Grassroots Corner - January 24, 2020

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  • Source: FAIRtax
  • 04/09/2021
Why Citizenship Based Taxation Needs to be Abolished
By Paul Malkovich
U.S. Citizen Living Overseas

[Editor’s Note: As you read through Paul Malkovich’s article describing how unfairly Americans abroad are treated by our Tax Code, keep in mind how unnecessary all this nonsense would be if only we had The FAIRtax!]

[Editor’s Executive Summary

[The United States is only 1 of 2 countries (the other being Eritrea) taxing the worldwide income of U.S. citizens or resident aliens who maintain no residence in the United States.

[The first income tax was enacted in 1861.

[In the following years the law was reformed to include non-residents.

[The accounting cost of filing a basic offshore tax return can be in the thousands of dollars.  The Foreign Account Tax Compliance Act (FATCA) imposes burdensome requirements on foreign institutions with U.S. clients.  The IRS does not become significantly richer by dealing with significantly increased accounting costs, and it does a poor job of communicating the requirement to file a tax return to expat citizens.  The result for Americans abroad is double taxation and difficulty in saving and investing.

[A Supreme Court case Cook v. Tait, 265 U.S. 47 {1924} challenged the constitutionality of citizenship-based taxation of income regardless of where the citizen lived.  The challenger lost.

[Citizenship-based taxation, in many ways, fails to measure up to The Bill of Rights.

[While Eritrea is a poor country and is not threatening to its expat citizens, U.S. citizens abroad must face off with the mighty IRS.  Other countries have abandoned citizenship-based taxation, including Romania, Vietnam, Myanmar and the Philippines.  Romania taxes its expats’ income only if the expats live in a country with whom Romania has no treaty.

[There is a lack of Congressional representation of expats (subject to an inserted explanatory note by your Editor).

[The European Union promulgates a General Data Protection Regulation (GDPR); FATCA conflicts with it.  “Jenny”, a former American expat living in the U.K., has brought a suit to fight back against the U.S. tax regime and data theft risks while breaching GDPR principles.   It's a longshot.

[Citizenship-based taxation has a discriminatory effect, and American businesses are being made uncompetitive because their American workers have a higher built-in tax.  To quote the CATO Institute: “a nation needs to make itself attractive to its own citizens, not stop their exit”.  The bottom-line is Americans should not be heavily penalized for making a living in Europe or anywhere else for that matter].

Chances are, you’ve never heard of citizenship-based taxation (CBT), unless you’re an American or green card holder who pays this dreaded tax on your worldwide income, doesn’t matter if you live in Munich or Mumbai

Civil War Roots
The first federal-income-tax legislation to fund the Civil War was enacted in 1861, basically penalizing American citizens for not being physically present in the U.S. and meeting their civic engagement obligations.  The earliest versions imposed a territorial tax, creating resentment among expatriates, which continues to this day.

In the following years, the law was reformed to include worldwide non-residents.  Beginning in 1864, all non-residents were mandated to pay the same tax rate as resident citizens.  The catch was they had to pay taxes on not just earnings sourced in the U.S. but their worldwide income.  It was rationalized by the Civil War narrative of fulfilling civic obligations.
Compliance & Administrative Concerns of CBT

The accounting costs of filing a basic offshore income-tax, even when no tax is owed to the United States, can amount to thousands of dollars.  The high costs of compliance enforced by the CBT taxation regime is stressful for non-resident citizens.  The IRS does a poor job of informing non-resident citizens of their tax obligations.  This, along with the extremely high penalties for non-compliance, enforced through the Foreign Account Tax Compliance Act (FATCA) further exacerbates pressure on citizens abroad.
The FATCA was enacted in 2010 with the objective of promoting tax compliance and deterring tax evasion.  The Common Reporting Standard (CRS), implemented soon afterwards, was based on the FATCA, and applicable to citizens of every registered country.

