Source: https://www.taxconnections.com/taxblog/61484-2/
Timestamp: 2019-04-19 16:20:56+00:00

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Citizenship And Worldwide Taxation: Citizenship As An Administrable Proxy For Domicile (Part 2) | TaxConnections is a where to find leading tax experts and tax resources worldwide.
There are two bases on which nations may exercise the jurisdiction to tax: source and political allegiance. 4 Under the heading of source, a nation taxes in rem income or assets located (“sourced”) within its borders regardless of where the owner of such income or assets lives. On a theoretical level, source-based taxation reflects the claim of the nation in which income arises or assets are held that such nation provides the benefits [*1294] within its territory that protect such income or assets. 5 On a pragmatic level, source-based taxation reflects the practical ability of the nation in which income or an asset is located to impose tax before such income or asset is remitted to the owner abroad.
Jurisdiction based on political allegiance is in person am in nature and is premised not on the source of income or assets but upon the political allegiance of the taxpayer who owns such income or assets. Nations other than the United States define political affiliation for tax purposes on the basis of residence and accordingly tax their residents on a worldwide basis without regard to the source of such residents’ incomes or assets and without regard to such residents’ citizenships. Most cognoscenti in this area judge the country of residence as better positioned than the country of source to assess an individual’s overall capacity to pay tax on a progressive basis, since the residence jurisdiction exercises in person am authority over the taxpayer and can require him to aggregate and report her entire income from all sources. Typically, a resident will keep much of her assets and earn much of her income in the country in which she resides. Since the taxpayer lives in that nation, she is most amenable to enforcement action there. By contrast, the source nation lays claim only to the part of a taxpayer’s income arising within the territory of that nation. Insofar as a tax system seeks to tax an individual on her overall ability to pay considering all her sources of income and wealth, residence-based taxation on worldwide income and assets is more compelling than is source-based taxation.
Consider, for example, A, a resident of country X, who owns and rents out a condominium in country Y. As the source country in which the rent arises, Y has an in rem claim to tax on the basis of the services it provides to A’s condominium, located within Y’s borders. On a practical level, Y has the initial ability to tax that rent by, for example, imposing an obligation on A’s tenant to withhold tax from his rent payment and send such withheld tax to Y’s tax department. 6 If necessary, Y can collect unpaid taxes by foreclosing on A’s condominium located within Y’s territory.
[*1295] On the other hand, Y is poorly positioned to assess A’s overall ability to pay if A has income from other countries. Suppose that, in addition to his rental income from Y, A works in and thus has earned income from X where he resides, and has a second, rent-producing condominium in country Z. Under these circumstances, most tax mavens conclude that X, the country in which A resides, has the strongest claim to tax A’s overall income and is in practice best positioned to assess A’s overall ability to pay tax. By virtue of its in personam contact with A, X can best demand and pool information about all of A’s income from X, Y, and Z, 7 and can most effectively enforce its revenue laws against A. Y and Z, in contrast, are capable of assessing only the part of A’s income arising within their respective borders.
For most taxpayers, the jurisdiction of source and the jurisdiction of residence are the same, since such individuals earn and invest their incomes in the same nations in which they reside. On the other hand, when an individual owes political allegiance to one nation but derives income or holds assets in another, both countries have jurisdiction to tax the same item.
of those assets or the residence of the deceased citizens. For example, in Article I of the 2004 protocol to the U.S.-French estate tax treaty, 16 the United States reserves the right to tax the estates and gifts of its citizens and former citizens as if there were no treaty between the two nations.
While the baseline of U.S. tax law is the worldwide taxation of U.S. citizens without regard to their respective residences, this policy is abated in important respects. Indeed, as I shall argue below, 17 these abatements, however meritorious they may be on other grounds, are in practice inconsistent with the traditional tax policy justification of citizenship-based [*1297] taxation, namely, the public benefits stemming from U.S. citizenship, since these abatements result in different nonresident citizens paying significantly different taxes for the same benefits of U.S. citizenship.
In the income tax setting, the most important abatements of the United States’ worldwide taxation of its citizens are the credit for foreign income taxes and the exclusion from gross income of personal service income earned abroad. The income tax credit 18 is among the most discussed provisions of the Internal Revenue Code. 19 The dollar-for-dollar credit is available both to U.S. citizens and to resident aliens to the extent they pay foreign income taxes on foreign-source income at or below the rate at which the United States taxes such income. By using the foreign income tax credit, the United States, as the nation of the taxpayer’s political allegiance, surrenders the tax it would otherwise collect from a citizen or resident with foreign-source income to the foreign-source jurisdiction from which the income is derived.
