Perpetuation of the foreign earned income exclusion: U.S. international tax policy, political reality, and the necessity of understanding how the two intertwine.

• Author: Sheppard, Hale E.

ABSTRACT

This Article discusses Section 911 of the Internal Revenue Code, also known as the Foreign Earned Income Exclusion (FEIE), as an example of a provision that has been sustained, not on the basis of sound economic analysis and compliance with established U.S. international tax policy, but rather because of effective lobbying and political circumstance. First providing an overview of the U.S. system of worldwide taxation, and the place of the FEIE within that framework, Mr. Sheppard explores the forces underlying the perpetuation of the FEIE. He demonstrates the that FEIE is inconsistent with each of the primary components of U.S. international tax policy, including meeting the revenue needs of the U.S. government in a fair and equitable manner, minimizing the burden of tax compliance and administration by reducing tax complexity, fostering economic efficiency through international tax neutrality, and ensuring the competitiveness of U.S. multinational businesses, but explains that the repeal of the FEIE is nevertheless improbable in the foreseeable future as a result of various political realities, such as the rebuilding of Iraq, the upcoming elimination or radical modification of major tax-based export promotion programs, a dwindling global presence of U.S. citizens due to fatal diseases and terrorism, and significant U.S. unemployment rates. He concludes by reemphasizing the complexity of tax policy issues, and by reminding the tax practitioner that a failure to comprehend the policy rationales behind a particular provision or set of provisions compromises the ability to dispense accurate and thorough advice.

TABLE OF CONTENTS I. INTRODUCTION II. OVERVIEW OF THE FOREIGN EARNED INCOME EXCLUSION III. RECENT ATTEMPTS TO REPEAL SECTION 911 IV. SUMMARY OF U.S. INTERNATIONAL TAX POLICY A. Fairness and Equity B. Minimizing Tax Complexity and Tax Compliance Burdens C. Economic Efficiency and International Tax Neutrality D. Promoting the Competitiveness of U.S. Multinational Businesses V. VIOLATIONS OF U.S. TAX POLICY BY SECTION 911 A. Fairness and Equity B. Minimizing Tax Complexity and Tax Compliance Burdens C. Economic Efficiency and International Tax Neutrality D. Promoting the Competitiveness of U.S. Multinational Businesses E. Tax Benefit Concept F. Cultural Ambassadors G. Increase U.S. Exports and Domestic Jobs H. Additional Arguments against Section 911 VI. POLITICAL REALITIES SURROUNDING SECTION 911 A. The Rebuilding of Iraq B. Historical Support of Tax-Based Export Promotion C. Dwindling U.S. Global Presence in Times of Terrorism and SARS D. High Unemployment Rates VII. CONCLUSION I. INTRODUCTION

Why? This question is undoubtedly the hallmark of curious children, those inquisitive youngsters tugging at coattails while incessantly asking, "Why, Mommy? Why, Daddy?" As fastidious as this inquiry may be to some, it should be foremost on the mind of all tax practitioners, especially those working in the ultra-complicated field of international taxation. For if one fails to comprehend the policy rationales behind a particular provision or set of provisions of the Internal Revenue Code (the Code), it is highly improbable that he or she will be able to dispense accurate and thorough advice in this area. (1) Equally (if not more) important for tax professionals in many cases is to understand the political climate existing at the time that specific parts of the Code were introduced, modified, or repealed. Indeed, to answer the pivotal question of why the Code functions in a certain manner or why a particular group of taxpayers receives special treatment, it is imperative to examine the applicable political realities.

Section 911 of the Code, which is also known as the Foreign Earned Income Exclusion (FEIE), is an example of a provision that has been sustained, not on the basis of sound economic analysis and compliance with established U.S. international tax policy, but rather because of effective lobbying and political circumstance. In an attempt to underscore the importance of thinking well beyond the express words of the Code, this Article explores in considerable depth the forces (both patent and latent) underlying the perpetuation of the FEIE.

