US Income Tax For Expats

US Income Tax For Expats Anafin Consulting Guide to US Income Taxes for US Expats Shilpa Khire Email: anafin.consulting@gmail.com Phone: +1 408 242 3553 Updated: January, 2017

This document has been compiled to serve as a guide for US citizens who are residing in a foreign country. Although it is a fairly detailed guide, the readers should be aware that this is only an overview of the tax laws. This should only be used as a guideline for reference and should not be construed as a substitute for professional advice. Your personal situation may be unique and the laws applicable in your situation may also be different. The US has Double Taxation Avoidance Agreements (DTAAs) with several countries and these agreements may also impact the taxability. It is always better to seek professional assistance before applying the tax laws. There is no professional advisor - client relationship established merely by reading this document. 2

Contents 1. Introduction... 4 2. Executive Summary... 5 3. Should I file US Income Tax Return?... 6 4. Working outside US? Avail Foreign Earned Income Exclusion... 8 5. Interest, Dividend and other passive income: Avail Foreign Tax Credit...11 6. Summary: Case Study...15 3

1. Introduction This document is intended to be a comprehensive reference guide for US Permanent Residents and US Citizens who are presently not living in the United States. Often residents from India or other countries immigrate to United States for higher education or work. After living for a few years acquiring either permanent residence (Green Card) or US Citizenship many decide to relocate back to their countries of origin. All of us have questions like: Should I continue to file US Income taxes I m not earning any income in the US anymore? Will I have to pay taxes in US for my stocks that I have sold in India? Should I declare my Indian salary in my US tax returns?.. These questions have no definitive guidance. In the process many delay complying with the law, not knowing what the right thing to do is and what the consequences for non-compliance are. If this resonates with you, this document is for you. After reading this document you will know: Should you be filing US income tax return What income should you be declaring in your tax return Tax planning advise and how to avoid double taxation Consequences of non-compliance and how to avoid them 4

2. Executive Summary Here's a quick summary of what you need to do with filing your US Tax returns Should you file US Tax return As a US Citizen or Permanent Resident you MUST file a US Tax Return even if you are now residing in a foreign country. You MUST declare your global income from all sources in your US Tax Return. This includes your salary in the foreign country, interest, capital gains and any other sources of income. You should file your taxes by the 15th June of each year (you can file for extension). Penalties for not filing or not paying taxes can add up quickly. So it is better to file as soon as possible. How can you avoid double taxation Using the Foreign Earned Income Exemption (Form 2555) you can exempt up to $ 101,300 (this exemption is for the year 2016 and the amount increases marginally every year) of your foreign wages or your business income if you qualify as an expat. This ensures that the wages you earned in a foreign country is not taxed again in your US Tax Return. Using the Foreign Tax Credit (Form 1116) you can take tax credit for taxes paid to foreign government on general as well as passive income such as interest, dividend, rental income etc. This avoids double taxation on this income. Other regulatory requirements You need to declare all your foreign accounts (FBAR) if the aggregate value of all such accounts is over $10,000. Starting 2011, you need to declare all foreign financial assets if they are over $400,000 on the last day of the year or $600,000 at any time during the (for individuals filing married filing joint who are residing abroad) using Form 8938. (Please check the reporting thresholds for Form 8938 reporting depending upon your filing and residential status). 5

3. Should I file US Income Tax Return? If you are a US Citizen or a Green Card holder and your global income exceeds over $20,700 (married filing joint) or self employment income over $400 (filing as married filing joint), you will need to file US tax return. These requirements are similar to what would be true if you were a resident. However don t worry filing a tax return is not the same as actually paying extra taxes to the US Government. Due to the Income Tax treaties and other exemptions (which we will look at later) available, almost all your income is likely to be exempt from US Income Taxes. However you will still need to file a return. So don t worry about extra payout, just file the return and you should be ok. Rule 1 If I am a US Citizen/GC Holder AND My income from all sources is greater than $20,700 THEN I need to file tax return even if I am living and working outside US How do I know if I am an expatriate (US Citizen/GC holder residing abroad) IRS provides for a simple test, if you fit in either of them you are an expat. As an expat you qualify for several tax credits and exclusions. Bona Fide Resident Test This is generally valid for expats who have permanently moved outside of US, perhaps bought a home there and settled down, are on the payrolls of a company where they are staying and pay taxes to the government of the country where they reside. For example, someone moved back to India and took up a job in a company based out of India and pay taxes to Indian government. If you qualify then you are eligible for several credits such as Foreign Earned Income Exclusion which can save significant taxes. Technically ALL these 4 conditions should be met for the Bona Fide Resident Test Be a US citizen (or a GC Holder of countries that share a US tax treaty) Have an established residence within a foreign country Reside inside that foreign residence for the entire calendar year Have intentions of staying inside that country indefinitely Note that residing in foreign residence for entire calendar year is important. Also you should have intentions to stay inside the foreign country indefinitely. The intention to stay indefinitely is important and someone who is merely staying for some assignment for one or two years and intends to go back does not qualify. Again note that there is some complex and subjective assessment that the IRS does to determine who is an Expat and when in doubt it s best to consult a professional. For example a US Citizen of Indian origin has relocated to India with family and taken up a job in India and residing here for a year will qualify as an Expat. 6