FATCA has drawn criticism for its burdensome IRS reporting requirement on foreign institutions with U.S. clients
, and affected how many non-resident citizens can access banking and financial services.  Between high compliance costs and stringent penalties for tax reporting errors, their experience with citizenship-based taxation has been decidedly negative.

The complexity of international tax forms means Americans residing abroad must engage professional tax preparation services.  That’s easily looking at over $2,000 to file a tax return.  Ironically, 80% of filers have no U.S. tax liability.  What’s more, the government doesn’t exactly become richer by several millions, while IRS has to deal with exorbitant processing costs thanks to complex international tax reforms.  It is a lose-lose for both citizen and government.

Double Taxation, and Difficulty Saving & Investing

Given IRS’ poor communication regarding the CBT law, many US citizens living abroad are genuinely unaware of their tax filing obligations.  Many non-resident citizens have highlighted how the American government made it difficult for them to open bank accounts as penalty for being ‘tax dodgers’.

Americans residing in another country are required to file a Report of Foreign Bank and Financial Accounts (FBAR).  This form needs to disclose any accounts Americans have that hold an aggregate of over $10,000.  Failure to file an FBAR attracts penalties, with fines dependent on whether or not the taxpayer acted willfully.  The fine for a non-willful filing starts at $10,000.  Wilful acts are punished by a $100,000 penalty or 50% of the balance of the account, whichever is greater.

FATCA also mandates foreign institutions to disclose U.S. citizens’ holdings.  In addition, American citizens living abroad must reveal their foreign mutual funds and insurance or pension products that they own.  The IRS views these holdings as passive foreign investment companies (PFICs).

In a nutshell, worldwide taxation prevents Americans abroad from meeting their savings and investing goals.  Moreover, currency fluctuation results in phantom capital gains, where tax is owed even if the actual return on the investment is negative.  U.S. citizens residing in countries that do not have a totalization agreement with the U.S. are required to pay into 2 social security systems.  The U.S. doesn't recognize foreign pension funds on the same terms as domestic funds; employer and employee contributions to foreign pension funds are taxed.

While foreign tax credit, a non-refundable tax credit for income taxes owed to a foreign government resulting from foreign income tax withholdings, generally mitigates double taxation, this is not the case for American expats.  U.S. citizens living abroad aren't permitted to apply for credits for VAT payments and wealth taxes paid to foreign governments.  Another spanner in the works is in the form of Obamacare, which increased double taxation on non-resident Americans to fund services and programs these citizens can’t even use.

Given foreign credits cannot be applied against this tax, the double taxation of investment income actually increases for expats.  Unsurprisingly, the CBT and FATCA have compelled Americans abroad to give up their US citizenship.

Cook v. Tait

The 1924 Supreme Court Case Cook v. Tait [265 U.S. 47 (1924)] justified citizenship-based taxation, and established it as constitutional.  The case involved a U.S. citizen George Cook who had been living in Mexico for over 2 decades, owned property there, and had no ties to his home country.  Cooke appealed to the Supreme Court against the attempt by the US government to impose income taxes on him.  He argued the U.S. had no constitutional right to levy income taxes on expats and on income earned outside the U.S.  In response, the U.S. government said it had the constitutional right to impose income-taxes on non-resident Americans, and those taxes could be levied on citizens’ worldwide income.

The Supreme Court ruled the United States possesses sovereign power as a country in relation to other countries and the United States’ relation with its citizens and theirs with the U.S. exists regardless of the citizen’s location.  They added there exists a presumption the U.S. government benefits its citizens no matter where they are in the world, and therefore, levying a tax for benefits delivered is fair and reasonable.

Digging deep, the court’s judgment suggests the United States’ power to tax non-resident citizens is not conditional on the government owing its citizens protection.  The United States is not required to demonstrate benefits as a condition to impose taxes on U.S. citizens living abroad.  Finally, the United States may levy taxes on non-resident citizens on the back of the presumption the government, by its very nature, is beneficial to its citizens.

