2009 expatriate tax technical positions version 1

Deloitte Tax LLP GLOBAL EMPLOYER SERVICES U.S. TAX TECHNICAL RELEASE- EXPATRIATE TAXATION PREPARATION OF 2009 U.S. EXPATRIATE TAX RETURNS RELEASE DATE: April 11, 2023

This release discusses common issues in preparing U.S. expatriate tax returns and the major uncertain areas and matters that require consideration in the preparation of returns for the 2009 taxation year. This release is to be used in conjunction with the Firm’s Tax Practice Manual available on TaxShare.

In completing income tax returns that report transactions for which the tax treatment is uncertain, professionals should consult with the appropriate GES competency group or Washington National Tax (WNT) specialist. In some cases, the local office tax QRM will need to be consulted. Please note that legislation was enacted and new regulations were issued during 2008 changing the professional standards affecting tax return paid preparers. See Section IX, Part C for a more detailed discussion of this legislation. Professionals should consult with their local office tax QRM for assistance and questions regarding the satisfaction of professional standards. Introduction GES U.S. Tax Technical Release — Expatriates sets forth common positions that should be considered in the preparation of U.S. tax returns for expatriates. Because of the complexity involved in the taxation of expatriates, there are a number of unsettled areas. This memorandum is based upon the Internal Revenue Code, treasury regulations and other administrative guidance, judicial decisions and legislative history existing upon its release.1 Subsequent legislation, IRS guidance, and court decisions could affect the conclusions stated herein. The tax professional preparing the income tax return is responsible for determining whether positions taken in an income tax return being prepared have been changed by subsequent legal developments. The positions described as acceptable in this document are those which the Global Employer Services competency group believes are generally supported by substantial authority. An income tax return preparer must determine the level of authority for a particular client based on that client’s facts. Positions that generally do not have substantial authority and that could require disclosure have been identified.

When an income tax return that takes a position that could be considered controversial is completed, the technical basis and advice for the position should be documented in the taxpayer file. In addition, the expatriate and, in the case of a company sponsored program, the employer must understand the position taken and the authorities supporting the position and those that would result in an alternative conclusion. For company sponsored programs, any controversial positions taken should be discussed with and

1 All references are to the Internal Revenue Code of 1986, as amended, and the regulations promulgated thereunder, unless otherwise indicated.

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GES U.S. Tax Technical Release for 2009 U.S. Returns — Expatriate Version 1.1 – March 12, 2010

agreed to by company personnel capable of understanding and evaluating the arguments and authorities applicable to the transaction.

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U.S. TAX TECHNICAL RELEASEExpatriate Taxation

TABLE OF CONTENTS

I. Section 911 Exclusion...............................................................................................................................6 A.Tax Home Requirement................................................................................................................................6B.Definition of Foreign Country......................................................................................................................7C.Bona Fide Residence (BFR) Test — Section 911(d)(1)(A).........................................................................7D.Physical Presence Test — Section 911(d)(1)(B)..........................................................................................8E.Other Considerations.....................................................................................................................................91) Treaty Exemption vs. Section 911 Exclusion.........................................................................................92) Restricted Countries..............................................................................................................................103) Adverse Conditions in Certain Foreign Countries................................................................................10

F.Foreign Earned Income Exclusion..............................................................................................................101) Exclusion Amount................................................................................................................................102) Attribution of Earned Income Rules.....................................................................................................11

G.Foreign Housing Exclusion........................................................................................................................121) Qualified Housing Expenses.................................................................................................................122) Housing Exclusion................................................................................................................................133) Housing Deduction...............................................................................................................................14

H.Section 911 and Partners............................................................................................................................14I.Income Tax Calculation After Considering the Exclusions.........................................................................15J.Revocation of Exclusions............................................................................................................................17II. Foreign Tax Credit..................................................................................................................................18A.Foreign Tax Deduction or Credit................................................................................................................18B.General Foreign Tax Credit Rules — Cash vs. Accrual.............................................................................19C.Creditable Foreign Taxes............................................................................................................................201) Social Security Taxes............................................................................................................................202) Converting Foreign Taxes to U.S. Dollars............................................................................................213) Section 901(j) Limitation for Certain Countries...................................................................................21

D.Determination of Income............................................................................................................................221) Compensation.......................................................................................................................................22

a. Hypothetical Tax as a Salary Reduction........................................................................................22b. Tax Equalization Advances............................................................................................................23c. Tax Equalization Exception to IRC Section 409A rules................................................................24d. Tax Equalization Payments to Employer.......................................................................................24e. Tax Loans and Advances...............................................................................................................26f. Interest-Free or Below Market Interest Rate Loans.......................................................................26g. Other Deferred Compensation Positions........................................................................................27h. Section 457A..................................................................................................................................27i. Employee Language Lessons and Cultural Training.....................................................................28j. Tax Return Preparation Fee............................................................................................................29k. Evacuation Allowances..................................................................................................................30l. Military Benefits............................................................................................................................30

2) Sourcing of Compensation — Treasury Reg. Section 1.861-4(b)........................................................32a. Days in a Business Year.................................................................................................................32b. Allocation of Home Compensation Components — Time Basis..................................................32

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c. Allocation of Assignment Compensation Components — Geographical Basis............................33d. Alternative Basis of Allocation......................................................................................................33e. Multi-year compensation................................................................................................................34

3) Treaty Re-sourcing of Compensation...................................................................................................354) Sourcing of Business Expenses and Itemized Deductions...................................................................37

a. Sourcing of Charitable Contributions............................................................................................38b. Sourcing Investment Interest Expense...........................................................................................38

E.Foreign Tax Disallowance Formula............................................................................................................381) Foreign tax amount...............................................................................................................................392) Associating tax with income.................................................................................................................393) Numerator ..........................................................................................................................................394) Denominator.........................................................................................................................................405) Separate Disallowance Formula for the Housing Exclusion................................................................41

F.Allocation of Foreign Taxes to “Baskets” of Income.................................................................................42G.Carryback and Carryforward......................................................................................................................44H.Alternative Minimum Tax..........................................................................................................................44I.Redetermination of Foreign Taxes...............................................................................................................45III. Moving Expenses...................................................................................................................................46A.Moving Expense Sourcing Rules Under Section 911................................................................................47B.Attribution rules..........................................................................................................................................48C.Disallowance of moving deduction............................................................................................................49D.Moves Back to the U.S...............................................................................................................................51IV. Away from Home Expenses - One Year Limitation..........................................................................51V. Exclusion of Gain on the Sale of a Principal Residence......................................................................52A.Sales Occurring in 2008 or Earlier.............................................................................................................52B.Sales Occurring after December 31, 2008..................................................................................................53C. Like-Kind Exchanges...............................................................................................................................54 D. State Taxes ..........................................................................................................................................54VI. Rental of Residence During Foreign Assignment..............................................................................55A.Home Mortgage Interest Deduction — Generally.....................................................................................55B.Section 469(j)(7).........................................................................................................................................55C.Qualified Residence Interest.......................................................................................................................55D.Year of Departure & Return from Foreign Assignment.............................................................................56E.Net Operating Losses on Rental Properties................................................................................................57F.Suspended Losses upon the Sale of a Residence covered by section 121..................................................57G.Extinguishing Debt for Rental Property.....................................................................................................58H.Extinguishing Debt on a Foreign Principal Residence...............................................................................58I.Rental of Foreign Residence........................................................................................................................59VII. Social Security and Self-Employment Tax Totalization Agreements..............................................63VIII. Retirement Plan Deductions..............................................................................................................64A.IRA Deductions ..........................................................................................................................................64B.Keogh Contributions/Deductions...............................................................................................................651) Sole Proprietors.....................................................................................................................................652) Partners ..........................................................................................................................................66

IX. Miscellaneous .......................................................................................................................................66A.Timely Filing Requirement........................................................................................................................661) Timely Filed Section 911 Elections......................................................................................................672) Timely Filed Returns — Foreign Postmarks........................................................................................683) Foreign Delivery Services.....................................................................................................................684) Timely Filed Refund Claims.................................................................................................................68

B.Treaty-Based Return Positions — Disclosure and Penalties......................................................................69C.Changes in Penalty Standards of Tax Return Preparers.............................................................................70D.State Returns ..........................................................................................................................................73E.Currency Exchange Rates...........................................................................................................................73

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F.Underpayment Penalties not Reduced by Foreign Tax Credit Carrybacks.................................................73X. Expatriation Provisions..........................................................................................................................73A.Individuals subject to the tax......................................................................................................................73B.Expatriation prior to June 4, 2004..............................................................................................................74C.Expatriation on or after June 4, 2004..........................................................................................................76D.Expatriation on or after June 17, 2008.......................................................................................................781) Mark to Market Deemed Sale...............................................................................................................78

2) Special rules for certain deferred compensation assets, interests in foreign trusts, and specified tax-deferred accounts..........................................................................................................................78

3) Tax on Gifts and Bequests....................................................................................................................80 4) Deferral of Tax.....................................................................................................................................80XI. Reporting Requirements of Foreign Bank and Financial Accounts................................................80XII. Trust/Gift Positions..............................................................................................................................83A.Foreign Trusts ..........................................................................................................................................83B.Reporting Requirement for U.S. Beneficiaries of Foreign Trusts..............................................................83C.U.S. Recipients of Foreign Gifts.................................................................................................................86

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I. Section 911 Exclusion To be eligible to claim the foreign earned income and housing exclusions under section 911, an individual must:

1) have his/her tax home in a foreign country, and

2) be a qualified individual who meets the requirements of either

a) the bona fide residence test (BFR) - A U.S. citizen who is a bona fide resident of a foreign country for an uninterrupted period that includes an entire taxable year, or

b) the physical presence test (PPT) - A U.S. citizen or U.S. resident who is physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months.2

A. Tax Home Requirement An expatriate must have a foreign tax home in order to qualify for the section 911 exclusions. The foreign tax home must be maintained throughout the period of bona fide residence or the full 330 days of physical presence. Only foreign-source income earned while an expatriate has a foreign tax home is eligible for exclusion under section 911.3 Wages earned prior to establishing a foreign tax home may not be excluded.

A taxpayer’s “tax home” is generally considered to be:

The taxpayer’s regular or principal (if more than one regular) place of business, or If the taxpayer has no regular or principal place of business, then at the taxpayer’s regular place

of abode in a real and substantial sense.4

The fact that a taxpayer’s trade or business is of such a nature that he has no principal place of employment (i.e., an individual who continuously travels to various business locations) does not necessarily mean that he has no tax home.5 An employee without a principal place of business may treat a permanent place of residence at which he incurs substantial living expenses as his tax home. If he does not maintain a regular abode, his tax home would move continuously with him. The IRS uses three objective factors to determine whether an individual’s claimed abode is his “regular place of abode in a real and substantial sense.”6 These factors are:

2 I.R.C. §911(d)(1)

3 I.R.C. §911(b)(1)(A).

4 Treas. Reg. §1.911-2(b), Revenue Ruling 73-529, 1973-2 C.B. 37, Revenue Ruling 60-189, 1960-1 C. B. 60.

5 Revenue Ruling 71-247, 1971-1 C. B. 54.

6 Revenue Ruling 83-82, 1983-1 C.B. 45, overruled on other grounds by Revenue Ruling 93-86, 1993-2 C. B. 71.6


1. Whether the taxpayer performs a portion of his business in the vicinity of his claimed home and uses it for purposes of lodging while performing such business;

2. Whether the taxpayer’s living expenses incurred at his claimed home are duplicated because his business requires him to be away; and

3. Whether the taxpayera. has not abandoned the vicinity in which his historical place of lodging and his claimed

home are both located, b. has a member or members of his family currently residing at his claimed home, or c. uses his claimed home for purposes of his lodging.

(See Revenue Ruling 83-82, 1983-1 C.B. 45.)

A taxpayer who satisfies all three factors is deemed to have a tax home at “a regular place of abode” for traveling expense deduction purposes. Satisfaction of fewer than three may subject the taxpayer to close scrutiny of the facts and circumstances.7 The taxpayer bears the burden of proving that contacts with a locality are sufficient to establish it as a tax home. In determining a taxpayer’s home, the courts have consistently held that objective financial criteria (i.e., payment of a mortgage) will be accorded more weight than elements which are indicative of a taxpayer’s subjective intent but easily manipulated (i.e., bank accounts, driver’s licenses, vehicle and voter registration, insurance).

B. Definition of Foreign Country The Code does not define “foreign” when used in conjunction with country. Treasury Reg. section 1.911-2(h) defines the term “foreign country” to include any territory under the sovereignty of a government other than that of the United States. Thus, possessions and territories (i.e., Puerto Rico, Guam, etc.) of the U.S. are not treated as foreign countries for purposes of section 911.8 Accordingly, income earned in these locations is not considered foreign earned income, nor is residence there considered residing in a foreign country for purposes of establishing a foreign tax home.

The Tax Court in Specking held that a demilitarization officer stationed on Johnston Island (a U.S. possession) was not entitled to the 911 exclusion.9 Most recently, the Tax Court held that Antarctica was not a foreign country for purposes of the section 911 exclusion.10

C. Bona Fide Residence (BFR) Test — Section 911(d)(1)(A)

7 Rev. Rul. 73-529.

8 Treas. Reg. §1.911-2(g).

9 117 T.C. 95 (2001).

10 Arnett v. Comm’r, 126 T.C. No. 5 (2006) affirmed by U.S Court of Appeals, 7th Circuit, Jan 16, 2007. This is in-line with the view taken in other revenue rulings and cases concerning the artic region in the northern hemisphere. See generally Revenue Ruling 67-52, 1967-1 C.B. 186, Martin v Comm’r, 50 TC 59 (1968). Several additional cases were decided later in 2007 that confirmed the same ruling.

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To qualify under BFR, a U.S. citizen: (1) must be a true, bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year;11 (2) may not have made a statement of nonresidence to the host country’s government;12 and (3) generally must be subject to any income tax imposed by the host country. However, it is possible to be considered a nonresident of a country while still qualifying as a bona fide resident of that country. An income tax exemption provided in a treaty or other international agreement will not in itself prevent a person from being a bona fide resident of a foreign country. Whether a treaty prevents a person from becoming a bona fide resident of a foreign country is determined under all provisions of the treaty, including specific provisions relating to residence or privileges and immunities. The test of bona fide residence turns primarily on the facts and requires an analysis of all relevant facts and circumstances. The intent of the taxpayer, as well as the purpose of the trip and the nature and length of the stay, plays an important role in determining whether a foreign residence has been established and maintained.13 Note that bona fide residence is not the same as domicile. Domicile is generally an individual’s fixed permanent home — the place to which the individual intends to and will always return.

Bona fide residence may begin with the date of a pre-move visit if during that visit the foreign assignment has been accepted and arrangements for housing are made. However, because the individual’s tax home must also be in the foreign country during this period, any reimbursements for lodging, meals, transportation, etc., in the host location must be included in taxable compensation and are not excludable business expenses. Once a taxpayer has qualified as a bona fide resident for a full tax year, any part of a year of continuous bona fide residence will qualify under the test. An individual may move from one foreign country to another foreign country or make temporary visits to the United States without interfering with his/her status, so long as the period is not interrupted with a period of U.S. residence.

Resident Alien

Code Section 911 states that BFR is available for U.S. citizens. U.S. residents are specifically not stated in this section. For a resident alien to qualify under BFR, the resident alien must be a citizen of a country that has an income tax treaty with the U.S., and the treaty must contain a non-discrimination clause in it. The non-discrimination clause within the treaty should provide that the resident alien be treated equally to a U.S. citizen. With this language in the treaty, the resident alien would be allowed to qualify for BFR, assuming he/she meets the other requirements.14

D. Physical Presence Test — Section 911(d)(1)(B)

11 I.R.C. §911(d)(1)(A).

12 I.R.C. §911(d)(5).

13 Sochurek v. Comm’r, 300 F.2d 34 (7th Cir. 1962), Jones v. Comm’r, 927 F.2d 849 (5th Cir. 1991), Schoneberger v. Comm’r, 74 T.C. 1016 (1980).

14 Revenue Ruling 91-58, 1991-2 CB 3408


To qualify under PPT, a U.S. citizen or resident must be physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months.15 The 330 days need not be consecutive days.

A full day is a continuous period of 24 hours from midnight to midnight. In departing from U.S. soil to go directly to the foreign country, or in returning directly to the U.S. from a foreign country, the time spent on or over international waters does not count toward the 330-day total. For example, if an individual leaves the U.S. on February 8th in the evening, flies directly over international waters and arrives in Germany in the morning of February 9th, the individual's first full day in Germany is February 10th.

