Another Common Misunderstanding of U.S. Tax Laws (Myth No. #8)

Posted on November 22, 2015

Myth #8:  As a U.S. citizen (USC) there is no need to pay tax on income or gains from assets outside the U.S., as long as the proceeds are not repatriated to a U.S. bank or financial institution.

As a follow-on to the post of Nov. 19, 2015, See WSJ = World/Expats – For an Excellent Overview of U.S. Taxation for U.S. Citizen Individuals in Plain English, I just heard this one this past week from a cross border businessman.  It has a perfect logic to it the same as the idea that a controlled foreign corporation that moves cash to its own U.S. bank account (as opposed to a financial account outside the U.S.), is subject to U.S. income taxation at that moment.

Laypeople often focus on – “where is the money” not “who has *’recognized’ the income” irregardless of where the money or property is physically located.

This international business operator is thoughtful and has been doing cross border business for some 20+ years with a principle part of his business outside the U.S.; although he is a dual national citizen and hence necessarily a U.S. income tax resident.

It’s a fairly common misunderstanding that I have seen multiple times in my career.

The federal tax law does not look to where the property or income is physically located or earned; unlike some countries which have a territorial based taxation system for individuals, e.g., Costa Rica, Hong Kong, Malaysia, Panama, Singapore and Paraguay, among many others which are smaller economies.

Plus, the federal tax law is not changed by the laws of the country where the income was earned.

Instead, the tax law looks to who “recognized”* the income, irrespective of where the property or cash from that income is located.

A common sense example brings home the concept.  Assume you live in Georgia (the one next to Florida not Russia) and sell real estate in Texas and leave the proceeds from the sale in a Texas bank.  Texas may not impose individual income taxation on the sale of the Texas real estate (where the property was physically located), but still the state of Georgia looks to who earned the income.  In this case, the income was earned by a resident of Georgia, so Georgia imposes taxation on the income from the sale, even though the cash proceeds from the sale are left in a Texas bank.

By analogy, this is how the U.S. federal government imposes taxation; with one important break in the analogy.  The U.S. federal government treats USCs as income tax residents, irrespective as to where they reside; whereas George only taxes those who are physically resident in their state on a worldwide basis.

For instance, a U.S. citizen residing in Singapore, who sells real estate in a country outside both the U.S. and even Singapore, e.g., Malaysia where the tax rate on the real estate capital gains is 0%, will have earned that income in Malaysia (the where).  Even if the U.S. citizen keeps his funds in a Malaysian bank or even moves the funds to a Singapore bank the country of residence (still the where), he or she will be subject to U.S. income taxation, since the USC status (the who) creates tax residency irregardless of the physical residency.  See, Supreme Court’s Decision in Cook vs. Tait and Notification Requirement of Section 7701(a)(50) posted June 27, 2014 and The U.S. Civil War is the Origin of U.S. Citizenship Based Taxation on Worldwide Income for Persons Living Outside the U.S. ***Does it still make sense? posted April 1, 2014.

It does not matter that the funds are not moved to a U.S. bank account, just like it did not matter for the Georgian resident that she kept her proceeds from the Texas real estate sale’s transaction in a Texas bank.

• *  The term “recognized” is a technical U.S. federal tax term that determines at that moment in time a U.S. taxpayer has income for federal tax purposes; and hence, generally the requirement to report the income on their tax return.