Expatriates & Sourcing
The tax code provides an exemption for expatriates to encourage US employees to work abroad and to ease the complications of being taxed in two jurisdictions. The first step is to determine if a US person qualifies as an expatriate. The second step is to determine how much they can exempt.
A U.S. person is an expatriate if they have a tax home in a foreign country. The concept of “tax home” was introduced in the discussion on Residency. If a person takes travel deductions when traveling away from their home in France, for instance, then you can conclude that their “tax home” is in France.
In addition to having a foreign “tax home”, a US person must ALSO meet one of the following requirements to be considered an expatriate. The US person must
– Spend 330 days of the year abroad, OR
– Be a Bona Fide resident of a foreign country (this is a subjective test where you look at intentions, activities, physical presence…)
Once we’ve determined that the taxpayer is an expatriate, we have to determine what exclusions are available to them. There are two exclusions available:
1/ Foreign Earned Income Exclusion (FEI): $102,100 of wages, salaries, fees…for services performed in foreign countries (it will be $104,100 in 2018).
– Where the services are performed is what matters, not where the income is paid to.
– The exemption only applies to Personal Services. Not gain on sale of property (unless property was created by taxpayer – art, royalties for writer).
2/ Foreign Housing Expenses (FH):
Applies to a reimbursement or stipend provided by the employer.
– Includes rent, fair rental value provided by employer, utilities repair, parking, insurance on property.
– Not included: purchase of house, capital improvements, mortgage, property tax. Furniture.
Excludes housing expenses to the extent they exceed 16% of the FEI exclusion, or $16,336. The theory here is that $16,336 is the amount that the average worker in the US would spend on housing. Anything above that is the additional cost the employee had to incur for working abroad, and therefore exempted to create a level playing field between US workers abroad and US workers in the US.
Jones has lived and worked in Peru from 2/1/15 to 12/31/15. He received a salary of $102,100 and housing cost reimbursements of $21,336.
He can take FEI exemption for the full $102,100 and a $5,000 FH exemption ($21,336 – $16,336).
Same as above but Jones’ housing cost reimbursement is $40,336.
He can take a $102,100 FEI exemption, and a FH exemption of only $14,294. The maximum amount of the FH exemption is $14,294 ((30% x $102,100) – $16,336). Even though his housing cost exceeds $16,336 by $24,000, only $14,294 is eligible for the FH exemption due to the 30% cap.
If Jones was living and working in Germany instead of Peru, he may be able to take a FH exemption of the full amount, because the 30% cap does not apply in high cost countries such as those in Europe or Japan.
Note that the addition of the 30% cap is fairly recent. Prior to 2006, there was no such limitation so long as the housing costs were reasonable.
There has also been a law change in 2006 regarding the tax rate that applies to the income that exceeds the FEI exemption amount.
Prior to 2006, if an expatriate worker earned $107,100, the excess amount over the FEI exemption of $5000 ($107,100 – $102,100) would be subject to the tax bracket of someone making $5000 which is 10%, resulting in a tax liability of $500 (10% of $5000). Under the new law, the tax bracket would be the same as someone earning $107,100, which is 28%, resulting in a tax liability of $1400 (28% of $5000).
Note that the amount that exceeds the FEI exemption may still be offset by a foreign tax credit. Typically, if the tax rates of the foreign country are higher than the US tax rates, the foreign tax credit would eliminate US tax liability. We will be discussing the details of the foreign tax credit later in the class.
Sources of Income
Now that we’ve determined the residence of the taxpayer, the next step is to establish whether the taxpayer’s income is US source or Foreign source.
The source of income is important for Foreign Residents because, for the most part, Foreign Residents are not subject to US tax on Foreign Source income (there are some exceptions that we’ll get into later).
Although US persons are subject to US tax on Worldwide income (i.e. both US and Foreign Source income), the source of income is still important since the amount of Foreign Tax Credit available to US persons will be based on the amount of the taxpayer’s Foreign Source income.
