A coherent policy proposal for U.S. residence-based taxation of individuals.

AuthorBlum, Cynthia

ABSTRACT

Taxation of the worldwide income of U.S. citizens has been a feature of the U.S. income tax since the Revenue Act of 1913. This Article proposes that the United States abandon its imposition of income tax based on citizenship and institute a new system for taxing individuals based solely on residence. This includes (1) a revised definition of "residency status" that would be based on physical presence and be monitored through an entry-exit system, (2) a proposal for an exit tax imposed on termination of residence with respect to unrealized appreciation accrued during the period of residence, and (3) new transitional treatment of residents who have left the United States within the past three years but have not yet made a decision to break off residential ties. These proposed rules are designed to achieve more uniform compliance, to reduce the administrative burden for U.S. taxpayers, and to facilitate IRS efforts to enforce U.S. tax obligations.

TABLE OF CONTENTS I. INTRODUCTION II. THE CURRENT LAW AND THE CASE FOR CITIZENSHIP-BASED TAXATION III. REJECTING CITIZEN-BASED TAXATION A. The Taxpayer's Perspective B. The IRS Perspective C. The Impact on the Case for Taxing Based on Citizenship IV. A PROPOSAL FOR TAXATION BASED ON RESIDENCE A. Defining Residence B. How an Individual Becomes a Tax Resident C. How an Individual Terminates Residence 1. The Three-Year Residence Retention Rule 2. Mark-to-Market Tax V. CONCLUSION I. INTRODUCTION

Taxation of the worldwide income of U.S. citizens has been a feature of the U.S. income tax since the Revenue Act of 1913. (1) Moreover, the United States has protected this basis for taxation in its negotiation of bilateral income tax treaties. (2) At the same time, very few countries have followed the U.S. approach of taxing nonresident citizens on worldwide income. (3) And a number of commentators have questioned the wisdom of the approach, in light of the inherent difficulties of enforcing U.S. tax obligations of a nonresident citizen and the inherent potential for overlapping claims of taxation by the United States and the residence country.

This Article advocates eliminating citizenship as a basis for imposing U.S. taxation. Although the equitable arguments for imposing tax burdens on U.S. citizens living abroad have merit, administration of the rule is too difficult and expensive for taxpayers and the IRS, particularly in light of the need for remedies to prevent double taxation resulting from other countries' disparate rules. Citizenship-based taxation should be replaced with a more practical system of residence-based taxation. Residence would be determined largely through days of physical presence, monitored through an electronic entry-exit system at the borders. Residence jurisdiction would generally be deemed to continue during a temporary absence abroad for less than three years; however, an unlimited exclusion for foreign earned income would be permitted in this case. A taxpayer whose residence terminates would be taxed on the unrealized appreciation that accrued on the taxpayer's worldwide assets during residence.

Part II will begin by briefly describing the current rules for taxing U.S. citizens and residents and the arguments that have been made in favor of retaining citizenship-based taxation. Part III will then explain the rationale for eliminating citizenship-based taxation. The remainder of the Article will describe a proposed new system of taxation for individuals based solely on residence and the considerations entering into its design.

  1. THE CURRENT LAW AND THE CASE FOR CITIZENSHIP-BASED TAXATION

    The United States imposes tax on the worldwide income of every U.S. citizen and every alien classified as a "resident alien" under [section] 7701(b) of the Code. (4) Under that provision, an alien is classified as a resident alien if the alien "is a lawful permanent resident" (i.e., a "green-card holder") at any time during the calendar year or meets the test of "substantial presence" for such year. (5) A U.S. citizen abroad may face overlapping taxation imposed by a foreign country based on residence in that country or his income having its source in that country, or both. (6) U.S. citizens are not generally permitted to avoid U.S. taxation by means of a U.S. treaty with another country in which they are residents; U.S. treaties block this through a "savings clause." (7) On the other hand, a U.S. citizen abroad may claim a limited exclusion for foreign earned income and, with respect to foreign-source nonexcluded income, may claim a credit against U.S. tax for foreign taxes paid or accrued. (8)