However, if in traveling from the U.S. to a foreign country, an individual passes over a foreign country before midnight of the day of departure, the day following the day of departure can qualify toward the 330-day total.16 Using the same example as in the prior paragraph, assume the flight leaves the U.S. at 8:00 PM on February 8th, enters the international air space of Canada at 10:00 PM, proceeds over the Atlantic Ocean and arrives in Germany at 10:00 AM on February 9th, the individual's first full day in Germany will be February 9th. The tax home requirement need only be met with respect to the 330 qualifying days, not the entire 12-month period, as stated in the final regulations. Example (4) of Treasury Reg. Section 1.911-4(f) provides that an individual who is physically present in a foreign country or countries for 330 days within a 12-consecutive- month period may choose any 12-consecutive-month period which begins prior to the individual’s actual commencement of physical presence in a foreign country. Treasury Reg. Section 1.911-3(d)(3) allows the 12-consecutive-month period to include days in which the individual is neither physically present nor maintains a foreign tax home, as long as the individual’s tax home is in a foreign country during each of the 330 days. Therefore, the 12-consecutive-month period can be moved backward or forward in order to maximize the exclusion amount under PPT. As an example, if an individual's first full day in France is July 1, 2009, and the individual does not travel back to the U.S. during the next 330 days, the 12-consecutive-month period can begin on May 27, 2009 in order to achieve a result that may be more advantageous than a July 1, 2009 - June 30, 2010 period. NOTE: The use of one test in a given year, e.g. BFR, does not prohibit the use of the other test, e.g., PPT, in a following year. E. Other Considerations

1) Treaty Exemption vs. Section 911 Exclusion Many U.S. income tax treaties provide a limited exemption for dependent personal services. The purpose of the treaty provision is to provide a tax exemption to individuals traveling temporarily to a treaty country on business. Section 911, however, provides an exclusion for employees on international assignment who have a foreign tax home and satisfy either BFR or PPT.

15 I.R.C. §911(d)(1)(B).

16 See generally Treas. Reg. §1.911-2(d)(2). 9


It is inconsistent to claim treaty exemption in the country where one is also claiming a section 911 exclusion under the BFR test. PPT can be claimed in concert with treaty exemption. It is possible that a particular treaty (e.g., the treaty with Australia) may include a miscellaneous provision preventing such “double dipping.” As in all cases involving treaty provisions, it is imperative that the treaty be reviewed.

2) Restricted Countries Section 911(d)(8) limits the provisions of the foreign earned income exclusion for individuals traveling or residing in certain restricted countries. Specifically, an individual is not considered a bona fide resident of, or as present in, a foreign country on any day the individual is present in one of these countries. Foreign earned income shall not include any income earned in a restricted country. Revenue Ruling 2005-3, 2005-3 IRB 1 is still applicable and notes that Cuba is the only restricted country.

Country Starting Date Ending DateCuba January 1, 1987 still in effect

However, please note Notice 2006-84, 2006-41 IRB 677, which indicates that individuals providing services at the U.S. Naval Base on Guantanamo Bay are performing services within a foreign country and are eligible for the exclusion under Section 911 provided they meet the other requirements of this section.

3) Adverse Conditions in Certain Foreign Countries

Section 911(d)(4) provides for an exception to the eligibility requirements to claim a section 911 exclusion for individuals who would have been otherwise qualified to claim the exclusion, but were required to leave the country because of war, civil unrest, or similar adverse condition that precluded the normal conduct of business. In Rev. Proc. 2010-17, the following countries were deemed to have war, civil unrest, or similar adverse conditions that precluded the normal conduct of business beginning on the specified date:17

Country On or after Madagascar March 18, 2009Guinea October 1, 2009

F. Foreign Earned Income Exclusion The Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) significantly changed the way the Section 911 exclusions are calculated, both the foreign earned income and the housing exclusions. These changes are reflected in the following material.

17 Rev. Proc. 2010-17, 2010 IRB 64. Please see Revenue Procedures 2001-27, 2002-20, 2003-26, 2004-17, 2006-28, 2007-28 and 2009-22 for additional countries affecting prior tax filing years.

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1) Exclusion Amount

Qualified individuals may elect to exclude their foreign earned income from gross income, subject to an annual limitation. Under Section 911(b)(2)(D), the exclusion for any of the calendar years between 2002 and 2005 is $80,000. Beginning after 2005, the exclusion amount will be adjusted for inflation.18 For 2009, the limitation of this exclusion will be $91,400, and for 2010, the limitation will be $91,500.19

An individual who does not qualify for the entire taxable year must pro-rate the maximum allowed exclusion on a daily basis. For example, assume an individual qualifies for the exclusion for the period August 1, 2009 - July 31, 2010. The qualifying period includes 153 days during 2009. The individual would have to pro-rate his/her 2009 exclusion limitation based on the number of qualifying days in 2009, or 153 days out of 365 days. Therefore, the maximum foreign earned income exclusion that can be claimed in 2009 is $38,313 ($91,400 * (153/365)).

Married Couples

If a husband and wife both qualify for the foreign earned income exclusion, the amount of excludable foreign earned income is determined separately for each spouse.20 They will each be required to complete their own Form 2555 to determine their qualifying period and to calculate the amount of the exclusion. For example, if, in 2009, one spouse has $50,000 of foreign earned income and the other spouse has $100,000 of foreign earned income, each spouse will file a separate Form 2555 and determine his/her separate exclusion on the basis of the income attributable to his/her services only. Therefore, assuming they both qualify for the full year, the first spouse will exclude $50,000 and the second spouse will exclude $91,400. The first spouse is prohibited from using the unused portion of the second spouse's exclusion.21

2) Attribution of Earned Income Rules Section 911(b)(1)(A) provides that income that qualifies for the exclusion includes foreign-source income earned for services performed during an individual’s qualifying period. Pursuant to section 911(b)(2)(D), income that qualifies for the annual exclusion in any given tax year includes only that income which is received for services performed in that tax year. Therefore, amounts received in 2009 for services performed in prior or future years will not qualify for the exclusion in 2009. Income which typically relates to years other than the year of receipt or to multiple years includes:

Moving reimbursements, Prepaid premiums and allowances, Tax equalization settlements, Foreign tax reimbursements (other than current withholding/gross-ups), Income from the exercise of stock options, Bonuses,

18 I.R.C. §911(b)(2)(D)(ii)

19 Rev. Proc. 2009-50

20 Reg.§1.911-5(a)(1)

21 Reg. §1.911-5(a)(2)11


Stock purchase plan income, Restricted stock awards, and Other deferred compensation.

These amounts must be attributed to the year in which they are earned. For example, a 2008 tax equalization settlement which is paid to the employee in 2009 is reportable as 2009 income, but is attributable to 2008. Therefore, it is considered prior year income and cannot be excluded based on the current year exclusion. Foreign earned income attributable to services performed in the prior tax year can only be excluded to the extent the exclusion may not have been fully utilized in such prior or future year. Under section 911(b)(1)(B)(iv), income received more than one year after being earned may not be excluded even though there may be unused exclusion amounts in the year the income was earned.

G. Foreign Housing Exclusion In addition to the foreign earned income exclusion, qualified individuals can also elect to exclude qualified housing expenses. Again, TIPRA significantly changed the way the housing exclusion is calculated.

1) Qualified Housing Expenses

Generally, qualified housing expenses include reasonable (not lavish or extravagant) expenses paid by a taxpayer during the year for housing for the individual and his/her dependents (if they live together) in a foreign country.22 Housing expenses may also include expenses for a second foreign household if certain conditions are met.23 Housing expenses are defined in Treasury reg. section 1.911-4(b) to include:

Rent, Fair value rental of housing provided in kind by the employer, Utilities (other than telephone charges), Real and personal property insurance, Occupancy taxes (contrast with those listed below), Nonrefundable fees paid to secure a lease (deposits that will be refunded are not excludable), Rental of furniture and accessories, and Residential parking.

It should be noted that temporary living expenses may be treated as qualified housing expenses to the extent the amounts relate to hotel or other lodging, but not to meals and incidentals. Housing expenses do not include:

Capital expenditures, Cost of purchased furniture or accessories,

22 I.R.C. §911(c)(3).

23 See Reg. § 1.911-4(b)(5) for additional information on expenses related to a second foreign household.12


Domestic labor (maids, gardeners, etc.), Payments of principal on a mortgage, Depreciation, and Telephone charges.

IRC Section 911(c)(3)(A)(ii) states that interest of the kind deductible as qualified residence interest under IRC Section 163 is not includible as housing expense. Treasury reg. sections 1.911-4(b)(2)(i) and (v) prohibit the exclusion of interest deductible as qualified residence interest. Per IRC Section 163(h)(3)(B)(ii), qualified residence interest is only deductible on acquisition indebtedness up to $1 million. Interest on acquisition indebtedness over $1 million is considered personal interest and not deductible interest. Therefore, some question whether interest on acquisition indebtedness over $1 million can be included as housing expense, since it is not deductible as qualified residence interest. The expectation is that the disallowed portion of qualified residence interest on acquisition indebtedness over $1 million is not a qualified housing expense under section 911, as it is still considered interest of the kind deductible as qualified residence interest. It may not be deductible under Section 163, but it is qualified residence interest, which is interest of a kind that is deductible.

Nevertheless, since the code and regulations reference to amounts that are deductible under Section 163, some have offered that there is a position that qualified residence interest on acquisition indebtedness over $1 million does not fall under the category of Section 163, and therefore, can be included as housing expense. However, there is no case law or other authority to support this argument. Therefore, before this position is taken on a return, it should be discussed with the engagement partner, the Global Employer Services competency group and WNT tax technical resources and your local tax QRM. In addition, it can only be claimed with proper disclosure on Form 8275. Finally, it should be discussed with the client to address all of the potential implications.

2) Housing Exclusion

If all or a part of an individual's housing amount is attributable to employer-provided amounts, the individual may elect to exclude the housing amounts from income. Employer-provided amounts are amounts paid or incurred on behalf of the employee by the employer and included in the employee's income for the taxable year.

Calculation

The housing exclusion is calculated as the amount of qualified housing expenses in excess of a base housing amount. Prior to 2006, qualified housing expenses were unlimited, subject to the provisions above regarding lavish or extravagant. The base housing amount was $11,894. Therefore, all qualified housing expenses over $11,894 could be excluded.

As a result of TIPRA, beginning with 2006, the amount of qualified housing expenses that can be excluded is limited to 30% of the foreign earned income exclusion limitation24 and the base housing amount is set at 16% of the foreign earned income exclusion limitation.25 Accordingly, the maximum

24 I.R.C§ 911(c)(2)(A)

25 I.R.C§ 911(c)(1)(B)13


amount of qualified housing expenses for 2009 is now limited to $27,420 ($91,400 * 30%), and the base housing amount for 2009 is set at $14,624 ($91,400 * 16%). Therefore, the maximum housing exclusion for 2009 is $12,796 ($27,420-$14,624).

In November, 2008, Treasury issued Notice 2008-107, which provided that the maximum amount of qualified housing expenses for taxable years beginning on or after 2008 could be higher in specific locations identified in the notice. Refer to this notice for further details. Treasury has not issued an updated notice since then. Instead, Treasury has included the table from this notice in the 2009 instructions for Form 2555. The annual amounts included in the instructions are the same as the amounts included in Notice 2008-107. The daily amounts are different, as a result of 2008 having 366 days as compared to 365 days in 2009, but otherwise, the amounts are the same.

The housing exclusion is calculated on a per day basis. For an individual who only qualifies to claim the exclusion for a part of the year, the amounts should be pro-rated based on the number of qualifying days in the year.

3) Housing Deduction

For self-employed individuals (i.e. partners), any part of the qualified housing expenses not attributable to employer-provided amounts is taken as a deduction rather than an exclusion from gross income. Self-employment income is not considered employer-provided compensation. See Part I on page 15 below regarding the income tax calculation after considering the exclusion for a further discussion regarding the housing deduction.

H. Section 911 and Partners The IRS has ruled that section 911 applies to partnership gross income and as such there is a requirement to allocate partnership expenses to the excluded income.26

With regard to whether income subject to the exclusion is gross or net, the regulations address sole proprietorships and other situations involving the self employed but are silent on partnerships. In Vogt v. United States, the Court of Claims did an extensive analysis of section 911 and the requirement to disallow deductions and credits attributable to excluded income.27 The court ruled that the IRS had tried to change a longstanding common law understanding that section 911 was applied to net partnership income. The court rejected the Service’s argument that Revenue Ruling 75-86, 1975-1 C.B. 242 was merely interpreting existing law. The Vogt case has been cited in at least five cases since then that involve challenges to the IRS requirement that section 911 applies to gross income in a variety of self-employed and sole-proprietor situations. In all cases, the courts have distinguished Vogt as concurring that partnerships are unique and net partnership income is the proper starting point for applying section 911. As a result of the Vogt case, there is substantial authority to not disallow partnership expenses attributable to included income. This does not carry to the individual partner’s expenses which are subject to the disallowance rule.

26 Revenue Ruling 75-86, 1975-1 C.B. 242; Revenue Ruling 76-163, 1976-1 C.B. 199.

27 Vogt v. United States, 537 F.2d 405 (Ct. Cl. 1976)14


Section 1402(a) defines self-employment income as the gross income derived by an individual from any trade or business, with adjustments as outlined. Section 1402(a)(11) specifies that there shall be no adjustment allowed to self-employment income for the provisions of section 911(a)(1). Section 911(a)(1) defines the general and housing exclusions. The housing deduction allowed for self-employed individuals is not covered in section 1402 and is not a prohibited deduction, so it should be subtracted from partners’ self-employment income.28

I. Income Tax Calculation After Considering the Exclusions

TIPRA instituted a stacking calculation to the actual tax calculation after claiming the exclusions. For 2005 and earlier years, the exclusion would be a reduction against gross income, and the final U.S. tax liability would be calculated based on taxable income after considering the exclusions. For 2006 and future years, the law now requires the taxpayer to determine his/her taxable income, after all deductions and exemptions, but before calculating the tax liability, the taxpayer must add back the amount of the exclusions, calculate the tax, and then subtract an amount of tax calculated as if the exclusion amount was the taxable income.29 An example of the tax calculation follows. Note that this example shows 2006 exclusion amounts and tax rates, but the same provisions apply for 2009.

Married Filing Joint, No children 2005 2006Gross Income Including WagesForeign Earned Income ExclusionHousing Exclusion ($50,000 Qualified Housing Expenses)Adjusted Gross IncomeLess: Standard/Itemized Deductions Personal ExemptionsTaxable Income

$150,000 (80,000) (38,106)$ 31,894

(10,000) ( 6,400)$ 15,494

$150,000 (82,400) (11,536)$ 56,064

(10,300) ( 6,600)$ 39,164

Calculation of TaxTaxable IncomePlus: ExclusionsTax Base Tax CalculationLess: Tax on Exclusions

Net Tax Liability

$ 15,494 N/A $ 15,494$ 1,594 N/A

$ 1,594

$ 39,164 93,936$133,100$ 26,672 16,599

$ 10,073

Housing Deduction

For self-employed individuals who claim the housing deduction, there is some question whether the

28 See Cook v. United States, 220 Ct. Cl. 76 (1979).

29 I.R.C. § 911(f)15


housing deduction amount should be added back to taxable income in the same way that the housing exclusion amount is. Instructions provided by the IRS over the past few years have been inconsistent in dealing with this question. In the Form 1040 instructions issued with the 2007 tax returns, the Foreign Earned Income Tax Worksheet instructed taxpayers to add back the amount from line 45 of the Form 2555. Line 45 was the sum of the foreign earned income exclusion and housing exclusion, but it did not include the housing deduction amount. The worksheet included in the 2008 and 2009 Form 1040 instructions now directs the taxpayer to add the amount from lines 45 and 50 of the Form 2555. Line 45 continues to be the sum of the foreign earned income and housing exclusions, and line 50 is the housing deduction amount. Therefore, in 2007, the IRS only considered the housing exclusion in the calculation, but beginning in 2008, they have changed their guidance to consider both the housing exclusion and the housing deduction.

In addressing this tax calculation, the statutory and regulatory language clearly specifies amounts that are excluded from income. IRC Sec. 911(f)(1), using language specified in the actual TIPRA legislation, states:

If, for any taxable year, any amount is excluded (emphasis added) from gross income of a taxpayer…(A) If such taxpayer has taxable income for such taxable year, the tax imposed by section 1 for such

taxable year shall be equal to the excess (if any) of(i) the tax which would be imposed by section 1 for such taxable year if the taxpayer’s

taxable income were increased by the amount excluded (emphasis added) under subsection (a) for such taxable year, over

(ii) the tax which would be imposed by section 1 for such taxable year if the taxpayer’s taxable income were equal to the amount excluded (emphasis added) under subsection (a) for such taxable year

IRC Sec. 911(a) states:

At the election of a qualified individual…, there shall be excluded from the gross income of such individual, and exempt from taxation under this subtitle, for any taxable year

1) the foreign earned income of such individual, and2) the housing cost amount of such individual.

In clarifying what is meant by the housing cost amount of Sec. 911(a), Sec. 911(c)(4)(A) differentiates housing expenses not provided by the employer. In this section, it states:

To the extent the housing cost amount of any individual for any taxable year is not attributable to employer provided amounts, such amount shall be treated as a deduction (emphasis added) allowable in computing adjusted gross income…

Therefore, in reviewing the statutory language of Section 911, it appears that there is a distinction between amounts that are excluded and amounts that are deducted. This is consistent with the reporting of the housing exclusion and housing deduction on page 1 of Form 1040. The exclusions are reported as a reduction to income on line 21 and factored into the determination of total income, whereas the

16


housing deduction is reported as a separate item to the left of line 36 as an adjustment to gross income to determine adjusted gross income.

