US Citizenship Based Taxation: Is Expatriation the Only Way Out?

The United States stands as one of only two countries in the world (Eritrea being the other) that assesses personal income tax based on citizenship as well as residency.

This distinctive tax system subjects US citizens to taxation on their global income and gains, irrespective of their place of residence. Consequently, managing tax affairs becomes notably intricate for US citizens living overseas, and experienced specialist tax advisers for international US-connected individuals becomes needed to identify tax planning opportunities, ensure compliance and avoid and/or mitigate (double-taxation) pitfalls.

US Citizenship Based Taxation and UK’s Remittance Basis Regime

With the application of the unique citizenship-based taxation regime, the need to consider US taxes does not end upon departure from US soil. It is therefore crucial that US citizens acquaint themselves with their tax and reporting obligations and fully grasp the dos and don’ts. Some will find that the need to carefully plan and consider matters with multiple taxing jurisdictions to be overwhelming. Subject to an assessment of immigration considerations, ties to the US and other personal factors – they may decide that expatriation* is the only way out. If so, they should expect another dance with complexity as they assess whether they are going to be exposed to an exit tax, mark-to-market tax and the impact of the transfer tax as they leave their US citizenship behind. The perception from the US Congress is that an expatriating individual should pay tax on the way out because their scope to recoup future taxes from a non-US person is obviously far reduced.

*expatriation – meaning the act of relinquishing or renouncing citizenship

The focus of this article will be on US citizens living in the UK, but it is worth noting that US green card holders are also subject to US tax and certain international reporting requirements, even if their green card has expired.

To frame this, we will consider a US citizen who has moved to the UK as a non-domiciled individual. The UK has (for now) a remittance basis regime that allows for eligible non-domiciled individuals to limit their tax exposure to UK sourced income and certain remitted funds, which can be hugely advantageous for many. However the US citizen in this situation would remain subject to tax on their worldwide income and gains in in the US on the income and gains that are being protected from UK tax. Whereas a non-US citizen could reduce their tax exposure with this approach. The benefits of the remittance basis will be drastically reduced for US connected individuals because they have a base level of US tax exposure regardless. If they decide to forego the remittance basis option then they will be taxed in both the US and the UK on the same income and gains, but with subtle differences. These subtle differences can cause double-taxation or a higher global tax rate on the income/gains. Some of these issues can be managed with the appropriate tax planning.

Additional International Information Reporting Requirements

In addition to the above, US citizens with an international footprint will often cause the size and complexity of their Federal tax return to increase with specific forms required to report foreign tax credits, foreign earned income exclusions, foreign bank account reporting, passive foreign investment companies, foreign trust reporting for non-US personal pension plans and so on and with sometimes disproportionate penalties for failure to comply. These issues are highlighted within the 2023 Annual Report to Congress (2023 Most Serious Problems – Taxpayer Advocate Service (irs.gov)), which noted that two of the top ten most serious problems encountered by taxpayers were :

  • International – The IRS’s Approach to International Information Return Penalties is Draconian and Inefficient, and
  • Compliance Challenges for Taxpayers Abroad – Taxpayers Abroad Continue to be Underserved and Face Significant Challenges in Meeting their US Tax Obligations

Expatriation – Accidental Americans

The tax burden for US citizens is like no other. If we add on that it is relatively easy to acquire US citizenship and that there are many ‘accidental Americans’ in the world then it is no surprise that the concept of expatriation continues to be a popular topic within that circle. We also have discussions with more US connected individuals who are seriously considering expatriation because of the onerous filing obligations and the intrusive nature of the international information returns. In our experience, expatriation is often not motivated by tax but more by paperwork and costs of compliance. Yes, there are many tax obstacles to overcome for US citizens living overseas but these can often be managed.

Although the reported numbers of US taxpayers relinquishing their citizenship rises almost every year, it is still a tiny fraction of the overall population, and the vast majority will work with tax advisers to help navigate their way through the multiple jurisdiction minefield and retain their citizenship. Many continue to have plans to return to the US or have family there and therefore the thought of expatriation is a non-starter. In summary, the tax position should rarely feature as the motivation for an expatriation.

Common Everyday International Tax and Reporting Issues for Americans Living Overseas

What are some of the common issues facing US citizens living in the UK?

