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Income Sourcing in Multinational Tax Planning and Compliance:

Navigating Residence Issues, Expatriation Rules, Foreign Earned Income

THURSDAY, JULY 7, 2016, 1:00-2:50 pm Eastern

FOR LIVE PROGRAM ONLY

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July 7, 2016

Income Sourcing in Multinational Tax Planning and Compliance

Yoram Keinan

Carter Ledyard & Milburn, New York

Keinan@clm.com

Richard Hartnig

Schwartz International, Atlanta

rhartnig@schwartzintl.com

mailto:Keinan@clm.commailto:rhartnig@schwartzintl.com

Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY

THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY

OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT

MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR

RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons,

without limitation, the tax treatment or tax structure, or both, of any transaction

described in the associated materials we provide to you, including, but not limited to,

any tax opinions, memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are

subject to change. Applicability of the information to specific situations should be

determined through consultation with your tax adviser.

5

INCOME SOURCING RULES

By Richard Hartnig

Schwartz International

July 7, 2016

6

CIRCULAR 230

Circular 230 Disclosure: To assure compliance with Treasury

Department rules governing tax practice, we inform you that

any advice contained herein (including in any attachments) (1)

was not written and is not intended to be used, and cannot be

used, for the purpose of avoiding any federal tax penalty that

may be imposed on the taxpayer, and (2) may not be used in

connection with promoting, marketing or recommending to

another person any transaction or matter addressed herein.

7

WHY IS SOURCING IMPORTANT?

1. If you are non-resident person or corporation you are taxable only on US source income; FDAP, effectively connected income, etc. We will discuss later the rules on residency.

2. There may be a withholding tax on US source income, particularly interest, dividends, etc.

3. Foreign Tax Credit can only be taken on net foreign source income, so income and expenses must be sourced.

4. Some types of US source income of a foreign person are taxed at a gross rate.

5. Determination of some types of Subpart F income can be based on source of income.

8

BASIC RULES ON SOURCING OF INCOME INTEREST

1. Normally where the payor is sourced so interest received from US corporations, individuals or the US government is US source.

2. A branch of foreign bank in the US is US source and a foreign branch of a US bank is foreign source

3. Certain payments by foreign partnership are foreign source if the partnership is

a) Predominately engaged in an active business outside the US, and

b) The interest is not paid out of the proceeds of a US trade or business or is not allocated to income effectively connected with US trade or business Section 861(a)(1)(B)

9

RECIPROCAL OF (3) ABOVE

“A” foreign person

“B” foreign person

“C” foreign or US person

“C” would be taxed on interest. The partnership should withhold if “C” is a foreign person or “C” should report the income if she is a domestic person.

Predominately engaged in US trade or business or to the extent paid out of effectively connected or trade or business income.

Foreign Partnership

10

80/20 RULE HAS BEEN REPEALED BUT SOME TRANSACTIONS GRANDFATHERED

US corporation or partnership with 80% or more foreign source income used to be able to pay interest which was not US source. Repealed in 2010.

Grandfather Rule 1:

Certain interest is exempt from withholding but is nonetheless US source

Grandfather Rule 2:

Loans to unrelated persons prior to August 10, 2010 which have not been materially modified still generate foreign source income

11

BASIC RULES ON SOURCING OF INCOME DIVIDENDS

1. A dividend from a domestic corporation is US source unless a Section 936 (possession tax credit) election is in place.

2. A dividend from a foreign corporation is US source if:

a) 75% more of income of corporation is effectively connected with a US trade or business for 3 years (but with a ratio test)

b) 243(e) – Paid out of earnings and profits accumulated while the corporation was subject to US tax

12

BASIC RULES ON SOURCING OF INCOME PERSONAL SERVICES

1. Generally if services are performed in the US the income is US source and if the services are performed in a foreign country the income is foreign source

2. Exception to US source treatment for limited employment by a non resident

a) Less than 90 days in US

b) Less than or equal to $3,000 in compensation

c) The employer is either not engaged in business within the US or is a US persons’ office in a foreign country

d) Employees of foreign vessel

3. Treaties often override the statutory rules

4. Apportionment is required if services done in US and abroad

13

BASIC RULES ON SOURCING OF INCOME RENTS AND ROYALTIES

1. Where is the property located?

1. If a person rents out US real property it is usually US source.

1. If a person has use of intellectual property in the US it is usually US source.

1. Must distinguish between a license, as sale of IP rights and / or commission

a) A license of IP from a foreign country would usually be US source

b) A sale of IP from a foreign country would usually be foreign source, but a different answer if contingent payments

c) A commission payable to a US agent may be a deduction against foreign source income

14

SPACE AND OCEAN ACTIVITIES

1. By statute all is US source if derived by a US person.

1. Under regulations, it is foreign source to the extent the income is taxed by foreign country.

1. A sale of space or ocean goods is sourced under 1.861-7(c), so a sale is US source if based on contingent payments from a US person.

1. If derived by a CFC, there is high standard to show that activities of the CFC produced the income. Otherwise it is US source.

