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Americans Working Abroad and Foreigners Working in America Both Face Challenges of Deciphering U.S. Tax Code

(RIVERWOODS, ILL., January 2007) – In addition to being gainfully employed, the hundreds of thousands of Americans working abroad and foreigners working in the U.S. share another thing in common: They all owe U.S. income tax on some or all of the income they’re earning. They also face tax situations that are among the most complex when it comes to trying to figure out what they owe in U.S. income tax, according to CCH, a Wolters Kluwer business and a leading provider of tax and accounting law information, software and services (CCHGroup.com).

For Americans working abroad, there is the added surprise for many that a tax law change made last year significantly restricts how much of their foreign housing they can deduct for income tax purposes on their 2006 return and may put them in a higher tax bracket on their taxable income. For foreign individuals employed in the United States, there is the overwhelming factor of trying to understand U.S. tax law and matching that up to the details of any corresponding treaty their country of citizenship may have with the United States.

“Behind the global economy, there are hundreds of thousands of workers who are citizens of one country, but working in another. This has sweeping tax ramifications,” said CCH Principal Federal Tax Analyst Mark Luscombe, JD, LLM, CPA. “The complex set of tax rules that apply to overseas assignments is something that more and more individuals need to understand as they take overseas assignments, whether they are Americans going to other countries or citizens of other countries coming to the United States.”

Learning the Language of the U.S. Income Tax

While many foreigners learn English well before they arrive to work in the United States, few are prepared to understand the complexities of the U.S. tax code.

Even before getting to the point of identifying what taxes are owed, non-citizens need to understand what their visa allows them to do while in the United States.

For example, as a non-citizen, your visa may allow you to be in the United States on a temporary or permanent basis to work — it may be a student visa or a visa issued to you as the spouse of someone working in the United States. The U.S. tax code treats individuals differently based on the type of visa you have.

“It’s not uncommon for tax preparers to find that the individual whose taxes they are preparing does not have the proper visa for declaring wage income. From the individual’s perspective, he may not have given it much thought: He may have come over on a student visa and is now working or he may have a visa to work in the United States, but his spouse also now has a job and doesn’t have a visa permitting this,” said Luscombe. “Employers are supposed to verify the visa status before hiring, but, if they don’t, it can cause complications for individuals trying to file a return, and even more complications if they find themselves in this situation while trying to gain permanent residency.”

Foreign workers also need to understand what treaties apply between their country of citizenship and the United States that relate to income earned while in the United States, and have an idea of how long they are going to be in the United States, as hundreds of countries have treaties with the United States that detail how and to what extent their citizens are obligated to pay the United States for income earned here. For example, if you are a resident alien from India, the first $10,000 of income you earn in the United States is not subject to U.S. income tax, and if you are a resident alien from Canada here for less than three months, you won’t be required to pay U.S. income tax on those earnings.

This brings up the next point: You need to understand how the distinction between resident alien and non-resident alien makes a difference in your tax obligation. A resident alien is generally a citizen of another country that lives in the United States and has resident status by law or visa (e.g., a “green card”) or has passed the substantial presence test, which generally requires that you must have been physically present in the United States for at least 31 days during the current year, and 183 days during the three-year period that includes the current year (with the current year being the tax year) and the two years immediately before. A non-resident alien is someone that is in the United States on a temporary basis but does not have the right to remain in the United States indefinitely.

However, special rules abound allow foreign individuals to exempt certain parts of their income from U.S. taxes, for example, individuals temporarily in the U.S. on behalf of a foreign government, such as a teacher, student or professional athlete in certain circumstances.

Generally speaking, if you are a resident alien, your income is taxed in the same way as a U.S. citizen’s and you are required to report all sources of income, including dividends, interest, wages or other compensation for services as well as income from rental property or royalties. This income must be reported whether or not it is from sources within or outside the United States.

As a resident alien, you should file Form 1040EZ, Form 1040A or Form 1040 depending on your particular tax situation. Your 2006 tax return is due by the same date as U.S. citizens, which is April 16, 2007 (April 17 in certain Northeast states).

A non-resident alien usually is subject to U.S. income tax only on income from U.S. sources. An exception to this, which starts with the 2006 tax year, is that a non-resident alien generally is not required to file a return if his earnings connected with a U.S. trade or business are less than the amount of one personal exemption ($3,300 for 2006).

If you are a non-resident alien, you should file Form 1040NR or Form 1040NR-EZ if you have any source of U.S. income on which the tax was not fully paid or you are involved in a trade or business in the United States (with the above-noted exception). The date for non-resident aliens to file their 2006 tax return is based on whether or not they have wages subject to income tax withholdings. Those individuals who had wages subject to withholdings must file their return by April 16, 2007; those who did not have wages subject to withholdings must file their return by June 15, 2007.

