The Culprit: U.S. Worldwide Taxation

The U.S. is one of the only countries left in the world that still taxes its citizens and residents on their worldwide income, regardless of where it is earned. Live and work in Rio De Janeiro? You must pay taxes to the U.S. government on your foreign-source income. Own a business in Bangladesh? The U.S. will tax the profits of that business. Very simply, U.S. taxpayers must report all of their income on their U.S. tax returns, even income earned outside of the United States.

For those unfamiliar with worldwide taxation, some background may be in order. Worldwide taxation is one of two systems by which a country can exercise jurisdiction to tax. The other type is a territorial tax system. Worldwide taxation is based on “political allegiance.”iii Political allegiance refers to the allegiance of the taxpayer who owns the income or assets. How a country defines the phrase, “political allegiance” leads to two different types of worldwide taxation: (1) “citizenship-based” and (2) “residence-based.”iv Taking what might be considered a “unique” position for a country that is at the epicenter of the global economy, the United States defines “political allegiance” as “an individual’s citizenship, regardless of his residence.”v Other nations define “political allegiance” for tax purposes on “the basis of residence.”vi In so doing, these countries tax an individual’s global income and holdings only if the individual resides in that nation.

As the poster-child of residence-based taxation, Canada imposes worldwide taxation on all of its residents without regard to Canadian citizenship. Many a taxpayer has asked the question, “Is the distinction between citizenship-based taxation and residence-based taxation one without a difference?” Or, to use a Shakespearian reference, “Is it much ado about nothing?” No.

So then what is the primary difference between the U.S. system of citizenship-based taxation and the Canadian system of residence-based taxation? A non-resident Canadian citizen – one who lives outside of Canada – does not pay Canadian income tax on the income that he earns in the foreign country in which he now resides.vii Instead, he only pays Canadian income tax on the income that is generated in Canada, if any. A non-resident U.S. citizen, on the other hand, must pay U.S. taxes not only on the income that is generated in the United States but also on the income that is generated in the foreign country in which he now resides.viii

No discussion of international tax systems would be complete without discussing the second type of tax system: a territorial tax system. Under a territorial tax system, taxation is limited to taxation of income or assets located within a country’s borders, no matter who derives it – a citizen, resident, or anyone else. “Territorial tax systems accommodate other tax systems in the simplest way possible – by not extending their own.”ix

Why is U.S. worldwide taxation so loathed? Because when a U.S. person or resident derives income or holds assets in a foreign country, the foreign country already taxes the item as their own. By the United States taxing the same item as if it was their own, a serpent comes slithering out of the shadows to rear its ugly head: “U.S. international double taxation.”

What is the main cause of U.S. international double taxation? “Inconsistent sourcing rules in different countries imposing overlapping taxes.”x If it were the norm, U.S. international double taxation would stop international commerce dead in its tracks.xi Recognizing this, the U.S. attempts to mitigate the harsh effects of worldwide taxation in three ways:

– Foreign tax credit;
– Foreign earned income exclusion;
– Section 911 exclusion for the personal service income of nonresident citizens and for
nonresident citizens’ housing costs.xii

Of these three, the foreign tax credit can unilaterally blunt this quagmire in one fell swoop. It is for this reason that I refer to it as “the equalizer.” As a preliminary matter, the foreign tax credit lies at the heart of the outbound system of U.S. taxation. When foreign tax rates and U.S. tax rates are roughly the same, the combination of worldwide taxation and the foreign tax credit virtually eliminates double taxation entirely.

What gives the United States the right to tax its citizens and residents on a worldwide basis in the first place? As may come as a surprise, the authority for U.S. worldwide taxation is not found in the Internal Revenue Code. Nor is it found in any piece of legislation passed by Congress. Nonetheless, it has long been established that the U.S. Constitution permits the federal government’s
worldwide taxation of nonresident U.S. citizens.

Who do we have to thank for that? None other than the U.S. Supreme Court in a little-known case by the name of Cook v. Tait, 265 U.S. 47 (1924). In an opinion that has been widely criticized as obscure and unintelligible, the Supreme Court upheld the federal income tax assessed by the IRS on a non-resident citizen’s Mexican-source income. In so doing, it interpreted the U.S. Constitution to allow worldwide taxation of nonresident U.S. citizens.

What rationale lies at the heart of the Supreme Court’s justification for worldwide taxation? The Court relied on the “public benefits” stemming from U.S. citizenship as the justification for U.S. worldwide taxation.xiii Specifically, the Court reasoned that a citizen who lives abroad and whose properly is located outside the United States receives benefits from the federal government.xiv
Precisely what benefits the Court was referring to we will never know because the Court did not expound on them. However, according to T. H. Marshall, author of “Citizenship and Social Class,” the Court viewed benefits as consisting of three distinct rights: “civil, political, and social rights.”xv

While the U.S. system of worldwide taxation is a contentious issue that has been the source of lively debate, the Court’s rationale for it, not to mention its pros and cons, are beyond the scope of this blog.

More to the point of this blog, if you live, work, and/or own a business overseas, you more than likely have a foreign bank account. And if you do, the interest income generated by that account – no matter how small – is also subject to U.S. taxation.

Endnotes:

iii Citizenship and Worldwide Taxation: Citizenship as an Administrable Proxy for Domicile, Edward
Zelinski, Iowa Law Review, 2011, p. 1294.
iv Id.
v Citizenship and Worldwide Taxation: Citizenship as an Administrable Proxy for Domicile, Edward
Zelinski, Iowa Law Review, 2011, p. 1295.
vi Citizenship and Worldwide Taxation: Citizenship as an Administrable Proxy for Domicile, Edward
Zelinski, Iowa Law Review, 2011, p. 1294.
vii Citizenship and Worldwide Taxation: Citizenship as an Administrable Proxy for Domicile, Edward
Zelinski, Iowa Law Review, 2011, p. 1325.
viii Id.
ix Joseph Isenbergh, International Taxation, Second Edition, Foundation Press (2005), p. 12.
x Id.
xi Id.
xii Citizenship and Worldwide Taxation: Citizenship as an Administrable Proxy for Domicile, Edward
Zelinski, Iowa Law Review, 2011, p. 1297-99.
xiii Citizenship and Worldwide Taxation: Citizenship as an Administrable Proxy for Domicile, Edward
Zelinsky, Iowa Law Review, 2011.
xiv Cook v. Tait, 265 U.S. at 56 (“government by its very nature benefits the citizen and his property
wherever found”).
xv T.H. Marshall & Tom Bottomore, Citizenship And Social Class 8 (1992).