15

COMMUNICATION ACTIVITIES

1. If by a US person or CFC

50% US source

50% foreign source

2. If by a a foreign person, normally foreign source unless the foreign person has income attributable to a fixed place of business in the US.

2. Where the satellite is located is irrelevant.

16

TRANSPORTATION ACTIVITIES

1. US to US is US Source

2. US to foreign or foreign to US is 50/50

1. Atlanta to Maine to Canada, 50/50 only applies to the last leg. The first leg is US source.

2. 4% tax on foreign persons of gross US source transportation income

17

INSURANCE ACTIVITIES

1. Generally source of insured risk.

2. Source of risk may determine if CFC insurance income is Sub F.

3. Foreign persons insurance or reinsurance of US risk is subject to an excise tax on gross income

a) Casualty, indemnity others 4%

b) Life, sickness, accident and annuity 1%

c) Reinsurance 1%

18

INCOME FROM CFCs

1. Subpart F income is normally foreign source. If more than 10% of the subpart F is from US sources you must apportion between US source and foreign source.

1. Dividends are sourced based on underlying source of income.

19

WHAT IF GOODS ARE MANUFACTURED IN US AND SOLD ABROAD?

1. If title passes overseas can apportion Treas. Reg. §1.863-(b).

1. If title passes in US all US source as the sale income is sourced under normal rules.

2. If qualified for apportionment you can elect 50/50 method or use specific allocation .

3. What constitutes title passage?

1. Can sell to a related party but subject to transfer pricing rules.

20

FINANCING AND GUARANTEE FEES

1. Financing fees like interest and sourced by location of borrower.

2. Guarantee fees

a) I always believed that loan guarantee fees were like interest. Lets say that a Brazilian parent guarantees a debt of a related US person. The US person could therefore borrow at 5% instead of 8%. Logically the fee should be taxed in the same manner as if foreign parent borrowed at 5% and lent at 8%. A case, Container Corporation of America, however, said the guarantee was a service done in the foreign country, so the income was foreign source.

a) Section 861(a)(9) was passed very quickly. Says that loan guarantees paid by a US person are always US source.

21

GUARANTEE FEES CONTINUED

c) This is a big problem for foreign guarantors in treaty countries.

d) If the fees were treated like interest, the treaties should have reduced the withholding rates. If Container Corporation had prevailed, the fee would have normally been foreign source as the service is provided by the foreign affiliate overseas, so no withholding.

e) Note 861(a)(9) says it is US source, but does not treat it as interest so treaty benefit depends on how the treaty taxes “other income”.

f) What if affiliate had a trade or business of providing loans or guarantees?

22

OTHER RULES

1. Disposition of US real property interest is US source.

2. Sale of imported inventory in US depends where title passes.

3. Other personal property is sourced by the residence of the seller.

4. Social Security benefit is US source

5. Guarantee amounts paid by US persons or guarantees paid by foreign persons in conjunction with effectively connected US business are US source

6. Lease of railroad rolling stock in US is US source

7. Depreciation recapture sourced to where the depreciation was taken

23

TREATY OVERRIDES

1. Sometimes what is otherwise US source income can be converted to foreign source income if taxed by a treaty partner.

2. Separate basket for foreign tax credit purposes

24

CITIZENSHIP AND RESIDENCY FOR US TAX PURPOSES

By Richard Hartnig

Schwartz International

July 7, 2016

25

CIRCULAR 230

Circular 230 Disclosure: To assure compliance with Treasury

Department rules governing tax practice, we inform you that

any advice contained herein (including in any attachments) (1)

was not written and is not intended to be used, and cannot be

used, for the purpose of avoiding any federal tax penalty that

may be imposed on the taxpayer, and (2) may not be used in

connection with promoting, marketing or recommending to

another person any transaction or matter addressed herein.

26

CITIZEN VERSUS RESIDENT

1. All US citizens are subject to US tax regardless of where they live.

1. A resident or green card holder might not be subject to world wide US tax under a treaty tiebreaker.

2. US citizens have more estate and gift tax exemptions/credits.

1. All citizens are bound by rules on expatriation, only long term green card holders are so bound.

27

CITIZEN VERSUS RESIDENT CONTINUED

5. There are full social security benefits for those citizens living abroad, only half benefits for residents. This, however, is often cured by bilateral agreement.

5. Different types of treaty provisions apply to citizens. Typically mere residents are more likely to get a treaty benefit if there is a conflict with the treaty jurisdiction.

28

TAXATION OF RESIDENTS VERSUS NON RESIDENTS

1. Residents and citizens are subject to tax on world wide income.

1. Non-residents are subject to tax on US source income only.

2. Citizens are always subject to the estate / gift tax.

1. Residents only are subject to the estate tax world wide assets if domiciled in the US. Thus, estate tax “residency” is different than income tax residency. If a non estate tax resident, estate tax only applies to US assets.

29

TAX RESIDENCE AS A RESULT OF PRESENCE IN THE US

1. Substantial Presence Test

a) You must be in the US > 31 days in the year.

b) You must have been in the US at least 183 days over the last 3 years.