The IRS offers an in-depth resource – U.S. Tax Guide for Aliens (IRS Publication 519) that covers various issues for foreign individuals trying to comply with the U.S. tax code. It also offers a wealth of information on its web sites and via an international tax law hotline.

Luscombe offers some additional advice.

“If there were a ranking of who needs to seek out the advice of a tax preparer, foreign workers in the U.S. would probably rank among the top individuals. Even if they think their tax situation is relatively straightforward, it can quickly become very complex.”

For Americans in Paris, Beijing or San Paulo, U.S. Taxes Are Now Costing More

U.S. citizens and aliens working abroad don’t have it all that much better when it comes to figuring out their taxes. Their worldwide income generally is subject to U.S. income tax regardless of where they live. The one advantage they do have is that they do not have to file their tax return until June 15, 2007. It’s important to note, however, if you owe any taxes, interest charges start adding up beginning on April 15. As a result, given the changes in the tax laws applicable to the 2006 tax year under the Tax Increase Prevention and Reconciliation Act of 2005, it’s wise to get an early start on calculating your taxes this year.

The tax law changes do offer one bright spot for Americans working abroad, but will likely have a negative impact on most when it comes to how much they owe. The good news is that the law increases the foreign earned income exclusion, allowing you to exempt $82,400 from U.S. taxes compared to the previous $80,000. To be eligible for the foreign earned income exclusion – which allows you to exclude $82,400 of income you made from working abroad from U.S. income tax – you generally must meet either the bona fide residence test or the physical presence test. The bona fide residence test requires you to establish residence in one or more foreign countries for an uninterrupted period that includes a full tax year. The physical presence test requires that your main place of business be in a foreign country and that you have been present in a foreign country or countries for 330 days out of any consecutive 12-month period.

But the increase in the foreign earned income exclusion will not offset the bad news which is that the new law for the first time assesses taxes on housing, education and other subsidies that are commonly provided by employers to help ease the relocation burden for their American workers living abroad.

“What makes this situation particularly unpalatable is that the law is retroactive to January 1, 2006, so individuals who generally owe little or no taxes may suddenly find themselves stuck with an unexpected tax bill and it will be particularly pronounced for those who didn’t adjust their withholdings mid-year to reflect the change in the law,” said Luscombe.

The new housing exclusion law now sets a new base housing amount at 16 percent (computed on a daily basis) of the foreign earned income exclusion ($82,400) multiplied by the number of days of foreign residence or presence for that year. And, it sets the maximum amount of the foreign housing cost exclusion for 2006 at $11,536 if the taxpayer lives year-round in a foreign residence. However, the IRS has subsequently created additional guidance for foreign cities that have high housing costs. For example, rather than a maximum of $11,536 for housing expenses, someone living in Tokyo for the full year can claim $85,700 in housing exclusions or $72,100 if they live in London. As with the foreign income exclusion, individuals must meet the bona fide residence or physical presence test to qualify for the housing exclusion.

“Many high-cost cities, including many cities in China, have not been included in these high-cost housing tables. Individuals are concerned because the higher rate is only applicable to those living within the city limits, so if you live in a suburb just outside of Tokyo, you’d still only be able to claim the $11,536 housing exclusion even though your real costs may be just as costly as someone living in Tokyo,” said Luscombe.

One final new change to the tax code that will not make Americans living abroad happy is that the Tax Reconciliation Act also now mandates that the tax bracket a taxpayer should use for determining how much they owe on any income in excess of the exclusion amount requires they add back in the exclusion amounts. This means individuals who had been able to push their tax bracket down to the 10 percent – or even ended up owing no taxes – could now be looking at tax rates of 25 percent or higher.

“Many companies were grossing up the income of these employees to help offset any extra taxes or other out-of-pocket expenses they may encounter by taking an assignment overseas,” said Luscombe. “But workers now need to keep in mind that with the new limits on exclusions and the higher tax rates on any income they have remaining after exclusions, they will owe more taxes.”

If you’re eligible to exclude any of your foreign earned income or housing expenses under the rules discussed above, usually you must file Form 2555, Foreign Earned Income, with your regular Form 1040, unless you have an income of $82,400 or less and are eligible to file the simplified Form 2555-EZ. One of these forms must be filed even if all of your foreign income is excluded and you don’t owe any tax. It should be noted that once you have elected either or both the foreign earned income or housing exclusions, it remains in effect until revoked.

