Taxation of Worldwide Income
The U.S. is the only country that has taxation of worldwide income for all of its citizens, no matter where they live and regardless of how long they have been overseas. Well, actually the U.S. is almost the only country. Eritrea has what is known as a “diaspora tax” on its citizens.
If you are a U.S. citizen or resident alien, the rules for filing income, estate, and gift tax returns and paying estimated tax are generally the same whether you are in the United States or abroad. With taxation of worldwide income, your U.S. and foreign income is subject to U.S. income tax, regardless of where you reside. It is a citizenship-based income tax.
Elsewhere in the world, the basic rule is that taxes are based on residency and not on taxation of worldwide income based on citizenship.
The origin of taxation of worldwide income is with the first federal U.S. income tax, enacted in 1861 in the early months of the American Civil War as part of the Revenue Act of 1861. It levied a 3% tax on incomes over $800, but a 5% tax on income earned in the U.S. by “any citizen of the United States residing abroad.”
The aim was to prevent wealthy people ducking their military and civic obligations by fleeing the U.S. in its time of crisis. In 1864, the tax was expanded to include income from all sources, no matter where generated. Scholars say this happened as the proud sense of being a citizen of the U.S. – with all its opportunities and obligations – first flowered out of the battlefields.
The defense of citizenship-based taxation and taxation of worldwide income rests on the belief that U.S. citizenship confers benefits independently of residence. It is not necessary that the amount of benefit received be reflected precisely in the amount of tax charged. Income tax liability is measured by the ability to pay, not by the amount of services used during the tax year. But benefit is an important consideration in the scope of an income tax. Many overseas taxpayers feel that taxing the income of nonresident citizens is justifiable only if they derive significant benefit from their U.S. citizenship.
Nevertheless, this model of citizenship-based taxation of worldwide income has remained in the U.S. law ever since, even as the rest of the world has gravitated to a different model, one that simply considers where the taxpayer is living at the moment. Over the years, there has been no serious attempt by lawmakers to end the taxation of citizens who do not reside in the U.S. Instead, the focus of the debate has generally been on the extent to which the earnings of Americans working overseas should be taxed – by both the country of work/residency and the United States.
Tax Residency Taxation Model
The question of whether the U.S. should now switch to the residency model has been generating more debate in recent years, particularly as the U.S. has stepped up tax enforcement on its non-resident citizens. Americans abroad are renouncing their citizenship in greater numbers over the last couple of years, in part because of the increased red tape.
Many say it’s time to fall in line with other countries, especially in an age of increased globalization. But others argue that increased mobility makes a case for maintaining the U.S. model of taxation of worldwide income, not getting rid of it.
For more information and resources on taxes for taxpayers that reside overseas and the taxation of worldwide income, including preparation of your expatriate tax return, please visit Tax Samaritan for additional information or assistance.
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