Part II of this Article provides an overview of the U.S. system of worldwide taxation, as well as an explanation of how the FEIE relates to this system. Part III gives details regarding the recent congressional attempt to repeal the FEIE. Part IV describes the primary components of U.S. international tax policy, including meeting the revenue needs of the U.S. government in a fair and equitable manner, minimizing the burden of tax compliance and administration by reducing tax complexity, fostering economic efficiency through international tax neutrality, and ensuring the competitiveness of U.S. multinational businesses. Part V demonstrates that, despite ardent arguments by FEIE backers to the contrary, Section 911 is inconsistent with each of the international tax policies. Part VI then explains that the repeal of the FEIE is nevertheless improbable in the foreseeable future as a result of various political realities, such as the rebuilding of Iraq, the upcoming elimination or radical modification of major tax-based export promotion programs, a dwindling global presence of U.S. citizens due to fatal diseases and terrorism, and significant U.S. unemployment rates. This Article concludes by reemphasizing the fact that understanding U.S. international taxation in general, and the FEIE in particular, requires that tax practitioners never stop posing the question of utmost importance why?

2. OVERVIEW OF THE FOREIGN EARNED INCOME EXCLUSION

   In the international context, countries generally base their capacity to tax persons on either the source of the income or the residence of the person who earns the income. In other words, in determining whether a country has the power to impose a tax on a particular item of income, a nation's tax system will focus on where the income was earned or, alternatively, on the nationality of the person earning the income. Under a source-based system (which is also known as "territorial taxation"), a country taxes the income that is earned within its borders, regardless of the nationality of the person who earns it. By contrast, a residence-based system (which is also known as "worldwide taxation") allows a country to tax the income earned by its citizens or residents, irrespective of the country in which it is earned. To the chagrin of many, the United States is one of the few nations that utilizes a system of worldwide taxation. Section 1 of the Code imposes a tax on the "taxable income" of every individual. (2) The term "gross income," the base from which an individual's taxable income is determined, encompasses "all income from whatever source derived," including for services performed by the individual). (3)

   Despite the apparent harshness of worldwide taxation, there are exceptions that mitigate its severity. Among these exceptions is the FEIE, a device that has been the target of dramatic modifications and considerable controversy since its introduction in 1926. (4) As mentioned above, the general rule is that the government taxes all of the income that a U.S. person earns each year, regardless of whether the income is derived from sources in the United States or elsewhere. (5) Under the FEIE, however, U.S. taxpayers who live and work abroad for extended periods of time are allowed to omit from gross income $80,000 per year of certain types of income, as well as a housing allowance. (6) In other words, the Code permits a "qualified individual" to exclude from gross income for a given year "foreign earned income" and "housing cost amount." (7)

   To be considered a "qualified individual" and thus eligible for the FEIE, a person must meet two conditions. (8) First, that person must have a "tax home" in a foreign country. (9) For purposes of the FEIE, a person's tax home is the location of his or her regular or principal place of business or, if the person has no regular or principal place of business, then the location of that person's place of abode "in a real and substantial sense." (10) Second, the person must be a U.S. citizen who is a bona fide resident of a foreign country for an entire year, a resident alien who is a citizen of a foreign country with which the United States has an income tax treaty in effect and who is a bona fide resident of a foreign country for an entire year, or a U.S. citizen or resident alien who is physically present in a foreign country for at least 330 full days during the year. (11)

   Provided that the person satisfies the definition of a "qualified individual," that person may avoid being taxed on as much as $80,000 annually of "foreign earned income." (12) The term "foreign earned income" means income (in the form of wages, salaries, fees, commissions, etc.) that a person receives as compensation for performing personal services while overseas. (13) However, the term "foreign earned income" does not include investment income (dividends or interest), pension or annuity payments, or certain deferred compensation. (14)

   In addition to excluding the foreign earned income, a qualified individual may exclude each year from gross income the "housing cost amount," which is the amount by which actual "housing expenses" exceed a fixed figure that is intended to approximate the typical housing costs of a person living in the United States. (15) The term "housing expenses" includes the reasonable expenses paid during the year by or on behalf of a qualified individual for housing in a foreign country, as well as those of the individual's spouse and dependents. (16) The reasonable expenses may include rent, most utilities, real and personal property insurance, occupancy taxes, nonrefundable security deposits, furniture rental, household repairs, and residential parking. (17) Reasonable housing expenses do not...