Computed as follows:

i. all the days in the current year

ii. 1/3 of the days in the prior year

iii. 1/6 of the days two years before the current year

2. To be safe someone should normally try not to be in the US for more than 120 days.

2. Vacation days count.

30

SUBSTANTIAL PRESENCE TEST EXAMPLE

1. Someone was in the US

a) 150 days this year

b) Zero days last year

c) 182 days two years before

2. 150

+ 0

+30.33

180.33

3. What if 153 this year?

31

NEED TO LOOK AT EXCEPTIONS TO DAYS

1. Daily commuting from Mexico and Canada.

2. Less than 24 hours in the US traveling between two foreign countries. For example, a person flies from London to Chicago, spends 12 hours there and flies to Mexico City.

3. Crew member of foreign vessel (boats and planes).

4. Cannot leave because of a medical condition which arises while you are in the US.

5. Exempt person test.

32

EXEMPT PERSON TEST SOME DAYS NOT COUNTED

1. If you are a foreign government official in the US, under an A or G visas, other than A-3 or G-5 visa.

1. Teacher or trainee in the US, under a J or Q visa. Must be in visa compliance. Only good for two years.

2. Student under F, J, M or Q 5 visas. Must be in visa compliance. Only good for 5 calendar years. December 30th example.

4. If exempted for certain years as a student, cannot get that number of years as a teacher or trainee if within a six year period.

4. Professional athlete temporarily in the US to compete in a charitable sports event

33

REAL WORLD MEDICAL EXAMPLE

1. Person A lived in Bermuda all his life. Had been in the US for a total of 50 days on May 31st. Had a brain aneurism which was beyond Bermudian hospital ability to treat.

2. Airlifted to US for surgery on June 1st, would have expected to be in US for three months.

3. August 1st had a heart attack.

4. Left November 1st for two weeks for immigration reasons.

5. Came back November 15th until the end of the year for rehabilitation after the heart attack.

6. Computation of days in US

Prior to June 1st, 50 days

June 1st to August 31st, 91 days

34

REAL WORLD MEDICAL EXAMPLE CONTINUED

Issue. Would doctor say he could have gone home on August 1st if not for heart attack. We could not get a doctor to say that. Would only get the doctor to say he could have left at the end of August.

September 1 – October 31, 61 days We did not count as doctor said he could have gone home on August 31st if not for the heart attack.

November 1 – November 15 not in US.

November 15 – December 31, 46 days. We counted these days because he came back while recovering. Note, that if he had not gone home for immigration purposes the days from November 1 to December 31st would probably not have been counted.

35

RELATIVELY NEW TRAP FOR UNWARY

1. Person A comes into the US on June 1st. On June 15th he comes into my office to discuss tax planning.

2. If he stays all year, he becomes a US tax resident in December, but as of June 11th, the day he was first here, (but for a ten day grace period).

3. If he does planning now he may be a US resident as of the 183rd day retroactive to June 11th

1. S election?

2. Unlike green card test which is as of the day one gets their green card.

36

GREEN CARD TEST

1. When you become a lawful permanent resident (“green card”)

2. As of the day you become a lawful permanent resident, unless you elect to be a resident for the full year or if you also meet the substantial presence test. One may want to do this to avoid gross income taxation.

3. If you take nothing else out of this presentation fully advise a client before letting him get a green card and do tax planning prior to the issuance of the card or preferably before he comes to the US.

37

DIFFERENCE IN SUBSTANTIAL PRESENCE AND GREEN CARD TEST

1. Substantial presence year to year computation.

2. Green card is permanent unless you expatriate.

1. No difference in taxation of either type of resident.

38

TREATY TIEBREAKER

1. Substantial presence test or green card test makes you a US tax resident.

2. What if you are also a tax resident of another country? Very common with green card holders, but can also happen with the substantial presence test.

3. If a non treaty country you have to rely on foreign tax credit or earned income exclusion as you are residents of both countries.

4. Treaties usually provide a tiebreaker.

39

TYPICAL TREATY TIEBREAKER

1. Where does the person have a “permanent home”

2. Where are the persons’ vital center of interests

3. Habitual abode – for example, a foreign tax resident with a US green card working in US different hotel every week.

4. Nationality

5. Competent Authority

6. One can be a resident of more than two countries.

40

TAXATION OF NON RESIDENT

1. FDAP – (Fixed Determinable Annual Periodic) dividends, interest royalties, etc. 30% final withholding tax.

2. Example

1. $10,000 in worldwide income (all US source).

2. $3,000 in tax even if you had expenses relating to the production of income

3. Sometimes better to be a US resident.

4. 30% is often reduced by treaty.

5. Special 30% rate on real property if present in US for more than 183 days (no exceptions in days).

6. Election to treat real property as a US trade or business.

41

TAXATION OF NON RESIDENT CONTINUED

7. Income from wages subject to normal tax rates and possibly FICA and FUTA.

8. Sale of shares of US companies are typically not taxable.

9. FIRPTA – if US real property or a company which is a US real property holding company is sold, taxable. No treaty relief.