Additionally, in Sec. 911(a), quoted above, the statute indicates that the exclusions are available to the taxpayer “At the election of a qualified individual…”. Regulation Sec. 1.911-7 reviews the procedural rules necessary to make this election. However, Reg. Sec. 1.911-7(a)(3) indicates that an individual does not have to make an election in order to claim the housing cost amount deduction. In practice, it is reported on Form 2555, similar to the exclusion, but it is reported separately from the exclusion calculation, and it is technically not required to be part of this election statement. Again, the regulations appear to clearly differentiate between the excluded amount and the deducted amount.

Based on the statutory and regulatory rules that have been promulgated by the IRS, it appears that they differentiate between the housing exclusion and the housing deduction. In drafting Sec. 911(f), Treasury was very specific to identify income that has been excluded from gross income as subject to the revised tax calculation. Accordingly, in spite of the IRS change to the Form 1040 instructions from 2007 to 2008, there is a position that amounts claimed as a housing deduction for self-employed taxpayers should not be added back to the tax calculation for purposes of Sec. 911(f). Based on our review, we believe that this position reaches a more likely than not level of authority.

Not that the following is authoritative, but BNA seems to have reached this conclusion, as summarized in Portfolio 918-2nd: Section 911 and Other International Tax Rules Relating to U.S. Citizens and Residents. In Section I, Part D, Calculating the Tax on Nonexcluded Income, they have an observation at the end of that Part that reads as follows: The stacking rule of Sec. 911(f) requires the taxpayer’s taxable income to be increased by “the amount excluded under subsection (a) for the taxable year.” On its face, this provision does not apply to the amount of housing expenses that a self-employed taxpayer is entitled to deduct under Sec. 911(c)(4), with the result that taxpayers may only be subject to the stacking rule in relation to their foreign earned income exclusion, and not in relation to their housing costs.

Nevertheless, it is important to note that the IRS did begin challenging this position on 2008 income tax returns. Consistent with the Form 1040 instruction, the IRS asserted that the housing deduction should be added back to the tax calculation. Accordingly, as mentioned above, while we believe this position reaches a level of authority of More Likely Than Not, this position should only be taken after consultation with the engagement PPD, and with acknowledgement of the client so that the client understands the difference in positions, understands the potential savings, and understands that the IRS may challenge the position through a notice.

J. Revocation of Exclusions

With the new limitation on the housing exclusion and the change in the tax calculation, there may be more circumstances where it is beneficial to choose not to claim the exclusions. As a result, revoking the exclusions and the potential implication of this revocation must be considered.

An individual may revoke the exclusions for any taxable year, including the first taxable year for which the election is available. The revocation is made by either filing a statement of revocation with the tax

17


return when filed, or if the individual had previously elected to claim the exclusions, and while still qualifying to claim the exclusions, chooses not to claim them in the current year. If the individual has never previously elected to claim the exclusions (e.g., first year on assignment), and chooses not to claim the exclusion, that is not considered a revocation. The exclusion must first be elected before it can be revoked. However, once the revocation is made, it is effective for that year and for all subsequent years.30

Once revoked, the individual may not, without the consent of the IRS, make the election to exclude income until the sixth taxable year following the taxable year for which the revocation was first effective.31 If the individual determines that it would be in his/her best interest to re-elect the exclusions prior to the sixth taxable year, the individual may apply with the IRS in accordance with Treas. Reg. Section 1.911-7(b)(2). The regulations provide several factors that the IRS can consider in deciding whether to consent to the re-election. These factors include a period of U.S. residence, a move from one foreign country to another foreign country with differing tax rates, a substantial change in tax laws of the foreign country of residence or physical presence, change of employer, and any other facts or circumstances that may be relevant to the determination.32

II. Foreign Tax Credit

A. Foreign Tax Deduction or Credit

To help avoid or minimize the impact of paying both U.S. taxes and foreign taxes on the same income, the tax code allows a taxpayer to elect to take either a deduction or a credit for foreign taxes paid or accrued. This election applies to all taxes paid in the year on any type of income. It also applies for both regular tax and alternative minimum tax (AMT). If a taxpayer chooses to claim a credit in any taxable year, these taxes may not be claimed as a deduction, unless an amended return is filed to switch the amount from a credit to a deduction.

A credit is allowed for foreign income, war profits, and excess profits taxes paid or accrued by a U.S. citizen or resident to a foreign country or a U.S. possession.33 Certain foreign social security taxes may also be considered as creditable taxes (see section below regarding social security taxes claimed as an income tax).

Foreign taxes claimed as a credit are not limited to that portion of the tax which is attributable to income subject to U.S. tax.34 Thus, foreign taxes related to income exempt from U.S. tax may be claimed as a credit. However, for foreign taxes claimed as a deduction, foreign taxes paid on income exempt from U.S. tax are not deductible, pursuant to section 265, which disallows deductions allocable to income that is “wholly exempt.”

30 Reg. §1.911-7(b)(1); Revenue Ruling 90-77, 1990-2 C.B. 183

31 I.R.C. § 911(e)(2)

32 Reg. § 1.911-7(b)(2)

33 I.R.C. § 901(b)(1)

34 Revenue Ruling 54-15, 1954-1 C.B. 129. 18


Any amount claimed as a deduction or credit is limited to the tax liability the taxpayer reasonably expects to pay. Thus, a taxpayer who does not expect to pay these amounts should not claim them as a deduction or credit. In any year in which a deduction is taken, no carryback or carryover from other years is allowed as a credit in that year. Further, any carryback or carryover must be reduced by the amount that would have been used had the foreign tax credit been chosen in that year. Thus, in order to receive any benefit for a foreign tax credit carryover or carryback to a year in which a deduction for foreign taxes was taken, an amended return must be filed to elect to credit the foreign taxes for the year to which foreign taxes are carried. B. General Foreign Tax Credit Rules — Cash vs. Accrual A taxpayer on the accrual method of accounting must claim foreign taxes in the year they accrue.35 However, most individuals are on the cash method of accounting. Under this method, a taxpayer may elect to claim the foreign taxes on either a paid basis or an accrued basis. If the taxpayer uses the paid basis, foreign taxes can be claimed as a credit in the year paid to the foreign taxing authority. If the taxpayer uses the accrual basis, foreign taxes can be claimed as a credit in the year the foreign tax liability accrues.36

The time for accrual is determined when all of the events have occurred that establish the tax liability (“all events test”).37 In most cases, this is the end of the tax year in the foreign country. When a taxpayer is on the accrual method for foreign tax credit purposes, and has a foreign tax year different from the U.S. tax year (e.g., United Kingdom, Hong Kong, Australia, South Africa), the foreign taxes generally do not accrue until the last day of the foreign country’s tax year. Therefore, no portion of the foreign taxes for a specific year can be accrued by the taxpayer until the U.S. year in which the foreign country’s tax year ends.38 Thus a taxpayer on the accrual method cannot claim any foreign tax credits for a foreign taxable year until the foreign taxable year ends, even though foreign taxes may have been paid via withholding.

In very limited circumstances, the “all events test” may be met prior to the end of the tax year of the foreign country. It is extremely rare for the IRS to agree with this presumption. Before claiming the accrued taxes prior to the end of the foreign country’s tax year, this position should be discussed with the Global Employer Services competency group and WNT technical specialists. In addition, if taken, clear disclosure on Form 8275 must be attached to the return.

Nevertheless, in the year of departure from the foreign country, it may be possible to accrue the foreign tax before the fiscal year end if and only if the country’s rules stipulate that the partial-year return is a final return with the year end at the departure date. The Hong Kong tax liability may arise upon the cessation of residence; therefore, an accelerated foreign tax credit accrual may occur. However, most

35 Treas. Reg. §1.905-1(a).

36 Reg.§1.905-1(a)

37 Reg.§1.461-(1)(a)(2)(i)

38 See generally, Revenue Ruling 61-93, 1961-1 C.B. 390. Also see Reg.§1.461-1(a)(2)(i) and Reg.§1.461-4(g)(6)(iii)(B).19


individuals in Hong Kong are on the cash basis for foreign tax credit purposes, and, thus, this rule does not apply. The accrual method may be elected for any tax year, even if the cash method was used in the prior year. The election is made by checking the box on part II of the Form 1116. Once the accrual method has been elected, it must be used in all future years39 and cannot be revoked with an amended return.40 However, note that if the paid method was claimed in a prior year, the taxpayer cannot elect to switch to the accrual method by filing an amended tax return for that prior year. Once the time period for filing that prior year return has passed, the method for claiming the foreign tax credit may not be changed.41

The determination of whether to use the cash method or the accrual method must be made on a case-by-case basis, considering both current and future years. It applies to both regular tax and the AMT. The cash method offers more flexibility. Additionally, it may be favorable for taxpayers residing in foreign countries with fiscal tax years, since taxes are creditable when paid, rather than on the last day of the foreign tax year, when they are considered accrued. The accrual method may be preferable if it increases the foreign tax credit currently allowable after considering the foreign tax credit limitation. Additionally, it may be favorable if a carryback refund is generated, even if the current-year credit is the same under both methods as a result of the foreign tax credit limitation.

C. Creditable Foreign Taxes

To be a creditable foreign tax, the tax must be one which is primarily imposed as tax against income, and required as a compulsory payment pursuant to the foreign country's authority to levy taxes.

1) Social Security Taxes

Some foreign social security taxes — e.g., Mexico — are creditable as an income tax. However, under section 206 of the Social Security Act, social security taxes paid to a country with which the U.S. has a totalization agreement and covered by the totalization agreement are not creditable. (See section below on Social Security Taxes and Totalization Agreements). Revenue Ruling 79-291, 1979-2 C.B. 273 held that there was no allowable credit for Social Security taxes paid to Italy; Revenue Ruling 80-94, 1980-1 C.B. 170 addressed German taxes; and Revenue Ruling 81-39 addressed Switzerland. While social security taxes are not creditable, there may be other employment taxes not covered by a totalization agreement that are creditable, e.g. unemployment taxes, as long as these taxes are in the form of an income tax (see explanation above regarding creditable taxes). As of the date of this release, totalization agreements are in effect between the U.S. and the following countries:

39 Treas. Reg. §1.905-1(a).

40 Revenue Ruling 59-101, 1959-1 C.B. 189.

41 Strong v. Willcuts, 36-1 USTC 9032 (D. Minn 1935); PLR833200320


Country Effective Date Country Effective Date Australia Oct. 1, 2002 Italy Nov. 1, 1978Austria Nov. 1, 1991 Japan Oct. 1, 2005Belgium July 1, 1984 Luxembourg Nov. 1, 1993Canada Aug. 1, 1984 Netherlands Nov. 1, 1990 Chile Dec. 1, 2001 Norway Sep. 1, 2003 (updated) Czech Republic Jan. 1, 2009 Poland Mar. 1, 2009Denmark Oct. 1, 2008 Portugal Aug. 1, 1989Finland Nov. 1, 1992 South Korea Apr. 1, 2001France July 1, 1988 Spain Apr. 1, 1988Germany Dec. 1, 1979 Sweden Jan. 1, 1987 Greece Sept. 1, 1994 Switzerland Nov. 1, 1980 Ireland Sept. 1, 1993 United Kingdom Jan. 1, 1985

Note: The U.S. signed an agreement with Mexico in June, 2004. However, as of February, 2010, the agreement has not been ratified and there is no estimated date whether this will be ratified.

http://www.ssa.gov/international/status.html

2) Converting Foreign Taxes to U.S. Dollars

Taxpayers who claim foreign tax credits on the paid basis, or the accrued basis when those taxes were paid before year end, must translate those taxes at the exchange rate in effect when the taxes were paid.42

When foreign taxes are withheld or payments are made monthly, the same exchange rate used to recognize income can be used to convert the foreign tax amounts.

Taxpayers who account for foreign taxes on the accrual basis may translate unpaid foreign taxes into U.S. dollars at the average exchange rate for the year to which the taxes relate.43 For taxable years beginning after December 31, 2004, accrual-basis taxpayers may elect to translate these taxes based on the exchange rate on the day the taxes are paid. The election must be made on an original tax return timely filed (including extensions). It cannot be made on an amended return. The election can only be made for foreign income taxes denominated in a currency other than the taxpayer's functional currency. Once made, it applies to the current year and all subsequent years unless revoked with the consent of the IRS.44

Note the yearly average rate provision does not apply to:

Foreign taxes actually paid more than two years after the close of such tax year;45

42 See Treas. Reg. §1.905-3T(b)(2).

43 See I.R.C. §986(a)(1)(A).

44 I.R.C. §986(a)(1)(D)

45 I.R.C. §986(a)(1)(B)(i). 21


http://www.ssa.gov/international/status.html

Foreign taxes actually paid in a tax year prior to the year to which they relate;46 Foreign taxes paid in an inflationary currency, as defined by regulations.47

3) Section 901(j) Limitation for Certain Countries Section 901 allows U.S. taxpayers to claim a foreign tax credit for taxes paid or accrued to any foreign country. However, section 901(j) denies a foreign tax credit for taxes paid on income derived in certain countries for certain periods. Based on information supplied by the Department of State, Revenue Ruling 2005-3 provides an updated list of countries pursuant to section 901(j).

Country Beginning date Ending date Afghanistan 01/01/87 08/04/94 Albania 01/01/87 03/15/91Angola 01/01/87 06/18/93 Cambodia 01/01/87 08/04/94 Cuba 01/01/87 In effect Iran 01/01/87 In effect Iraq 02/01/91 06/27/04 Libya 01/01/87 12/09/04 North Korea 01/01/87 In effect South Africa 01/01/88 07/10/91 Sudan 02/12/94 In effect Syria 01/01/87 In effect Vietnam 01/01/87 07/21/95 Yemen 01/01/87 05/22/90

Revenue Ruling 92-62, 1992-2 C.B. 193 and Revenue Ruling 95-63, 1995-2 C.B. 85 provide guidance on positions arising in tax years when section 901(j) ceases to apply to a particular country.

Section 901(j) also creates a separate basket for foreign tax credit purposes. Income derived from the above countries is allocable to the special section 901(j) basket.

D. Determination of Income

1) Compensation

For most expatriate taxpayers, the main item of income that must be addressed in calculating the foreign tax credit is compensation. This will be addressed in detail in the subsequent section on sourcing of compensation. First, this section will discuss certain other items of compensation.

a. Hypothetical Tax as a Salary Reduction

46 I.R.C. §986(a)(1)(B)(ii).

47 I.R.C. §986(a)(1)(C).22


An expatriate’s salary is often reduced for a hypothetical tax amount. These amounts will not be currently included in income if the company’s policies and procedures comply with the key technical requirements established by the IRS such that the amounts are never made available to the individuals.

As a general rule, payments made to an employee are included in income only when the employee actually or constructively receives them.48 In addition, amounts are included in income if the employee receives an economic benefit. Thus, if an employee does not have a claim to or control over the hypothetical tax amount, the amount is not otherwise available to the employee, and the employee does not derive any economic benefit from the amount. The employee therefore will not be taxed on the amount.

Revenue Ruling 78-139, 1978-1 C.B. 23 stated that a salary reduction agreed upon by the employer and employee was not included in current-year wages. In the revenue ruling, the individual taxpayer was appointed as United States representative to a public international financial organization owned by its various member governments. The amount of compensation the taxpayer was entitled to receive from the organization exceeded the rate applicable to Level V of the Executive Compensation Schedule, and thus was in violation of the U.S. law. By an exchange of letters with an officer of the organization authorized to act in the matter, the taxpayer legally modified the terms of the taxpayer’s employment contract so as to receive compensation not in excess of Level V.

Building off of Revenue Ruling 78-139, Revenue Ruling 78-374, 1978-2 C.B. 67 concluded that a “staff assessment” required by the International Civil Aviation Organization (ICAO) was not income to the employee because:

The “staff assessment” was never made available to or received by the employee, The amount was not payable under any type of deferred compensation plan, and The amount could not be used to offset any foreign tax liability or other liability of individuals

employed by ICAO.

In Letter Ruling 9604017, the IRS ruled an internal tax withheld on employees was a permitted salary reduction and was not subject to tax. The employer was an international organization that was created as a result of a multilateral agreement among the Bank’s member nations. The bank charter provides that the Bank may subject its Directors, Alternate Directors, officers, and employees to an internal effective tax on salaries and emoluments for the benefit of the Bank. On April 15, 1991, the Board of Governors of the Bank adopted a tax regulation specifying conditions and rules relating to the internal effective tax. The tax regulation provides that each month the Bank will withhold amounts in respect of the internal effective tax from salaries and emoluments paid by the Bank. The amount withheld is calculated under a

48 Income although not actually reduced to a taxpayer's possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions. Thus, if a corporation credits its employees with bonus stock, but the stock is not available to such employees until some future date, the mere crediting on the books of the corporation does not constitute receipt. Treas. Reg. §1.451-2(a).

23


certain formula. Both U.S. and foreign individuals are subject to this tax. Relying on both Revenue Ruling 78-139 and 78-374, the IRS held that the withheld amounts from employee’s salaries were not subject to income tax. Similarly, in Letter Ruling 8204074, salaries of employees assigned to work abroad were reduced by the amount of the estimated hypothetical U.S. tax and such amounts were not includible in the employees’ gross income. See also Letter Ruling 7927002 which reached the same conclusion.

