U.S. Taxes, Local Taxes, and Planning to Avoid Double Taxation
Tax systems vary widely, country to country. Some countries tax only locally sourced income (Hong Kong, Malaysia and Singapore, for example). Most developed countries (Japan and most of Europe) tax all residents on their entire worldwide income. Many countries combine aspects of both these systems of taxation. The United States is one of only two countries in the world that taxes based on both citizenship and residency. This citizenship-based taxation means that no matter where an American decides to live, the U.S. Internal Revenue Service will expect him or her to file U.S. Federal tax returns, reporting all sources of income regardless of its origin. Of course, filing a tax return does not necessarily mean one owes U.S. taxes. Americans abroad are able to reduce or eliminate their U.S. tax liability by applying:
- The foreign earned income exclusion, and/or
- Tax credits for taxes paid in their foreign country of residence.
Because the U.S. generally recognizes the first right of other countries to tax U.S. citizens residing in their countries, the U.S. also provides foreign tax credits to offset U.S. taxes payable with foreign taxes paid. This relief is helpful but incomplete. The practical result is that many Americans living abroad still face some amount of double taxation. The magnitude of double taxation depends to a large degree on how effectively the complex interaction of U.S. and local tax rules are managed. Careful tax and investment planning can minimize, and even eliminate, the negative impact of double taxation for Americans living abroad.
Uniquely American Exceptions: FATCA and Citizenship-Based Taxation All American citizens retiring or living abroad will have to contend with uniquely American legal and tax mandates that substantially complicate their financial lives. One important and commonly encountered mandate is FATCA – the Foreign Account Tax Compliance Act. FATCA is U.S. legislation passed in 2010 that compels every financial institution around the world to report directly to the IRS on financial accounts held by Americans. American expat retirees should assume that all of their U.S. and non-U.S. financial accounts are visible to the IRS. This transparency underscores the importance of full and correct reporting of non-U.S. assets.
The catch is, however, that non-U.S. assets are generally subject to special, complex reporting requirements and are often taxed at punitive rates. This is especially true of most types of non-U.S. sourced investment income. The combination of FATCA and citizenship-based taxation leads most Americans abroad to conclude that it makes the most sense to keep their investment accounts and the center of most of their financial affairs back in the U.S. Yet, to live abroad, a local bank account is almost always necessary.
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