An IRS International Tax Gap Overview (Who is at Risk?)

Click Here to Schedule a Reduced-Fee Consultation
The IRS Seeks to Close International Tax Gap (An Overview)

The IRS Seeks to Close International Tax Gap (An Overview)

The IRS Seeks to Close International Tax Gap

The concept of a tax gap is the concept that there is a gap in the amount of tax that is due — and the amount of tax that is collected. As a result of a tax gap (from the US government’s perspective) the Internal Revenue Service is missing out on collecting tax money for both US and foreign income generated. In order to recoup the missed tax monies, the IRS develops plans and strategies to close the tax gaps. When it comes to international tax, there are various considerations such as the taxation of non-residents, self-employment tax for businesses abroad, departing aliens and expatriation, and Americans abroad who have not been filing tax but are required to do so (aka expats). With the Internal Revenue Service recently receiving a significant amount of funding, it is important for US taxpayers who have international-related income that they may have missed to understand with the IRS is looking for –– so the taxpayers can comply.  Let’s look at some of the Key Tax Gaps for International Tax.

 As provided by the IRS:

Departing Aliens

      • Before leaving the United States or any of its possessions permanently or for an extended amount of time, all U.S. resident aliens and nonresident aliens (with certain exceptions) must prove they have met all federal tax requirements. This is done by obtaining a tax clearance document, commonly called a “sailing permit” or “departure permit”, from the IRS.

Who Must File US Tax Returns?

      • U.S. citizens and U.S. residents are taxed on their worldwide income. This applies whether a person lives inside or outside the United States. Foreign income must be reported on a  U.S. tax return whether or not the person receives a Form W-2, Wage and Tax Statement, a Form 1099 (information return) or the foreign equivalent of those forms.  Foreign source income includes but is not limited to earned and unearned income, such as wages and tips, interest, dividends, capital gains, pensions, rents, and royalties.

      • Nonresident aliens are generally subject to U.S. income tax only on their U.S. source income.   They are subject to two different tax rates, one for effectively connected income, and one for fixed or determinable, annual, or periodic (FDAP) income.  Effectively connected income (ECI) is earned in the U.S. from the operation of a business in the U.S. or is personal service income earned in the U.S.  (such as wages or self-employment income).  It is taxed for a nonresident at the same graduated rates as for a U.S. person.  FDAP income is passive income such as interest, dividends, rents or royalties.  This type of income is taxed at a flat 30% rate, unless a tax treaty specifies a lower rate.  

      • Generally, a foreign corporation must file a U.S. tax return if it is engaged in a trade or business in the United States, whether or not it had income from that trade or business. It must also file if it had income, gains, or losses treated as if they were effectively connected with a U.S. trade or business, and if it had income from any U.S. source (even if its income is tax exempt under an income tax treaty or code section).

What Should You Do If You Have Not Filed Your Tax Returns? 

      • Taxpayers should file all tax returns that are due, regardless of whether or not full payment can be made with the return. Depending on an individual’s circumstances, a taxpayer filing late may qualify for a payment plan. All payment plans require continued compliance with all filing and payment responsibilities after the plan is approved. 

      • For taxpayers living abroad and/or with offshore accounts, refer to the Offshore Voluntary Disclosure Program Frequently Asked Questions and Answers 2014 for more details on a program for taxpayers who come forward voluntarily and report their previously undisclosed foreign accounts and assets. (See New VDP)

      • Taxpayers who continue to not file a required return and fail to respond to IRS requests for a return may be considered for a variety of enforcement actions.  Continued non-compliance by flagrant or repeat nonfilers could result in additional penalties and/or criminal prosecution.  A taxpayer’s timely voluntary disclosure of a substantial unreported tax liability has long been an important factor in deciding whether the taxpayer’s case should ultimately be referred for criminal prosecution.  

