Background and History of Tax on U.S. Expatriation | TFX (2024)

Part 1: History of citizenship-based taxation

Citizenship-based taxation has been an issue throughout the 150-year history of the U.S. income tax.

Interestingly, the United States started with a residence-based tax system. The first income tax enactedby Congress, passed in 1861 to help fund Civil War efforts, only taxed citizens abroad on their income fromU.S. investments; overseas income was specifically excluded.

In 1864, Congress moved to citizenship-based taxation and passed a new law which taxed non-resident citizenson their non-U.S. income as well. The tax, both for residents and non-residents, was only in effect until1872.

Congress introduced an income tax law in 1894 which included taxation on all income of non-residentcitizens. The law was ruled unconstitutional by the Supreme Court the following year (for reasons unrelatedto non-resident taxation).

14 years later, the 16th Amendment to the Constitution was passed to overturn this Supreme Court decision,and the modern federal income tax was begun.

The new income tax regime forming the basis of the modern system of U.S. taxation, created in 1913 andrevised in 1916, applied to "every citizen of the United States, whether residing at home or abroad".

The provision of the new law taxing non-resident citizens on their global income was immediatelycontroversial. Already by 1914, U.S. citizens in London had begun to renounce citizenship in order to escapedouble taxation, and American Abroad groups challenged the legality of the new provision. The challengesreached their climax in 1924 when the Supreme Court ruled in a case brought by a U.S. citizen living inMexico that taxing non-resident citizens on their global income was indeed constitutional.

Debate about if - and how - to avoid double-taxation of Americans abroad

Since the 1924 Supreme Court decision, there has been no serious attempt by lawmakers to end the taxation ofcitizens who do not reside in the U.S. Instead, the focus of the debate has generally been on the extent towhich the earnings of Americans working overseas should be taxed by both the country of work/residency andthe United States.

A 1918 provision in the tax law allowed Americans to take a credit for taxes paid to a foreign government.

In 1926, Congress created the foreign earned income exclusion, which allowed taxpayers to shield anunlimited amount of foreign income from U.S. taxes. In 1962, Congress put a limit on how much foreign incomecould be excluded from U.S. taxes.

There have been numerous attempts to rescind the foreign-earned income exclusion completely, so that allincome earned outside the United States would be subject to U.S. taxes. The exclusion was replaced by analternate structure from 1978 to 1981, but was reinstated and is still in effect today.

The foreign-earned income exclusion was set at $75,000 in 1981 (equivalent to $178,000 in 2008 dollars).Above that amount, foreign earnings are taxed both in the U.S. as well as in the source country and/orcountry of residence.

Legislation was enacted to raise the limit by 1986 to $95,000 (equivalent to $186,000 in 2008 dollars).However, in several subsequent "revenue enhancement" sessions, Congress opted to leave the amount virtuallyunchanged for the next 2 decades, thereby effectively - and stealthily - letting inflation cut away the realvalue of the benefit.

By 2006, the foreign earned-income exclusion had increased slightly in nominal terms to $82,400. In realinflation-adjusted dollars, this represents a fall in value of 51% in the 25 years since the passage of the1981 law.

2005 Law significantly increases taxes of Americans abroad

New legislation in 2005 tied the foreign-earned income exclusion to inflation. The foreign-earned incomeexclusion is $91,400 for 2009 and $91,500 for 2010.

However, the same legislation significantly reduced the benefit through 2 changes. First, a “stackingprocedure” was introduced where the rate used to calculate tax is what would have applied if the exclusionwas not used. Because of the progressivity of tax rates, the taxpayer is forced to pay higher marginal rateson any amount above the foreign-earned income exclusion because he loses the benefits of the lower marginalrates for lower income amounts. The difference was significant and effectively reduced the net benefit ofthe foreign earned-income exclusion despite the apparent increase. Secondly, a new cap of $11,536 forhousing exclusions for citizens living overseas was introduced.

The net change caused by the 2005 legislation significantly increased the taxes of Americans workingoverseas.

