a future post.

References
1 For the statutory basis of citizenship tax, see below, Section II.A.
2 “Alien” is an archaic and somewhat alienating term for a person of foreign nationality, which survives mainly in tax and immigration law. Herein I use “nonresident alien” to align with § 7701(b)(1)(B) of the US Internal Revenue Code (IRC), and intend no association with extraterrestrial life.
3 IRC §§ 861–865 characterize the source of income; § 61 includes income “from whatever source derived” except as modified by other provisions
4 IRC § 871(b)(2), § 864(c)(4)(A). As always, exceptions apply—in rare cases, even the foreign-source income of a nonresident alien may be subject to US tax on the basis of being “effectively connected” with US trade or business. IRC § 864(c)(4)(B).
5 For example, the “bona fide resident” test for the foreign earned income exclusion, § 911(d)(1)(A).
6 IRC § 901
7 IRC § 911
8 IRC § 904
9 IRC § 911(f)(1)
10 I leave to a future post the details of the analysis which demonstrates this result, but mention it here to caution the reader against blindly assuming the beneficiality of the FEIE.
11 See e.g. US-Canada treaty Art. XXIV(4-6), providing additional foreign tax credit in the “re-sourced by treaty” category.
12 IRC § 121(b), excluding up to $250000 for single filers or $500000 for joint filers
13 Income Tax Act (Canada), s. 40(2)(b)
14 IRC § 1295
15 IRC § 1411
16 Reg. § 1.1411-1(e)
17 See e.g. Kevyn Nightingale, “Americans Living Abroad and the Net Investment Income Tax”, The Tax Adviser (Apr. 1, 2014)
18 It is disputed whether a TFSA is a trust within the meaning of Reg. § 301.7701-4; see e.g. Max Reed, “Classification of the Canadian TFSA for US Tax Purposes”, Wolters Kluwer Tax Topics No. 2215 (Aug. 21, 2014)
19 T.D. 6500, 25 FR 11402 (1960), at 11424
20 John Richardson, Laura Snyder, and Karen Alpert, “A Simple Regulatory Fix for Citizenship Taxation,” Tax Notes Federal, Vol. 169 (Oct. 12, 2020), p. 275, at 280
21 IRC § 1(a)(1): “every married individual”; § 1(c): “every individual… who is not a married individual”
22 RJR Nabisco, Inc. v. European Community, 136 S. Ct. 2090 (2016), at 2100, citing Morrison v. National Australia Bank Ltd., 561 US 247 (2010).
23 United Sav. Ass’n of Tex. v. Timbers of Inwood Forest Assocs., Ltd., 484 US 365, 371 (1988)
24 Income from US sources which is not “effectively connected” is taxed separately under § 871(a) at a flat 30% rate. For more on this distinction, see my previous post, Effectively Complicated Income.
25 IRC § 911(d)(1)(A)
26 IRC § 7701(b)(1)(B) explicitly excludes citizens from the definition of “nonresident alien” (though the plain meaning doctrine might have sufficed)
27 The reader will note that the definition of “United States person” in IRC § 7701(a)(30) has not been mentioned, because it is of no consequence here. It impacts certain reporting obligations, but is entirely disconnected from the imposition of tax under § 1. Many commentators appear to have misunderstood this.
28 265 US 47 (1924).
29 232 US 293 (1914)
30 232 US 299 (1914)
31 Reuven S. Avi-Yonah, “The Case Against Taxing Citizens”, 58 Tax Notes Int’l 389, 391 (May 3, 2010).
32 Cook, at 56.
33 558 F.2d 37 (1st Cir. 1977).
34 Rexach, at 42.
35 Alex Mills, “Rethinking Jurisdiction in International Law”, British Yearbook of Int’l Law, Vol. 84, Issue 1 (2014), pp. 187-239, note 30 (p. 196) and surrounding text
36 Allison Christians, “A Global Perspective on Citizenship-Based Taxation”, 38 Michigan Journal of Int’l Law 193 (2017), at 226
37 Christians, note 131 (p. 227), characterizing “customary international law”; cf. Restatement (Third) of the Foreign Relations Law of the United States (American Law Institute 1987), § 102(2).
38 Agreement Between the Government of the United States of America and the Government of Canada to Improve International Tax Compliance through Enhanced Exchange of Information under the Convention Between the United States of America and Canada with Respect to Taxes on Income and on Capital, 27 June 2014 (“US-Canada IGA”)
39 2019 FC 960 (CanLII), [2020] 1 FCR 411 (pending appeal)
40 Deegan, para. 430
41 Michael S. Kirsch, “Citizens Abroad and Social Cohesion at Home: Refocusing a Cross-Border Tax Policy Debate”, 36 Virgina Tax Review 205 (2017)
42 Kirsch, at 248
43 Ruth Mason, “Citizenship Taxation”, 89 Southern California Law Review 169 (2016)
44 Mason, at 238
45 H.R. 7358 (115th Congress)
46 Christians, note 61 (p. 208)

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