The Physical Presence Test This is generally designed for expats who are temporarily away from the United States for a period of more than 330 days of any 365 day period. As a rule of thumb, if you are outside the US for more than 11 months in any 12 month period, you qualify. If you qualify you will be eligible for several tax credits and exclusions such as the Foreign Earned Income Exclusion and Foreign Housing Credit. These are explained later. Bottom line is that if you can save a lot of taxes using these credits and if you are travelling for more than 330 days check out if you qualify for this. There is some fine print and if you are not sure if you qualify, consult with us for checking out. This flow chart will help you understand better. If you are a US Expat, good news.. Most of your foreign earned income will be exempted (up to $101,300 in 2015) by availing the Foreign Earned Income Credit 101 7

4. Working outside US? Avail Foreign Earned Income Exclusion As a US Expat living and working in a foreign country you may typically be earning income by way of salary or consulting fees. Typically income earned by actively working in the given year (salary, consulting fees etc..) is categorized as Income from Active Sources. Now let s define what constitutes Foreign Earned income. Earned typically means the income earned from Active sources such as salary (if working) and consulting fees (if self employed). Income from passive sources such as Interest, Capital Gains, Dividend, Rental income DOES NOT qualify as Earned. As a US Expat you MUST declare your global income on your US Tax return which includes the income that you earn by way of salaries/consulting fees in a foreign country. For example.. John is a US Citizen who has permanently located to work in India (US Expat) and is working in Infosys and drawing a salary of Rs 11.19 million (Rs. 111.9 lakh) per year (say about $160,000 USD) Now the first question John has: Question: I am paying taxes to Indian government for the salary that I get there. Should I declare that income in my US tax return? John s friends have advised.. it s not required to declare your Indian salary in your US Tax Return.. Nothing happens How would they (IRS) know.. What you earn in India should be shown on India tax return, what you earn in US on US tax return.. simple The correct answer is: As a US Citizen/GC Holder you are supposed to file your US Income Tax return on your GLOBAL INCOME which INCLUDES the salary you get in India. So you need to include your Indian salary in your US return. The next question that comes to mind.. Question: But I already paid taxes to Indian Government. Now why do I have to pay again to US Government and that too for income earned in India (foreign country) Answer: While everyone will have this concern, don t worry. Here is where Foreign Earned Income Credit comes to your rescue. As a US Expat, you are exempted on paying US taxes on Foreign Earned Income up to $101,300 (for 2016). So using Foreign Earned Income Credit you can straight away get an exemption of up to $101,300 (in 2016) on the earned income outside US. You just need to declare it in your tax return. To avail of the Foreign Earned Income Exemption, you will need to fill Form 2555: Foreign Earned Income 8

You can take professional help from our tax preparation services and use the Foreign Earned Income Credit to your advantage and save taxes. Remember up to $101,300 of your Foreign Earned Income can be exempted from US taxes using this credit. Computing Tax on Foreign Earned Income that is NOT excluded IRS instructs that the tax calculation for the part of the Foreign Earned Income that is NOT excluded should be done using the worksheet below. Mostly this means that you will pay taxes at a higher progressive rate than what you would have paid otherwise. In our example John s Taxable Income (after availing the Foreign Earned Income Exclusion) is 34,900 (Line 43 of Form 1040) As per the IRS Tax Computation Worksheet for Married Filing Jointly John Tax liability on $34,900 would be: 8,725 [As per calculation shown below John s Actual Tax liability using the Foreign Earned Income Tax Worksheet : 8,725 (Computation shown below) Effectively John s tax liability is HIGHER, effectively because the income that is remaining after the Foreign Earned Income Exclusion is taxed at a higher progressive tax rate. Effectively IRS is ensuring that those claiming Foreign Earned Income Exclusion don t get an unfair tax advantage by BOTH claiming the exclusion and getting a lower marginal tax rate on the amount in excess of the exclusion. Now what do you do if your salary income does not get covered fully in the Foreign Earned Income Exclusion? As in our example where John is earning $ 160,000, he can claim a FEIE of 101,300. For the remaining income of $58,700, he can avail the Foreign Tax Credit (FTC). We will be covering the concept of FTC in the next section. But conceptually this is how it works. If you have paid a tax of $ 10,000 on the income of $58,700 in India, you will be able to claim a credit of $10,000 on your US tax return. If your US tax on this income is $12,000, you will have pay the balance $2,000 ($12,000-$10,000) in the US. If the US tax liability is $9,000, you will be able to carry over a credit ($10,000-$9,000) for future years. 9

