During the 2020 election campaign, President Biden regularly stressed the need for: “Tax reform that rewards work, not wealth.” A couple of months after he took office, the means of delivering that wish was set out in draft legislation. However, none of those proposals found their way into the US Internal Revenue Code during 2021. With Republicans in Congress being implacably opposed to the President’s tax proposals, he needed the united backing of his own Party. This was particularly the case in the Senate, where just one waverer would deliver a death blow.
While many Democrats in Congress were unified behind the President, there were opposing voices from both wings of his own Party. According to some, the proposed tax legislation was too radical while, in the minds of others, it was not radical enough. Senator Manchin (W. Virginia) was particularly vocal from the ‘too radical’ side. His continuing opposition to the President’s proposals resulted in their abandonment in the 2021 Congressional year.
The President has now presented a 2022 package to Congress. With much of last year’s tax reform material being recycled into the current Budget, what are the chances of them being passed into law at this second attempt?
Initial omens are not good, with Senator Manchin taking an immediate and distinct dislike to the so called ‘billionaire tax’. Strictly speaking, this is a new element in President Biden’s Budget package, as he did not have it in his 2021 Budget. However, the reality is that he has borrowed a proposal made in the summer of 2021 by Senator Wyden, who chairs the Senate Finance Committee.
Included in the recycled proposals are:
- An increase in the corporate tax rate from 21% to 28%.
- For individual taxation, increasing the top rate from 37% to 39.6%.
- Individuals with taxable income exceeding $1 million to be taxed on their long-term capital gains at ordinary income rates. (43.4% – being the proposed 39.6% top rate, plus the 3.8% net investment income tax.)
- Partnership ‘carried interests’ to be taxed as ordinary income, not as capital gain, if the partner’s taxable income exceeds $400,000.
- Trusts. Various provisions impacting grantor trusts, grantor retained annuity trusts (GRATs), and dynasty trusts.
- Forced gain recognition on appreciated assets owned at the time of death.
Not everything announced by the President is borrowed material or proposals recycled from last year’s Budget. US individuals who live and work outside the USA, such as the expat population in the UK, remain subject to US Federal Income Tax on their world-wide income. The following, if enacted, would be helpful to some Americans living outside the USA.
1. Home loans denominated in a currency other than the US dollar
A US individual who borrows for non-business purposes in a currency other than the US dollar may have an unpleasant surprise in the year that the loan is repaid. The US tax accounting must be done in US dollars. Consequently, an exchange rate movement over the life of a loan will translate into a US dollar loss or gain.
For tax accounting purposes, the US dollar liability to the lender is determined by the exchange rate at the time of borrowing. If the dollar has strengthened against the foreign currency, it takes ‘less’ dollars to extinguish the liability than the historic dollar debt. This produces US taxable income.
Similarly, if the dollar has weakened against the other currency, it will take more dollars to settle the debt and there is a loss. However, such personal loss is non-deductible.
The Budget proposes to allow individuals to deduct foreign currency losses realised with respect to mortgage debt secured by a personal residence. That relief is restricted to the amount of any gain taken into income on the sale of the residence which is attributable to foreign currency fluctuations.
While a welcome suggestion, the relief being suggested is conditional on the loan being repaid at the time that the associated personal residence is sold. However, it is not uncommon for a home loan to be repaid without a simultaneous sale of the personal residence that it was used to finance. For example, an ‘early’ repayment will occur when borrowing is refinanced at more advantageous terms with a new lender. Additionally, it fails to address the issue of when loan repayment results in a taxable gain and the individual taxpayer does not have the necessary funds to pay the tax.
2. Passive Foreign Investment Companies (PFICs)
Owning shares in a PFIC is not a good idea for a US individual. Taxation can be punitive when an ‘excess distribution’ is received from the PFIC.
The official line is that the PFIC rules are intended to prevent taxpayers from,
a) Deferring the taxation of income from passive investments and,
b) Transforming the character of income from those investments from ordinary income into capital gain.
However, the US mutual funds industry did lobby in favour of these rules, which had the effect of removing overseas competitors from the US domestic market. The PFIC rules make all non-US mutual funds unattractive to US individuals.
In some fact patterns it is possible to avoid the worst aspects of the PFIC rules by making a qualified electing fund (QEF) election. By making this election, the taxpayer generally is required to report annually his/her pro rata share of the income/gains of the PFIC thereon.
US individuals living overseas and investing locally might unknowingly acquire shares in a PFIC and only realise the full implications later. However, to make a retroactive QEF election requires formal consent from the US Internal Revenue Service (IRS).
The Budget proposes that taxpayers would be eligible to make a retroactive QEF election without requesting consent, but only in cases that do not prejudice the U.S. Government. For example, if the taxpayer owned the PFIC in taxable years that are closed to assessment, the taxpayer would still need to obtain consent and to pay an appropriate amount to compensate the Government for the taxes not paid in the closed years on amounts that would have been includable in the taxpayer’s income if the taxpayer had made a timely QEF election.
3. ‘Accidental Americans’ wishing to give up their US citizenship
U.S. citizens are subject to U.S. income taxation on their worldwide income, even when living outside the USA. An ‘Accidental American’ is someone who acquired US citizenship at birth, but only becomes aware of that US connection (and the associated tax responsibilities) later in life. US citizenship will have been acquired either by being born in the United States (or in certain U.S. territories), or by having one parent who was a U.S. citizen.
Typically, an ‘Accidental American’ will have dual citizenship, of both the US and the country where they have lived for most of their life.
On becoming aware of their US connection, many ‘Accidental Americans’ choose to formally relinquish their US citizenship, or expatriate. There are additional tax consequences in the year of ceasing to be a US citizen, if the expatriating individual falls within the definition of a ‘covered expatriate’.
The Budget proposes to provide relief from the rules for covered expatriates for a narrow class of lower-income dual citizens with limited U.S. ties. This relief would apply only to individuals who:
a) Have a tax home outside the United States, and
b) Satisfy other conditions (not yet announced) that ensure that their contacts with the United States are limited, and
c) Whose income and assets are below a specified (not yet announced) threshold.
It has been suggested that evidence of limited contacts with the United States may include a demonstration that the taxpayer’s primary residence has been outside the United States for an extended period. Evidence of the taxpayer’s income and assets may include a foreign tax return, information about the value of property owned by the taxpayer and the taxpayer’s sources of income.
The Prospects of Tax Legislation Being Passed in 2022
It is not immediately apparent how what failed to reach the statute book in 2021 is likely to fare any better now that it has been reintroduced in 2022. In Congress, there is the same resistance as last year. Senator Manchin, who holds the critical ‘swing ’vote in the Senate, is vehemently against part of the package. However, Manchin, has signalled that he is willing to talk with the Administration in late April or May on a slimmed-down version of the President’s tax and spending plan.
Besides the main headline grabbers, the devil will be in the detail of the other proposals which affect overseas US taxpayers. It therefore remains a case of, ‘watch this space’ as to how much will make it to draft legislation and then ultimately pass.
Would you like to know more?
If you would like to discuss how the above may impact you, please get in touch with your usual Blick Rothenberg contact, John Havard using his email at the top of this page, or using the form below.