The way to approach a Source analysis is to take the following three step approach:
1- Identify the type of income: Interest, Dividend, Royalty, Compensation for Services, Gain from the Sale of Property, Inventory Gain)
2- Identify the General Rule for sourcing the income: For example, for Interest Income the general rule is that the income is sourced according to the residence of the debtor. For Income Compensating Services the general rule is that the income is sourced according to the location where the service was performed.
3- Determine if any of the Exceptions apply. For every rule there is usually an exception. For example, the General Rule for Interest Income is that the income is sourced according to the residence of the debtor (the party who is paying the interest). So if you have a US corporation paying interest to the Taxpayer, under the General Rule the Income would be US source. However, if more than 80% of the US corporation’s income is from “active foreign business income” then the interest income is Foreign source.
Assignment 2 will require you to make an outline using this methodology. This will serve as a valuable tool for the exams and for professional uses. It will also allow me to assess how well you understand the Sourcing rules.
A note on sourcing income from the Sale of Property
The General Rule for Gain from the sale of property is that it is sourced according to the Residence of the Seller. So if the taxpayer is a US resident, her gain from the sale of a car would be US source income.
Here’s the tricky part: So far we’ve determined that the residence of a taxpayer is determine by using one of the following tests: Citizenship, Legal Residency (green card), SBT1 and SBT2. However, for the purposes of determining source of gain from the sale of property, there is a different definition of residence. Here, Residence is determined based on the “Tax Home” of the taxpayer. So if Tom, a US citizen, has a home and operates a business in Hungary, Tom would be a US person under the General Residence rules. However, if Tom sold his car and realized gain of $1000, that income would be Foreign source income because his Tax Home is not in the US.
A note on sourcing income from the Sale of Inventory
The general sourcing rule for gain from the sale of property does not apply for inventory (i.e. goods that are held for resale).
Inventory is sourced based on where title (ownership) is transferred). To determine where title is transferred you must look at where risk of loss is transferred.
For example: Assume a contract specifies that a US Seller sells bicycles to a German Buyer and the German buyer will receive title when the goods arrive in Germany. However, the contract also specifies that the goods are transferred F.O.B. Long Beach (free-on-board Long Beach, means that if anything happens to the goods after they leave the port of Long Beach, the Seller is not responsible for any risk of loss). Hence, if the boat carrying the bicycles sinks, the German Buyer would still have to pay for them. Although the FORM of the contract stated that ownership was transferred in Germany, the SUBSTANCE of the agreement implies that ownership is really transferred in the US. The source of the gain is therefore US source. This is an example of the doctrine of Substance over Form.
A note on sourcing income from the Sale of Manufactured Inventory
Although gain from the sale of inventory is sourced according to where title is transferred, gain from the sale of inventory that is manufactured in the US will be sourced in the US. So if title is transferred outside the US but the goods are manufactured in the US, the gain is sourced in the US. Likewise, gain from the sale of inventory that is manufactured outside the US will be foreign source income.
This is a new rule as a result of the Tax Cuts and Jobs Act of 2017. For years prior to 2018, the gain in such situations would be divided into foreign source and US source income according to one of the following methods (the taxpayer was able to choose among the three methods):
50/50 Method: 50% of the gain is sourced in the US and 50% of the gain is sourced outside the US.
Independent Factory Price Method (IFP): Requires sales to independent distributors.
Books and Records Method: the gain is sourced based on how it is recorded in the taxpayer’s Books and Records (this method requires approval from the IRS).
A note on Interest Expense
Prior to 2018, the taxpayer could choose to allocate interest expense based on basis of assets or based on the Fair Market Value (FMV) of assets. This is covered in the reading on the second paragraph of page 67.
Under the Tax Cuts and Jobs Act of 2017, only allocation can only be made according to the basis of the assets and not the FMV.