Thus, if a hypothetical tax arrangement is designed to meet and operates in conformity with the standards set forth in Revenue Ruling 78-374, the amount will not be included in income currently. However, where company policy does not meet these standards or does not apply these standards in administering its expatriate tax arrangements, amounts should be included in income currently.

b. Tax Equalization Advances Employers generally reimburse expatriates for additional U.S. and foreign taxes resulting from international assignments. An annual reconciliation of the expatriate’s actual U.S. and foreign taxes compared to a hypothetical tax equal to the amount of taxes the employee would have paid had he or she not been assigned overseas is usually performed to determine the amount of excess taxes paid or tax benefits received. In making this reconciliation, amounts withheld as hypothetical tax are excludible from taxable income and not included as taxes paid if the requirements discussed above are met.

The annual reconciliation generates excess tax amounts or tax benefits which are known as tax equalization payments. Generally, the employer reimburses any excess tax amounts to the employee, along with an amount equal to the taxes imposed on the excess tax amount payments. This amount is compensation when paid or used to offset the required advance repayment. If this compensation amount is includible in income in a year following the year in which services were rendered, the payment will be deferred compensation and the section 409A rules need to be considered. However, in most cases, as discussed below, the exception related to tax equalization payments will cause section 409A not to apply.

In the case of a tax benefit, the employee generally either remits the amount of the benefit to the employer within a reasonable period after the reconciliation has been performed or retains the benefit amount to apply against a future tax liability. If tax benefit amounts are retained, the amount would be compensation when paid or could be treated as a loan. Again, if the amounts relate to services provided in an earlier year and are not treated as a loan, the amounts will be deferred compensation which needs to consider the section 409A rules. See discussion below related to an exception under IRC Section 409A for tax equalization arrangements.

c. Tax Equalization Exception to IRC Section 409A rules

If amounts are deferred compensation, the payments need to meet one of the exceptions for applying the rules of section 409A or the arrangements need to conform to those rules. There are two exceptions — the short term deferral exception (see below) and the tax equalization rule — that could apply.

Under the tax equalization exception, payments under tax equalization arrangements which compensate

24


the expatriate for any differences in taxes resulting from the overseas assignment are not subject to the section 409A rules if payment is made no later than the end of the second calendar year beginning after the calendar year in which the individual’s U.S. federal income tax return is required to be filed (including extensions) for the year to which the tax equalization payment relates.

d. Tax Equalization Payments to Employer

As part of the tax equalization process, year-end settlements are regularly calculated. As discussed above, in circumstances where the tax equalization settlement reflects a balance due to the employee, the amount paid to the employee is included in income in the year paid. Similarly, in circumstances where the tax equalization settlement reflects a balance due from the employee to the employer, the amount of the payment from the employee can reduce the amount of income reportable for that employee. Reducing the employee’s taxable income is a source of many questions.

When an employee accepts an expatriate assignment and is covered by a tax equalization agreement, this agreement is part of an overall contractual arrangement between the employer and the employee. The employer agrees to pay various allowances to the employee, including housing, cost of living and payment of actual tax liabilities. In return, the employee agrees that he/she will be subject to a hypothetical tax liability that would be the equivalent of the tax liability they would have paid had they stayed at home. As part of this contractual relationship, it is agreed that the employer will complete a calculation to ensure that the employee did not pay any more or any less than the employee’s hypothetical liability. If the employee in fact pays too little in taxes, the employee agrees to pay that additional amount to the employer.

It is well established that “if an adjustment of a contract or obligation results in the repayment of a portion of income received prior to the close of the taxable year, the taxpayer is only taxable on such adjusted amount.”49 This principle has been extended to wages under sections 3401(a) and 3121(a).50

The fact that the repayment of current year wages is intended to satisfy a prior year obligation should not change this conclusion.

Several general counsel memoranda have concluded that if an employer withholds payment of a portion of an employee’s pay during the year to offset advances paid to the employee in prior years, the amounts withheld are excludable from the employee’s gross income. However, if the employer does not withhold payment and instead, the employee repays the advance, the employer cannot exclude the payment from gross income.51 These general counsel memoranda cite Moorman v. Commissioner, 26 T.C. 666 (1956), acq. 1956-2 C.B. 7, for the proposition that the exclusion from gross income is appropriate only when the employee both receives no cash payment and never has the right to receive payment. Neither Moorman nor the general counsel memoranda addresses the inconsistency between this conclusion and the conclusion that amounts paid to an employee and repaid to the employer during the same taxable year are excludable from gross income and wages. In addition, these cases all involve

49 GCM 36369 (Aug. 11, 1975) (citing H.C. Couch, 1 B.T.A. 103 (1924), acq., IV-1 C.B. 1 (1925); Guy Fulton, 11 B.T.A. 641 (1928), acq., VII-1 C.B. 11 (1928); Albert W. Russel, 35 B.T.A. 602 (1937), acq., 1931-1 C.B. 22); see also Revenue Ruling 75-531, 1975-2 C.B. 3150 See, e.g., Treasury. Reg. § 31.6413(a)-1(a); Revenue Ruling 79-311, 1979-2 C.B. 25; GCM 36851 (Sept. 17, 1976).

51 GCM 36852 (Sept. 17, 1976); GCM 36851 (Sept. 17, 1976); GCM 36369 (Aug. 11, 1975). 25


repayment of advances previously paid by the employer. Payment of a tax equalization settlement, as part of an overall contractual arrangement between the employer and employee, is not considered an advance previously made by the employer. Accordingly, payment of a tax equalization settlement by the employee to the employer can be treated as a reduction to income in the year paid.

In circumstances where the employee is paid other amounts by the employer, the employer can either reduce payments to the employee or the employee can pay the settlement to the employer, and the taxable income that would otherwise be reported on the Form W-2 will be reduced. The employer will not be entitled to a deduction for such amounts.

If the settlement exceeds the other amounts paid by the employer during the year, or if the employee is not paid any other amounts by the employer during the year, after settlement, the employer can reduce the Form W-2 to report zero wages and the employee will be entitled to a miscellaneous itemized deduction subject to the 2 percent floor for the remainder of the payment in the year of payment. This deduction for the employee is considered an employee business expense and is not considered a claim of right deduction. This deduction is also subject to the required reduction of itemized deductions under section 68. This amount would not be deductible for AMT purposes.

In addition, the employee could be entitled to a cash payment for the employment taxes (FICA/Medicare) withheld on the amount repaid to the employer. To obtain this amount, the employer can adjust its current employment taxes payable for such amount by claiming a credit on Form 941c in the quarter in which this payment is made to the employee.52

e. Tax Loans and Advances

If an employer advances the expatriate an amount to cover the estimated excess taxes associated with international assignments, unless the arrangement is properly structured as a loan from the employer to the employee, the tax equalization advance received by the expatriate must be included in income.53 To qualify as a bona fide loan, the arrangement must be a written unconditional obligation of the expatriate to repay the advance. The agreement needs to specifically state repayment terms and those terms must be consistently enforced, even if the expatriate dies, becomes disabled, or terminates employment. Both parties to the agreement must intend for the employee to repay the advance. The employer should account for the advance as a receivable. If the loan agreement so states, any excess taxes paid as determined under the annual reconciliation can be used to offset required advance repayments.

Tax advances and loans are generally part of a tax equalization program intended to offset only the excess tax liabilities surrounding an international assignment. As a result, section 409A will not apply to such arrangements (see discussion above). However, in the event that the IRS determines that the loan or advance arrangements do not meet the requirements of a bona fide loan, the amount of the advance or loan will likely be includible in the employee’s income in the year of the loan or advance. In addition, other penalties can apply if the loan arrangement was not a good-faith arrangement.

f. Interest-Free or Below Market Interest Rate Loans

52 See IRS Info. Letter 2005-0146.

53 Old Colony Trust Company v. Comm’r, 279 U.S. 716 (1929).26


If an expatriate receives tax advances with an outstanding balance in excess of $10,000 that constitute bona fide loans for which the stated interest is less than the applicable federal rate, a question arises as to whether section 7872 interest must be imputed. Under proposed Treasury reg. section 1.7872-5T(b)(14), loans whose interest arrangements have no significant tax effect on any federal tax liability of the lender or borrower are exempt from section 7872. Under proposed Treasury reg. section 1.7872-5T(c)(3), whether the interest arrangements on a loan have significant tax effect will depend on all the facts and circumstances including (1) whether the income and the deductions offset each other, (2) the amounts of such items, (3) the cost to comply with section 7872, and (4) any nontax reasons for the loan. These regulations were issued under the authority granted in section 7872(h)(1)(C) and incorporate the factors discussed in the Committee Report to the Deficit Reduction Act of 1984 (P.L. 98-369).

When all of the above factors are considered, tax advances to U.S. expatriates constitute a class of transactions that do not have a “significant tax effect” because:

In the case of a properly structured tax advance, there is no significant impact on the federal tax liability of the borrower. Any imputed income would increase foreign-source earned income, and the resulting U.S. tax impact would be substantially reduced by an increase in the section 911 exclusion and/or the foreign tax credit. 54

There are significant nontax reasons for making the advances and the administrative costs and efforts to comply with section 7872 are excessive in relation to the income to be taxed.

g. Other Deferred Compensation Positions

As mentioned above, if amounts are deferred compensation (e.g., repatriation bonuses that are committed to at the beginning of the assignment but will not be paid until the assignment ends) not related to the tax equalization settlement, the payments need to meet the second exception for applying the rules of section 409A or the arrangements need to conform to those rules. This second exception is the short term deferral exception.

Under the short term deferral exception, an employer must pay amounts on the expatriate’s behalf by the later of the 15th day of the third month following the end of the service provider’s or the service recipient’s year in which the amount vests or a substantial risk of forfeiture lapses. If payment is made by this date, amounts are not subject to the section 409A rules.

To the extent that a payment related to services provided in an earlier year does not meet the short-term deferral exception — perhaps because the payment is not made timely — the arrangement should be modified to conform to the section 409A rules. This can be done by either stating a specified date on which the payment will be paid, or ensuring that there is a substantial risk of forfeiture to the payment. An arrangement which specifies eligibility or payment upon the occurrence of a certain event (e.g., separation from service, retirement, return to the US as an employee) will comply with the section 409A

54 See also Treasury reg. section 1.7872-5T.27


rules. Other events where the date is not the occurrence of a certain event (e.g., final acceptance of an income tax return by the taxing authorities, end of assignment) will not comply.

For more details regarding deferred compensation positions, please consult with a member of the Compensation and Benefits practice.

h. Section 457A

IRC § 457A was added to the Internal Revenue Code in late 2008. § 457A requires income recognition for promises to pay compensation in the future if the payer is a tax indifferent party. However, as currently drafted, there is no obligation on the employer to report this income, if applicable, on the employee’s Form W-2. Accordingly, it is the taxpayer’s responsibility to report this income on the tax return as additional wages.

Generally, in order for this section to apply, deferred compensation must meet two conditions. First, the compensation must be deferred under a “nonqualified deferred compensation plan”, and second, the plan must be provided by a “nonqualified entity” (see below for detailed summary of these two requirements). If deferred compensation meets these two conditions, it is includible in gross income upon “vesting” or, if the amount is not determinable upon vesting, when the amount becomes determinable (with an additional 20% tax). It applies to deferred compensation attributable to services performed after December 31, 2008, and it applies to compensation paid by foreign corporations and partnerships which are not subject to a comprehensive foreign income tax.

1. A nonqualified deferred compensation plan (NQDCP) is any arrangement or agreement that provides for the deferral of compensation, including, for example, some foreign pension plans, deferred bonus plans, certain equity compensation plans, and others. Most equity compensation plans where the exercise price of the underlying stock is equal to the fair market value of the stock on the date of grant are not subject to these rules. However, stock appreciation rights settled in cash and restricted stock unit plans are subject to these rules even if the exercise price equals the fair market value. If the exercise price is not equal to the fair market value on the date of grant, the types of plans that need to be considered include restricted stock plans, incentive stock options, nonstatutory stock options, and stock appreciation rights settled in stock. In addition, amounts paid not later than 12 months after the end of the taxable year in which amounts vested are not considered deferred compensation. Vesting occurs once a person’s rights to compensation are no longer conditioned upon the future performance of substantial services by the person.

2. A nonqualified entity includes a foreign corporation or any partnership unless substantially all of its income is: (a) effectively connected with the conduct of a trade or business in the United States (“ECI”), or (b) subject to a comprehensive foreign income tax. Generally speaking, substantially all of the income of an entity means, for a corporation, that 80 percent of the entity’s income is effectively connected to the United States or subject to a comprehensive foreign income tax or, for a partnership, 80 percent of income is allocated to entities other than foreign persons not subject to comprehensive foreign income tax or tax-exempt entities. Comprehensive foreign income tax means either that the corporation is eligible for the benefits

28


of a comprehensive income tax treaty or is resident in a country that has a comprehensive income tax.

If a taxpayer had nonqualified deferred compensation during the taxable year that was attributable to services provided to a nonqualified entity, then that deferred compensation may be includable in income this year.

i. Employee Language Lessons and Cultural Training Reimbursement for language lessons for an expatriate should be considered a deductible employee business expense and, if paid under an accountable plan, can be excluded from income. An employer’s accountable plan must require the employee to substantiate the expenses and refund to the employer any expense reimbursement overpayments within a reasonable time.55 Any plan that permits the employee to retain any excess reimbursements or does not require expense substantiation is not an accountable plan, and amounts received as reimbursements must be included in the employee’s income.56

In Kosmal, the Tax Court allowed an attorney to deduct the cost of language lessons which were “proximately related to job skills required in his employment” in accordance with Treasury reg. section 1.162-5(a)(1).57 However, if the employer excludes the reimbursements from an individual’s W-2, the individual may not take a deduction.58

Reimbursements for language lessons for the expatriate’s spouse and family do not constitute deductible employee business expenses and should be included as a taxable allowance. Such amounts will not be deductible by the expatriate.

j. Tax Return Preparation Fee To minimize the cost of expatriate assignments, employers often engage outside tax advisors to prepare an employee’s tax returns and the annual reconciliation that determines excess taxes paid or tax benefits.

In Field Service Advice 200137039, the IRS concluded that the value of employer-provided tax return preparation services for overseas employees could not be excluded from income as a working condition fringe benefit under section 132(d). An item qualifies as a working condition fringe if it is the type of expense that would be deductible under section 167 or section 162 if not paid by the employer. Treasury reg. section 1.132-5(a)(1)(iii) states that expenses deductible under sections other than section 162 and section 167, such as section 212, do not qualify for working condition fringe benefits. Expenses paid or incurred by an individual for tax counsel or expenses paid in connection with the preparation of his tax

55 Treas. Reg. §1.62-2(c)(2).

56 I.R.C. §62(c).

57 Kosmal v. Comm’r, T.C. Memo 1979-490.

58 Only amount reimbursed under an employer’s accountable plans are excluded from the employee's gross income, are not reported as wages or other compensation on the employee's Form W-2, and are exempt from the withholding and payment of employment taxes. Treas. Reg. §1.62-2(c)(4).

29


returns are deductible under section 212.59 Since the tax return preparation deduction for individuals is specifically allowed under section 212, and not section 162 or section 167, the FSA held that the deductions were not working condition fringe benefits and must be included in income in the year paid.

Because the tax return preparation expenses are not working condition fringe benefits, the value of tax return preparation would be subject to income tax withholding unless the employer reasonably believed that the amount would be excludable from the employee’s wages as a result of the section 911 exclusion. (IRC section 3401(a)(8)(A)(i).) Amounts would be subject to FICA taxes.

The position in the FSA is consistent with the conclusion reached in Private Letter Ruling 8547003, in which the Service held that the employee was required to include in income the value of tax preparation services provided by the company as a result of his foreign assignment. The individual was not required to have his return prepared by the company-designated accounting firm, but did so voluntarily. The taxpayer argued that the taxpayer should receive bifurcated treatment of the expense, reasoning that the portion of the expense for the benefit of the employer was not taxable and the portion that was deemed to be of personal benefit to the employee was taxable. The taxpayer’s unsuccessful argument relied on Gotcher.

The Gotcher case can be easily distinguished from the individual on a foreign assignment simply on its facts. The taxpayer in Gotcher was a businessman considering starting a Volkswagen dealership in the United States. As part of his due diligence on the dealership, he was flown to Germany at the expense of Volkswagen America and Volkswagen Germany. The Fifth Circuit held that the trip was not for the benefit of the taxpayer, but was for the benefit of Volkswagen in trying to entice the taxpayer to buy a dealership in a U.S. social climate that was generally anti-Volkswagen. The tax court held that the portion of the paid trip that was for the personal benefit of the taxpayer's wife would be included in his income.

Revenue Ruling 92-69, 1992-2 C.B. 51 cannot be relied upon to support an exclusion for these amounts because the ruling is limited to tax preparation expenses relating to the taxpayer’s Schedule C business, and expressly holds that tax preparation services for other portions of his return are not section 162 deductions, and are properly classified as section 212 deductions reportable on Schedule A.