10. Income effectively connected with a US trade or business is taxable. Sometimes subject to treaty relief.

Expatriation Tax Rules

Yoram Keinan

Presenter

• Yoram Keinan, Partner, Chair of Tax Department, Carter Ledyard & Milburn, LLP.

• Tel: (212) 238-8790

• Email: keinan@clm.com

43

Overview of the Expatriation Rules • Section 301 of the Heroes Earnings Assistance and Relief

Tax Act of 2008 added new sections 877A to the Code with respect to individuals who on or after June 17, 2008, relinquish United States citizenship or cease to be lawful permanent residents of the United States (“Expatriate”).

• Section 877A(a) generally imposes a mark-to-market tax (the “Expatriation Tax”) on Expatriates who are covered by section 877A (“Covered Expatriates”), which generally means that all property of a covered expatriate is deemed sold for its fair market value on the day before the Expatriation Date.

• Any gain arising from the deemed sale is taken into account for the tax year of the deemed sale notwithstanding any other provisions of the Code.

44

Overview (cont.) • Any loss from the deemed sale is taken into

account for the tax year of the deemed sale to the extent otherwise provided in the Code, except that the wash sale rules of IRC 1091 do not apply.

• The amount of any gain or loss subsequently realized (i.e., pursuant to the disposition of the property) will be adjusted for gain and loss taken into account under the IRC 877A mark-to-market regime, without regard to the exclusion amount. A taxpayer may elect to defer payment of tax attributable to property deemed sold.

45

Exemption Amount

• Under section 877A(a)(3), the amount that would otherwise be includible in gross income by reason of the deemed sale rule is reduced (but not to below zero) by $693,000 (adjusted for inflation).

• In other words, the first $693,000 of Expatriation Tax is not taxable; only the excess is taxable.

• Pursuant to section 877A(b), a taxpayer may elect to defer payment of tax attributable to property deemed sold.

46

Definitions

“Expatriate”

• Section 877A(g)(2) provides that the term “Expatriate” means: (1) any United States citizen who relinquishes his or her citizenship, and (2) any long-term resident of the United States who ceases to be a lawful permanent resident of the United States (within the meaning of section 7701(b)(6), as amended).

48

“Covered Expatriate” • The determination as to whether an individual is a Covered

Expatriate is made as of the Expatriation Date. • Section 877A(g)(1)(A) defines the term “Covered Expatriate” to

mean an Expatriate who: (1) has an average annual net income tax liability for the five preceding taxable years ending before the Expatriation Date that exceeds a specified amount that is adjusted for inflation ($161,000 in 2016, the “Tax Liability Test”); (2) has a net worth of $2 million or more as of the Expatriation Date (the “Net Worth Test”); or (3) fails to certify, under penalties of perjury, compliance with all United States federal tax obligations for the five taxable years preceding the taxable year that includes the Expatriation Date, including, but not limited to, obligations to file income tax, employment tax, gift tax, and information returns, if applicable, and obligations to pay all relevant tax liabilities, interest, and penalties (the “Certification Test”).

49

“Expatriation Date”

• Section 877A(g)(3) defines the term “Expatriation Date” as the date an individual relinquishes his or her United States citizenship or, in the case of a long-term resident of the United States, the date on which the individual ceases to be a lawful permanent resident of the United States within the meaning of section 7701(b)(6).

50

“Relinquishment of Citizenship” • Section 877A(g)(4) provides that a citizen will be treated as relinquishing

his or her United States citizenship on the earliest of four possible dates: – (a) the date the individual renounces his or her United States nationality

before a diplomatic or consular officer of the United States pursuant to paragraph (5) of section 349(a) of the Immigration and Nationality Act (8 U.S.C. 1481(a)(5)), provided the renunciation is subsequently approved by the issuance to the individual of a certificate of loss of nationality by the United States Department of State;

– (b) the date the individual furnishes to the United States Department of State a signed statement of voluntary relinquishment of U.S. nationality confirming the performance of an act of expatriation specified in paragraph (1), (2), (3), or (4) of section 349(a) of the Immigration and Nationality Act (8 U.S.C. 1481(a)(1)-(4)), provided the voluntary relinquishment is subsequently approved by the issuance to the individual of a certificate of loss of nationality by the United States Department of State;

– (c) the date the United States Department of State issues to the individual a certificate of loss of nationality; or

– (d) the date a court of the United States cancels a naturalized citizen’s certificate of naturalization.

51

Expatriation of Long Term Residents • For long-term residents, as defined in IRC 7701(b)(6), a

long-term resident ceases to be a lawful permanent resident if: – the individual’s status of having been lawfully accorded the

privilege of residing permanently in the United States as an immigrant in accordance with immigration laws has been revoked or has been administratively or judicially determined to have been abandoned, or

– the individual: • commences to be treated as a resident of a foreign country under

the provisions of a tax treaty between the United States and the foreign country,

• does not waive the benefits of the treaty applicable to residents of the foreign country, and

• notifies the IRS of such treatment on Forms 8833 and 8854.

