Differences in taxation based on residency and citizenship
To understand the financial impact expatriation can have, we first have to look at the massive differences in taxation faced by U.S. citizens and non-U.S. citizens.
All U.S. citizens face the same federal tax obligations whether they live in the U.S. or abroad. They all have the same personal income tax on their global earnings, the same inheritance tax on their global assets, and the same reporting requirements.
In contrast to every other country in the world, a U.S. citizen does not leave the U.S. tax system by permanently moving outside the country. For his entire life, a U.S. citizen is legally obligated to pay U.S. taxes on his global income every year regardless of his residence. And at death, his estate is subject to U.S. inheritance tax (the estate tax), regardless of where he lives in his final years.
The situation is signficantly different for non-U.S. citizens living outside the U.S.
Non-U.S. citizens who do not reside in the U.S. face an entirely different U.S. tax system. They pay significantly lower – and often, zero – taxes on investment and interest income derived from the U.S. Earnings and investment income from outside the U.S. are not taxed at all by the U.S. government. They face no U.S. inheritance taxes.
As an example, consider a U.S. citizen and a non-U.S. citizen who live and work in the same non-U.S. country. They both have the same earnings from their job and both have the same investment portfolio, consisting of both U.S. and non-U.S. government bonds and bank deposits.
Both of them will pay taxes to their country of residence. In addition, the U.S. citizen will be fully taxed by the U.S. on all his global earnings and investment income. On the other hand, the non-U.S. citizen will not only pay no taxes to the U.S. on his earnings and foreign investment income, he will also pay nothing to the U.S. on even his U.S-source investment income, thanks to U.S. laws designed to encourage foreign investment.
The chart below summarizes in a very simplified form the basic taxes which apply to 3 groups: a citizen of the U.S. who resides in the U.S., a citizen of the U.S. who legally resides outside the U.S., and a non-U.S. citizen who resides outside the U.S.
|U.S. Citizen residing in the U.S.||U.S. citizen residing outside the U.S.||Non-U.S. citizen residing outside the U.S.|
|Earnings from the U.S.||Fully taxed.||Fully taxed.||Fully taxed.|
|Earnings from outside the U.S.||Fully taxed.||Fully taxed.
Allowed foreign earned income exclusion of $91,500 in 2010 / $92,900 in 2011. Above that amount, income taxed at rates which would have applied had the exclusion not been applied. Also allowed very limited deduction/credit for certain foreign housing costs.
|Not subject to U.S. taxes.|
|Investment income from outside the U.S.||Fully taxed.||Fully taxed. No credits or exclusions due to residency outside the U.S.||Not subject to U.S. taxes.|
|Interest income from the U.S.||Fully taxed as income at individual’s top marginal rate.||Fully taxed as income at individual’s top marginal rate. No credits or exclusions due to residency outside the U.S.||Not taxed if income is from U.S. bank deposits, government bonds, or portfolio interest from domestic U.S. corporations.|
|Short-term and long-term capital gains from U.S. stocks||Fully taxed.||Fully taxed. No credits or exclusions due to residency outside the U.S.||Not taxed. (Long-term capital gains from mutual funds also not taxed).|
|Dividends from U.S. stocks||Taxed at 15% if stock held long enough to qualify. Otherwise, taxed at individual’s marginal rate. Starting in 2013, all dividends will be taxed at individual’s marginal rate regardless of holding period.||Taxed at 15% if stock held long enough to qualify. Otherwise, taxed at individual’s marginal rate. Starting in 2013, all dividends will be taxed at individual’s marginal rate regardless of holding period.||Flat tax of 30%. Bilateral tax treaties with individual’s country of residence often reduce the rate; 15% is a standard rate under these treaties.|
|Estate tax (tax on all assets upon death)||Fully taxed. (Until the end of 2012, the rate is 35% of any amount above $5 million for an individual / $10 million for a couple).||Fully taxed. (Until the end of 2012, the rate is 35% of any amount above $5 million for an individual / $10 million for a couple). [Note that while transfers to a U.S.-citizen surviving spouse are tax-free, transfers to a non-U.S. citizen spouse are subject to estate tax].||Not subject to U.S. taxes.|
An individual who renounces citizenship will immediately move from the “citizen” column to the “non-citizen” column. But in renouncing, he could possibly face the expatriate exit tax created in 2008. Please click on the link below to explore this tax in detail.