Therefore, the value of income tax preparation services must be included in income. Tax return preparation is not eligible for the section 132(d) working condition fringe because it is not deductible under section 162. The value of the tax preparation benefit to the employee will be the fair market value of the services — generally $200-$1,500, depending on the complexity of the return. (Treasury reg. section 1.61-21(a)(2).) However, the preparation of the annual reconciliation to determine the tax equalization amount should constitute a deductible section 162 business expense if incurred by the employee. As such, the value of the annual reconciliation may be excluded from the employee’s W-2 income under section 132(d).

k. Evacuation Allowances

Evacuation allowances are taxable, with the exception of those paid for military personnel. Gross

59 Treas. Reg. §1.212-1(l).30


income, however, does not include allowances paid to or on behalf of members of the uniformed services and civilian employees of the military to evacuate them from areas of conflict or crisis.60

l. Military Benefits

The IRS has extended tax relief to military personnel serving in areas certified by the Department of Defense as being in direct support of military operations. Specifically, members of the U.S. armed forces and support personnel (and their spouses) serving in the combat zone or in an area designated as serving in direct support of a combat zone will not have to file their income tax returns until at least 180 days after they leave that area.61 No interest or penalties will be charged during this extension period.62

Direct SupportThe following areas have been designated as serving in direct support of a combat zone by the Assistant Secretary of Defense:63

In support of Operation Iraqi Freedom (Arabian Peninsula Areas combat zone): Turkey — Jan. 1, 2003 through Dec. 31, 2005; Israel — Jan. 1 through July 31, 2003; Mediterranean Sea east of 30° East longitude — Mar. 19 through July 31, 2003; Jordan — Mar. 19, 2003; Egypt — Mar. 19 through Apr. 20, 2003.

In support of Operation Enduring Freedom (Afghanistan combat zone): Incerlik Air Base in Turkey, effective Sept. 21, 2001 through Dec. 31, 2005; Pakistan, Tajikistan and Jordan, effective Sept. 19, 2001; Uzbekistan and Kyrgyzstan, effective Oct. 1, 2001; The Philippines (only troops with orders referencing Operation Enduring Freedom), effective

Jan. 9, 2002; Yemen, effective April 10, 2002; Djibouti, effective July 1, 2002; Somalia, effective Jan. 1, 2004.

Combat ZonesAfghanistan and the airspace above was designated a combat zone effective Sept. 19, 2001.64

The following locations in the Kosovo area and the airspace above were designated as a combat zone and a qualified hazardous duty area effective March 24, 1999:65

60 Revenue Ruling 63-258, 1963-2 C.B. 22 (Evacuation of Guantanamo Naval Base during Cuban missile crisis).

61 For definition of support personnel, see Notice 2002-17, 2002-1 C.B. 567, Q&A 15-17.

62 See IRS News Release IR 2002-18 (Feb. 11, 2002) and IRS Notice 2002-17 (Feb. 11, 2002).

63 IRS Tax Tip 2005-40 (Feb. 25, 2005).

64 Exec. Order No. 13239.

65 Exec. Order No. 13119; PUB. L. NO. 106-21.31


The Federal Republic of Yugoslavia (Serbia/Montenegro); Albania; The Adriatic Sea; The Ionian Sea — north of the 39th parallel.

The following locations in the Arabian Peninsula areas and the airspace above were designated as a combat zone effective Jan. 17, 1991:66

The Persian Gulf; The Red Sea; The Gulf of Oman; The part of the Arabian Sea that is north of 10 degrees north latitude and west of 68 degrees east

longitude; The Gulf of Aden; The total land areas of Bahrain, Iraq, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab

Emirates. The IRS will also suspend all tax return examinations and actions to collect back taxes owed by these taxpayers for years prior to 2001 until at least 180 days after the taxpayer leaves the combat zone. During this suspension, no interest or penalties will be added to the tax due.

Military pay received by enlisted personnel is exempt from income tax for any month that the person spends any time in the combat zone. For commissioned officers, this exclusion is limited to the highest rate of enlisted pay, plus imminent danger/hostile fire pay.

For more information on military pay, see IRS Publication 3.

2) Sourcing of Compensation — Treasury Reg. Section 1.861-4(b)

The IRS on July 13, 2005 issued final regulations (T.D. 9212) that address the proper method for determining the source of compensation for personal services performed partly within and partly without the United States (“split compensation”) under section 861. They are effective for tax years beginning after July 13, 2005. For years prior to 2006, we can use a reasonable method, including, but not limited to, the method outlined in these final regulations.

Treasury reg. section 1.861-4(b) sources split compensation — based on all the facts and circumstances — on either a time or geographical basis (described below). The regulations note that in many cases the time basis (described below) is the most appropriate sourcing method. Time basis compensation is calculated as “the amount that bears the same relation to the individual’s total compensation as the number of days of performance of the labor . . . by the individual within the U.S. bears to his or her total number of days of performance of labor.” For multi-year compensation arrangements such as options, the applicable time period to consider is the period between grant and vesting.

Some states have also published rules on sourcing which need to be considered in applying state income tax withholding rules and preparing state income tax returns.

66 Exec. Order No. 12744.32


a. Days in a Business Year

For purposes of allocating compensation as U.S.- and foreign-source income, 240 business days should be used (20 days/month) unless the actual number of days worked is provided by the expatriate. In counting work days for U.S. purposes, partial (i.e. half) days are allowed. Days on which no affirmative services are required to be performed, including holidays, vacation days, weekends in many cases, and temporary leaves of absences are generally excluded. 67 There is no direct authority concerning sick days, however, for sick days where no services are provided, consistent with the above approach, they should not be counted.

b. Allocation of Home Compensation Components — Time Basis Items of compensation to be allocated based upon U.S. and foreign workdays include, inter alia, salary, incentive compensation, and taxable group term life insurance premiums. Each client’s policy should be considered to meet the primary requirement of Treasury reg. section 1.861-4(b)(1) that a specific amount is paid for labor or personal services performed overseas. Each company should have contracts stating that, although allowances are paid on a monthly basis, they are deemed to be earned by the employees solely for services in foreign countries and not for services performed in the United States.

These compensatory items are sourced based on business days worked over the period of time earned: Base compensation; Vacation pay; Overtime pay; Incentive awards; Cost of living adjustments; Flexible compensation; and Excess group term life insurance

c. Allocation of Assignment Compensation Components — Geographical Basis

Geographical Basis Allocation: Allowances specifically related to a work assignment can be allocated on a geographical basis. The final regulations68 list certain fringe benefits that should be sourced geographically, and set forth the following sourcing provisions:

Housing — Sourced on the location of the individual’s principal place of work;69

Education — Sourced on the location of the individual’s principal place of work;70

Local transportation — Sourced on the location of the individual’s principal place of work; The regulations define the amount to be treated as local transportation as limited to the actual expenses incurred for local transportation and the fair rental value of any vehicle provided by the

67 See Stemkowski v. Commissioner, 76 TC 252, Aff’d on this issue, 690 F.2D 40 (2D Cir. 1982). 68 Treas. Reg. §1.861-4(b)(2)(ii)(D), T.D. 9212 (July 13, 2005).

69 Treas. Reg. §1.861-4(b)(2)(ii)(D)(1).

70 Treas. Reg. §1.861-4(b)(2)(ii)(D)(2).33


employer and used predominantly by the individual or the individual's spouse for local transportation. These expenses do not include the cost of the purchase of the car.71

Tax reimbursements — Sourced on the location of the jurisdiction that imposed the tax; The regulations specify that this applies to foreign tax reimbursements only. Other tax reimbursements, including US tax gross-ups, should be sourced based on time allocation.72

Hazardous or hardship duty pay — Sourced based on the duty zone for which the fringe benefit was paid;73

Moving expenses — Sourced on the location of the employee’s new principal place of work or former place of work, if the individual provides sufficient evidence that such determination of source is more appropriate under the specific facts and circumstances.74

d. Alternative Basis of Allocation

The regulations provide that if an alternative basis more appropriately reflects the sourcing of income, an individual may use the alternative basis if certain requirements are met. Employees who use an alternative basis must retain in their records documentation setting forth why an alternative basis more properly determines the source of the compensation.

According to the preamble to the final regulations, it is expected that individuals with $250,000 or more in compensation for the tax year who use an alternative method will be required to respond to questions included on the appropriate federal tax forms and to attach to their income tax returns a written statement that sets forth: (1) the specific compensation income or the specific fringe benefit for which an alternative method is used; (2) for each such item, the alternative sourcing method used; (3) for each such item, a computation showing how the alternative allocation was computed; and (4) a comparison of the dollar amount of the compensation sourced within and without the United States under both the individual’s alternative basis and the basis for determining source of compensation described in Treasury reg. section 1.861-4(b)(2)(ii)(A) or (B).75

e. Multi-year compensation

The regulations prescribe source rules for “multi-year compensation” (such as stock option income). This is compensation that is included in income for one taxable year but is attributable to a period that includes two or more taxable years. Multi-year compensation is sourced on the time basis, applied to the entire period to which the compensation is attributable (determined on the basis of all the facts and circumstances).

An important example in the section 1.861-4 regulations applies the time basis for stock option income to the time period between grant date and vesting date, rather than between the grant date and the

71 Treas. Reg. §1.861-4(b)(2)(ii)(D)(3).

72 Treas. Reg. §1.861-4(b)(2)(ii)(D)(4).

73 Treas. Reg. §1.861-4(b)(2)(ii)(D)(5).

74 Treas. Reg. §1.861-4(b)(2)(ii)(D)(6).

75 T.D. 9212 (July 13, 2005).34


exercise date.76

Assume an employee is granted nonstatutory options on 48,000 shares of stock with a $5 exercise price on January 1, 2005. Twenty-five percent of the options will vest on each anniversary of the grant:

Tranche A: 12,000 vest on January 1, 2006;Tranche B: 12,000 vest on January 1, 2007;Tranche C: 12,000 vest on January 1, 2008;Tranche D: 12,000 vest on January 1, 2009,

The employee exercises 24,000 options on January 1, 2007, when the fair market value of the stock is $10. He then moves overseas and has no workdays in any country other than the country where he resides. On January 1, 2009, Employee exercises another 24,000 options when the fair market value of the stock is $15.

TrancheGrant Date

Vesting Date

Location of Services Appropriate Sourcing

Allocation2005 2006 2007 2008

A 1/1/05 1/1/06 100% US N/A N/A N/A 100% US

B 1/1/05 1/1/07 100% US 100% US N/A N/A 100% US

C 1/1/05 1/1/08 100% US 100% US 100% Foreign

N/A 66.67% US33.33% Foreign

D 1/1/05 1/1/09 100% US 100% US 100% Foreign

100% Foreign

50% US50% Foreign

Tranche A: ($10 FMV - $5 Exercise Price) x 12,000 options = $60,000 x 100% = $60,000 US-source income.

Tranche B: ($10 FMV - $5 Exercise Price) x 12,000 options = $60,000 x 100% = $60,000 US-source income.

Tranche C: ($15 FMV - $5 Exercise Price) x 12,000 options = $120,000 x 66.67% = $80,000 US-source income.

Tranche D: ($15 FMV - $5 Exercise Price) x 12,000 options = $120,000 x 50% = $60,000 US-source income.

76 Treas. Reg. §1.861-4(b)(2)(ii)(G) Ex. 6. In LTR 9037008, the IRS (applying IRC Sec. 451 (rule for year of inclusion)) ruled that such income was to be apportioned on a time basis because restrictions on the options related to future performance and the services giving rise to the income were performed during the applicable vesting period (ie date of grant to date of vesting).

35


The example disregards the days worked between the vesting date and exercise date. This method of allocation conforms to the section 861 regulations. The impact of allocations based over the period of vesting versus exercise will vary based upon the facts of each individual. The more critical issue will be the conflicts that will arise for countries that continue to source over the period from grant to exercise. Such differences in allocations may result in a significant worldwide tax increase unless competent authority relief under a tax treaty is available.77

3) Treaty Re-sourcing of Compensation Treaty re-sourcing provisions allow you to re-source U.S.-source income as foreign. Treaty re-sourcing provisions may be relied on for assignees on assignment to any treaty country that has a re-sourcing provision to ensure optimal sourcing of compensation, in cases in which such re-sourcing is applicable. You must, however, review whether treaty re-sourcing applies. Generally, the cost of the expatriate assignment must be borne in the assignment country. If the cost is borne in the U.S., then under the dependent personal services article, the U.S. would continue to have the right to tax the income and the re-sourcing provision would not apply.

The purpose of treaty resourcing is to avoid double taxation between the two effected countries. Before resourcing, therefore, it is important to communicate with the local country office to confirm how income is being taxed in the local jurisdiction. If the treaty provides for treaty resourcing, but for some reason, the local jurisdiction exempts some of the income from tax, treaty resourcing may not be available.

As of the time of this release, the IRS currently acknowledges re-sourcing provisions in the treaties in a number of countries. They have not released an updated list for 2009 yet. Once the IRS publishes their 2009 list, we will update this release.

In addition to this list, after reviewing the treaties, we have identified a significant number of additional countries that provide for resourcing. The IRS-authorized list is included in first table below. We have listed the additional qualifying countries in the second table.

IRS-Identified CountriesAustralia1 Germany New Zealand

Austria Ireland Portugal

Bangladesh Belgium

IsraelJapan

SloveniaSouth Africa

Canada Luxembourg Sweden

Denmark Mexico Switzerland

Finland Netherlands United Kingdom

France1. Effective 7/1/06, new law in Australia exempts “temporary residents” from tax on foreign source income other than employment income

(e.g. interest, dividends, capital gains, etc.). Therefore, treaty resourcing on this income should only be applied through 6/30/06.

77 For procedures in requesting competent authority relief, see Revenue Procedure 2002-52, 2002-2 C.B. 242. 36


Resource Deloitte Identified Countries

Country Notes

China China taxes Chinese source income and income paid from PRC enterprises or individuals for the first 5 years of residence.

Czech Republic Taxes worldwide income to residents.

India For taxpayers subject to tax on US source income.

Jamaica Has resident but not ordinarily resident status that applies to most expatriates who are taxed on host source income or income received in the host country.

Latvia Taxes worldwide income to residents.

Lithuania Resourcing shall be deemed to arise in that state which may tax the income under the treaty.

Thailand Residents are taxed on Thai source income or other income remitted to Thailand.

Tunisia Taxes worldwide income to residents.

Turkey Normally, expatriates are taxed on Turkish sourced income only.

For these countries, treaty re-sourcing will result in the same net U.S. tax or lower tax than using the sourcing rules outlined above. For countries without a resourcing provision or for those with such a provision that cannot be used because of the company’s chargeback policy, sourcing should conform to the regulatory rules.

4) Sourcing of Business Expenses and Itemized Deductions Treasury reg. section 1.861-8 requires that business and itemized deductions be allocated and/or apportioned to properly reflect income from sources within and without the U.S. for foreign tax credit purposes. A deduction is allocable to U.S. or foreign-source income if it is “definitely related” to a class or item of such income.78 A deduction shall be considered definitely related to one or more items or classes of gross income if it is incurred in whole or in material part as a result of, or incident to, the activities from which such gross income is derived.79 If a deduction is not definitely related to any item or class of gross income, it is apportioned ratably to all gross income.80 Gross foreign-source income for this purpose is determined before reduction for section 911 exclusions. One exception to this rule is that personal mortgage interest is to be allocated based on gross income after deducting the section 911 exclusion.81

78 Treas. Reg. §1.861-8(b).

79 Treas. Reg. §1.861-8(b)(2).

80 Treas. Reg. §1.861-8(c)(3).

81 Treas. Reg. §1.861-9T(d)(1)(iv).37


The following lists serve as a general, but not all-inclusive, guide in allocating and apportioning itemized deductions when preparing expatriate returns:

1. Items always to be allocated against U.S.-source income:

State and local income taxes where the employee is not considered a state resident during the foreign assignment period (i.e., the state tax is only assessed on state source income),

Interest expense on U.S. business property (includes U.S. rental), Real estate taxes on U.S. business property (includes U.S. rental), and Charitable contributions.82 (See below)

2. Deductible expenses that are not definitely related to any item or class of gross income and should be ratably apportioned to all classes of gross income:

State and local income taxes where the employee is considered a state resident during the

foreign assignment period (i.e., the state tax is assessed on worldwide income), Mortgage interest on personal residence (special allocation method),83 Real estate taxes on personal residence and personal property tax,84

Medical expenses,85 and Alimony.86

3. Deductible expenses that usually are directly allocable to an item or class of gross income:

Unreimbursed business expenses, including automobile expenses — Allocate on wage income (also subject to section 911 disallowance),

Stock exchange taxes — Allocate based on investment asset, Margin account/investment interest — Allocate based on investment asset, Investment expenses - Allocate based on investment asset, Safe deposit box fee — Allocate based on investment asset, and IRA deduction — Allocate to earned income after section 911 exclusion

a. Sourcing of Charitable Contributions

The IRS issued final regulations (T.D. 9212) on July 13, 2005 regarding the treatment of U.S. charitable deductions effective for tax years beginning after July 13, 2005. The new rules simplify the method of allocating and apportioning deductible U.S. charitable contributions for foreign tax credit purposes by allocating such deductions only to U.S.-source income. Prior regulations required an apportionment of U.S. charitable deductions to both U.S. and foreign-source income which generally limited the use of

82 Treas. Reg. §1.861-8(e)(12).

83 Treas. Reg. §1.861-8(e)(9)(i).

84 Treas. Reg. §1.861-8(e)(9)(ii).

85 Treas. Reg. §1.861-8(e)(9)(iii).

86 Treas. Reg. §1.861-8(e)(9)(iv).38


foreign tax credits. Therefore, the new rules will have a positive foreign tax credit impact for individuals and corporations that make U.S. charitable contributions and receive foreign-source income.

