The United States is the only developed country that requires its citizens living abroad to pay taxes on their worldwide income. And as the IRS increases its vigilance on enforcing its rules outside of home, it is important to know the correct procedures on other things that need to be reported like investments and overseas retirement plans.

By Tsering Namgyal

Given the growing number of Americans who are living abroad, the US Internal Revenue Service (IRS) is becoming increasingly strict about enforcing regulations on US citizens living outside the home jurisdiction.

The US Senate has estimates that the tax evasion of Americans living abroad results in an annual loss of nearly US$150 billion in tax revenues per year for the Internal Revenue Service (IRS), according to BNY Mellon Wealth Management.

“When you see a number like that, it is no wonder that the government is cracking down,” says Joan Crain, Senior Director and Wealth Strategist for BNY Mellon Wealth Management, at a recent AmCham talk.

A US person

The United States is the only country that actually imposes tax on the “worldwide income” of its subjects regardless of where they live. Unlike the US, most countries – for instance, Canada – base this primarily on residence rather than citizenship.

According to the IRS regulations, a “US person” includes American citizens as well as Resident Aliens (RA) with permanent status (green card holders) and people currently classified as US residents by voluntary election, or the number of days per year spent in the States.

“If you are in any of those categories, then you are taxed on worldwide income. No matter where you live, you are taxed on your income,” Crain says.

A US person can also treat a Nonresident Alien (NRA) spouse as a US resident for income tax purposes, so the couple can file a joint income tax return. To do so, the NRA spouse needs to obtain a social security number, or Taxpayer Identification Number (TIN). “Filing jointly may be useful and may save taxes, depending on the relative income and deductions of the partners,” she points out.

BNY Mellon suggests it is advisable to have an experienced tax specialist calculate the various options, as it could be more efficient for the US person to file separately, or as Head of Household if they are dependent children.

All of this also applies to people known as “Accidental Americans” – people who were born in the United States but never lived there. Unless they have formally renounced the citizenship, they are also subjected to these rules.

Double taxation

Not surprisingly, US persons working outside the US continue to face the possibility of at least some measure of double taxation, much of which is a result of mismatches in tax calendars between the United States and other countries.

The US tax calendar runs from January 1st to December 31st but Hong Kong’s tax calendar, for instance, is from April 1st to March 31st.

“Many of the times trying to avoid double taxation does not work because the calendar years do not match,” she says. “So looking to offset one with another just does not happen.”

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One way of avoiding double taxation is through different tax treaties and agreements (the United States has tax treaties with nearly 60 countries). While they are helpful to reduce or eliminate taxes on foreign workers in their countries, they do not necessarily reduce tax liability for US citizens.

Yet the challenge is not only that these treaties are different from one another, but they are also very complicated and always changing.

“Don’t expect that the US-Denmark treaty is the same as the US-Canadian treaty because they are always being negotiated and renegotiated. So you have to read them very carefully,” Crain says.

For example, while the US has a tax treaty with the People’s Republic of China, this treaty does not cover Hong Kong. There is currently no treaty between the United States and Hong Kong.

Then there are “Foreign Tax Credits” through which you pay much less tax. But here too are a lot of caveats on deductions, credits and exclusions, which means it is important to see if they are actually applicable to the person.

To start with, Americans living outside the States can use “Foreign Earned Income Exclusion” through which they could exclude up to US$108,000 (as of 2015) from their income earned abroad.

Deductions can also be achieved through the “Foreign Housing Exclusion” as well as “Employer Provided Meals Exclusion.” For instance, those living in HK, where housing is expensive, you can get a much higher housing exclusion, Crain recommends.

Overseas retirement plans

The most complicated of all are the retirement plans.

“Foreign retirement plans are very often not considered ‘Qualified Retirement Plans’ by the IRS,” she says.

The reason is because foreign pension or retirement plans are often not structured to conform to the complex rules under IRC Section 401. For instance, they do not include anti-discrimination provisions related to highly compensated employees, or if the trust holding plan assets were not created or organized in the US.

“Many of the retirement plans are considered foreign trusts by the IRS. So many of the tax benefits to the US plans do not work for the foreign plans,” Crain says.

Meanwhile, the assets in those retirement accounts also need to be reported to the IRS by the financial institutions that hold those retirement plans. Many institutions are reluctant to take on new accounts due to very stringent and complicated disclosure requirements under the US regulations.

If it does not qualify, then whatever contribution you make as clients to those plans are considered as taxable compensations and may not be deductible. Even worse, the income from retirement plans such as dividend and income are taxed under a foreign plan.

“However, the bright side is that the distributions that come out of foreign taxes are tax-free,” Crain says. “The IRS says that if you paid tax going in, you will not pay tax going out. So you can receive your distributions, without paying tax.”

Hong Kong’s MPF, however, does qualify as a social security plan under IRS regulations.

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A lot of foreign pension plans are often known as “Foreign Guarantor Trusts,” which means they must be reported on IRS Form 3520. But there are exceptions with few countries with which the United States has comprehensive pension treaties (Canada is one example).

BNY Mellon advises that complete reporting and compliance are essential. A US person who is a beneficiary of a foreign grantor trust has to file at least three forms: 1) Report annual income on their Individual Income Tax Return (Form 1040); 2) Report contributions and distributions on Form 3520; 3) Report plan as asset on Forms 8938 and FBAR.

Staying compliant and punctual

IRS regulations on investments made by US citizens living abroad are particularly complicated. Those investing in mutual funds should be wary of whether it triggers the rules governing Passive Foreign Investment Company (PFIC) or not. They should also study the accounting and reporting requirements for a US person’s accounts and see if their investment advisor has the necessary capacity to properly report on a US person’s accounts.

Clearly, the reporting process is not simple. “The reporting has become very complicated even for [the IRS]. They are still figuring out how to make the reporting simpler,” Crain says. Even after the exclusions, citizens need to pay attention to what they are doing.

“The fact that you have excluded the first US$100,800 does not mean that you can start off with the 15 percent tax bracket,” the executive stresses. In other words, when claiming the “Foreign Earned Income Exclusion”, taxpayers who have excluded income must start off at the (usually higher) marginal rate at which they would have been if they had not excluded any income.

BNY Mellon says it is advisable for US persons to stay compliant with the regulations and pay taxes on time as the IRS is cracking down hard.

The good news is that for those who might have failed to file taxes on time, the IRS has provisions that allow them to make amendments – one of them is through the “Offshore Voluntary Disclosure Program”.

If US persons can convince the IRS that they were not deliberate then they can file the past forms and not pay any penalty.

“Offshore voluntary forms are pretty generous but [can be] pretty harsh on people who have willfully ignored the tax,” Crain says. “It’s really important to advise the clients to file their past returns and come clean because the enforcement is increasing rapidly.”

Tsering Namgyal has been a writer specializing in business and finance for over 10 years. A graduate of the University of Iowa and University of Minnesota, his articles have appeared in Asia Asset Management Review, Fund Strategy, IPE Real Estate, South China Morning Post, amongst others.