Broad-ranging changes

By John Lowden & Kathy Fu
Illustration: Mike Constable

How the American Jobs Creation act affects tax planning and compliance requirements for those on expatriate assignment

In response to the World Trade Organization’s declaration that the US extraterritorial income exclusion regime constituted a prohibited export subsidy under the relevant trade agreements, US Congress approved the American Jobs Creation Act of 2004 and President George W. Bush signed it into law on October 22, 2004. The act represents the most sweeping revisions to the US since the 1986 Tax Reform Act and amends almost 600 Internal Revenue Code (IRC) sections.

The centrepiece of the act and the primary basis for the broad range of changes to the IRC is the repeal of the tax code’s extraterritorial income exclusion. While the act has a significant impact on many corporate matters, there are also provisions that affect individuals. These changes will require employers to review their global mobility programs along with determining the effect on their expatriate employees. This article discusses issues of a crossborder nature for individuals, including:

• foreign tax credit (FTC) provisions;
• alternative minimum tax (AMT) limit on foreign tax credit provisions;
• penalties for failure to report interests in foreign financial accounts;
• expatriation rules.

While some of the changes are effective immediately, others will take effect in the future. It is imperative to be aware of the new provisions in order that income tax planning opportunities are not missed and the required US compliance is completed correctly in a timely manner.

FTC provisions
The credit for foreign taxes is subject to an FTC limitation, which is essentially the lesser of the foreign taxes paid or accrued, or the US tax otherwise payable on foreign source income. In addition, this limitation applies separately to nine categories or baskets of income, which include, in part, passive income, high withholding tax interest, shipping income and general income. An excess tax credit from one basket in any given taxation year cannot be used to offset a US tax liability in any other basket, therefore potentially restricting an individual’s ability to fully obtain a credit for taxes paid to foreign countries.

The act reduces the foreign income baskets to two from nine baskets for taxation years beginning after December 31, 2006. There will now be a passive income basket and a general income basket. Unutilized FTCs carrying forward from any taxation year beginning before January 1, 2007 will be assigned to one of the two baskets as appropriate.

This provision simplifies the calculation of the FTC limitation for many taxpayers and allows them to pool previously segregated income for the purposes of calculating their FTC limitation.

Due to the above limitations, an excess credit amount that may not be used to offset the current year tax liability may arise. Previously, excess FTC could be carried back two years and forward five years. The new provisions in the act extend the carryforward period to 10 years and reduce the carryback period to one year.

The carryforward provisions apply to excess foreign taxes arising in years beginning October 22, 2004 and to excess foreign taxes that may be carried over to any tax years ending after October 22, 2004. For example, excess FTC arising from the 1999 taxation year that would otherwise expire if not used in the 2004 tax year will now expire in 2009.

The carryback provisions will apply to excess FTC arising in tax years beginning after October 22, 2004. Therefore any excess FTC arising in the 2004 taxation year can still be carried back two years. 

The implication of the extended carryforward period is that it allows taxpayers to potentially use FTCs that might have otherwise expired. As a result, it may impact the number of years a tax-equalized employee has to be kept on a firm’s expatriate tax program after the completion of his or her foreign assignment in cases where any benefit of an FTC claim obtained in future has to be repaid to the employer.

AMT limit on foreign tax credit provisions
Taxpayers are subject to an AMT imposed on their alternative minimum taxable income, which is the taxpayer’s taxable income increased by certain regular tax deductions and preferences. Taxpayers may reduce their AMT liability through an AMT foreign tax credit claim, however, the claim was limited to 90% of the AMT. Accordingly, in many cases, a taxpayer could not offset the entire AMT liability through foreign tax credits. The act repeals this limitation for tax years beginning after December 31, 2004.

This provision should significantly ben- efit individuals who are US citizens or green-card holders with little, if any, US source income and who have accumulated excess AMT foreign tax credits because of the 90% limitation. This change coupled with the extended FTC carryover rules, discussed above, should provide near-term tax relief to many individuals. It will also reduce, in many instances, the tax equalization cost to employers for employees who were otherwise subject to the 90% limitation.