Foreign Charitable Contributions Contributions made directly to a foreign church or other foreign charitable organization are generally not deductible (exceptions apply to Canadian, Israeli, and Mexican charities via treaty provisions).87 However, contributions to a charitable foreign organization are deductible if a U.S. organization controls the use of the funds by the foreign organization or if the foreign organization is merely an administrative arm of the U.S. organization.88

b. Sourcing Investment Interest Expense Most interest should be allocated between U.S. and foreign sources based on underlying assets. Because interest expense is apportioned based on underlying assets, interest expense will generally not be allocated to earned income unless debt is incurred by the expatriate to generate earned income. Additionally, interest expense should generally not be disallowed because the interest is not allocated to earned income, including foreign earned income. Treasury reg. section 1.861-9T(d)(1)(iv) provides an exception for qualified residence interest, which must be allocated using the gross income method.

E. Foreign Tax Disallowance Formula Section 911(d)(6) requires that, in order to avoid a double tax benefit, a portion of the otherwise fully creditable foreign taxes must be disallowed to the extent the income to which they relate has been excluded under section 911. This disallowed amount is computed by multiplying the foreign taxes that are paid or accrued on foreign earned income by a fraction, as follows:

Disallowed Amount = Creditable Foreign Tax X Section 911 Exclusion - Allocable Deductions

Foreign-Source Income- Allocable Deductions

When both spouses have foreign taxes and exclusions, the disallowance can be computed on either a joint or individual basis.

1) Foreign tax amount The amount of foreign tax to be used in computing the disallowance is generally the foreign taxes paid or accrued which are being reported on Form 1116. However, if foreign taxes are assessed separately on more than one type of income (e.g., withholding on investment income and separately taxed compensation), only the foreign tax related to compensation is subject to the disallowance rules. If more than one class of income is combined for purposes of the foreign tax assessment, the items (other than compensation) subject to tax are added to the denominator of the disallowance ratio and the full amount of foreign tax is subject to disallowance.

87 I.R.C. §170(c)(1), §170(c)(2)(A).

88 I.R.C. §170(c) (flush language).39


The disallowance formula is never applied to foreign tax carryover or carryback amounts. These amounts have previously been subjected to disallowance (where applicable) in the year they were paid or accrued.

2) Associating tax with income When associating foreign taxes paid to a particular year, one of two methods can be used. The “income year” method — the preferred approach — treats foreign taxes as accrued when the underlying income is received or accrued. No proration is therefore necessary if the foreign tax is paid or accrued in the tax year the associated income is earned. However, if the tax is paid or accrued in a year other than when the income was earned, or if the tax was assessed on a fiscal year basis, matching of the foreign tax with the associated income is required. In these situations, any reasonable method of allocation should be used, such as an income basis (compensation, taxable income) or a time basis (months, days). This latter method is applicable for an individual that accrues tax for a country with a fiscal year-end. A second method of associating foreign taxes paid to a particular year is the “tax year” method. This cash basis/taxable year computation uses foreign tax paid or accrued in the taxable year and income and exclusion amounts which are included in that year’s tax return. The concept is similar to situations in which current year’s income amounts are used in making apportionments between classes of income without the requirement of tracing to other taxable years. Before claiming the tax year method, this position should be discussed with the Global Employer Services competency group and WNT technical specialists and the local tax PPD. Taxpayers using the tax year method should disclose this position on Form 8275. Note that as the overall U.S. tax for assignment is unlikely to change materially, based on the method selected, a more conservative approach should be considered.

3) Numerator The numerator in the disallowance fraction is the section 911 exclusion less properly allocated disallowed expenses. Generally, the housing exclusion is included.

4) Denominator The denominator is the total foreign-source income earned during the foreign assignment qualifying period (e.g., BFR or PPT), regardless of the year to which it relates, less properly allocated deductible expenses. Deductible expenses in this situation should include expenses prior to any disallowance attributable to excluded foreign earned income (referred to as the otherwise deductible amount). Treasury reg. section 1.911-6(c)(1) states that if the foreign tax is imposed on foreign earned income and some other income (e.g., U.S.-source income, or other income not subject to tax in the U.S.) and the taxes on the other amount cannot be segregated, then the denominator equals the total of the amounts subject to tax less deductible expenses allocable to all such amounts. In the case of a housing deduction claimed by a self-employed individual, the housing deduction is subtracted from foreign-source income

40


for purposes of determining the disallowance ratio denominator.89

Unbundling of Tax Returns to Isolate Tax on Certain Foreign Income It may be possible in some circumstances to “unbundle” foreign tax returns to isolate taxes on certain earned income on the premise that none of the particular amounts constitute excluded income or qualifying foreign earned income. An example of the type of item that could be subject to such special treatment would be section 401(k) contributions that are subject to tax in the foreign jurisdiction. This could be done by one of two methods:

Additions to the disallowance fraction in the denominator, or Allocating the foreign tax to an item or class of income that is not part of the exclusion or

excludible income. The ability to unbundle foreign tax returns to isolate taxes on certain earned income assumes that none of the particular income is excludible income. It is also important that it be clearly demonstrated that the amount to which special treatment is applied is taxed in the foreign jurisdiction. For purposes of calculating the disallowance ratio, the denominator should include all items of earned income, including partnership income and pension income (if such income is taxed or could be taxed by the foreign country). To summarize, for calculating the denominator in order to determine the foreign tax credit disallowance fraction:

If a foreign government taxes only foreign earned income, the denominator is foreign earned income less otherwise deductible expenses.

If a foreign government does not tax some element of foreign earned income (i.e., foreign services premium), the denominator is still total foreign earned income less otherwise deductible expenses.

If a foreign government taxes both foreign earned income and U.S. earned income, the denominator is the aggregate of these two amounts less otherwise deductible expenses.

If a foreign government taxes worldwide income, similar to the basis for taxation in the U.S., the denominator is the aggregate of income less otherwise allocable expenses.

In the following circumstances, the taxpayer must be able to demonstrate that the additional types of income are, in fact, subject to tax in the foreign country.

If a foreign government taxes both earned and unearned income and the tax on unearned income cannot be properly segregated, the denominator should include the total amount subject to tax, less otherwise deductible expenses. The total amount subject to tax includes income amounts which may not be subject to tax in the U.S. (e.g., muni bond interest).

In situations where the U.S. has a tax treaty with the foreign country, the treaty may provide rules to determine the sourcing of income and deductions which may differ from the rules

89 I.R.C. §911(c)(3).41


provided by the Internal Revenue Code. Income and/or deductions that would normally be U.S. source in this case may be treated as foreign and included in the denominator.

Finally, it is preferable to use a cash basis method of computing the denominator over the accrual method for the following reasons:

It is a reasonable method of applying the regulations under section 911(d)(6);90

It is less complex than the accrual method, avoiding the necessity of continually amending tax returns when income earned in one year is received in another; and

It more accurately matches the foreign taxes subject to disallowance (which are normally assessed on income recognized on the cash basis) with the income and related exclusion on which the foreign tax was incurred.

5) Separate Disallowance Formula for the Housing Exclusion For housing, we generally source foreign earned compensation in one basket. This includes compensation relating to housing as well as other compensation. There is some support, subject to substantial risk, that the disallowances related to the foreign earned income and housing exclusions should be computed separately. For example, assume an individual receives $250,000 in compensation and included in this amount is $100,000 of housing reimbursements and $70,000 of foreign tax. Assume the host country does not tax housing. The 2009 housing exclusion is limited under TIPRA to $12,796 and the foreign earned income exclusion is $91,400.

In this example we generally would calculate the disallowed foreign taxes as follows: Disallowed foreign taxes = Total Exclusion (Housing and Foreign Earned Income) x Foreign Taxes

Total Earned Income $29, 175 = $104,196 x 70,000

$250,000 In countries where housing is taxed favorably, foreign earned income and compensation relating to housing can be segregated into two baskets. This can then be scaled down in two iterations: one for the foreign earned housing exclusion and one for all other compensation. If in the above example the host country taxes 6 percent of housing at a 50 percent rate, your calculation is as follows: Tax on housing reimbursements = Housing reimbursement x % of housing taxed x tax rate = $100,000 x 6% x 50% = $3,000

90 Treasury reg. section 1.911-6 (c)(2)(ii) — relating to the accrual of foreign taxes — provides the following: For purposes of this paragraph (c), foreign taxes imposed on foreign earned income shall be deemed to accrue, on a pro rata basis, to income as the income is received or accrued. The taxes so accrued shall be apportioned to the taxable year during which the income is received or accrued. This rule applies for all individuals, regardless of their method of accounting.

42


Scale down for foreign taxes related to housing =

Housing exclusion x foreign taxes related to housing Total compensation

$ 12,796 x 3,000 = $154 250,000

Disallowed foreign taxes relating to general FEI exclusion =

FEI exclusion x foreign tax not related to housing Total comp.

$91,400 x 67,000 = $24,495 250,000

Therefore the total disallowance is reduced from $29,175 to $24,495. Where this approach is taken, the Global Employer Services competency group and WNT technical specialists, and your local tax QRM must be consulted.

F. Allocation of Foreign Taxes to “Baskets” of Income The “basket rules” of section 904 and the regulations thereunder determine what taxes are allocated to different types of foreign-source income (i.e. baskets). These rules also determine the amount of foreign taxes attributable to U.S. sources and therefore not creditable against U.S. tax liability (but for the re-sourcing provisions of some income tax treaties). Treasury reg. section 1.904-4 provides guidance on the proper basket for foreign-source income. Treasury reg. section 1.904-6 provides guidance for the allocation of foreign taxes to the separate baskets of income. The application of the basket rules can have a significant impact on the ability to utilize foreign taxes.

Two-Basket Regime: Legislation enacted in 2004 reduced the number of baskets to two for taxable years beginning after December 31, 2006.91 The two baskets are passive category income and general category income. Passive category income include passive income as currently defined by section 904(d)(2)(A) (i.e. dividends, interest, etc.) and “specified passive category income” defined as dividends from a DISC, distribution from a foreign sale corporation, and foreign trade income. All other income is general category income. The legislation also allows a greater cross-crediting of taxes. Income earned from a foreign rental property may be allocated to the passive basket or the general limitation basket depending on the facts. If the owner is actively involved in the approval of tenants, repairs, contracts, etc., the activity may not be passive for foreign tax credit purposes. If the rental activities can be classified as an active trade or business, the income is allocated to the general limitation

91 P.L. 108-357, §404(a).43


basket.92 One commonly misunderstood matter in the Form 1116 instructions relates to treaty re-sourcing income. Specifically, the instructions provide that:

"If a sourcing rule in an applicable income tax treaty treats any of the specific types of income described below as foreign source and you elect to apply the treaty, the income will be treated as foreign source:

Certain gains (section 865(h)) or Certain income from a U.S.-owned foreign corporation (section 904(g)(10)).93 You must compute a separate foreign tax credit limitation for any such income for which you claim benefits under a treaty, using a separate Form 1116 for each amount of re-sourced income from a treaty country. Add the amounts from line 21 of each separate Form 1116 and enter the total on line 24 of your summary Form 1116 (that is, the Form 1116 for which you are completing part IV). In addition, you may be required to file Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b) for the resourced income. Other types of income that are re-sourced under the terms of an income tax treaty (for example, compensation for services performed in the United States by a U.S. citizen resident in a foreign country) are not subject to a separate foreign tax credit limitation. However, the specific treaty may provide for other restrictions on the amount of income that is re-sourced or the amount of credit that is allowed with respect to the foreign tax paid on re-sourced income. See, for example, Article 24, paragraph 1, of the treaty between France and the United States."

Specifically, treaty re-sourcing provisions typically stipulate that income may be re-sourced only to the extent necessary to offset the extra tax incurred from that country — i.e. you are limited to re-sourcing income under the U.S.-French treaty to the amount necessary to claim credit for French taxes. If there were no French taxes available for credit but the individual had Italian foreign tax credit carryovers, then the re-sourcing provisions would be limited to the amount necessary to offset French tax.

The new instructions are much clearer than they were in the past. It is now clear that the IRS is not taking a position that re-sourced income constitutes a separate basket of income. Rather, the instructions relate to provisions contained in the individual treaties limiting the use of foreign tax credits on capital gain income re-sourced under that particular treaty.

G. Carryback and Carryforward

In any year in which the foreign taxes paid or accrued in the current year exceed the limitation on the foreign tax credit in that year, any excess credits should be carried back and/or forward to years where there is capacity to utilize these excess credits. The unused foreign tax credit should first be carried back one year, and if there are still excess credits, carried forward for 10 years.

92 Treas. Reg. §1.904-4(b)(2), 1.954-2(c).

93 See Treas. Reg. §1.904-5(m)(7) for an example.44


Carrybacks and carryforwards must be applied against the proper basket of income from which they originated. In other words, credits from general category income must be applied against other general category income and credits from passive income must be applied against passive income.

H. Alternative Minimum Tax

The foreign tax credit rules apply equally for regular tax purposes as they do for alternative minimum tax (AMT) purposes, including calculations on the limitations of the credit, the foreign tax disallowance formula, and carrybacks and carryforwards. Prior to 2005, there was a limitation that the maximum AMT foreign tax credit that could be claimed was limited to 90% of the AMT liability. That rule no longer applies and a foreign tax credit is now allowed against the full AMT liability.94

Simplified AMT Foreign Tax Credit Limitation Section 59(a)(3) provides an election to use a “simplified” AMT foreign tax credit limitation. Note the election, once made, applies to all future tax years, unless revoked with the consent of the IRS. Also, the election may be made only for the first tax year after December 31, 1997 for which the taxpayer claims an AMT foreign tax credit. The simplified limitation is the ratio of the taxpayer’s foreign-source regular taxable income to the entire alternative minimum taxable income (AMTI). Because the simplified limitation uses foreign-source regular taxable income rather than foreign-source AMTI, the taxpayer is not required to reallocate and reapportion deductions for AMT purposes.

It appears this “simplified” calculation will be unfavorable to the majority of taxpayers. For this reason, we do not see widespread use of it.

Refundable Long-Term Unused Minimum Tax Credit

Individuals with long-term unused minimum tax credits for any tax year after December 20, 2006, but before January 1, 2013, are allowed to claim as their alternative minimum tax credit an amount not less than the AMT refundable credit amount for that year. An additional amount is added to this credit to account for paid penalties and interest related to an increase in the AMT due to an exercise of an incentive stock option (ISO). Long-term unused minimum tax credits are defined as the portion of the AMT credit attributable to taxable years before the 3rd prior taxable year. The AMT refundable credit amount is the greater of:

1) 50 percent of the amount of the long-term unused minimum tax credit for such taxable year, or2) The amount (if any) of the AMT refundable credit amount determined for the taxpayer’s

preceding tax year (determined without regard to any increase in the credit for interest and penalties already paid)

94 I.R.C§59(a).45


The long-term unused minimum tax credit for the year is phased out at the income levels used for the phase out of personal exemptions. The allowed long-term unused minimum credit amount is reduced by 2 percent for every $2,500 or part thereof by which modified AGI exceeds the phase out threshold amount. For purposes of calculating modified AGI, the exclusions taken under Section 911 must be added back to regular AGI.95

In 2008, a law was added that abated any underpayment of tax outstanding on October 3, 2008 or interest and penalties related to this underpayment attributable to the exercise of an ISO. The AMT refundable credit amount for 2008 and 2009 is increased by 50 percent of the aggregate amount of the interest and penalties paid by the taxpayer prior to October 3, 2008 and which would have been abated had they still be outstanding on that date.

I. Redetermination of Foreign Taxes New temporary regulations related to foreign tax redeterminations were released in November, 2007. The following summary has been updated to reflect these temporary regulations.

A “foreign tax redetermination” is any change in the foreign tax liability that may affect a U.S. taxpayer’s foreign tax credit.96 Examples of a foreign tax redetermination include:

1. A refund of foreign taxes;

2. Accrued taxes that when paid differ from the amounts added to post-1986 foreign income taxes or claimed as credits by the taxpayer (such as corrections to overaccruals and additional payments);

3. Accrued taxes that are not paid before the date two years after the close of the taxable year to which such taxes relate; and

4. For taxes taken into account when accrued but translated into dollars on the date of payment, a difference between the dollar value of the accrued foreign tax and the dollar value of the foreign tax actually paid that is attributable to fluctuations in the foreign currency exchange rate between the date of accrual and date of payment.

