Even if your foreign income is exempt overseas, if you are a U.S. Taxpayer (U.S. Citizen, Legal Permanent Resident or Foreign Person who meets the Substantial Presence Test) one of the main ways people get into trouble is when the person earns income overseas and does not report the income to the United States.Golding & Golding – International Business Tax Lawyers
This foreign income is still subject to U.S. (even if exempt in the foreign country), but there are legitimate reasons why millions of taxpayers are unaware that they must report this income in the United States. Why? Because in several countries different types of income is not taxed the same way that it is taxed in the United States.
The United States is a tough tax boss – it does not let you get away with much of anything when it comes to reclassifying income. Essentially, any income earned is taxed. It is very rare that the IRS has designated a particular type of income and stated that it is not taxed – but the same does not hold true in foreign countries.
Here are some typical examples:
Malaysia – Capital Gains Income
In the United States, there is tax on capital gains. For example if you purchase stock for $40 a share, when you go to sell that stock and you receive $50 per share then you have to pay a “capital gains tax” of $10 per share that was sold in that group of shares.
Depending on how long you held the stock (or other asset) you have to pay either long-term capital gain (Lower Tax Rate) or short-term capital gain (Higher Tax Rate). The same does not hold true in Malaysia. In Malaysia, there is no tax on capital gain income. Therefore, no matter how much profit you earned from the sale of the item, you do not have the pay tax.
This becomes a problem when a person is either a US Citizen, Legal Permanent Resident, or foreign national otherwise subject to US tax. That is because if you earned capital gains income in Malaysia and are required to file US tax return then you are also required to include this capital gains income in your US tax return.
Moreover, since Malaysia does not tax capital gain you would not qualify for a foreign tax credit for this particular item – since it is not been tax previously and therefore there is no tax credit to be had. FEIE does not apply since it is not “earned” income.
Singapore – Investment Income
Singapore is another tax friendly country when it involves earning passive income. In other words, passive income is generally nontaxable in Singapore (unless it involves income earned from property rental).
For example, if you opened up bank accounts in Singapore that generated interest income, this interest income does not have to be taxed in Singapore. As in the prior example, this generous tax scenario does not apply to the United States. United States taxes interest income as regular income. Therefore, when it comes time to complete your US tax return, you will be required to include this income on your tax return.
Usually foreign interest income will be included on your schedule B. When the interest income you earned is only sourced from the United States you generally do not have to file is schedule B until you have more than $1500 worth of interest income and/or domestic dividends; otherwise, you can simply total the amount included on the first page of your 1040.
The same does not hold true for foreign interest. When you have ownership or signatory authority over a foreign account, you are required to identify this on question seven of your schedule B. Thus, by merely having ownership or signatory authority over a foreign bank account you are required to file a schedule B.
In addition, because you have filed the schedule B you are also required to include the interest income you earned from your foreign bank account. Therefore, the interest you earn from the foreign bank account will be included in your income analysis of your tax return.
Moreover, even though Singapore does tax individuals on rental income, if you invest into a Real Estate Investment Trust (REIT) than even though the income you are earning is passive income from real estate, it is tax-free since it is considered a passive income dividend or interest income type of tax (REITs have both interest income and rental income)
In addition, Singapore does not tax most types of dividend income.
Cayman Island – Personal Income Tax
One of our favorite loopholes of days past is the good old Cayman Islands. The Cayman Islands has the best tax rate on personal income tax – 0%. That is correct, the Cayman Islands does not tax residents or nonresidents on income tax. Sounds great, right?
Unfortunately, if you are a US taxpayer US citizen, legal permanent resident, or foreign national otherwise subject to US tax then it does not matter. That is because the United States taxes you on your worldwide income and just because you are working in the Cayman Islands does not mean you get away tax free. You still have to report this foreign income the same way you would have to report for income that was earned in the United States.
There may be some glimmer of hope if you qualify for the foreign earned income exclusion – which can be a difficult nut to crack in its own right. For most people, they will attempt to qualify for the physical presence test, which simply means that a person resided outside of the United States for at least 330 days (including most travel days) of the year. In addition, the 330 days does not have to be a traditional tax year of January 1st through December 31st – rather, it just has to be 330 days of any 365 day consecutive.
India – Non-Resident Income Exemption
Without getting too complicated, there are certain exemptions for Indian citizens who are nonresidents of India but return to India to work. India is a haven for many ex-pats due to the low cost of living and the ability to pay significantly reduced rates for labor. The cost to have five employees in the United States can probably get you 20 to 30 employees in India.
To that end, if you qualify for this loophole in the Indian tax system then you can usually avoid taxation of your profits and income generated while you are residing and working in India.
Of course, this tax avoidance does not apply when completing your US tax return. As with the other sources of income identified above, you must still report your foreign income that was earned as exempt income in India under US tax return. Moreover, simply because you reside in India for work does not mean you are exempted from having to file the US tax return.
Foreign Income and Impact on OVDP/FATCA
Oftentimes, when individuals have earned income overseas in a foreign country they maintain for bank accounts as well. In addition, it is not uncommon for individuals with foreign bank accounts who were earning income overseas to not realize that they are required to report this information and disclose their accounts on their US tax return.
The failure to meet the IRS tax compliance reporting requirements can result in very high penalties against taxpayer. Depending on the facts and circumstances surrounding the failure to disclose income and report the overseas accounts cannot penalty so high that they essentially wipe out the full account balance that you have.
There are ways to combat these archaic penalties, which is to enter one of the voluntary disclosure programs. There are generally four types of programs which are most common, as follows:
OVDP is the Offshore Voluntary Disclosure Program for people who willfully or intentionally failed to disclose foreign accounts. If a person qualifies for this program, they file eight years of FBARs, amend their tax returns for eight years, pay any outstanding income tax and interest – along with a 20% penalty on the taxes due, and pay either a 27.5% or 50% penalty on the maximum account balance going back eight years.
- The person will look at the maximum account balance for the annual aggregate total of all their foreign accounts for each tax year, perform a currency exchange into US dollars, select the highest balance and multiply by either 27.5% or 50% (depending if the money is in a bad bank). While this penalty may seem high, it is better than 100% penalty and criminal prosecution.
IRS Streamlined Domestic Program
The streamlined domestic program is similar and for people who or non-willful. They will amend their tax returns for three years, file past FBARs for six years, pay any outstanding tax and interest (no penalty on the outstanding tax) and pay penalty a 5% on the highest balance based on year-end totals.
- Therefore, instead of looking back eight years and taking the highest balance, the person will look back six years, determine what the balance was on the last day of each year (“year-end balance” for all their foreign accounts – pick the highest balance and multiply it by 5%.
IRS Streamlined Foreign Program
The streamlined foreign program is similar to the domestic program and what needs to be prepared (although the streamlined domestic letter is simplified) except that the applicant does not have to pay any penalty.
- To qualify for the streamlined foreign program, a person generally has to qualify something similar to the physical presence test under the foreign earned income exclusion analysis but it has to be 330 days in any tax year – which is generally January 1 through December 31.
Direct reporting is when a person submits amended returns and FBARs with a reasonable cause statement (not silent or quiet disclosure). Direct reporting can be very risky especially of a person is not aware of all the different tools and tricks the IRS can use against them.
**The United States and IRS take the failure to report foreign income and disclose foreign accounts very seriously, and if you find yourself in this situation, it is best to consult first with an experienced international tax attorney before initiating communications with the IRS or Department of Treasury.