There was a storm of protests from groups representing Americans working abroad and numerous attempts toreinstate the previous laws, but little has changed since. If anything, the political climate since seems tofavor further reducing the tax benefits given to Americans abroad.

Note that investment earnings have never received any benefit and are subject to U.S. taxation in additionto taxation from the taxpayer's country of residence.

Also important to note is that many tax benefits allowed to U.S. residents are not available to citizensoverseas. For example, donations to charities outside the U.S. are not tax deductible, property cannot betransferred tax-free to spouses who are not U.S. citizens, Medicare benefits cannot be received.

While there have been debates about how much foreign-earned income should be excludable and to whom theprovisions should apply, Congress has been very clear throughout 150 years that all global income of anyAmerican citizen, living inside or outside the U.S., is subject to U.S. tax.

In a century since introduction of the modern income tax system, no law to tax based on residency ratherthan citizenship has ever passed Congress. As far as we are aware, no such legislation has even beenintroduced and voted upon.

There have been proposals by academics and interest groups representing overseas Americans to introduce aresidence-based tax system similar to every other country in the world, but they have not receivedwidespread attention. As the 150 years of lawmakers' quotes in the next section below show, the politicalreality of scrapping a citizenship-based tax system is essentially zero.

Americans working overseas and the income they earn soars in last 20 years

While the U.S. tax system remains fixed to citizenship-based taxation, U.S. workers have become increasinglymobile. As the economies of the world become more connected and barriers to working abroad fall, the foreignearnings of U.S. citizens have grown much more rapidly in the last few decades than domestic earnings:

From 1987 to 2001, IRS data shows that while overall income by U.S. citizens grew by 43% in real terms,foreign-source income more than quadrupuled.

The number of U.S. citizens affected by foreign tax issues has also expanded dramatically even morerecently:

In 1991, 220,165 individuals reported foreign earnings to the IRS. In 2006, it had grown by 52% to 334,851.This represents an increase of 114,686 more Americans working overseas in just 15 years.

Part 2: Background on Non-residency, expatriation and tax

The income of citizens abroad can come from two sources: U.S. or foreign. The cases and controversies aboutcitizenship-based taxation and expatriation have arisen because of both sources.

The first 19th-century tax laws aimed at non-resident citizens were intended to prevent Americans livingabroad from earning income from U.S. investments while not paying taxes:

"If a man draws his income from our public debt, or from property here, and resides in Paris, skulking awayfrom contributing his personal support to the Government in this day of its extremity, he ought to pay ahigher income tax."
- Senator Jacob Collamer (Rep., Vt.), 1862

Although eventually struck down by the Supreme Court, the tax law that Congress passed at the end of the19th century was similarly aimed:

"[The point of citizenship-based taxation is so that] if an American citizen went abroad and carried theprotection of his country, of his citizenship with him, he did not escape its burdens... There are a greatmany people, I am sorry to say, who go abroad for that very purpose, and some of them went abroad during thelate [Civil W]ar. They lived in luxury, at the same time at less cost, in a foreign capital; they had noneof the voluntary obligations which rest upon citizens, of charity, or contributions, or supporting churches,or anything of that sort, and they escaped taxation."
- Senator George Hoar (Rep., Mass.) , 1894

The intent of citizenship-based taxation at the start of the modern tax regime in 1913 was similarly clear:

"You know who they [the U.S. Government] are really after the idle rich, who come here [to London] to buyproperty and spend here incomes drawn from the United States."
- An "influential member of the American Society" in London, as quoted in NY Times, March 6, 1914

Despite the political focus on U.S.-sourced earnings, the Supreme Court, in its first decision oncitizenship-based taxation, focused on foreign-source income. In the case of Cook v. Tait in 1924, it ruledthat taxation of the foreign-source income of non-resident citizens is legal.

Congress makes U.S. a tax haven for foreigners' investments in 1966

A significant alteration in the tax code in 1966 designed to encourage foreign investment in the U.S. markedthe start of a new regime for individuals who renounce their citizenship.