If a foreign tax redetermination occurs, the taxpayer may be required to file an amended return.97 See below for further clarification for when an amended return is required. Where no amended return is required, a taxpayer who had a foreign tax credit carryover for the year the credit was claimed may adjust the carryover instead of filing an amended return. If the foreign tax redetermination reduces the amount of foreign taxes and an amended return is required, the taxpayer will generally have to file an amended return by the due date of the return

95 I.R.C. § 53(e)

96 Treas. Reg. §1.905-3T(c).

97 See I.R.C. §905(c), Treas. Reg. §§1.905-3T, 1.905-4T.46


(including extensions) for the year in which the redetermination occurs. For example, assume a 2007 accrued foreign tax is redetermined during 2009, and an amended return is required, the amended return is due by April 15, 2010 or later, if the 2009 tax return is extended. Nevertheless, since interest accrues to the IRS on any additional tax due, the amended return should be filed promptly. If the foreign tax redetermination increases the foreign taxes and an amended U.S. income tax return is required, the taxpayer generally has 10 years from the date prescribed by law for filing the return for the year in which the taxes were paid or accrued to file an amended return.98

When is an amended return required? An amended return is required when:

1. Accrued tax amounts when paid differ from the amounts claimed as credits, 2. Accrued taxes are not paid within two years after the close of the tax year to which they relate, or 3. Any tax paid is refunded in whole or in part.

A redetermination is not required, and an amended return does not need to be filed, where the difference between the dollar value of the accrued tax and the dollar value of the tax paid is attributable to currency fluctuations, and the amount of the foreign tax redetermination is less than the lesser of $10,000 or two percent of the total dollar amount of the foreign tax initially accrued for that year.

III. Moving Expenses As a general rule, moving expense reimbursement will be included in an employee’s income unless the expenses are considered qualified moving expenses under section 132.99 If a lump sum payment is made to an employee and no accounting occurs, the payment is deemed not to be a payment for qualified moving expenses, and thus the payment is includable in income. If moving expense reimbursements are included in compensation, the taxpayer may deduct the expenses as an above-the-line deduction on Form 1040, Line 26 by preparing Form 3903 if the expenses meet the statutory requirements for moving expenses under section 217.

Qualified Moving ExpensesIf an employee receives qualified employer reimbursed moving expenses, these amounts will not be included in the employee’s taxable income, and the employee will not be entitled to a deduction.100

Qualified moving expenses include:

Household goods shipment, customs clearance expenses, insurance on goods, reimbursement for damaged goods to the extent the employer self-insures, and installation and/or removal costs;

98 See IRC section 6511(d)(3)(A).

99 I.R.C. §82.

100 I.R.C. §132(g). 47


Transportation expenses of the individual and family, visa costs and medical exams required by the company;

Other moving expenses, such as storage of household goods while on foreign assignment.101 Meals do not qualify as moving expenses.

Section 217 provides that expenses, such as traveling and transportation of personal belongings attributable to moving an alien and his family to a new principal place of business in the United States, are deductible. There is no dollar limitation on the amount of moving expenses that can be deducted; however, it should be noted that only “reasonable” moving expenses as set forth in section 217(b) are allowed.102 For purposes of the determining reasonable expenses, the travel must be made by the shortest and most direct route with no personal diversions and the expenses cannot be for lavish or extravagant travel or lodging.

A. Moving Expense Sourcing Rules Under Section 911 For the purpose of determining whether a moving expense reimbursement is attributable to services performed within a foreign country or within the U.S., in the absence of evidence to the contrary, the reimbursement shall be attributable to future services to be performed at the new principal place of work.103 Thus, a reimbursement received by an employee from his employer for the expenses of a move to a foreign country will generally be attributable to services performed in the foreign country. A reimbursement received by an employee from his employer for the expenses of a move from a foreign country to the U.S. will generally be attributable to services performed in the U.S.

Evidence to the contrary includes, but is not limited to: An agreement between the employer and the employee or A statement of company policy.

The agreement or policy statement must be set in writing before the move to the foreign country, and Must state that the employer will reimburse the employee for moving expenses incurred in

returning to the U.S. regardless of whether the employee continues to work for the employer after the employee returns to the U.S.;

May contain conditions upon which the right to reimbursement is determined as long as the conditions set forth standards that are definitely ascertainable and the conditions can only be fulfilled prior to, or through completion of, the employee’s return move to the U.S. that is the subject of the writing; and

Must be entered into or established to induce the employee or employees to move to a foreign country.

In no case will an oral agreement or statement of company policy concerning moving expenses be

101 I.R.C. §217(h).

102 Treas. Reg. §1.217-2(b)(2)

103 Treas. Reg. §1.911-3(e)(5)(i); See Rev. Rul 75-84, amplified by Rev. Rul 76-162. 48


considered evidence to the contrary.104 In 1981, the Tax Court in Dammers held that where an employer agreed to move the individual back to the U.S. as a condition of the assignment, the reimbursement for the return move (to the U.S.) relates to services performed during the foreign assignment and is, therefore, foreign source income.105 The Dammers court found that the moving expense reimbursement for the return to the U.S. was agreed to before the beginning of the assignment was an inducement to the employee to perform services in the foreign country, and thus should be sourced to the foreign country. This holding is consistent with the section 1.911-3(e)(5) regulations.

However, if the move is to the U.S. and the taxpayer begins work for a new employer after his return and the reimbursement is made by the new employer, the reimbursement will not be considered an inducement for a foreign assignment, and thus can be distinguished from Dammers and will be U.S.-source income under Treasury reg. section 1.911-3(e)(5).

For the purpose of determining whether a storage expense reimbursement is attributable to services performed within a foreign country, the reimbursement shall be attributable to services performed during the period of time for which the storage expenses are incurred.106

B. Attribution rules The regulations require that specific items of compensation be attributed to a particular year for purposes of determining the foreign earned income exclusion.107 According to the regulation, foreign-source moving expense reimbursements are attributable to services performed in the year of the move provided the individual qualifies for the section 911 exclusion for a period that includes at least 120 days in the year of the move. If the qualifying period in the year of the move is less than 120 days, a portion of the reimbursement must be attributed to services performed in the preceding or succeeding taxable year. Where such an allocation is required, the following ratio should be used:108

The number of qualifying days (as defined by Treasury reg. section 1.911-3(d)(3)) in the year of moveThe number of days in the year of the move

The numerator should include all qualifying days under the PPT, even though such days may be before or after the actual period of foreign assignment. The portion not allocable to the current year is attributed to the following year if a move is from the U.S. and to the prior year if a move is to the U.S. For moves from the U.S., the portion of the moving reimbursement sourced to the following year qualifies

104 Treas. Reg. §1.911-3(e)(5)(i).

105 Dammers v. Comm’r, 76 T.C. 835 (1981); See also Redding v. Comm’r, T.C. Memo 1982-111.

106 I.R.C. §217(h); Treas. Reg. §1.911-3(e)(5); §1.911-6(b)(2).

107 Treas. Reg. §1.911-6(b)(2).

108 Treas. Reg. §1.911-6(b)(2).49


for the subsequent year’s exclusion.109 If a portion of the subsequent year’s exclusion is not utilized on the tax return for that year, it may be claimed on the return covering the year of the move by filing an amended return. C. Disallowance of moving deduction If the section 911 exclusion is elected, moving expense deductions are limited under section 911(d)(6).110 For moving expenses attributable solely to the year of the move (see 120-day rule above), the disallowance is computed as follows:111

Current Year Exclusion Moving Expense X Foreign-source income qualifying for current-year exclusion

Note that foreign-source income attributable to prior or future years is not to be included in the denominator. In situations where the taxpayer qualifies for the exclusion for less than 120 days in the year of the move, the scaledown calculation involves the exclusion and foreign-source income for the year of the move and the preceding or succeeding year, as shown in the following example.

Assume an individual moves with 100 days left in the year. The following exclusions and qualifying income existed for each year as noted:

2008 2009Exclusion $23,934 $91,400Qualifying Income $78,000 $135,000

For $20,000 of deductible moving expenses, the disallowed amount would be:

23,934 + 91,400 $20,000 X 78,000 + 135,000 Because the succeeding year’s figures are generally not available at the time when the current year’s returns are prepared, the following procedure should be followed: Year of move

1. Compute the portion of the moving deduction attributable to the current year: Qualifying days in current year

Moving deduction X Number of days in current year

109 Treas. Reg. §1.911-6(b)(4).

110 Treas. Reg. §1.911-6(b)(1).

111 Treas. Reg. §1.911-6(b)(3).50


2. Apply the ratio of current-year exclusion to total current-year qualifying foreign- source income

to the result of (1). 3. Claim a moving deduction on the return for the year of the move reduced only by the amount

computed in (2). Succeeding Year

1. Compute correct scaledown amount using the exclusions and qualifying income figures for both years.

2. Any disallowed amount in excess of the scaledown computed in the prior year is added to

taxable income (termed “moving expense recapture”). This income is foreign-source income which does not qualify for the section 911 exclusion.

Continuing with the prior example, the following deduction calculations would be appropriate: 2008

Moving deduction before disallowance $ 20,000 $20,000 Attribution ratio (# days) X 100/366 Subtotal 5,464 Scaledown ratio ($23,934/$78,000) X .307 Estimated Disallowed amount 1,677 (1,677) Moving deduction $18,323

2009

Moving expense (on 2009 return) $20,000 Scaledown ratio (23,934 + 91,400) (78,000 + 135,000) 0.541474 Actual disallowed amount 10,8292006 scaledown amount (1,677) Moving recapture income $ 9,152

Note that the denominator of the ratio used to determine the recapture amount may also be increased for income received in 2008, which related to 2009. A common example of this would be the portion of the 2008 moving reimbursement, which is attributed to 2009 as a result of the qualifying period being less than 120 days.

51


Also note that in situations where the maximum qualifying period slightly exceeds 120 days, it may be advantageous to utilize the flexibility of the PPT to adopt a qualifying period of 119 days. This will generally result in a lower overall tax liability for the year of the move and the following year, since the moving expense disallowance is significantly reduced in the year of the move. There may be no compensating increase in tax the following year when recapture income results, provided sufficient foreign tax credits are available. D. Moves Back to the U.S. For moves back to the United States, Treasury reg. section 1.911-6(b)(2) should be followed. This section provides for the scale down of the moving expense deduction to the extent the corresponding reimbursement has been excluded from income under section 911. A disclosure statement under section 6662 on Form 8275-R must be included in tax returns where this regulation is not followed. However, we must be alert to situations where it is better to treat both the reimbursements and deductions as U.S. source (per Revenue Ruling 75-84, 1975-11 I.R.B. 8), thereby avoiding the partial disallowance of the moving deduction. This opportunity is available when the taxpayer has no written policy or agreement guaranteeing that moving expenses will be reimbursed and there are insufficient foreign tax credits available to offset the U.S. tax on the moving reimbursement.

IV. Away from Home Expenses - One Year Limitation As a general rule, a deduction is allowed for ordinary and necessary traveling expenses incurred by a taxpayer while away from home in the conduct of a trade or business.112 Section 162(a) specifically provides that for purposes of this general rule, a taxpayer “shall not be treated as being away from home during any period of employment if such period exceeds one year.” (An exception applies to certain federal government employees.)

In the case of individuals on foreign assignments, there is an important difference between travel away from home for a temporary assignment and a permanent assignment. The IRS issued guidance on the treatment of away-from-home expenses in Revenue Ruling 93-86, 1993-2 C.B. 71. Expenses related to “temporary” assignments are deductible by the employer under section 162(a)(2) and are not required to be included in the employee’s income. If the individual is not on a temporary assignment, the expenses paid by the employer are includable in the employee’s income.

Revenue Ruling 93-86 provides three general guidelines for determining the nature of a period of employment:

If the period of employment is expected to last (and in fact does last) for one year or less, the employment will be considered temporary in the absence of facts and circumstances indicating otherwise.

o RESULT: Expense reimbursements are not included in Form W-2. If the period of employment is initially expected to last for one year or less, but at a later date the

112 I.R.C. §162(a)(2); Treas. Reg. §1.162-252


period of employment is expected to exceed one year, the employment should be treated as temporary until the date that the expatriate’s expectation changes, in the absence of facts and circumstances indicating otherwise.

o RESULT: Expense reimbursements not included in Form W-2 while the assignment was considered temporary. After the expectation changes, the employer must include the expense reimbursements in Form W-2.

If the period of employment is expected to last for more than one year, the employment is indefinite, regardless of whether it actually exceeds one year.

o RESULT: Expense reimbursements must be included in Form W-2. Therefore, where an expatriate’s foreign assignment is expected to last more than one year, the tax home will be considered foreign and the expatriate should be eligible to claim the section 911 exclusion. Where the assignment is for 11 to 12 months (e.g., within the PPT 330 day period), the tax home is considered to be in the foreign location so long as the facts support the situation and the individual is not being treated as away from home for business expense reimbursement purposes. In other cases, it may be more advantageous to treat expenses as travel away from home expenses than as relocation and housing reimbursement costs.

V. Exclusion of Gain on the Sale of a Principal Residence A. Sales Occuring in 2008 or Earlier

Gains on the sale or exchange of principal residences are taxable unless excluded under section 121. For sales or exchanges taking place on or after May 7, 1997, taxpayers are allowed in certain cases to exclude from taxable income up to $250,000 (or $500,000 if married filing jointly) in realized gain. The exclusion does not apply to any depreciation claimed with respect to the rental or business use of a principal residence after May 6, 1997. The portion of gain related to depreciation claimed after May 6, 1997 will be subject to a special 25 percent tax regardless of whether the individual qualifies for the $250,000/$500,000 exclusion.113

An NOL does not preclude the exclusion under section 121 of gain realized on the sale of an expatriate’s residence as long as the residence qualifies as a principal residence. If the gain is 100 percent excluded, the sale will not be reported anywhere on the return. If some of the gain is taxable, the transaction should be reported on Schedule D. Recapture of the May 6, 1997 depreciation is required, to the extent of gain. Under such circumstances, a Form 4797 (Sale of Business Property) may also be needed.

Qualifying for the Exclusion

To qualify for exclusion, the taxpayer must have owned and occupied the home as a principal residence for an aggregate of at least two of the five years before the sale or exchange. The exclusion applies to

113 Treas. Reg. §1.121-1(e).53


only one sale or exchange every two years. If a taxpayer has two residences, the principal residence would be the one where the taxpayer spends the most time.114

Proration of Exclusion

If a taxpayer does not meet the ownership or residence requirements, a pro-rata amount of the $250,000 or $500,000 exclusion applies if the sale or exchange is due to a change in place of employment, health, or unforeseen circumstances.

The reduced exclusion is calculated by multiplying the maximum exclusion by a fraction. The numerator of the fraction would be the shortest of:

The period of time that the taxpayer owned the property as the taxpayer’s principal residence during the five-year period ending on the date of the sale or exchange;

The period of time that the taxpayer used the property during the five-year period ending on the date of the sale or exchange; or

The period of time between the date of a prior sale or exchange of property for which the taxpayer excluded gain under section 121 and the date of the current sale or exchange.

The numerator of the fraction could be expressed in days or months. The denominator of the fraction is either 730 days or 24 months, depending on whether the numerator is expressed in days or months.115

The regulations specify that where the two-year ownership and occupancy period is not met and the prorated exemption is claimed based on unforeseen circumstances, the sale must be proximate to the event that created the unforeseen circumstance. Therefore, if a taxpayer owned and occupied a principal residence and rented the home for four years prior to the sale, the unforeseen circumstances rule probably could not be used.

B. Sales Occurring after December 31, 2008

For sales of principal residences after December 31, 2008, gain attributable to a period of nonqualified use by the taxpayer is no longer excludable from gross income. The amount of gain allocated to a period of nonqualified use is the total amount of the gain multiplied by a fraction, with the numerator being the total period of nonqualified use during the entire period the property was owned, and the denominator being the entire period the property was owned.

A period of nonqualified use is defined as any period (not including any period before January 1, 2009) during which the property is not used by the taxpayer, the taxpayer’s spouse or former spouse as a principal residence. Three exceptions apply to this definition of nonqualified use:

1. Any period of the five-year period after the last day the property is used as a principal residence of the taxpayer or spouse,

114 Treas. Reg. §1.121-1(b)(2)

115 See Treas. Reg. §1.121-3(a).54


2. Any period, up to 10 years, during which the taxpayer or spouse is on extended duty with the military, Foreign Service or the intelligence community, and

3. Any period, up to two years, during which the taxpayer is temporarily absent by reason of change of employment, health conditions or other unforeseen circumstances.

The provisions regarding depreciation on the property have not changed.

These new provisions are best described through some examples:

Example 1: Assume a single individual owns a principal residence for the last three years. He then accepts a three-year assignment abroad, and rents out the property while on assignment. If the taxpayer sells the property after the assignment ends without re-occupying the residence, there is no change in the law. The taxpayer will still meet the two-of-five year test, and since the rental period is a period of use after the last day that the property was used as a principal residence of the taxpayer, it is not considered a period of nonqualified use. Accordingly, the taxpayer is still entitled to the full exclusion of $250,000, subject to the depreciation being taxable.

Example 2: Assume the same facts, except that after the assignment, the taxpayer moves back into the home for a year and then decides to sell the property. Assume the gain on the sale is $200,000.

a) Since the taxpayer re-occupied the property, he no longer meets the first exception above, as the period of nonuse preceded the last day the property was used as a principal residence.

b) At the same time, the taxpayer does meet the exception that the period of nonuse was because of a change in the place of employment. However, this exception is only valid for two years.

