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Expat Tax Regulations Evolution

The Tax Reconciliation Act 2005

Under the Tax Reconciliation Act 2005 (signed by President Bush in May, 2006) the Foreign Earned Income Exclusion was indexed to US inflation as of the 2006 tax year, meaning that the maximum deduction in 2006 was $82,400, up from $80,000 in 2005. For 2009, the maximum foreign earned income exclusion is up to $91,400 (2008: $87,600) per qualifying person. If married and both individuals work abroad and both meet either the bona fide residence test or the physical presence test, each one can choose the foreign earned income exclusion. Together, they can exclude as much as $182,800 (2008: $175,200) for the 2009 tax year.

Another significant change, known as a 'stacking' provision, was designed to tax US-source income as if it was earned on top of the excluded foreign income; previously, the excluded foreign income was disregarded in calculating taxable US income. Evidently, this pushed many taxpayers into a higher tax bracket for their US-source income, affecting many middle-income people.

The IRS confirmed that: "Effective for tax years beginning after 2005, the amount of foreign earned income (and foreign housing costs) excluded from an individual's gross income will be used for purposes of determining the rate of income and alternative minimum tax (AMT) that applies to his or her nonexcluded income."

"The Tax Increase Prevention and Reconciliation Act of 2005 (P.L. 109-222) adds a new section 911(f) to the Internal Revenue Code. An individual's tax will be the excess of the tax that would be imposed if his or her taxable income were increased by the amount(s) excluded, and the tax that would be imposed if his or her taxable income were equal to the excluded amount(s)."

"For this purpose, the excluded amount(s) will be reduced by the aggregate amount of any deductions or other exclusions otherwise disallowed. In many cases this will have the effect of increasing an individual U.S. federal income tax to an amount greater than it would have been under prior law." When tax credits are available against the additional taxable income (they cannot be claimed in respect of excluded income), then if the foreign income was taxed highly, as is the case in most of Europe, there would be no signicant effect on after-tax income; but if the foreign location has low income taxes or none (as in many offshore locations, eg Bermuda), then the stacking' provision would hit home.

Foreign Tax Credit Changes 2007

In March 2007, the IRS and Treasury announced the release of proposed regulations that would disallow foreign tax credits for foreign taxes purportedly paid in connection with certain artificially engineered, highly structured transactions. The IRS explained that foreign tax credits are designed to relieve taxpayers from double taxation of their foreign source income. Transactions addressed by the regulations, in contrast, are structured so that the taxpayer voluntarily subjects itself to foreign tax where an ordinary business transaction generally would result in little or no foreign tax paid by the taxpayer.

The significant impact of these transactions on the US tax base was brought to the attention of the IRS by members of the Joint International Tax Shelter Information Centre (JITSIC). JITSIC is an information exchange arrangement under which the US, the UK, Canada and Australia exchange information bilaterally on tax avoidance schemes.

The Heroes Earnings Assistance and Relief Tax (HEART) Act 2008

On June 18, 2008, President Bush signed into law the "Heroes Earnings Assistance and Relief Tax (HEART) Act of 2008." This legislation contains many types of tax relief for military personnel, and other tax-related provisions. One provision requires US employers doing federal contract work for the US government and using foreign subsidiaries to compensate their US employees working abroad, to begin paying Social Security and Medicare taxes on behalf of these employees.

The provision increases the Foreign Earned Income Exclusion and advances the inflation-adjustment provision that was set to begin in 2008. However, the Act also includes a "stacking provision" that requires the Foreign Earned Income to be excluded against the lowest tax brackets first. Additionally, the Act limits the related Foreign Housing Exclusion to a figure based on the excess of 16% of the value of the Foreign Earned Income, with a cap of 30% of the value of the exclusion. (Previously, the figure was the excess of 16% of the salary of a federal worker grade G-14 Step 1, with no cap.) The Treasury was given authority to adjust this exclusion amount depending on cost-of-living factors in differing world metropolises.

The other offset provision seeks to make certain that individuals who relinquish their US citizenship or long-term US residency pay the same Federal taxes for appreciation of assets, such as stocks or bonds that they would pay if they sold them as US citizens or residents. Under this legislation, individuals are treated as if they sold all of their property for its fair market value on the day before they expatriate or terminate their residence.

Foreign Tax Credit Modification Bill - 2010

President Obama signed Aug. 10 legislation that makes a handful of changes to the foreign tax credit. The Senate passed the bill Aug. 5 by a 61-39 vote.The legislation imposes a new limit on the amount of foreign taxes deemed paid with respect to tax code Section 956 inclusion and denies the use of foreign tax credits in cases in which foreign income is not subject to U.S. taxation by reason of covered asset acquisitions. It also repeals special rules for interest and dividends received from persons meeting the 80 percent foreign business requirements. The bill eliminates the advance refundability of the earned income tax credit. Obama urged passage of the legislation, saying the offsets will close expat tax loopholes that encourage corporations that ship jobs overseas.