Foreign Earned Income Exclusion

      • United States citizens and resident aliens are taxed on their worldwide income, whether the person lives inside or outside of the United States. However, qualifying U.S. citizens and resident aliens who live and work abroad may be able to exclude from their income all or part of their foreign salary or wages, or amounts received as compensation for their personal services. In addition, they may also qualify to exclude or deduct certain foreign housing costs.

      • A common misconception that contributes to the international tax gap is that this potentially excludable foreign earned income is exempt income not reportable on a US tax return. In fact, only a qualifying individual with qualifying income may elect to exclude foreign earned income and this exclusion applies only if a tax return is filed and the income is reported.

Foreign Tax Credits

      • Foreign tax credits allow U.S. taxpayers to avoid or reduce double taxation. You may choose to take a deduction for foreign taxes paid instead of choosing a credit. In most cases, it is to your advantage to take foreign income taxes as a tax credit.

Foreign Trusts

      • A U.S. person includes a citizen of the United States, a domestic partnership, a domestic corporation, any estate other than a foreign estate, any trust if a court within the United States exercises primary supervision over the administration of the trust and if one or more U.S. persons have the authority to control all substantial decisions of the trust, and any person that is not a foreign person.

      • Tax consequences apply to U.S. persons who are treated as owners of a foreign trust under the grantor trust rules of Internal Revenue Code (IRC) sections 671-679 and may apply to U.S. persons treated as beneficiaries of a foreign trust, and to the foreign trust itself. Both income tax and transfer tax consequences should be considered.

      • In addition to tax consequences, there a number of information reporting rules that can apply to a U.S. person who enters into transactions with a foreign trust or is treated as an owner of a foreign trust under the grantor trust rules, or receives distributions from a foreign trust, including information reporting on Forms 3520 and 3520-A; on Form 8938, Statement of Specified Foreign Financial Assets; and on FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR).

      • This page focuses on information reporting requirements on Forms 3520 and 3520-A (under IRC section 6048), as well basic income tax considerations. 

Income Tax Consequences

      • U.S. owner of a foreign trust – In general, a U.S. person who is treated as the owner of a foreign trust under the grantor trust rules (IRC sections 671-679) is taxed on the income of that trust. IRC section 679 applies specifically in the context of foreign trusts and will treat as an owner of a foreign trust a U.S. person who transfers assets to a foreign trust which has or is presumed to have a U.S. beneficiary. Each U.S. owner of a foreign trust should receive a Foreign Grantor Trust Owner Statement (Form 3520-A, page 3) from the foreign trust, which includes information about the foreign trust income they must report on their own U.S. income tax return. 

      • U.S. beneficiary of a foreign trust – In general, a U.S. beneficiary of a foreign non grantor trust will report its share of foreign trust income to the extent of distributable net income (DNI). Depending on whether the U.S. beneficiary is a beneficiary of a grantor or non grantor trust, the beneficiary should receive a Foreign Grantor Trust Beneficiary Statement or a Foreign Non Grantor Trust Beneficiary Statement, which includes information about the taxability of distributions the beneficiary has received. 

      • U.S. transferor of assets to a foreign non grantor trust – IRC section 684 requires the recognition of gain on certain transfers of appreciated assets to a foreign trust by a U.S. person.

Information Reporting

Form 3520

          1. who must file a Form 3520;

          2. when and where the Form 3520 must be filed; and 

          3. possible penalties for filing the Form 3520 late or filing incomplete or inaccurate information.

            1. See Form 3520 filing tips below. See also Gifts from Foreign Persons for information about reporting receipts of certain large gifts or bequests from certain foreign persons.

Form 3520-A

      • U.S. persons who are treated as owners of a foreign trust under the grantor trust rules must ensure that the foreign trust timely files a complete and accurate Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner, and furnishes the required annual statements to its U.S. owners and U.S. beneficiaries. If a foreign trust fails to file Form 3520-A, the U.S. owner must: 

        1. complete and attach a substitute Form 3520-A to a timely filed Form 3520, and

        2. furnish the required annual statements in order for the U.S. owner to avoid penalties for the foreign trust’s failure to file a Form 3520-A.

