One of the provisions inserted by the Conference Committee into the Tax Increase Prevention and Reconciliation Act of 2005, signed by President Bush on May 17, 2006, was a tax increase on citizens working abroad. The provision was not in either the House or Senate versions of the legislation, although Congress has considered a number of proposals related to the taxation of citizens working abroad over the years, including some Senate bills in the current Congress.It is estimated that over 4 million citizens work abroad. The U.S. Census does not count them, so we have no accurate numbers. The Treasury does try to tax them, but with questionable effectiveness. For the 1999 tax year, out of 127,667,890 returns filed, 1,350,890 had foreign addresses, but this included the APO and FPO addresses of members of the armed forces, as well as some Puerto Rico residents with offshore income. A 2004 Internal Revenue Service study reported that in 2001, fewer than 300,000 tax returns reported foreign-source-earned income.
U.S. citizens working abroad are generally taxed on their income in the country where they live and earn their money, and also by the U.S. The U.S. is the only major industrial country that does not fully exempt from taxation the foreign-earned income of its citizens who are working abroad.
The U.S. does provide a foreign tax credit that basically results in U.S. citizens working abroad paying the higher of either the U.S. tax or the tax of their country of residence. The exclusions provided for in Code Sec. 911 try to ameliorate the fact that U.S. citizens working abroad are obligated to pay the higher tax, while other foreign workers in the same country generally are subject only to the tax of the country of residence.
Code Sec. 911 changes
TIPRA made four changes to the exclusions under Code Sec. 911. First, the foreign-earned income exclusion of $80,000, which was scheduled to be adjusted for inflation starting in calendar years after 2007, will now be adjusted for calendar years after 2005. The 2006 exclusion is therefore expected to be $82,400. This change is obviously favorable to taxpayers.
The next two of the four TIPRA changes involve the employer-provided housing exclusion. Under prior law, the base housing amount, above which reasonable housing costs qualify for the exclusion, was calculated based on 16 percent of the annual salary of a grade GS-14 government employee, the Step 1 amount. This would have resulted in a base housing amount of $12,447 for all of 2006.
Under TIPRA, the base housing amount is calculated based on 16 percent of the foreign-earned income exclusion limitation computed on a daily basis, multiplied by the number of days of foreign residence in that year. For 2006, this amount would be $13,184 for the full year. Since the base amount would be larger under the TIPRA change, the exclusion would be smaller.
In a related change, while reasonable foreign housing expenses paid by an employer in excess of the new base housing amount can still be excluded from a qualified individual's gross income, the overall amount of the exclusion is now also limited to an overall 30 percent of the taxpayer's foreign-earned income exclusion. Under prior law, the only limit on the exclusion was a reasonableness test.
This change effectively ties the housing exclusion and the earned income exclusion into one overall limit, while in the past there had been two separate calculations. As a result, the maximum housing exclusion for 2006 comes to $11,536 (30 percent of the maximum earned income exclusion of $82,400, less $13,184).
For many employees, attractive housing abroad (often better than the housing that they had in the U.S.) was one of the benefits of an overseas assignment. This change may impact the attractiveness of those arrangements, and may also increase the costs to U.S. businesses that have to offer more compensation to get employees to work abroad, or renegotiate existing compensation arrangements where the company has agreed to compensate the employee for adverse tax changes.
The new law does authorize regulations to adjust the 30 percent limit to reflect regional differences in housing costs. However, until those regulations are adopted, U.S. taxpayers working in countries with expensive housing markets could see a significant reduction in the employer-provided housing exclusion to which they are entitled.
The fourth and final TIPRA change may be the most expensive of all.
Normally, to calculate a tax due involving an exclusion, the exclusion is subtracted and the taxpayer pays a tax on the remaining taxable income as if the excluded income had never been earned. TIPRA, however, requires taxpayers to determine the marginal tax rate that applies to the non-excluded income by taking into account the excluded income as well.
For example, if a taxpayer had $150,000 of earned income and $110,000 qualified for the foreign-earned income and/or employer-provided housing exclusion, instead of the remaining $40,000 being taxed at a maximum marginal rate of 15 percent for a joint filer, that $40,000 would be taxed at a 25 percent marginal rate.
Congress has been pulled in two different directions on the Code Sec. 911 exclusions. One school of thought would remove any limits on the exclusions, effectively dropping U.S. efforts to tax foreign-earned income in order to make us more competitive with our trading partners. The other school of thought would eliminate the Code Sec. 911 exclusions, relying on the foreign tax credit alone to compensate for any perceived double-taxation of U.S. citizens working abroad.
In 1978, Congress did pass a repeal of the exclusion, only to have it reinstated and increased in 1981. A further effort at repeal was mounted in the Senate in 2003, and an industry coalition was formed to successfully fight the effort. There is evidence that the 1978 repeal did result in a decline in the number of citizens working abroad. There have also been assertions that there is a direct correlation between the number of U.S. citizens working abroad and the volume of U.S. exports.
It is not clear if the 2003 industry coalition would have been as concerned over the TIPRA changes, since they were far short of repeal, or whether their counterpart today simply did not voice concern because they were caught by surprise by the sudden emergence of the changes in the Conference Committee without first appearing in either the House or Senate bills under consideration.
The TIPRA changes to Code Sec. 911 are projected to raise $2.126 billion for the Treasury over 10 years. They are currently effective for tax years beginning after Dec. 31, 2005.
While the impact is certainly less significant than total repeal, tax practitioners who work with U.S. taxpayers residing overseas will want to alert their clients to the changes and the potential adverse impact on 2006 taxes. Practitioners serving U.S. businesses with overseas employees will be equally concerned to alert their clients to the adverse tax impact on their employees, and the potential for increased obligations under employee contracts or the potential need to revise those contracts due to the tax law changes.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH, a Wolters Kluwer business.
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