One main point to be remembered while using Foreign Earned Income Exclusion: You do not necessarily have to first exhaust the FEIE before claiming foreign tax credit. You can directly claim the FTC on your entire salary/ consultancy income. What is the best option will have to be decided on the facts and circumstances of every individual case. Please consult us if you need more clarification. Now you will have the next set of questions. After all, Salary/Bonuses/Consulting are not your only income sources. You have some Fixed Deposits in the bank that earn some Interest. You have some Capital Gains that you don t know if they are taxed. You have a property that you have rented out and earning you some rental income. Also some of you may have got some Stock Options or Restricted Stock Units (RSUs) from the company that you work for and now you are not sure how they will be taxed. Answers to all these questions we will explore in the next chapter. 10

5. Interest, Dividend and other passive income: Avail Foreign Tax Credit As with salary/wages, Interest, Dividend and income from ALL sources has to be declared in your US Income Tax Return. So you WILL need to include the interest earned in India, Capital Gains earned from investing in the Indian Stock Market in your US tax return. This is often a source of confusion. More than 90% of our expat clients are not aware of this and taken by surprise when we mention that you need to include your Indian interest, Capital Gains and other income in your US tax returns. Lets come back to our illustration.. John, who is a US Expat has some bank deposits in US and India. His interest income for 2016 is US Interest = $2,000 India Interest = $3,000 Total Interest that John needs to show on his tax return is $5,000 (add the interest received in India and US). This will add up while reporting the interest component in your Form 1040 Now John has also paid taxes to the foreign country (India) government on the interest that he has earned in India. Let s assume that John has paid tax on Interest income in foreign country (India) of $720. If John pays taxes to US on interest which he has earned/paid taxes in foreign country (India) that will amount to DOUBLE taxation. Why declare and pay taxes in India and then again declare income and pay taxes in US. However the law says that US Citizens should declare their GLOBAL INCOME from all sources in their tax return. So how can John be compliant with the law and yet avoid paying double taxes to US Government. This is where he needs to leverage the Foreign Tax Credit Avoid Double Taxation: Leverage Foreign Tax Credit John can leverage the Foreign Tax Credit to REDUCE his US Tax liability by the amount he has paid in taxes to the Foreign Government. The entire amount (John paid $720 as taxes to Indian government on the $3,000 interest income that he earned in India) of taxes paid to foreign government can be availed as Foreign Tax Credit on your US return. Our expert tax professionals can help you take benefit of the Foreign Tax Credit and reduce your US Tax liability. Here we try to explain in brief how you can reduce the US tax liability by using the Foreign Tax Credit intelligently. Form 1116 is the IRS form that needs to be filled for this purpose. While quite simple to understand, doing the math while filling Form 1116 can be quite tedious and our professional assistance can help you get the maximum benefit. 11

First of all we will need to determine How much of your total US tax liability is because of the interest income in India. The foreign tax credit can only be used to limit the part of your tax liability COMING FROM the interest earned in India. The purpose is to avoid DOUBLE taxation on foreign income and so we need to compute how much of your total tax liability is coming from the foreign interest component. Now let s go back to our Form 1040 which has details of the Total Taxable Income, Foreign Source Taxable Income (we will just consider the Interest part here) and Total US Tax. Form 1040 12

