During a recent interview with NPR, Boris Johnson, the Mayor of London, said he would refuse to pay his U.S. taxes, calling them “outrageous.” Johnson, who was born in New York and is a U.S. citizen, was objecting to the U.S. tax (and potentially associated fines and penalties) that could be due on the sale of his London home. But, by making his dispute so public, he may be doing the worst possible thing – admitting that he’s not paying the tax merely because he doesn’t like it. Penalties for “willful” tax evasion are much higher than those for individuals who are merely confused or mistaken about the complexities of international tax.
It’s a Worldwide World
Of course, at the root, it’s really not complex at all. Americans pay tax on their worldwide income. This isn’t a new rule. U.S. tax is the price one pays for being able to take advantage of all the U.S. system has to offer–whether that’s the ability to come and go freely, using the much shorter resident/citizen lines–or the relatively stable, mature U.S. market and extensive infrastructure.
Looked at from a systemic point of view, perhaps it’s not inherently unreasonable – it’s a simple “black line” rule, hard to avoid, not too hard to enforce, and someone has to pay to keep the lights on after all - but that doesn’t mean the taxpayer has to like it. It also doesn’t mean the taxpayer has to pay more than is legally required. With proper planning, tax may be legally minimized in multiple jurisdictions. But for individuals with international contacts, life isn’t as simple as they might wish.
Tax Treaties
In general, tax treaties obviate true double taxation, requiring one country to yield to the other – and grant the taxpayer a credit for taxes paid to the other country. This system results in a “higher of” tax result, so that at the end of the day, the taxpayer pays tax equal to whatever the tax would have been in the jurisdiction that taxed more.
Often, this means that while the dual-citizen’s taxes are complex, they aren’t a lot higher than anyone else’s. But once in a while, there’s a pitfall for the unwary – or the under-advised. Johnson may have fallen into one such trap. After all – if his tax was no different after application of the U.S.-U.K. income tax treaty, why would he be proclaiming the injustice of the U.S. tax system so loudly? On the U.K. side, he’s likely taken advantage of certain legal ways to minimize tax on the sale of his London home. If however, he failed to consider whether similar tax-saving measures were available in the United States, he might have fallen into a situation in which the United States would charge $24 in tax and the United Kingdom would charge $5. While the United States has to allow him a tax credit against his U.S. tax for U.K. taxes paid, a $5 credit would still leave him with $19 of U.S. tax!
Mismatch Between Jurisdictions
There are several areas that practitioners in this area know often produce a mismatch between jurisdictions – places where the tax in one is much higher or lower than the tax in the other. This mismatch occurs often on the sale of a personal residence and with retirement accounts. A foreign retirement account may be fully taxable in the United States, even if the foreign country considers it a tax-deferred vehicle. Sometimes, this type of mismatch can’t be avoided – but often, with a little planning, it can.
Some parts of the financial press aren’t really helping people understand the rules either. More than one recent article reports that: (1) Boris Johnson owes tax as a result of the Foreign Account Tax Compliance Act (FATCA), and (2) FATCA requires people with “no existing ties” to the United States to pay U.S. taxes. Bottom line: Johnson is subject to U.S. tax because he’s a U.S. citizen. FATCA didn’t make that the law. The law has been than way since the income tax was enacted in 1913. (That act taxed “all income from whatever source derived” and credit for foreign taxes paid on the same item of income were not introduced until 1918.)
Take It or Leave It
One way to avoid lots of U.S. tax is to minimize ties to the United States – and the biggest tie of all is U.S. citizenship or residency. When NPR interviewer Susan Page pressed Johnson to say whether he would pay the tax he deemed “outrageous” he replied, “Why should I? I think, you know, I'm not a -- I, you know, I haven't lived in the United States for, you know, well, since I was five years old.” What Johnson tripped over was the statement that he wasn’t a “U.S. person” and U.S. persons are subject to taxation on their worldwide income.
For these purposes, the term "U.S. person" includes an individual who’s either a U.S. citizen or a tax resident. While there are other ways to reach this status, the holder of a green card is generally characterized as a tax resident. These rules apply even if the individual involved is living abroad and doesn’t maintain a current U.S. passport.
So if Johnson doesn’t want to pay U.S. taxes, why doesn’t he simply give up his U.S. citizenship? According to reports, he’s considered it. In the November NPR interview he said merely that: “it's very difficult to give it up.” It’s actually not that difficult mechanically to give up U.S. citizenship, but it does take some thought and planning – and you have to be willing to give up the privileges U.S. citizenship (or residency) brings with it – like those short(er) lines at U.S. Customs and Immigration.
Covered Expatriates
There’s another issue. U.S. citizens (and long-term green card holders) who are wealthy (net worth of more than $2 million or a 5-year average U.S. income tax liability exceeding $160,000 or so) or who are unable to certify under penalty of perjury that they’ve complied with their U.S. tax requirements for the five preceding tax years, are considered “covered expatriates” and may have a big tax to face when they leave.
Covered expatriates are deemed to have sold all of their property at fair market value on the day before their expatriation date. For 2014, there’s a $680,000 exclusion amount (for 2015 the amount is $690,000, adjusted for inflation) applied to the gain resulting from the deemed sale; the resulting tax is due with the taxpayer's timely filed return for the year of expatriation. Because Johnson’s annual income is estimated to exceed £394,000 (about $610,700), and his profit on the sale of that London residence alone was reportedly around £730,000 (about $1.13 million), the likely tax he’d face if he gave up his U.S. citizenship is quite a pretty penny. With proper planning and structuring, this tax can often be mitigated or even avoided altogether. Even simple pre-expatriation gifting could save a million dollars or more in tax.
Cutting Off Your Nose to Spite Your Face
There are some foreign financial advisors who’ve called Johnson’s refusal to pay his taxes “noble and brave.” Actually, it’s pretty stupid. It seems like he doesn’t like the rules so he’s just refusing to play by them. If, on the other hand, he’d gotten some good advice on how to manage his international tax situation, he might not have such a high tax to pay after all.