Until then, non-resident non-citizens who earned income from U.S. sources were taxed at the same rates asU.S. residents.

To encourage foreign investment in the U.S., Congress passed in 1966 a law (the Foreign Investors Tax Act)which gave significant tax advantages to non-resident non-citizens. For them, interest on bank deposits,coupon payments from U.S. government debt, and portfolio interest paid by U.S. domestic corporations becametax-free, and other investments enjoyed other tax benefits. The U.S. became a de facto tax haven for foreigninvestors.

These benefits were limited to non-citizens living outside the U.S. Citizens outside the U.S. continued tobe taxed in the same manner as citizens resident in the country.

Congress tries to counter the incentive to expatriate

Lawmakers recognized that the new difference in tax between citizens and non-resident non-citizens caused bythis tax-haven legislation significantly increased the financial incentive to renounce citizenship.

To combat the incentive to expatriate caused by the favorable tax-status they gave to foreigners'investments in the U.S. in 1966, Congress enacted the first tax aimed directly at individuals who renouncecitizenship.

The 1966 law applied a 10-year tax on U.S.-source income of individuals whose main motive for expatriationwas tax avoidance. In practice, though, the legislation was ineffective at reducing the tax benefit ofexpatriation: the IRS was not informed of expatriations, determining the “tax avoidance” motive wasdifficult, individuals could fairly easily restructure many of their assets to escape the tax, and enforcinga 10-year tax regime on foreign citizens living outside the U.S. was impossible.

Politicians enraged in 1990s by expatriation of wealthy Americans

In the mid-1990s, the expatriation of several wealthy U.S. citizens drew enormous media attention andmassive Congressional scrutiny. President Clinton himself supposedly read an article in Forbes and demandedaction (see here for link to the article that started the fury).

The political debate was emotionally charged. Lawmakers from both parties in Congress and officials in theWhite House were in unison:

"[These are] Benedict Arnolds who would sell out their citizenship, sell out their country in order tomaintain their wealth. Jet setters who are able to... enjoy the full benefits of all the wealth that theyhave accumulated in the United States of America as citizens, and renounce."
- Rep. Neil Abercrombie (Dem, Haw.), 1995

"[T]hese [are] wealthy individuals [who] have engaged in the despicable act of renouncing their allegianceto the United States [due to the supposedly] punitive levels of taxation in this country... Their argumentthat our taxes are at punitive levels is totally false. The United States has one of the lowest tax burdensof all industrialized nations in the world. It is true that our rates exceed those provided by the taxhavens to which these wealthy people are fleeing. However, those individuals can reside safely in thosehavens only by reason of the defense expenditures of this country which enable wealthy expatriates to livesafely anywhere in the world... They condemn as class warfare our attempt to make a handful or two of thewealthiest of the wealthy bear the same burden of tax as all the rest of us."
- Rep. Sam Gibbons (Dem., Fl.), 1995

"If you've gotten your riches from America, you should pay your fair share of taxes. These expatriates arereally like economic Benedict Arnolds."
- Leslie Samuels, Assistant Secretary for tax policy, U.S. Department of the Treasury, 1995

The rallying cry in Congressional debate was "to close the billionaires' loophole". As Rep. Peter DeFazio(Dem, Or.) stated, Congress' goal was to stop the "billionaires and centi-millionaires" from "escaping" fromthe U.S. tax system.

A few voices were raised that "billionaires and centi-millionaires" were at most a handful of the thousandsof expatriation cases. Others mentioned the irony that while moving abroad and reducing taxes was consideredby U.S. lawmakers to be "escape", "illegal action", and the act of "taking advantage of a loophole thatscoundrels have now begun to exploit", it was in fact completely legal and standard in every other countryof the world. Or that, as Rep. Nancy Johnson (Rep., Conn.) pointed out, "when a nation makes the decision tooppose a unique and extraordinarily broadly burdensome tax, even if it is on a small group, it sends amessage to all those choosing to invest that investing in America could be hazardous to their interests."