52

The Dual Citizen Exception • Section 877A(g)(1)(B) provides that an Expatriate will

not be treated as meeting the Tax Liability Test or the Net Worth Test of section 877(a)(2)(A) or (B), and thus will not be treated as a Covered Expatriate, if: – (i) the Expatriate became at birth a United States citizen

and a citizen of another country and, as of the Expatriation Date, continues to be a citizen of, and is taxed as a resident of, such other country, and has been a United States resident for not more than 10 taxable years during the 15 taxable year period ending with the taxable year during which the Expatriation Date occurs; or

– (ii) the Expatriate relinquishes United States citizenship before the age of 18.5 and has been a United States resident for not more than 10 taxable years before the date of relinquishment.

53

IRS Form 8854

• Whether or not a taxpayer who intends to Expatriate is a Covered Expatriate, s/he must file an IRS Form 8854.

• Failure to file the IRS Form 8854 or to sign the return under penalties of perjury will cause an Expatriate who does not satisfy either the Net Worth Test or the Tax Liability Test to be treated as a Covered Expatriate and thus become subject to the Expatriation Tax.

• Failure to file the IRS Form 8854 not only subjects the Expatriate to a $10,000 penalty, it also subjects the person expatriating to the same Expatriation Tax as a Covered Expatriate.

54

IRS Form 8854 (cont.)

• All United States citizens who relinquish their United States citizenship and all long-term residents who cease to be lawful permanent residents of the United States must file an IRS Form 8854 in order to certify, under penalties of perjury, that they have been in compliance with all United States federal tax laws during the five years preceding the year of Expatriation.

• Individuals who fail to make such certification on the IRS Form 8854 will be treated as Covered Expatriates within the meaning of section 877A(g) whether or not they also meet either the Tax Liability Test and/or the Net Worth Test.

55

IRS Form 8854 (cont.)

• The Expatriate must file the IRS Form 8854 with the IRS Form 1040NR or Form 1040, whichever is applicable, for the Expatriate’s taxable year that includes the day before the Expatriation Date.

• An Expatriate who is required to file an IRS Form 8854 for such taxable year will be considered to have timely filed the IRS Form 8854 if it is filed by the due date of the original IRS Form 1040NR or Form 1040 (including extensions) for such taxable year.

56

Dual Status Returns

• Expatriates who are United States citizens or long-term residents for only part of the taxable year that includes the day before the Expatriation Date must file a “dual-status return.”

• The Expatriate must file a dual-status return if he was a United States citizen or long-term resident for only part of the taxable year that includes the day before the Expatriation Date. A dual-status return requires the Expatriate to file an IRS Form 1040NR with an IRS Form 1040 attached as a schedule.

57

Dual Status Returns (cont.)

• Example 22 of IRS Notice 2009-85 provides as follows: – A relinquishes his citizenship on December 1, 2009. Under

section 877A(a)(1), A is deemed to have sold all of A’s property on November 30, 2009, the day before the expatriation date. A must certify on a Form 8854 filed with Form 1040NR for the 2009 taxable year that A has complied with all of A’s federal tax obligations for 2004 through 2008. For the portion of the taxable year that includes the day before the expatriation date, A must attach a Form 1040 (or other schedule, as provided in Treas. Reg. § 1.6012-1(b)(2)(ii)(b)) to his Form 1040NR. If A does not file Form 8854, A will be treated as a covered expatriate even if A does not meet the tax liability test or the net worth test.

58

Dual Status Returns (cont.) • As the dual citizen return requires, a person who has been a US

citizen for part year, and stopped being a US citizen during such a year (because of his Expatriation) and who resides in another country (meaning s/he is no longer a US resident under any of the citizenship test, greencard test or physical presence test) at the end of the year would file an IRS Form 1040NR for the year of Expatriation, which is the return required from people that are not US residents under any of the tests described above.

• However, because the Expatriate was a US citizen during the year (up to the date of Expatriation), s/he must also file an IRS Form 1040 (that applies to all US citizens wherever they reside).

• The IRS Form 1040 is only submitted as an attachment to the IRS Form 1040NR (which will be the lead return). The IRS Form 1040 will only include items relevant for the period in which the Expatriate was a US citizen.

59

Foreign Earned Income Exclusion and Foreign Housing Exclusion

Yoram Keinan

Presenter

• Yoram Keinan, Partner, Chair of Tax Department, Carter Ledyard & Milburn, LLP.

• Tel: (212) 238-8790

• Email: keinan@clm.com

61

Overview • To claim the foreign earned income exclusion, the foreign housing

exclusion, or the foreign housing deduction (i) TP must have foreign earned income, (ii) TP’s tax home must be in a foreign country, and (iii) TP must be one of the following: – A U.S. citizen who is a bona fide resident of a foreign country or

countries for an uninterrupted period that includes an entire tax year; – A U.S. resident alien who is a citizen or national of a country with

which the US has an income tax treaty in effect and who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year; or

– A U.S. citizen or a U.S. resident alien who is physically present in a foreign country for at least 330 full days during any period of 12 consecutive months.