The last point may sound pretty preposterous for obvious reasons:  American citizens living abroad must pay taxes to the government in their country of residence, they have to meet tax obligations stipulated by their country of citizenship, and a vast majority have to endure costly double taxation which isn’t offset by tax treaties.  There is insufficient evidence suggesting the United States provides benefits to its non-resident citizens.  Benefits enjoyed by resident Americans, including social welfare, are not accessible to non-residents.  The only visible benefit of citizenship is that it grants the right to live in the U.S.
Fails The Bill of Rights

Taxing Americans living abroad challenges the fundamental right of “no taxation without representation”.  The U.S. Census doesn't take into account those citizens who reside outside The United States, and as the U.S. Census determines state representatives based on the population of each state, non-resident citizens have no representation.  The Congress simply points to their ‘right’ to tax citizens abroad as it benefits and protects them.  The 9th Amendment in The Bill of Rights says:
"The enumeration in The Constitution, of certain rights, shall not be construed to deny or disparage others retained by the people".

It means the rights citizens are entitled to are not limited by those that appear in the Constitution.  The goal of this amendment is to highlight rights not explicitly listed in the Constitution don't exist.  9th Amendment rights are additional fundamental rights safeguarded against governmental infringement, and they exist alongside fundamental rights stated in the 1st 8 amendments.

The point is the right to ‘no taxation without representation’ is a non-enumerated right the government is failing on account of CBT and other tax loopholes and burdens imposed on non-resident citizens.
Statistics On CBT Implementation

Eritrea, the only other country with a worldwide tax system, levies a flat 2% tax on citizens living abroad.  In comparison to Eritrea’s minimal rate, American expats have to cough up a 39.6% federal tax rate.  Unlike Eritrea, a poor country whose tax system is anything but threatening, U.S. citizens abroad have the mighty IRS to face-off with, an encounter they don’t wish for, and hope to resolve through legislation, once they can manage Congressional representation.

Many countries have implemented worldwide taxation previously, and given it up for several reasons, which include fair treatment for all citizens.
  • Mexico had it in place for many years until 1981
    • Mexico’s current worldwide tax law applies only to citizens who take off to the tax havens of Monaco or the Bahamas, and the 3-year rule applies here too.
  • Romania abandoned this tax practice in the forties
    • Today levying a flat personal income tax of 16% on the worldwide income of Romanian residents living abroad, except on the income they receive as salary for the work rendered and received abroad
    • Romania only taxes residents on their worldwide income if they reside in a country with whom it doesn’t have a tax treaty in place.  After the 3 years, they only need to pay taxes on income derived in their country of citizenship. 
  • Bulgaria dropped its worldwide taxation regime in the years following economic reform after its emergence from the Soviet Bloc.  Its current flat tax rate of 10% applies to all personal income, with a few exceptions
  • Similarly, Vietnam, Myanmar and the Philippines, have done away with citizenship-based taxation

The fact remains, no country who previously followed a policy of taxing its citizens on their worldwide income, has made it an enduring feature of their tax framework.  While their reasons for renouncing have ranged from poor logistics and insufficient administrative capacity to economic reform, the reality is their tax system has not created vulnerable citizen communities abroad.
A Lack Of Congress Representation
Yet A New U.S. Bill Brings Hope

Worldwide taxation is not a kitchen conversation in America.  In fact, most Americans aren’t aware of CBT and those who those who know are unaware of its implications on fellow Americans.  Given how it’s not a hotly debated topic, this facet of the American tax regime is not as fiercely challenged as those at its receiving end would like.  American citizens living abroad don’t have a dedicated representative fighting their case in the Congress.  The physical absence and distance make it challenging to start a campaign to bring the issue to the public sphere.