As I discuss below, 28 the Code’s disparate treatment of different kinds of foreign taxes produces different U.S. tax liabilities for different U.S. citizens depending upon the nature and amount of tax assessed by the nations in which those citizens live and earn their respective incomes. These divergent tax liabilities cannot be squared with the benefits rationale for citizenship-based taxation, since all nonresident U.S. citizens receive the same benefits of U.S. citizenship while paying different U.S. taxes (or sometimes no U.S. taxes) for those benefits.
The conventional justification for § 911 is that it facilitates the ability of U.S. citizens to work abroad. However, as we shall see, 39 that argument, whatever its plausibility as a matter of economic policy, is incompatible with the benefits rationale for citizenship-based taxation. In particular, the § 911 exclusion (like the Code’s provisions relative to the crediting, deductibility, and nondeductibility of different foreign taxes) can in practice result in nonresidents who receive the same benefits of U.S. citizenship while paying radically different U.S. taxes.
As a general rule, 48 a U.S. citizen or resident employed outside the United States by “an American employer” 49 pays FICA 50 taxes on his salary. This rule is subject to many exceptions. These exceptions include totalization arrangements under which the U.S. citizen-employee pays social security taxes to the foreign nation in which he works and consequently accrues social security benefits under that nation’s system. Another important exception allows certain foreign affiliates of U.S. parents to join the U.S. social security system. 51 In that case, the U.S. citizen employed by such a foreign affiliate pays FICA taxes on his salary. Section 911 does not apply to FICA taxes. 52 Thus, absent an applicable totalization agreement, a [*1301] U.S. citizen employed abroad by a U.S. employer pays FICA taxes on wage income even if that income is excluded from gross income for income tax purposes.
Just as the Code provides a dollar-for-dollar income tax credit for foreign income taxes paid by a U.S. citizen, the Code, subject to certain limits, 53 furnishes a credit against the federal estate tax for “any estate, inheritance, legacy, or succession taxes actually paid to any foreign country in respect of any property situated within such foreign country.” 54 Thus, when a U.S. citizen dies owning property located abroad, U.S. estate taxation is abated on account of foreign death taxes paid on such property. Like the income tax credit for foreign taxes (which is available to both resident and nonresident citizens of the United States), the credit for foreign death taxes applies to the estates of deceased U.S. citizens whether they resided at home or abroad. Also like the foreign income tax credit, the estate tax credit avoids double taxation by ceding primary tax jurisdiction to the source nation in which the deceased citizen owned her assets.
In the estate tax context, Code § 2107 provides a special rule if a former citizen dies within the ten-year transition period established in § 877. In particular, during such transition period, the gross estate of a deceased former resident covered by § 877 includes the value of a foreign corporation’s stock to the extent that the deceased former citizen had a significant interest in such corporation and the corporation owns assets located in the United States.
In 2008, at the same time that Congress decreed that expatriation will cause the immediate income taxation of a “covered expatriate[‘s]” unrealized appreciation, Congress augmented the estate taxes due on the death of such an expatriate. In particular, new Code § 2801 requires a U.S. citizen or resident receiving property on account of the death of a “covered expatriate” to pay an estate tax on such property unless the deceased expatriate’s estate pays tax on such property.
For example, if A, a French citizen with no ties to the United States, gives shares of Microsoft to his children who are also French citizens, no U.S. gift tax is levied on this transfer, even though the gifted shares are of a U.S. corporation. If, however, the French citizen is a former U.S. citizen who makes his gift to his French offspring during the ten-year transition period established in § 877, he owes gift tax on the transfer. If the former U.S. citizen is a “covered expatriate” and his children receiving Microsoft shares are themselves U.S. citizens or residents, these donee-children owe U.S. gift taxes by virtue of new § 2801.
Although Cook provides constitutional underpinning for the federal government’s citizenship-based taxation, as we shall see, 64 the benefits rationale of that decision proves unpersuasive, both in theory and as implemented by the provisions of the Internal Revenue Code that tax different U.S. citizens different amounts for the same benefits of U.S. citizenship.
Citizenship And Worldwide Taxation: Citizenship As An Administrable Proxy For Domicile – Part 2 is a continuation of Professor Edward Zelinsky’s publication on Citizenship And Worldwide Taxation.
As TaxConnections CEO, Kat Jennings founded the leading tax platform connecting tax professionals and taxpayers worldwide. TaxConnections blogs educate tax professionals and taxpayers on the impact of tax laws affecting citizens all over the world.
I think it would be worth Mr. Zelinsky’s while to also discuss the realities of enforcement and compliance with US extraterritorial taxation. Approximately 85 percent of non-resident US persons do not file tax returns. FATCA is not changing that number. What does Mr. Zelinsky think should be done? Should the IRS try to encourage greater compliance – surely it can be sold on the basis of its many virtues! – or accept de facto residency-based taxation for the vast majority who do not voluntarily participate?

References: § 911
 § 911
 § 2107
 § 877
 § 877
 § 2801
 § 877
 § 2801