      • The instructions for Form 3520-A include more information about: 

        1. who must file a Form 3520-A or ensure that a Form 3520-A is filed; 

        2. when and where the Form 3520-A must be filed; and 

        3. possible penalties for filing Form 3520-A late or filing incomplete or inaccurate information. The instructions for Form 3520-A and Form 3520 also provide information about filing a substitute Form 3520-A.

Exceptions to filing Forms 3520 and 3520-A

      • Forms 3520 and 3520-A are not required to be filed for Canadian registered retirement savings plans (RRSPs) and Canadian registered retirement income funds (RRIFs).  See Rev. Proc. 2014-55

      • In addition, Forms 3520 and 3520-A are not required to be filed for certain tax-favored foreign retirement trusts or tax-favored foreign non-retirement savings trusts, provided that the U.S. owner is an “eligible individual” and the tax-favored foreign trust meets certain requirements. See Rev. Proc. 2020-17

        •  Caution: These exceptions do not affect any reporting obligations that a U.S. person may have to report specified foreign financial assets on Form 8938 or any other reporting requirement, including the requirement to file FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR).

Form 3520 and Form 3520-A filing tips to avoid penalties

      • Form 3520

        • File Form 3520 by the 15th day of the fourth month following the end of the U.S. person’s tax year, or April 15th for calendar year taxpayers, subject to any extension of time to file that may apply. If you are a U.S. citizen or resident who lives outside the Unites States and Puerto Rico or if you are in the military or naval service on duty outside the United States and Puerto Rico, then the due date to file a Form 3520 is the 15th day of the 6th month following the end of the U.S. person’s tax year.

            • If an extension was filed with respect to your income tax return, be sure to check Form 3520, Box 1k, and enter the form number of the income tax return to avoid your Form 3520 being treated as filed late. 

      • Form 3520-A

        • File Form 3520-A using an Employer Identification Number (EIN) for the foreign trust on Line 1b of the form rather than the U.S. owner’s SSN or ITIN. If the foreign trust does not have an EIN, refer to How to Apply for an EIN.

        • File Form 3520-A by the 15th day of the 3rd month after the end of the trust’s tax year.  An automatic 6-month extension may be granted by filing Form 7004, Application for Automatic Extension of Time to File Certain Business Income Tax, Information and Other Returns. 

          • Form 7004 must be filed under the foreign trust’s EIN.

        • If the foreign trust will not file a Form 3520-A, the U.S. owner of the foreign trust must file a substitute Form 3520-A by completing a Form 3520-A to the best of their ability and attaching it to a timely filed Form 3520, including extensions (see Form 3520 and Form 3520-A instructions for more information on filing a substitute Form 3520-A). Do not separately file a duplicate Form 3520-A if you are filing a substitute 3520-A.

Americans Abroad

      • Globalization continues to affect us all. Businesses are no longer defined by national borders. Individuals and capital move freely from one country to another. It is estimated that more than 7 million Americans reside outside of the United States (not including military personnel). The IRS recognizes that it must find innovative ways to meet the needs of the growing number of U.S. taxpayers who live in other countries, so a special tax page on the IRS web site is available to specifically address the tax issues of U.S. Citizens and Resident Aliens Abroad.

      • This updated tax page contains a wealth of information on where and when to file, and how to get tax help. It also includes links to many more international tax topics, such as information on reporting foreign bank accounts and how to take advantage of tax provisions like the foreign tax credit and foreign earned income exclusion.

      • The IRS is eager to meet the needs of all of our customers, both domestically and in the international arena.  We continue to look for ways to make taxes less taxing.

      • For example, U.S. taxpayers here or abroad with tax questions can refer to the International Taxpayers landing page and use the online IRS Tax Map and the International Tax Topic Index to get answers. These online tools assemble or group IRS forms, publications and web pages by subject and provide users with a single entry point to find tax information.