Penalty for failure to report interests in foreign financial accounts
The act modifies the penalties for failure to report interests in foreign financial accounts effective October 22, 2004. A US citizen, US resident or persons doing business in the US with a financial interest in or signing authority over any financial accounts in a foreign country must report that relationship to the US Treasury on or before June 30 of the succeeding year on Form TD F 90-22.1 — Report of Foreign Bank and Financial Accounts. This reporting requirement does not apply if the aggregate value of these financial accounts does not exceed US$10,000 at any time during the calendar year.

Previously, a taxpayer who willfully neglected to report holdings or signing authority in foreign financial accounts may have been subject to a penalty equal to the greater of US$25,000 or the value of the holdings to a maximum of US$100,000. The new provision increases the civil pen- alty, in the case of willful neglect, to the greater of US$100,000 or 50% of the transaction or the account value at the time of the violation.

The new law imposes an additional civil penalty of up to US$10,000 on any person who violates the reporting requirement, regardless of willfulness. However, this penalty may be waived if there is a reasonable cause for the failure but only if the income from these financial holdings is properly reported on Schedule B of Form 1040 of the US personal income tax return.

Employers should ensure that employees are aware of reporting requirements and the implications of not complying.

Expatriation rules
US citizens who renounce their citizenship and long-term residents (defined as individuals who have had a green card for eight out of the past 15 years) who surrender their green card with a principle purpose of avoiding US taxes are subject to an alternative tax regime for the 10 years following the expatriation. Under this regime, the individual is subject to US tax on a broad scope of US source income generally at tax rates applicable to US citizens. Whether tax avoidance is a principle purpose for expatriation is a subjective determination, although certain individuals are treated as having such a principle purpose based on the individual’s US federal tax liability for the five preceding tax years or the individual’s net worth on the date of expatriation.

A tax avoidance motive is presumed if the following tax liability or net worth tests were met:

• the individual had an average annual net income tax liability in excess of US$124,000 for the five-year period preceding the date of expatriation; or
• the individual had a net worth of US$622,000 or more on the date of expatriation.

The act introduces significant changes to the expatriation provisions effective to persons who expatriate after June 3, 2004. Changes include:

• Objective standards replace the subjective standards to determine whether the expatriated individuals are subject to the alternative tax regime.
• An expatriated individual will continue to be treated as a US resident until the individual gives notice of an expatriating act or termination of residency to the Secretary of State or the Secretary of Homeland Security, and provides a statement under Section 6039 (G).
• The net worth test (as described) will increase to US$2 million from US$622,000, but it will not be adjusted for inflation. The average tax liability figure of US$124,000 referred to above will be indexed for inflation.
• An individual subject to the alternative tax regime will be required to file a tax re- turn for the 10 years following expatriation regardless of whether any US federal income tax is due. The penalty for noncompliance is US$10,000.
• An expatriated individual subject to the alternative tax regime who is physically present in the US for more than 30 days in any given calendar year during the 10-year period following expatriation will be subject to full US federal taxation in that year.
• Even if the individual is below the threshold of tax liability or net worth tests, he or she must still certify, under penalties of perjury, that they have complied with all of the US federal tax obligations for the preceding five years. In addition, evidence of compliance may be required.
• Gift taxes will apply in some situations.

The ongoing filing obligations can put a significant administrative burden on individuals relinquishing their US citizenship or US residency in the case of expatriates.
From a US federal tax perspective, a nonresident alien individual entering the US should consider obtaining a visa other than a permanent residence visa (green card). If an individual obtains a green card, such individual should avoid becoming a long-term resident by not being taxed as a resident for more than seven years.

This provides the reader with only a brief summary of some significant changes relating to individuals with crossborder tax and compliance issues. Given the complexity of many of the new provisions, even a careful analysis will leave many unanswered questions. Certain issues will remain unresolved until the US Treasury and the Internal Revenue Service provide further guidance through various announcements, notices and regulations.