    The idea that an individual who has a strong connection with the United States should incur U.S. income tax on the basis of worldwide income has not generally been controversial; (9) if taxation is to be based on "ability to pay," foreign-source as well as U.S.-source income must be taxed. (10) The more controversial question has been determining which individuals have a strong enough connection with the United States. (11) Recently, Professor Michael Kirsch has argued that the justification for taxing citizens abroad remains valid today and has even been strengthened by economic developments involving increased globalization. (12) Kirsch reviews the benefits afforded citizens residing abroad, such as "personal protection," "property protection," "right to vote," "right to enter," and "past benefits," and concludes that these benefits "provide a basis for concluding that the United States is justified in exercising some type of taxing jurisdiction over those citizens." (13) In addition, he argues that citizens abroad should be treated as "members of U.S. society" and thus subject to "ability to pay" taxation because their failure to renounce citizenship "reflects a self-identification with the population of the United States (or the belief that the benefits of citizenship are worth the tax cost)." (14) Moreover, he notes that "[c]itizens living in the United States also view U.S. citizens living overseas as part of U.S. society, particularly in times of crisis." (15) Finally, he concludes that "it is difficult to determine the extent, if any, that citizens living abroad bear a heavier overall tax burden than those living in the United States," which might justify elimination of U.S. taxation. (16)

    In making the case for citizenship-based taxation, Kirsch also argues that such taxation serves the goal of neutrality by "minimiz[ing] the role of taxes in a citizen's residency decision." (17) He recognizes, however, that "it might not be neutral with regard to a person's decision to retain or surrender citizenship." (18) He acknowledges the difficulties posed by citizenship taxation with respect to "compliance and enforcement" but points to a trend of improving enforcement and the fact that the actual degree of noncompliance is not known. (19) His final argument is that eliminating citizenship-based taxation might lead to residents believing that "citizens abroad 'are getting away with something"' and "consequently los[ing] confidence in the tax system and the social norm of tax compliance." (20)

  2. REJECTING CITIZEN-BASED TAXATION

    Our disagreement (21) with Professor Kirsch about the wisdom of citizenship-based taxation centers (22) on issues of compliance and administrability. U.S. citizens overseas often face a difficult task in meeting their U.S. filing obligation and computing any tax owing. The IRS faces a difficult and relatively unrewarding task in seeking to remedy the significant noncompliance that likely occurs. As discussed below, the Authors contend that these problems seriously undermine the case for citizenship-based taxation.

    1. The Taxpayer's Perspective

      The IRS provides very little in the way of on-site service for U.S. citizens overseas. Currently, the IRS has overseas offices only in London, Paris, and Frankfurt. (23) This makes it more difficult and expensive for overseas U.S. citizens to obtain IRS assistance in computing their taxes or resolving controversies. (24) In addition, overseas citizens find it harder and more expensive to obtain private tax preparation services, although multinational companies will often provide tax services for those employees moving overseas. (25) At the same time, overseas citizens will often face overlapping residence-based taxation on the part of the country in which they live. (26) Although they may be able to avoid double taxation by using the foreign earned income exclusion (27) and foreign tax credit, (28) they are nevertheless required to file a U.S. return and to determine the application of these relatively complex provisions. Moreover, many overseas taxpayers have misconceptions about the requirement to file returns when overseas. (29)

      A particularly striking example of overseas U.S. citizens facing considerable burdens in becoming tax compliant are so-called "accidental citizens." Many of these are children born in the United States to noncitizen parents visiting the United States as workers on temporary assignment, as students, or as exchange visitors. They (and their parents) are frequently unaware of their status as U.S. citizens or their tax obligations on returning to their home country. (30) If they should become aware of their own noncompliance, they would likely see no reason to remedy it unless they plan to travel to the United States or they begin employment with a U.S. employer abroad. In that case, they would generally need to file back returns for a period of six years and would need to provide an explanation for late filing in order to use the [section] 911 exclusion on a late-filed return. (31)

    2. The IRS Perspective

      The IRS is at a serious disadvantage in monitoring compliance by U.S. citizens overseas because of the lack of many of its usual sources of information. (32) As noted, it lacks a significant physical presence in foreign countries. In the case of overseas citizens...

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