North Carolina Republican Congressman George Holding tabled a bill moving to end America’s citizenship-based taxation regime by taxing only citizens residing in the country.  Holding deemed the current tax system ‘archaic’, highlighting its ‘costly burden’ on expatriate Americans.  His bill proposes giving non-resident Americans the option to replace the current CBT regime with a “territorial taxation for individuals” (TTFI) system.  Those who would like to continue being taxed under the existing CBT regime will be permitted to do so.  However, the bill is unlikely to make much progress without a Democrat co-sponsor.

[Editor’s Note:  A change in the law enabled most American Citizens who live abroad and who maintain no residence in the United States to vote for candidates for federal offices, i.e., House of Representatives, Senate, & President.  This change in the law took place after Your Editor moved back to the United States from Germany in 1980].
GDPR A Savior?

The General Data Protection Regulation (GDPR), which came into effect in May last year, strengthens the rights to data privacy and security for each individual citizen of the European Union and the European Economic Area.  If FATCA needs to continue being applied, the process by which EU institutions share data with the U.S. government, must adhere to GDPR rules.  Unless FATCA plays catch up soon, its legitimacy is likely to come under threat in the EU and the UK, which has agreed to implement GDPR following Brexit.  Americans in Europe may just find GDPR to be their silver lining in their fight against CBT and FATCA.

“Jenny”, a former American expat living in the U.K., has brought a suit forward to fight back against the brutal U.S. government tax regime and data theft risks while breaching GDPR principles.  It's longshot, but to challenge any law where the defendant is the government requires substantial money and superior legal plaintiff skills.

Most troubling is American civil liberty organizations and U.S. based media generally ignore the ongoing violations of civil rights laws.  FATCA upends the idea Americans have rights that are enjoyed by Americans stateside as stated earlier.  What are the criteria for these organizations to get help against obvious abuse?  Unremarkable, the best reporting has been from overseas outlets, because the problem is in their backyard.  They are asking, “why are we giving our data to a foreign government” which is a reasonable question to ask.
Un-Democratic Principles

GDPR aside, Jenny’s situation highlights the perilous structures in place which deny Americans abroad Constitutional protections.  If that is not bad enough, local politicians (overseas) are gob smacked into compliance because they way they see it, it's better to safeguard a handful of banks from U.S. government punishment versus millions of Americans abroad losing their rights.  They offer no help.
Costly Citizenship

Finally, the Cook v Tait decision was incorrect and ignored underlying historical facts on how power and resources are distributed in the U.S.  The “unrepresented” experience a different and much more onerous set of laws than the majority who have a voice.  The unrepresented can expect a much more dire economic outlook as a result.  The Court decision is also bad for the 21st century and was decided long before the Civil Right Act of 1964.  Under Titles II and III of the Act, it outlaws discrimination based on national origin, yet this is exactly what FATCA does.

Under Title VI, citizenship-based taxation violates non-discrimination in federal assisted programs.  Many blatant violations exist under this Title, but one of them is Americans abroad aren't included in the counting of the Census, which is a key problem why Americans abroad are not represented in Congress.

Congress, over many years, has imposed a separate and much more punitive tax code on tax residents of other countries.  As a result, the cost to be an American abroad is extraordinarily high.  For instance, citizenship-based taxation puts American overseas businesses at a competitive disadvantage because American workers have a substantially higher built-in compliance tax.  The centuries old practice of passing wealth to your heirs is taxed at a higher rate than if the same event happened in Illinois, for example. 

Building wealth through a foreign employer provided type 401(k) program is seen as a tax evasion vehicle in the U.S. Internal Revenue Code and is subject to additional IRS scrutiny, whereas a similar offering by a stateside employer is treated differently.

As the CATO Institute’s Centre for Global Liberty and Prosperity stated, “a nation needs to make itself attractive to its own citizens, not stop their exit”.  For reasons not explained, the U.S. government is making U.S. citizenship less and less attractive.  They seem to hate anyone with a foreign zip code.  The bottom-line is Americans should not be heavily penalized for making a living in Europe or anywhere else for that matter.

Citizenship-based must come NOW to an END!

Paul Malkovich
Living Overseas
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