Other tax consequences that expatriates need to keep in mind as they start to prepare their tax returns:

• Deduction or Credit for Foreign Income Tax Paid – If you can’t exclude all of your income under either the foreign earned income exclusion or the housing exclusion, you can still claim a deduction or a credit for the amount of income tax you paid to a foreign government. The deduction would be claimed as an itemized deduction on Schedule A of your 1040 form; the credit would be claimed on a special form, Form 1116, Foreign Tax Credit. Whether claiming the deduction or claiming the credit would be more advantageous depends on your individual situation; you may have to figure your tax both ways (or have your tax professional do this) before you can decide.

• Social Security and Medicare Taxes – The exclusions, deduction and credit discussed above apply for federal income tax purposes, but they don’t apply for Social Security and Medicare tax purposes. You may need to pay these taxes regardless of where you worked, unless the U.S. government has signed a formal agreement with the government of the country in which you work. Generally, these agreements provide that you will only have to pay Social Security-type taxes to one country, and they specify which country will eventually pay your benefits. If no such agreement is in effect for your country, you may end up paying taxes to both the United States and the foreign government.

• Other Exemptions, Deductions and Credits – As a U.S. citizen or resident alien living outside the United States, you are eligible for many of the same exemptions, deductions and credits as if you were living in the United States, including such things as deductions for moving expenses and exemptions for dependents.

You will most likely also be taxed in the foreign country in which you are residing, as most countries impose an income tax on individuals living or working there. So that you are not penalized from a tax standpoint by your foreign assignment, however, many employers have adopted tax equalization policies.

Under these policies, an employer usually ensures that you will pay the same amount of tax while on foreign assignment as you would have in the United States. As an example: You pay your company income taxes (through withholding on your compensation) on the income you would have earned had you stayed in the United States and your company pays all of the U.S. and foreign income taxes that you actually owe during your foreign assignment.

Once you have filed your tax return, your employer performs a tax equalization calculation to determine a final tax settlement, which is the amount owed to or from the employer to you.

“With Americans working abroad now subject to higher taxes given the changes in the tax law related to housing exclusions and tax brackets, it’s going to be a lot more costly for companies that are offering tax equalization policies, because they will have to make up the difference,” said Luscombe. “It’s likely after seeing the impact this year, that many employers will rethink their deployment of U.S. employees abroad.”

Another, less popular, type of policy designed to protect you from tax consequences of working abroad is a tax protection policy. Unlike tax equalization policies, tax protection policies allow you to keep any tax benefit realized if the amount of your taxes while on foreign assignment is less than it would have been for you if worked in the United States.

As you get ready to file, keep in mind that the amount you report on your return must be reported in U.S. dollars, even if you receive all or part or your income or pay all or part of your expenses in foreign currency.

Most U.S. citizens living abroad get a two-month extension to file their returns (June 15), but, if you owe, interest charges start adding up on any taxes due beginning on April 15. This applies if you are a U.S. citizen or resident and both your tax home and your abode are outside of the United States or Puerto Rico on the regular due date.

Help from the IRS

“Tax issues as they relate to expatriates are extremely complicated, and you would probably be best advised to seek the assistance of a tax advisor before you accept or leave on your overseas assignment,” notes Luscombe. “There is, however, also a range of assistance available from the IRS as tax time approaches.”

If you’re struggling with your taxes while you are outside of the United States, the IRS offers services to help you complete and file timely and correct tax returns. During the filing period (January to mid-June), you can get the necessary federal tax forms and publications from U.S. embassies and consulates. The IRS also makes available a special kit for overseas filers, Package 1040-7, containing special forms with instructions and Publication 54.

The IRS has full-time permanent staff in four U.S. embassy and consulate locations in Frankfurt, London, Paris and Puerto Rico that can provide tax forms and publications; answer federal income tax questions; help with problems; and assist with the preparation of current and prior year tax returns. IRS trained volunteers are also available at some embassies and consulates.

About CCH, a Wolters Kluwer business

CCH, a Wolters Kluwer business (CCHGroup.com) is a leading provider of tax and accounting law information, software and services. It has served tax, accounting and business professionals and their clients since 1913. Among its market-leading products are The ProSystem fx® Office, CCH® Tax Research NetWork™, Accounting Research Manager® and the U.S. Master Tax Guide®. CCH is based in Riverwoods, Ill.

Wolters Kluwer is a leading global information services and publishing company. The company provides products and services for professionals in the health, tax, accounting, corporate, financial services, legal and regulatory, and education sectors. Wolters Kluwer has annual revenues (2005) of €3.4 billion, employs approximately 18,400 people worldwide and maintains operations across Europe, North America, and Asia Pacific. Wolters Kluwer is headquartered in Amsterdam, the Netherlands. Its shares are quoted on the Euronext Amsterdam (WKL) and are included in the AEX and Euronext 100 indices. For more information, visit www.wolterskluwer.com.

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