Now part of the Taxable Income of $51,100 is because of the $3,000 Interest that John received in India. As we discussed taxes have already been paid to the foreign government (India) on the amount of Interest earned in India. John paid a total of equivalent of $720 in taxes. Now here is how foreign tax credit helps reduce double taxation. Firstly we need to find How much percentage of John s total taxable income($51,100 : Line 41 in Form 1040) is because of the interest component ($3,000) that was earned in foreign country The math is simple: 3,000/51,100 = 5.8% So if 5.8% of John s Taxable income is because of the interest earned in India, logically I can attribute 6% of the taxes that are payable due to interest earned in India. This comes to 6% of 8,725 = Approx $523. However, the amount will be a little lower since we will also have to allocate the standard deduction ($12,600) proportionately to the taxable income. Now John has already paid taxes of $720 to Indian government. The Foreign Tax Credit is applicable only to the extent that John has already paid the taxes to the foreign government. Doing some other math and filling the Form 1116 : Foreign Income Credit, we have ensured that the tax paid is taken as a Foreign Tax Credit and this has ensured that John DOES NOT pay DOUBLE taxes. This is a simplified visual representation of the computations Foreign Source Taxable Income Total Taxable Income Before Exemptions X Total US Tax = Foreign Sourced US Tax Foreign Tax Credit Lower Of Foreign Sourced US Tax OR Taxes paid to Foreign Government Now let s look at the relevant section of the Form 1116 which has the specific computation. While we have tried to simplify it for easier understanding, there are many more complex computations and special conditions that our tax professionals know of and can help ensure that we get the maximum Foreign Tax Credit possible when preparing your return. 13

Taxation of Dividends and Capital Gains is conceptually very similar to the taxation on foreign earned Interest. You need to include it in your income and then avail of the Foreign Tax Credit to ensure that there is no double taxation. Some of us also have Restricted Stock Units (RSU). Mostly foreign subsidiaries of US Companies follow the practice of allocating RSUs to their employees. While the tax treatment for RSUs is quite complex, you can also avail of the Foreign Tax Credit to reduce your tax burden. Similarly many US Expats buy and sell real estate and Foreign Tax Credit will help reduce your tax burden on the Capital Gains from these transactions. Bottom line is that Foreign Tax Credit is your friend and helps reduce your double taxation burden. 14

6. Summary: Case Study John is a US Citizen working in Infosys (India), getting salary in India and paying taxes to the Indian government on that salary. John came back from US in March 2014. For 2014 his company rented an apartment in Mumbai and paid the expenses for him. and bought a house and took up a job in India. He still has some investments in US, mostly in stocks and fixed deposits and gets some dividend and interest income. He also has investments in India in form of fixed deposits, stocks and a second house which he has rented out. John s wife is also working in India. She has a Greencard but did not apply for US Citizenship. John was not aware that he needs to file his US taxes after he relocated to India and hence did not file taxes for 2014 and 2015. He has now realized that he needs to file the returns. What should he do? Let s look at John s case for 2014: Income Type Expat Status Income Tax Tips US Salary (Jan Feb 2016) Income from US Sources. Will be included in his US Tax return since John will get W2 Indian Salary (March Dec 2016) Bona Fide Residence Test : FAIL John is not a resident in India for an entire tax year Physical Presence: PASS John is outside US from March 2016 Feb 2017 (More than 330 days in a 12 month period) Eligible for Foreign Earned Income Exclusion. Eligible for Foreign Tax Credit to ensure that taxes paid to Indian Govt. are taken as Foreign Tax Credit Max Credit Allowed for 2016 = Days in US in 209(300/366) * 101,300(max credit for year) = 83,032 US Interest Income and Capital Gains for 2016 Indian Interest, dividend and rental income for 2016 Use Form 2555 or Form 1116 Income from US Sources and will be taxed on the US return. Add to Interest income in US Tax Return Will need to be included in US Tax Return as this is part of Global Income. Taxes would have been paid on the Indian income in which case these taxes will be eligible for Foreign Tax Credit. This will avoid double taxation. However items like Dividend are not taxed in India (so no tax credit) and will now be taxed in US (as part of global income) So while there is no double taxation, you may still end up paying more tax. 15

We hope that the information presented in this document has been useful to the readers. In case you have any further queries or would like to understand your situation better, please get in touch with us. We would be more than happy to assist you. Anafin Consulting Email: anafin.consulting@gmail.com Phone: +1 408 242 3553 The information contained in this document represents the current view of Anafin Consulting on the issues discussed as of the date of publication. This White Paper is for informational purposes only. Anafin Consulting MAKES NO WARRANTIES, EXPRESS, IMPLIED, OR STATUTORY, AS TO THE INFORMATION IN THIS DOCUMENT. Complying with all applicable copyright laws is the responsibility of the user. Without limiting the rights under copyright, no part of this document may be reproduced, stored in or introduced into a retrieval system, or transmitted in any form or by any means (electronic, mechanical, photocopying, recording, or otherwise), or for any purpose, without the express written permission of Anafin Consulting. 2011 Anafin Consulting. All rights reserved.. 16