But pointing out these inconvenient facts was politically untenable in the face of the "unpatrioticbillionaire" meme. Lawmakers of all political stripes were unified in their disgust at expatriation andpolitical action was guaranteed.

1996 law against "taxpatriation": strict and onerous intent, unworkable result

With such unified political will, Congress in 1996 enacted new legislation to stiffen penalties againstexpatriation. For legal and practical reasons, legislators only revised the 1966 law and did not enact asonerous a burden as many wanted:

"This proposal is not designed to prevent Americans from shifting their assets and citizenship to anothercountry. If it was my instruction, it would. Why should I give two hoots about somebody that wants to giveup their U.S. citizenship and shift their income to another country...?

It has been brought up about double taxation. I say, 'You can triple or quadruple tax them as far as I'mconcerned, run it up to a hundred percent if they want to give up their citizenship because they don't wantto pay their taxes.'

How can you say that we should all do our share in America, including making all the kids, and the elderlypeople, and everybody else, have to contribute to the deficit, to bring it down, and at the same time allowthese sleazy bums, who don't want to pay their taxes, to leave this country, and renounce their citizenship,and expect me to have one iota of sympathy for them."
-Rep. Neil Abercrombie (Dem, Haw.), 1995

In essence, the new law retained most of the 1966 law's features, including the 10-year post-renunciationtax, but attempted to correct the practical problems. In particular, the 1996 law created the assumptionthat tax avoidance was the principal motivation for expatriation for any individual whose net worth was atleast $500,000 or whose average income tax in the 5 years prior to expatriation was over $100,000. The lawalso provided that an individual who renounced citizenship would still remain subject to U.S. taxation onhis global income until he officially informed the IRS of his expatriation.

Another provision was added ordering the IRS to make public the names of all individuals who renouncecitizenship (see here for summary and analysis of the data resulting from this provision). The intent behindthis so-called "name-and-shame" statute was described by one legislator:

"I hope that one day we will just publish the names of people that America has given so much to and thatthey care so little about that citizenship that they would flee in order to avoid taxes."
- Rep. Charles Rangel (Dem., NY), 1995

Congress inserted another provision, the so-called Reed Amendment, barring entry to the U.S. to anyindividual whose motivation for expatriation was tax avoidance.

There were several challenges to the 1996 law on both legal and practical terms. Legally, the expatriationtax regime existed on shaky constitutional footing.

In essence, the law created a separate class of citizen who had no benefits of citizenship "the right tolive and work in the U.S., the right to vote, the right to protection of the U.S., etc" but who still hadthe tax obligation of citizenship. Numerous legal scholars noted the problems, but no case was brought tochallenge this issue.

Separately, individuals contested the assumption that the principal motivation for renouncing for anyonemeeting the economic thresholds was tax avoidance. In the first five years after the law was passed, 270people applied to the IRS for a ruling that they had expatriated for non-tax reasons. Of them, half receivedfavorable rulings, 11 were rejected, and the rest received "neutral" rulings (which apparently allowed themto ignore the law pending a specific request for review by the IRS).

Enraged that so many individuals were deemed to have expatriated for reasons other than tax avoidance,Congress strengthened the presumption in 2004. The changed regulation stipulated that all individuals whomet the economic thresholds by definition expatriated solely to avoid taxes, and no argument to the contrarywas acceptable.

From the IRS's view, the 1996 legislation still suffered from the same difficulty of enforcing a tax regimefor 10-years against foreign citizens living in a foreign country. Administration of the law was difficult,and verification virtually impossible.

And the Reed Amendment barring entry to the U.S. was unworkable and never enforced (see this section formore details).

2008 law introduces first exit-tax in U.S. history

Renunciation tax law was given a major overhaul in 2008. The 10-year tax regime was replaced with an exittax on the expatriating citizen. We describe the current system in detail in the next section.