International Tax Corner: Edition 2

The International Tax Corner: Edition 2

Why Worldwide Income Matters

For those of you playing, Eritrea is the answer to the last blog’s quiz. Eritrea is the only country besides the US that taxes non-resident citizens. It has a different regime for resident citizens, so it’s not the same as US law, which treats both equally.

Really?! Isn’t US tax law complicated enough without having to tax citizens on worldwide income regardless of residency? What happens if the country of residency also taxes on worldwide income – are the US citizens simply stuck? Let’s slow down and get back to tax on citizenship.

Why do we care about Cook v. Tait, Collector of Internal Revenue 265 U.S. 47 (1924))? [Argued April 15, 1924. Decided May 5, 1924.] Cook was a US Citizen and resided and was domiciled in Mexico City. Note: This case is a bit close to my heart as I lived there almost 2 ½ years when working in the international tax group of a Big Four accounting firm. Long story short, the court ruled Congress has the power to impose a tax upon income received by a US citizen, regardless of where resident.

Citizens benefit even though living abroad. For instance, citizens have access to the local Embassy/Consulate to seek protections. Remember the medical school students “rescued” in Grenada by the US military in the 1980s?

I’m not saying I love the rule – just providing some background.

So, for starters, there is only limited US tax planning for US citizens. Further, many renounce their citizenship. This can be tricky and, perhaps not surprisingly, is a taxable transaction. Later we’ll examine residency issues for non-citizens, applicable for Green Card holders and others, and then we’ll cover expatriation.

Suppose Pat is a US citizen living and working in Australia. Forget about foreign currency for a moment. Say Pat earns 100 and faces Australia tax of 30. Pat also reports 100 on the US tax return and has a US liability of, say, 35. Does Pat pay 65 tax on 100 income – good grief! No, that’s not what happens. The US provides various mechanisms to avoid this “double tax”. Typically, Pat can claim a foreign tax credit. Internal Revenue Code Section (“§”) 901 (Taxes Of Foreign Countries And Of Possessions Of United States) allows a credit.

  • 901(a) combined with §901(b)(1) allow a credit for US citizens and domestic corporations, the amount of any income, war profits, and excess profits taxes paid or accrued during the taxable year to any foreign country or to any possession of the United States. . .. What’s that mean?

Pat may claim a credit for the 30 paid in Australia so there’s only 5 payable in the US, resulting in an effective tax rate of 35%, as if Pat lived in the US. The numbers don’t always work so clearly due to §904, which imposes a limitation on the foreign tax credit.

Pat could also claim a deduction for foreign taxes. That would mean income is 70 (100, less 30 Australia tax). The US tax at 35% is 24.5. The effective rate is then 54.5%. Still pretty high. That’s an example showing why credits are typically more advantageous than deductions.

In certain situations, Pat may be able to exclude certain active income under §911. That figure is $120,000 for 2023. There are advantages/disadvantages to claiming this exclusion, to be discussed another time. The key takeaway is Pat doesn’t necessarily come out of pocket for full foreign and US tax.

About Schwartz International

The International Tax Nerds at Schwartz International team with individuals, companies of all sizes and other accounting and law firms to provide practical international tax, compliance, and legal advice.

We live and breathe international tax daily, and since we’ve lived in various countries, we understand the diverse cultural challenges you face. We work in four key areas: International Tax Advisory; International Tax Compliance; Cryptocurrency; and Law via our sister company, The Schwartz Law Firm.

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