• The amount of foreign earned income (and foreign housing costs) excluded from an individual's gross income will be used for purposes of determining the TP’s rate of income tax and AMT that applies to his or her nonexcluded income.

62

Exceptions • Foreign earned income does not include the following

amounts: – Payment received as a military or civilian employee of the U.S.

government or any of its agencies; – Payment for services conducted in international waters (not a

foreign country); – Payment in specific combat zones that is excludable from

income; – Payments received after the end of the tax year following the

year in which the services that earned the income were performed;

– The value of meals and lodging excluded from income because it was furnished for the convenience of the employer; and

– Pension or annuity payments, including social security benefits.

63

Self-employment income

• An individual may claim the foreign earned income exclusion on foreign earned self-employment income.

• The excluded amount will reduce the individual’s regular income tax, but will not reduce the individual’s self-employment tax.

• Also, the foreign housing deduction – instead of a foreign housing exclusion – may be claimed.

64

Tax Home in Foreign Country

65

Foreign Country

• Any territory under the sovereignty of a government other than that of the United States.

• Does not include U.S. possessions such as Puerto Rico, Guam, the Commonwealth of the Northern Mariana Islands, the U.S. Virgin Islands, or American Samoa.

• Does not include ships and aircraft traveling in or above international waters, nor does it include offshore installations that are located outside the territorial waters of any individual nation.

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Tax Home • The general area of the TP’s main place of business,

employment, or post of duty, regardless of where s/he maintains family home.

• The place where the TP is permanently or indefinitely engaged to work as an employee or self-employed.

• In the absence of a main place of business the tax home may be the place where the TP regularly lives.

• If TP has neither a regular or main place of business nor a place where s/he regularly lives, TP is considered an itinerant and his/her tax home is wherever s/he works.

• Having a "tax home" in a given location does not necessarily mean that the given location is the TP’s residence or domicile for tax purposes.

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Abode • TP is not considered to have a tax home in a foreign country

for any period in which his/her abode is in the US. • However, TP’s abode is not necessarily in the US while s/he

is temporarily in the US. • TP’s abode is also not necessarily in the US merely because

s/he maintains a dwelling in the US, whether or not TP’s spouse or dependents use the dwelling.

• "Abode" has been variously defined as one's home, habitation, residence, domicile, or place of dwelling; it does not mean your principal place of business.

• "Abode" has a domestic rather than a vocational meaning and does not mean the same as "tax home."

• The location of the TP’s abode often will depend on where s/he maintains her/his economic, family, and personal ties.

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Example • TP is employed on an offshore oil rig in the

territorial waters of a foreign country and works a 28-day on/28-day off schedule. TP returns to his/her family residence in the US during off periods.

• TP is considered to have an abode in the US and does not satisfy the tax home test in the foreign country.

• TP cannot claim the exclusions or the housing deduction.

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Bona Fide Residence Test

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Overview • TP meets the bona fide residence test if s/he is a resident

of a foreign country for an uninterrupted period that includes an entire tax year.

• TP can use the bona fide residence test to qualify for the foreign earned income and foreign housing exclusions and the foreign housing deduction only if s/he is either: – A U.S. citizen; or – A U.S. resident alien who is a citizen or national of a country

with which the US has a tax treaty in effect.

• TP does not automatically acquire bona fide resident status merely by living in a foreign country for 1 year.

• The bona fide residence is not necessarily the same as domicile, which is the permanent home, the place to which TP always returns or intends to return.

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Statement to Foreign Authorities

• TP is not a bona fide resident of a foreign country if s/he makes a statement to the authorities of that country that s/he is not a resident of that country and the authorities hold that s/he is not subject to their income tax laws as a resident.

• If TP has made such a statement and the authorities have not made a final decision on TP’s status, TP is not considered to be a bona fide resident of that foreign country.

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Special Agreements and Treaties

• An income tax exemption provided in a treaty or other international agreement will not in itself prevent TP from being a bona fide resident of a foreign country.

• Whether a treaty prevents TP from becoming a bona fide resident of a foreign country is determined under all provisions of the treaty, including specific provisions relating to residence or privileges and immunities.

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Uninterrupted Period that Includes Entire Tax Year

• To qualify for bona fide residence, TP must reside in a foreign country for an uninterrupted period that includes an entire tax year (from 1/1 through 12/31 for taxpayers who file their income tax returns on a calendar year basis).

• TP can leave the country for brief or temporary trips back to the US or elsewhere for vacation or business.

• TP must have a clear intention of returning from such trips, without unreasonable delay, to the foreign residence or to a new bona fide residence in another foreign country.

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Example • TP is the Lisbon representative of a U.S. employer. • S/he arrived with his/her family in Lisbon on 11/1/12. • The assignment is indefinite, and s/he intends to live there

with the family until the company sends her/him to a new post.

