Citizenship Based Taxation is not going Away, but these 5 Changes Would Change the Game (for the better)
Many Americans living abroad have been advocating aggressively for the repeal of Citizenship based taxation (CBT). These advocates argue that the rules that tax US citizens abroad are unfair and overly punitive.
Although I do not entirely disagree with the arguments against CBT, the current US tax expat structure would have the be overhauled if citizenship-based taxation was abolished. The US would have to implement a more comprehensive non-resident and exit tax system to go along with these potential changes.
In reality, as much as many expats would love this change it’s highly unlikely to happen any time soon, especially considering how uncooperative Congress has been recently.
A more practical approach, as argued below, would be to lessen the tax and compliance burden on US expats by simplifying the current tax rules while ensuring tax revenues are not eroded.
The following are some measures that would greatly reduce the tax complexity and burden on US expats abroad:
Increase the FBAR reporting threshold
The current FBAR reporting threshold is $10,000. Therefore any US taxpayer living abroad with total aggregate account values in excess of $10,000 will be required to file an FBAR (form 114). This filing threshold is unnecessarily low which results in a lot of foreign account reporting for individuals with relatively small accounts. In turn, this forces US expats to either have to deal with the added complexity of FBAR reporting or pay a professional to help them with the process.
Increasing the filing threshold of the FBAR would greatly reduce the complexity of filing for many US expats while also decreasing unnecessary work by the treasury department. We already have additional reporting requirements with much higher reporting thresholds on form 8938 that is required to be included on your 1040 return. Perhaps simply eliminating the FBAR filing requirement and consolidating the reporting into the 8938 is a simple and effective solution.
Clarify 3520 and 3520-A reporting requirements for Canadian investment accounts
3520 and 3520-A reporting for TFSAs and RESPs has been a huge thorn in the side of US expats for a long-time. Not only have US expats not been able to defer income with RESPs and TFSAs they have been burdened by prohibitively expensive and tedious 3520 and 3520-A reporting requirements.
3520 and 3520-A disclosures certainly have their place as the IRS will want to know about Americans with foreign trust assets, gifts from foreign persons, and trust distributions. But considering RESP and TFSAs are already disclosed on FBAR and 8938 forms additional reporting should not be necessary.
In march of 2020, the IRS released some welcomed news for expats by exempting RESPs from 3520 and 3520-A reporting. Unfortunately, they did not change the tax deferral rules for these accounts or further extend the rules to TFSA accounts.
This is really a simple change that needs to happen ASAP. The TFSA account essentially mimics the tax treatment of US ROTH IRA accounts. The IRS does not need additional reporting for these accounts as this simply increases the amount of compliance the IRS is required to review and process while adding no value in terms of disclosure of added tax revenue. Sure, some expats may pay US tax on their internal TFSA earnings, however, this amount should be relatively insignificant to overall tax revenues.
Further exempting TFSAs from the 3520 and 3520-A requirements would not only align the RESP rules but would lessen the review and compliance burden at the IRS with respect to these forms.
Allow TFSA and RESP tax deferral for US tax purposes
Even if 3520 requirements were relaxed for TFSA accounts the taxation of the actual accounts would not change. This would require additional tax change measures by Congress.
Assuming a change to the Canada-US treaty is not in the works, a simple change to the IRS code or a separate tax election similar to the relatively recent ROTH IRA election available to Canadian residents would work just fine.
Implementing these measures would allow US expats to invest just like regular Canadians and would eliminate unnecessary and burdensome compliance.
Exempt Canadian mutual funds from PFIC reporting
Investment planning and PFIC (Passive Foreign Investment Company) reporting has been challenging for US expats in Canada for many years. Although some Canadian mutual fund companies do provide PFIC reporting for expats, form 8621 is still required and additional work needs to be performed for those that hold these investments.
In fact, Congress and the IRS never intended to include regular Canadian mutual funds into the PFIC reporting and taxation rules. Canadian mutual funds simply fit the definition for PFICs and therefore were subject to the same rules as all other PFICs. The original intention of the PFIC rules was to ensure US tax residents didn’t offshore capital into foreign companies. US expats living in Canada, investing in Canadian mutual funds, that in most cases distribute all of their income each year, is hardly a tax avoidance issue.
