It’s coming. July 1, 2014 marks a type of “D-Day” for US citizens who maintain foreign financial accounts and/or assets. It is the effective date for the Foreign Account Tax Compliance Act, commonly referred to as FATCA, which is designed to prevent underreporting of foreign assets maintained by US citizens residing within the United States or abroad. US citizens have always been required to report worldwide income on their tax returns, but FATCA extends its powers to the foreign financial institutions that aid US persons in underreporting. Specifically, FFIs must report financial information pertaining to its US customers directly to the Internal Revenue Service or be subject to a mandatory 30% withholding tax on US source income. With this broad stroke, the US transforms these foreign institutions into tax watchdogs for the IRS in an attempt to generate revenue by eliminating tax evasion through the use of offshore accounts.
Laws that merely aid in the enforcement of existing tax laws seemingly should not be a big deal – after all, these taxpayers are being required to simply pay what they owe. But it is a big deal. Firstly, the discovery of these foreign accounts has been underway for some time through whistleblowers and other disclosure measures resulting in $6 billion in taxes, penalties, and interest paid to the IRS. This scratch of the surface indicates there is a significant source of US taxable income lingering overseas (i.e. big money, big deal). And secondly, there is a policy issue. The US is the only country to tax income of its citizens regardless of where that income is earned. Taken together with it having the highest corporate rate (35%-39%) and one of the highest personal income rates, US persons who have lived outside of the US for many years are really just paying the price for being American (and not for access to its infrastructure or market like taxpayers residing within the US).
Naturally, in the most dramatic form of tax avoidance, many US citizens responded by renouncing their citizenship. With a 221% increase in citizenship renunciations in the earlier part of this year, 2014 is set to have the most renunciations in any given year. And this great emigration is not limited to US individuals. Major US corporations, such as Pfizer and Medtronics, sought to shed their US ties by acquiring non-US competitors, thereby assuming the characterization of a foreign-based entity. Pfizer’s attempt was unsuccessful, but we should expect to see other corporations making the move across the pond.
It is an oft-cited myth that renouncing US citizenship for individuals would result in treatment akin to that of a terrorist, such as a complete ban from the US. But really the effect is more like a recharacterization from citizen to a foreign person. Travel to the US is permitted but you must obtain a visa or demonstrate admission eligibility through the Visa Waiver Program. Also, you will no longer be under the protection of the US government, which may not be a negative consequence depending on the countries to which you travel.
The major downside of renunciation is the exit tax. Did you really think Uncle Sam would let you go without having one last whack at you? The exit tax generally applies to US persons who have a net worth of $2 million or higher or had an annual net income tax of $155,000 for the previous 5 years. At the time of renunciation, the person is treated as having sold all of his or her assets for market value, and after adjustments, a tax is applied. A hefty price to pay to be free from the US tax regime.
If renunciation is not an option, then consider these steps:
Report worldwide income. The law requires US persons to report all income regardless of the country in which it was earned. You may be allowed to exclude foreign earned income up to $100,000. If you have $50,000 at the end of the tax year or had $75,000 at any time during the year, then you must include the Statement of Specified Foreign Financial Assets with your tax return. If you have $10,000 at any time during the calendar year, then you must include the Report of Foreign Bank and Financial Accounts with your return. For a side-by-side comparison of these forms, visit the IRS’ website.
Disclose. The Voluntary Disclosure Program allows taxpayers to remedy past errors without fear of criminal prosecution; however, it will not eliminate the burden of accrued interest and penalties. A quiet disclosure is a gamble. Maybe the IRS will notice, maybe it won’t. But if it does, especially in this high enforcement climate, you could face prosecution in addition to the interest and penalties.
Of course, there is an argument to change the current structure of the US tax system, a point agreed to by most people. But how that change is drawn out leaves room for consideration. FATCA targets those parties best situated to pay without substantially compromising their lifestyle or impairing business. And these parties comprise a significant portion of the US tax base. But if the current tax system forces these parties outside of its borders, then that much needed tax base starts to deplete exponentially. And the competition to attract profitable businesses is steep (e.g. the UK’s current corporate tax rate is 23%, down from 28% just a few years prior and expected to drop again to 20% in 2015). In the meantime, the law is to pay taxes irrespective of your opinions regarding the rates. And if you choose to remain a citizen of this free country… well, it just simply isn’t free.