      • Taxpayers who are looking for return preparers abroad should visit the Directory of Federal Tax Return Preparers with Credentials and Select Qualifications.

      • To help avoid delays with tax refunds, taxpayers living abroad should visit the Helpful Tips for Effectively Receiving a Tax Refund for Taxpayers Living Abroad page.

      • The IRS also has videos available on the IRS YouTube page of interest to taxpayers abroad, with more to be released in the near future. The videos now available are:

      • Upcoming videos will deal with the foreign tax credit, filing status for a U.S. taxpayer married to a foreign spouse and an introduction to the IRS web site for international taxpayers.

      • The IRS has also added new international tax topics to Tax Trails, the agency’s interactive online tool that helps taxpayers get answers to their general tax questions.  The more recent new topics are:

        • Am I Required to File a U.S. Individual Income Tax Return (for U.S. Citizens/Resident Aliens Living Abroad and Nonresident Aliens)?

        • Filing Status of a U.S. Citizen or Resident Alien Married to a Nonresident Alien.

      • In addition, the IRS uses a variety of social media tools to share the latest tax information with interested taxpayers both in the United States and around the world. These include the IRS2Go phone application, YouTube, Tumblr and Twitter.

      • A listing of IRS social media tools is available on IRS.gov.

      • To protect taxpayer privacy, the IRS only uses social media tools to share public information, not to answer personal tax or account questions. It advises taxpayers to never post confidential information, like a Social Security number, on social media sites.

International Pensions & Treaty Benefits for Pensions/Annuities – General Rule

      • As a general rule, the pension/annuity article of most income tax treaties allows for exclusive taxation of pensions or annuities under the domestic law of the resident country (as determined by the residence article). This is generally true unless a treaty provision specifically amends that treatment. For example, some treaties provide that the country of residence may not tax amounts that would not have been taxable by the other country if you were a resident of that country. There also may be special rules for lump-sum distributions.

      • With respect to government pensions/public pensions/annuities (typically covered under the Government Service article) or social security payments, generally the payments are only taxable by the country in which the government is making the payments. Note that what constitutes a government pension or public pension is dictated by the treaty, and the rule may apply narrowly.

      • If you reside in a foreign country and receive a pension/annuity paid by a U.S. payor, you may claim an exemption from withholding of U.S. Federal Income Tax (FIT) under a tax treaty by completing Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting, and delivering it to the U.S. payor. You must report your U.S. Taxpayer Identification Number (TIN) on Form W-8BEN for it to be valid for treaty purposes.

      • If you live in the United States and receive a pension/annuity paid by a foreign payor, you must claim the appropriate treaty withholding exemption on the form, and in the manner specified by the foreign government. If the foreign government, and/or the foreign withholding agent, refuses to honor the treaty claim, make the treaty claim on your income tax return, or other prescribed form, filed with the foreign country. Additionally, you may be able to claim a Foreign Tax Credit on your U.S. federal individual income tax return for any foreign income tax withheld from your foreign pension or annuity. Be aware that a Foreign Tax Credit generally would not be permitted for tax withheld that is in excess of the liability under foreign law, taking into consideration applicable income tax treaties.

      • Always ensure you read each treaty’s relevant articles in their entirety as there may be special provisions which affect the taxability of your income. In addition, ensure that you read any Protocols (amendments) to the treaty as they may revise the relevant articles of the treaty and affect your eligibility for benefits or the taxability of your income. The Technical Explanation accompanying the treaty may also provide insight, in particular, with respect to what meets the treaty’s definition of a pension, public pension, or a pension paid in connection with government service. You need to look at each treaty carefully as benefits vary from treaty to treaty – just because one treaty allows a certain treatment does not mean another treaty will allow the same treatment.

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure.

Contact our firm today for assistance.