• TP immediately establishes residence there. • On 4/1/13, TP arrives in the US to meet with the employer,

leaving the family in Lisbon. • TP returns to Lisbon on 5/ 1, and continue living there. • On 1/1/14, TP completes an uninterrupted period of

residence for a full tax year (2013), and may qualify as a bona fide resident of a foreign country.

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Bona Fide Residence Status Not Automatic

• TP does not automatically acquire bona fide resident status merely by living in a foreign country for 1 year.

• For example, if TP goes to a foreign country to work on a particular construction job for a specified period of time, s/he ordinarily will not be regarded as a bona fide resident of that country even though s/he works there for one tax year or longer.

• The length of your stay and the nature of the job are only two of the factors to be considered in determining whether you meet the bona fide residence test.

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Physical Presence Test

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330 Full Days • Applies to both U.S. citizens and U.S. resident aliens. • TP meets the physical presence test if s/he is physically

present in a foreign country 330 full days during a period of 12 consecutive months (the 330 days do not have to be consecutive).

• TP can count days spent abroad for any reason (employment, vacation, personal or business).

• The test is based only on how long TP stays in a foreign country and does not depend on the kind of residence TP establishes, intentions about returning to the US, or the nature and purpose of the stay abroad (intentions with regard to the nature and purpose of the stay abroad are relevant in determining the “tax home” test, see above).

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The 12-month Period • The 12-month period can begin with any day of the month;

it ends the day before the same calendar day, 12 months later.

• The 12-month period must be made up of consecutive months.

• Any 12-month period can be used if the 330 days in a foreign country fall within that period.

• TP does not have to begin the 12-month period with the first full day in a foreign country or to end it with the day s/he leaves; s/he can choose the 12-month period that gives her/his the greatest exclusion.

• In determining whether the 12-month period falls within a longer stay in the foreign country, 12-month periods can overlap one another.

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Example

• TP is a construction worker who works from time to time in a foreign country over a 20-month period.

• TP might pick up the 330 full days in a 12-month period only during the middle months of the time s/he works in the foreign country because the first few and last few months of the 20-month period are broken up by long visits to the US.

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Computing the Foreign Earned Income Exclusion

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TP Must file Tax Return

• A common misconception about the foreign earned income exclusion is that it is exempt income not reportable on a U.S. tax return.

• In fact, only a qualifying individual with qualifying income may elect to exclude foreign earned income, and the qualifying exclusion applies only if the qualifying individual files a tax return and reports the income.

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Limits on Excludable Amount

• The exclusion amount is adjusted annually for inflation.

• For tax year 2016, the maximum foreign earned income exclusion is up to $101,300 per qualifying person.

• If the individuals are married and both work abroad and meet either the bona fide residence test or the physical presence test, each spouse can elect the foreign earned income exclusion.

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Amounts Paid in Year Following Work

• TP is considered to have earned income in the year in which s/he does the work for which s/he receives the income, even if s/he works in one year but is not paid until the following year.

• If TP reports the income on a cash basis, s/he reports the income on the return for the year s/he receives it.

• If TP works one year, but is not paid for that work until the next year, the amount s/he can exclude in the year s/he is paid is the amount s/he could have excluded in the year s/he did the work if s/he had been paid in that year.

• TP cannot exclude income received after the end of the year following the year s/he does the work to earn it.

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Amounts Earned Over More than 1 Year

• Regardless of when TP actually receives income, s/he must apply it to the year in which s/he earned it in figuring the excludable amount for that year.

• For example, a bonus may be based on work done over several years.

• TP determines the amount of the bonus that is considered earned in a particular year in two steps: – Divide the bonus by the number of calendar months in the

period when TP did the work that resulted in the bonus; – Multiply the result of (1) by the number of months TP did

the work during the year - This is the amount that is subject to the exclusion limit for that tax year.

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Example • TP was a bona fide resident of Brazil for 2011 and 2012. • TP report s income on the cash basis. • In 2011, TP was paid $79,800 for work done in Brazil during

that year. • TP excluded all of the $79,800 from income in 2011. • In 2012, TP received $18,800 for work done in 2011. • TP can exclude $13,100 of the $18,800 from income in 2012

($92,900 maximum foreign earned income exclusion in 2011 minus the $79,800 actually excluded in that year)

• TP must include the remaining $5,700 in income in 2012 ($18,800 - $13,100) because s/he could not have excluded that income in 2011 if s/he had received it that year.

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Part Year Exclusion • IF TP qualifies under either the bona fide residence test or the

physical presence test for only part of the year, s/he must adjust the maximum limit based on the number of qualifying days in the year.

• The number of qualifying days is the number of days in the year within the period on which TP both: – Have tax home in a foreign country, and – Meet either the bona fide residence test or the physical presence test.

• For this purpose, TP can count as qualifying days all days within a period of 12 consecutive months once s/he is physically present and have the tax home in a foreign country for 330 full days.

• To figure the maximum exclusion, multiply the maximum excludable amount for the year by the number of qualifying days in the year, and then divide the result by the number of days in the year.