The easiest fix to this problem is a simple change to the code that exempts Canadian public mutual funds and ETFs from the PFIC reporting rules. A simple fix for a problematic situation.
In fact, congress and the IRS never intended to include regular Canadian mutual funds into the PFIC reporting and taxation rules.
Introduce a filing threshold for US expats
In many cases, US expats living abroad simply earn employment income and own very little in the way of investments. As such, their US income tax return is relatively straight forward and they will, in most cases, not owe any US taxes.
In these cases, it makes sense to apply a higher filing threshold than the current standard deduction limit available to most. This threshold, which could mimic the current 2555 foreign income exclusion threshold coupled with a higher FBAR filing threshold could exempt tens of thousands of Americans living in Canada from annual filings. Once an American expat is required to file, it’s not just form 2555 that will be required, but all the additional filing requirements, treaty elections and forms within the current year 1040 income tax return.
By increasing the filing threshold many expats would be able to avoid filing while ensuring US tax revenue is not lost.
Develop an information reporting for Expats that meet the thresholds outlined above
The proposal above could work, however some will argue that this could be challenging as some taxpayers may have additional income sources that could result in additional US tax. For example, they may have US rental income, US dividend income or US pension income for example.
In order to help support an increased filing threshold for expats the IRS could introduce a one-page information reporting that expat’s certify outlining why they qualify for the expat exemption. First, this will serve to ensure they report to the IRS to qualify for the exemption, and second, it will result in significantly reduced compliance for many American expats.
Forms like this actually already exist and are used by potential US taxpayers each year. For example, Canadian snowbirds that meet the US substantial presence test are eligible to file form 8840 if they can show that they have a closer connection to Canada. In this case, they are not required to file anything further than the single form 8840.
A similar approach could be used to help US expats living in places like Canada simplify their reporting requirements, while ensuring the IRS does not collect less tax revenue from abroad.
Of course, this potential change would only be available to those with very straightforward tax returns. That being said, many expat fit into this category and would benefit greatly from this change.
Exempt certain private company holdings from 5471 reporting requirements
Under current US tax law US Citizens and Green Card Holders that own certain percentages of private foreign corporations are required to file from 5471. This form includes significant amounts of disclosures, financial information, and tax calculations.
In 2017 the US administration enacted new tax rules that would make it much more difficult for Americans living in Canada from deferring income and saving within their private Canadian companies. A one time tax on retained earnings of private company equity controlled by US Citizens was applied. In addition to this tax on accumulated earnings new GILTI tax rules (Global Intangible Low Tax Income) also taxed active income earned within these controlled Canadian companies.
The original intention of these 2017 tax rules was to ensure large multinational companies were not offshoring earnings in an effort to avoid US tax. Unfortunately, it pulled in many small business owners and professionals into significant compliance and tax filing measures.
Once again, a threshold needs to be applied here. As outlined above the 2017 rules were intended to ensure large corporations didn’t reduce their US tax liabilities by offshoring earnings. By applying a threshold to these rules not only will small private business owners be able to avoid such prohibitive tax responsibilities, the IRS will have much less compliance to administer that doesn’t result in much tax collection regardless.
The IRS could make it quite straightforward, applying a threshold based on gross revenue. For example, any controlled foreign company (which would include Canadian corporations controlled by Americans living in Canada) with less than $10,000,000 in revenue would not be subject to GILTI tax. There is still a question whether Congress could retroactively reverse the 965 tax on retained earnings applied in 2017, however simply changing the thresholds for GILTI tax on private Canadian businesses would be a welcome start.
Conclusion
As you can see from the analysis and proposal outlined above, the solution for reducing the complexity and burden of expat returns often lies in additional simplified information reporting and increased filing thresholds. Many of these changes outlined above do not reduce US tax revenues from abroad and significantly reduce the compliance burden for US expats in Canada.
If we assume that citizenship-based taxation is not going to be abolished any time soon, reducing the complexity of expat filings and introducing appropriate filing and taxation thresholds would be an alternate solution that would result in significant support among Americans abroad.