Issue Explanation
Foreign tax credit timing There is a need to align the timing of foreign tax credits to the associated income/gains to ensure a benefit is received. Timing mismatches can lead to double-taxation.
Stocks and shares ISAs These are tax free in the UK but remain taxable in the US. Often without appropriate planning these will also contain Passive Foreign Investment Companies which are taxed more punitively than regular investment income and gains.
Sale of a main home This will often be fully exempt in the UK but the non-taxable amount in the US is limited to $250,000 on the sale of a (single) main home for US tax purposes.
Exchange rate fluctuations US citizens are at the mercy of exchange rate movements, which can significantly impact their capital gains tax position on disposals of non-USD investments.
Mortgage repayments Ordinary and mundane transactions such as making capital repayments on a non-USD denominated mortgage can lead to phantom exchange rate gains for US tax purposes.
Foreign bank account reporting obligations Overlooked filing obligations to report maximum balances of non-US financial accounts can be costly. Understanding the low reporting threshold and what constitutes a foreign financial account for these purposes is key.
Trust reporting for certain non-US personal pension plans Many non-US personal pensions are structured as trusts, and there are additional reporting obligations for US citizens with an interest in a non-US trust, reportable on Form 3520/3520-A. Failure to file these forms timely will almost certainly lead to automated and severe penalty notices.

This list could be much longer, but these are some of the key issues that face US citizens living abroad.

How can these complexities be managed?

We are specialists in assisting with these matters and help with making sense of complexity. Fundamentally, our approach is to enhance awareness on the key issues and to be on the front foot. At a base level, it is important to manage foreign tax credits appropriately, and understand and apply the relevant double tax treaty to mitigate double-taxation matters.

What options are there to eradicate the annual US tax and information return obligation?

As outlined earlier, these tax and information return obligations do not disappear by moving overseas, in fact the information reporting obligations are increased. The only viable route to bring an end to the annual US tax filing obligations is to formally expatriate, which is often not recommended if you have emotional ties, connections, or plans to return to the US. There may also be adverse tax consequences from expatriating and the situation is different for each and every taxpayer.

Will I be taxed punitively if I formally expatriate?

As is often the case, the answer is “it depends”. The first step is to identify whether you are an individual of interest to the IRS i.e. are you a covered expatriate? Are you deemed to have expatriated as a high net worth individual or as a non-compliant individual? Do you meet any of the exceptions, such as the dual-citizen from birth exception?

There are many factors to consider.

Assuming there are no available exceptions, what makes someone a covered expatriate?

You are a covered expatriate if:

1) Your net worth exceeds $2m (which has not been adjusted for inflation since it was first introduced as part of the American Jobs Creation Act (AJCA) of 2004).
2) Your average tax liability exceeds $201,000 (the 2024 threshold, up from $190,000 in 2023).
3) You cannot certify compliance with your US filing obligations for the prior five years.

If you are not a ‘covered expatriate’ then the expatriation rules of IRC section 877A are relatively toothless but there is a paperwork obligation.

As a covered expatriate you will be:

  • subject to a mark-to-market tax as if you sold all of your assets the day before expatriating,
  • taxed as if your pensions and other deferred compensation items have been distributed in full (unless elections are made for certain eligible US plans), and
  • potentially exposed to a transfer tax regime, whereby any future gifts or bequests to US resident recipients could be subject to a transfer tax on the recipient (subject to certain exceptions).

A ‘covered expatriate’ would have a paperwork plus tax conundrum to work through. Again, it is essential that the appropriate expertise is sought to work through this quagmire prior to going ahead and formally expatriating.

What are the appropriate steps to assess my situation?

  1. Speak with an immigration lawyer and specialist tax advisers to fully understand the implications of an expatriating act.
  2. What would we do to help (as the specialist tax adviser)?
  3. Compile a snapshot balance sheet of your worldwide assets and liabilities,
  4. Consider the exchange rate impact,
  5. Consider your average five-year tax liability,
  6. Ensure you can satisfy the five-year compliance certification obligation,
  7. Identify what your position would be now, a worst-case scenario, without tax planning and whether this is a palatable position,
  8. Implement any planning to mitigate your exposure and address any exit tax, mark-to-market tax or transfer tax questions or concerns,
  9. Ensure elections are considered for deferred compensation plans and the tight deadlines are adhered to, and
  10. Prepare your final year dual-status Federal tax return and Form 8854 ‘Expatriation Information Statement’ return.

The tax landscape for US citizens living abroad, particularly those residing in the UK, is marked by a myriad of complexities and challenges. Citizenship-based taxation means that regardless of residency, Americans are subject to taxation on their worldwide income, necessitating careful planning and compliance with international reporting requirements.

The decision to expatriate, though an option to alleviate tax burdens, is a significant one that requires thorough consideration of personal circumstances, potential tax consequences, and emotional ties to the US. While some individuals may find relief through expatriation, it is not a decision to be taken lightly, as it may trigger additional tax obligations and compliance costs.

Managing the complexities of US taxation as an American living overseas requires specialized expertise and proactive measures. From aligning foreign tax credits to navigating double taxation issues, to understanding the implications of expatriation and compliance requirements, seeking professional guidance is paramount.

Ultimately, while expatriation may offer a solution for some, for many US citizens living abroad, retaining their citizenship and working with tax advisors to navigate the intricate tax landscape remains the preferred course of action. By staying informed, proactive, and seeking expert advice, individuals can effectively manage their tax obligations and secure their financial well-being across borders.

Contact us if you have any questions.