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Electing the Foreign Earned Income Exclusion

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Overview • TP can elect the foreign earned income exclusion and

the foreign housing exclusion by completing IRS Form 2555.

• Foreign Earned Income Exclusion generally must be made with: – a timely filed return (including any extensions), – a return amending a timely filed return, or – a late-filed return filed within 1 year from the original due

date of the return (determined without regard to any extensions).

• TP can elect the exclusion on a return filed after the periods described above, provided s/he owes no federal income tax after taking the exclusion into account.

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Foreign Tax Credit • Once the TP elects to exclude either foreign

earned income or foreign housing costs, s/he cannot take a foreign tax credit for taxes on income excluded.

• If TP does take the foreign tax credit, one or both of the elections may be considered revoked.

• However, TP can elect to take the foreign tax credit on any amount of foreign income which has not been excluded under the foreign earned income exclusion or the foreign housing exclusion.

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Revocation of the Foreign Earned Income Exclusion

• TP may revoke the election for any tax year, by attaching a statement that s/he is revoking one or more previously made elections to the return or amended return for the first year that that TP does not wish to claim the exclusion(s).

• TP must specify which election(s) s/he is revoking. • TP must revoke separately an election to exclude

foreign earned income and to exclude foreign housing amounts.

• If TP revoked an election and within 5 tax years again wishes to elect the same exclusion, s/he must apply for IRS approval by requesting a ruling from the IRS.

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Foreign Earned Income Exclusion - Which Form to File

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Form 2555 and Form 2555-EZ • Form 2555, Foreign Earned Income, can be used

to claim the foreign earned income exclusion and the foreign housing exclusion or deduction.

• In some cases, TP can use Form 2555-EZ instead. • TP must attach Form 2555 to the Form 1040 or

1040X. • Form 2555 shows how TP qualifies for the bona

fide residence test or physical presence test, how much of the foreign earned income is excluded, and how to figure the amount of allowable foreign housing exclusion or deduction.

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IRS Form 2555-EZ • TP can use this form if all of the following apply:

– TP is a U.S. citizen or a resident alien; – Total foreign earned income for the year is not more than

the maximum foreign earned income exclusion for the corresponding tax year;

– TP has earned wages/salaries in a foreign country; – TP is filing a calendar year return that covers a 12-month

period; – TP did not have any self-employment income for the year; – TP did not have any business or moving expenses for the

year; and – TP is not claiming the foreign housing exclusion or

deduction.

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IRS Form 673 - Reduce Withholding

• A foreign employer is not required to withhold U.S. income tax from the portion of wages earned abroad that is equal to the foreign earned income exclusion and foreign housing exclusion if the employer has good reason to believe that TP will qualify for these exclusions.

• TP can provide a statement to the employer indicating that s/he will meet either the bona fide residence test or the physical presence test and indicating the estimated housing cost exclusion.

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Foreign Housing Exclusion or Deduction

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Overview • TP can also claim an exclusion or a deduction from

gross income for housing amount if TP’s tax home is in a foreign country and s/he qualifies for the exclusions and deduction under either the bona fide residence test or the physical presence test.

• The housing exclusion applies only to amounts considered paid for with employer-provided amounts, which includes any amounts paid to TP or paid or incurred on TP’s behalf by the employer that are taxable foreign earned income for the year (without regard to the foreign earned income exclusion).

• The housing deduction applies only to amounts paid for with self-employment earnings.

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Computation • Your housing amount is the total of the housing

expenses for the year minus the base housing amount.

• The base housing amount (line 32 of Form 2555) is tied to the maximum foreign earned income exclusion.

• The amount is 16% of the maximum exclusion amount (computed on a daily basis), multiplied by the number of days in the qualifying period that fall within your tax year.

• Housing expenses include reasonable expenses actually paid or incurred for housing in a foreign country for the TP and (if they lived with TP) for spouse and dependents.

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Limitations • Housing expenses do not include expenses that are lavish or

extravagant under the circumstances, the cost of buying property, purchased furniture or accessories, and improvements and other expenses that increase the value or appreciably prolong the life of the property.

• TP cannot include in housing expenses the value of meals or lodging that are excluded from gross income (under the rules for the exclusion of meals and lodging), or that are deductible as moving expenses.

• Also, housing expenses eligible to be considered in calculating the housing cost amount may not exceed a certain limit, which is generally 30% of the maximum foreign earned income exclusion, but it may vary depending upon the location in which TP incurs housing expenses.

• The limit on housing expenses is computed using the worksheet on page 3 of the Instructions for Form 2555.

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Limitations (cont.) • Additionally, foreign housing expenses may not exceed

the total foreign earned income for the taxable year.

• The foreign housing deduction cannot be more than the foreign earned income less the total of (1) foreign earned income exclusion, plus (2) the housing exclusion.

• Although the foreign housing exclusion and/or the deduction will reduce the regular income tax, they cannot reduce self-employment tax.

• Housing expenses may not exceed a certain limit, which varies depending upon the location in which TP incurs housing expenses.

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