The overall period of ownership by the taxpayer is seven years: the three years prior to the assignment, the three years during the assignment, and the one year after the assignment. The period of nonqualified use is one year: the three years the property was rented less the two-year exception for a change in place of employment. Therefore, the ratio to use to allocate the portion of the gain to the nonqualified period is 1/7. As a result, $28,571 ($200,000 * 1/7) of the gain is allocated to nonqualified use and is not eligible for the exclusion. The remaining gain, $171,429, is less than the $250,000 exclusion, so it will be fully excluded from gross income. Of course, if any of this remaining gain is attributable to depreciation, the depreciation amount must be recognized as well.

C. Like-Kind Exchanges

For federal tax purposes, the exclusion of gain on the sale or exchange of a principal residence does not apply if the principal residence was acquired in a like-kind exchange in which any gain was not recognized within the prior five years.

D. State Taxes

The tax treatment of gain on the sale of a principal residence in any particular state may differ significantly from federal tax treatment. Be sure to consult the appropriate authorities in each particular state as well as the updated Deloitte Tax State Tax Guides — located in Innosphere and TaxShare — for

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state income tax implications.

VI. Rental of Residence During Foreign Assignment

Many expatriates choose to maintain their principal residence during their foreign assignment. If these properties are offered for rent, the associated expenses (mortgage interest, real estate taxes, depreciation, maintenance, etc.) are deducted on Schedule E (Supplemental Income and Loss). These rental activities are typically subject to the passive activity rules of section 469. The question is whether there is a position to claim the mortgage interest related to this rental property as non-passive.

A. Home Mortgage Interest Deduction — Generally

Ordinarily, per Section 163(h)(3), a taxpayer may deduct qualified residence interest, which is defined as interest paid on acquisition indebtedness related to the principal residence (within the meaning of Sec. 121) of the taxpayer, and one other residence selected by the taxpayer if not rented, or if the residence is rented during the year and the taxpayer uses it for more than the greater of 14 days a year or 10 percent of the time it is rented.116

As described in the section above regarding exclusion of gain on sale of principal residence, per Sec. 121, to be a principal residence, the taxpayer must have owned and occupied the home as a principal residence for an aggregate of at least two of the five years before the sale or exchange.

B. Section 469(j)(7)

Section 469(j)(7) states that the passive activity loss of a taxpayer shall be computed without regard to qualified residence interest within the meaning of section 163(h)(3). Therefore, even if the property is rented, if the interest qualifies as qualified residence interest (see below), it would not be passive and could be claimed as a non-passive loss.

C. Qualified Residence Interest

As described above, section 163(h)(3) defines qualified residence interest as interest on a principal residence within the meaning of section 121. As stated above, a taxpayer must own and occupy the home as a principal residence for an aggregate of at least two of the five years to qualify as a principal residence.

The regulations to Section 121 provide a list of factors that may be used to determine whether a certain residence is a principal residence. The factors include, but are not limited to:

The taxpayer’s place of employment; The principal place of abode of the taxpayer’s family members; The address listed on the taxpayer’s federal and state tax returns, driver’s license, automobile

registration, and voter registration card;

116 I.R.C. §163(h)(4)(A)(i)(2) (referring to the test under §280A(d)).56


The taxpayer’s mailing address for bills and correspondence; The location of the taxpayer’s banks; and The location of religious organizations and recreational clubs with which the taxpayer is

affiliated.

In addition, there is now a new standard that requires that the home be occupied to be considered a principal residence.

The new, objective standards under section 121 supplant the subjective standard of the prior section 1034 and associated case law that previously allowed a residence to retain its status as a permanent residence while it was being rented because the taxpayer intended to return to the residence upon the completion of the assignment. Accordingly, based on a thorough examination of the statutory, regulatory, and case law history concerning the definition of a principal residence under section 121 and its predecessor section 1034, the conclusion is that the former personal residence will usually cease to be a principal residence when the taxpayer commences rental of the property.

As such, the section 469(j)(7) classification of the interest expense as nonpassive does not apply to the interest associated with the rental property. The interest expense, along with all other expenses associated with the rental activity, should be reported on Schedule E and be fully subject to the passive activity rules under section 469.

It should be noted that if the property is located in the United States, the interest expense is sourced 100 percent against U.S.-source income under the asset method of allocation.

Nevertheless, in limited cases, there may be authority, based on case law under former section 1034, to continue to claim the interest expense as nonpassive under section 469(j)(7). There would have to be a clear statement from the taxpayer of his/her intent to return to the property and use it as a personal residence at the conclusion of the assignment. Preferably, if the assignment has subsequently ended, the assignee should have already re-occupied the property. In the taxpayer is willing to affirmatively state their intent to return to the property and reside in it to meet the 2 of 5 year test, a position under 469(j)(7) would apply.

Since this position of the definition of principal residence is based on former section 1034, which has now been deleted from the Code, there is not substantial authority that this position will be allowed. Accordingly, this position should not be taken without first consulting with a national tax technical resource. Additionally, the position cannot be taken without attaching a Form 8275 to the return disclosing the position.

D. Year of Departure & Return from Foreign Assignment

If an individual departs on or returns from a foreign assignment, resides in the property for part of the year, and rents the property in the same year, the rules of section 280A apply if the residence is used partly as rental and partly for personal purposes during the period of rental. If the property is immediately converted to rental upon beginning the assignment, or immediately converted back to personal use at the end of the assignment, then the rental rules apply without considering any allocation

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for personal use.

In the case of mixed use, the section 280A rules will allocate interest and property taxes between Schedule A and Schedule E, and the overall expenses associated with the rental will be limited to the income from such unit under section 280A(c)(5). As such, there can be no loss from the property in the year of initial rental and thus the passive loss rules under section 469 apply. If the house is not rented in year of departure or return, the use test of section 280A(d) will most probably be met and the individual will be entitled to a full deduction on Schedule A for the personal use portion.

E. Net Operating Losses on Rental Properties Subject to passive activity loss rules, net losses resulting from rental of U.S. residences while overseas may be used to offset other income. Section 172(d)(4) limits an individual’s net operating loss (NOL) to losses generated from a trade or business. Nonbusiness deductions are allowed only to the extent of gross income not derived from a trade or business, and therefore cannot generate an NOL. In determining whether a trade or business exists for purposes of section 172(d)(4), the facts and circumstances of the situation must be considered. Several cases have held that, under the right circumstances, the rental of a single piece of property can constitute the operation of a trade or business. One particular circumstance that may indicate a rental trade or business exists when a taxpayer’s deductible expenses with respect to the property are greater than 15 percent of the rental income from the property. Therefore, subject to the passive activity loss rules, an expatriate may realize an NOL if the rental of his or her U.S. residence qualifies as a trade or business. F. Suspended Losses upon the Sale of a Residence covered by section 121

Upon the completion of the individual’s assignment, two situations are likely to occur: (1) the individual may return to the residence and use it as his or her principal residence, or (2) the individual may sell the residence. If the taxpayer returns to the residence, the suspended losses will continue to be suspended until the residence is sold to a third party (unless the taxpayer has other passive income).117 If the residence is sold at any time after the rental period begins, the taxpayer’s gain or loss on the residence must be analyzed under section 121 and section 469.

1) Sale of the Residence — IRC section 121 does not apply.

If the sale occurs when the principal residence rules of section 121 do not apply, and therefore, the gain/loss on the sale is fully subject to tax, any passive activity losses that were disallowed in prior years due to section 469 will be allowed in the year when the entire interest in the residence is disposed of in a fully taxable transaction. In most cases, a fully taxable transaction is a sale or exchange of the property to a third party at arm’s length in a bona fide transaction.118

The gain realized on the sale will be recognized under the provision of section 1231, which will likely include unrecaptured section 1250 gain taxed at ordinary rates. The suspended loss will be allowed to offset nonpassive income to the extent it exceeds income from other passive activities.

117 I.R.C. §469(f)-(g).

118 S. REP. NO. 99-313, at 725 (1986).58


2) Sale of the Residence — IRC section 121 applies

If the sale occurs when the residence qualifies as a principal residence and is therefore eligible for the exclusion of gain under section 121, the general rule is that this is not considered a fully taxable transaction and the suspended losses would continue to be suspended. However, section 121(d)(6) provides for gain to be included in gross income equal to the lesser of the actual gain realized on the sale or prior depreciation deductions taken. Thus, to the extent that section 121(a) gain exclusion does not apply to a portion of the gain realized (e.g. the prior depreciation), that portion of the gain may be considered passive and the equivalent suspended losses can be utilized.

For taxpayers who qualify for a section 121 exclusion and have passive rental income in the year of sale, the taxable gain would be passive and the passive loss could offset the gain. On the other hand, Treasury reg. section 1.469-2T(c)(2)(3) states that gain from the disposition of an activity that is not a passive activity to the taxpayer in the year of disposition is treated as nonpassive income. For taxpayers who reoccupy the house after returning from the assignment, thus effectively ending the ‘passive’ status of the income from the residence, the regulation would treat any subsequent taxable gain as a result of depreciation recapture as nonpassive. Alternatively, the former passive activity rule of section 469(f) might allow losses up to the amount of the nonpassive gain recognized due to section 121(d)(6) to offset such gain. Under either scenario, any excess suspended loss after the disposition would continue to be suspended and could only be utilized if the taxpayer had other passive income. If the suspended passive loss was in excess of the excluded gain and a taxpayer had no near-term prospects of using the loss, a taxpayer might consider electing out of section 121.

G. Extinguishing Debt for Rental Property

Assume a client owns property in a foreign country and wants to repay the mortgage on the property. The correct treatment of the gain or loss on the mortgage retirement depends on whether the rental of the residence constitutes a trade or business. If the rental is not a trade or business, the client will realize ordinary gain when the mortgage is retired because the mortgage relates to the client's rental activities, which are by definition passive.119 Accordingly, the gain realized upon repayment would constitute ordinary gain and can be used to offset any suspended passive activity losses.

If the rental constitutes a trade or business, then it will likely constitute a Qualified Business Unit (QBU) under section 989. If the rental is a trade or business and the books are kept in the foreign currency, the QBU treatment is allowed.120 Under this scenario, gain or loss is calculated in the base currency, and so long as the proceeds are maintained in that currency no gain has occurred. If the proceeds are transferred to the U.S. or converted to U.S. currency, then a gain or loss could occur on the exchange transaction.

119 I.R.C. §469(c)(2).

120 Treas. Reg. §1.989(a)-1(b)(2)(ii)(A).59


H. Extinguishing Debt on a Foreign Principal Residence

Most expatriate policies discourage U.S. employees from purchasing a personal residence in a foreign country by providing a generous rental allowance and/or by stipulating that the employee is responsible for all taxes incurred as a result of the purchase/sale of a foreign home. Nonetheless, in some instances an expatriate will purchase a home while on foreign assignment. It is therefore important to inform the expatriate and his or her employer of potential gain arising from foreign currency fluctuations upon the repayment of a foreign currency mortgage. Mortgage interest deduction limitations for mortgages over $1 million also apply to mortgages taken out on foreign residences. When measuring the total amount of the mortgage for this purpose, the exchange rate at the time the mortgage is taken out or at the time of a refinancing where the term materially changed should be used to compute the principal amount for determining disallowed interest. It is not necessary to revalue the total mortgage principal annually for this purpose. Revenue Ruling 90-79, 1990-2 C.B. 187 provides that “gain or loss realized by a U.S. citizen from the sale of a personal residence may not be offset by loss or gain realized from the repayment of a nonfunctional currency denominated mortgage loan used to finance the purchase of a residence.” Since these gains or losses may not be used to offset each other, it is possible for an expatriate to realize a loss, which would be nondeductible, on the sale of the home, and a currency gain which would be taxable as ordinary income, on retirement of the foreign mortgage. In a situation where the host country’s currency weakens during the expatriate’s period of service, a foreign currency gain must be recognized as ordinary income on the retirement of the mortgage in addition to any gain on the sale of the residence. Similarly, a gain on the sale of a foreign residence may not be offset with the loss incurred on repayment of the mortgage when foreign currency has strengthened relative to U.S. currency.121 The District Court in Quijano held that the house sale and the mortgage repayment are transactions which must be considered separately, and since both are personal in nature, a loss cannot be claimed on the repayment of the mortgage. The source of any gain on repayment should be determined under the interest income rules of Treasury reg. section 1.861-2, which generally sources interest income based on the residence of the debtor on the date the mortgage is repaid. For foreign tax credit purposes, the gain should be treated as passive income. Section 988(e) provides that currency gains of less than $200 per transaction arising from personal transactions are exempt from income tax. This de minimis provision can be used, for example, to argue that each monthly payment on a foreign mortgage is exempt from the exchange rate gain provisions.

I. Rental of Foreign Residence

The record-keeping and subsequent tax treatment of a foreign rental property may be subject to the foreign currency rules under Sections 985-989. Under Sec. 985(a), all determinations for income tax

121 Quijano v. United States, 76 A.F.T.R.2d (RIA) 7739 (D. Me. 1995), aff’d, 93 F.3d 26 (1st Cir. 1996), cert. denied, 519 U.S. 1059 (1997). .

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purposes shall be made in the taxpayer’s functional currency. Sec. 985(b)(1) provides that functional currency means the U.S. dollar, except that for a qualified business unit (QBU), it means the currency of the economic environment in which a significant part of the entity’s activities are conducted and which is used to keep the books and records of the activity.122 Sec. 989(a) and Reg. Sec. 1.989(a)-1(b)(1) define a QBU as a separate and clearly identified unit of a trade or business of a taxpayer which maintains separate books and records. Per Reg. Sec. 1.989(a)-1(b)(2), an individual by definition is not a QBU. Therefore, for individual taxpayers, the functional currency will be the U.S. dollar, and non-dollar denominated items of income and expense of the individual generally would be translated into dollars on the date received or paid. A foreign rental property may qualify as a QBU, however, even if the property is solely owned by an individual. If the activity related to the property rises to the level of a QBU, the functional currency of the QBU would typically be the currency of the country where the property is located (assuming separate books and records are kept in such currency), which would impact the method of tracking and reporting the income and expenses for purposes of the U.S. tax return.

Reg. Sec. 1.989(a)-1(c) indicates that the determination of whether an activity is a trade or business is ultimately a facts and circumstances question. Generally, a trade or business is an activity that constitutes an independent economic enterprise carried on for profit, the expenses related to which are deductible under Section 162 or 212. The activity must ordinarily include the collection of income and the payment of expenses. Based on the above, a rental property which is operating as a viable business, collecting rental income during the year and paying rental expenses, and keeping separate books and records to track the income and expenses, would be treated as a QBU. As such, keeping separate books and records is an important component of treating a rental property as a QBU. If the owner of the property commingles the funds with his/her general funds, this may not satisfy the requirement that separate books and records be maintained and may result in the QBU having to use the U.S. dollar as its functional currency.123

1. Income Recognition of QBU

Once it is determined that the rental property is attributable to a QBU, the net income or loss from the QBU is determined in its functional currency and then translated into U.S. dollars at the average exchange rate for the year. Therefore, in computing the income and expenses of a foreign rental property that is a QBU, it is important to track all income and expenses in the foreign functional currency. This would include the value of the property for depreciation purposes. The depreciation expense would be computed by applying the appropriate U.S. depreciation method to the depreciable basis, as stated in the functional currency. The depreciation expense, along with any item of income earned by the QBU, would then be translated to dollars at the average exchange rate for the year. Accordingly, it is probable that the depreciation amount reported on Schedule E of the taxpayer’s return will change each year, as the exchange rate fluctuates. However, the depreciation will be consistent in the functional currency of the QBU.

2. What if property was a QBU in a prior year, but never treated as such

122 However, a QBU that conducts its activities primarily in U.S. dollars must use the U.S. dollar as its functional currency. 123 See Reg. Sec. 1.985-1(c)(3) for the presumption regarding maintaining books and records.

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During the first year that a taxpayer is in the US, or the first year that a taxpayer begins renting a foreign rental property, the taxpayer should evaluate whether the property qualifies as a QBU, and if it does, the taxpayer should make sure that the proper functional currency is used in reporting income, expenses, depreciation, etc. However, in some circumstances, it is possible that a taxpayer, either mistakenly or unaware of the rules, may not have treated a foreign rental property as a QBU in prior years. The question is what should be done in this circumstance, both in terms of the prior years and the current year.

Per Section 985(b)(4), a change in the functional currency is treated as a change in method of accounting. This would typically require permission of the Commissioner to make a change in the method of accounting. However, if the prior year calculations were made in error, taxpayers may correct their prior year numbers to reflect the proper reporting in the correct functional currency. For example, if the depreciation expense had been erroneously calculated by translating the cost of the building into U.S. dollars at the historical exchange rate and then calculating the depreciation based on that U.S. dollar amount, the depreciation expense may be recomputed in the foreign functional currency and translated each year into U.S. dollars using the average exchange rate for that year.

If the change would only have resulted in an adjustment to the suspended loss from that year, then the only change necessary is to adjust the suspended loss carryforward. However, if the change would have resulted in an actual change to the taxable income of the taxpayer, amended returns may be required.

3. Gain/Loss Recognized on Remittance

Section 987 sets forth currency translation and certain gain or loss recognition rules for taxpayers that have one or more QBUs with a functional currency other than the U.S. dollar. Section 987(3) provides that a taxpayer must make “proper adjustments (as prescribed by the Secretary)” for transfers of property between QBUs of the taxpayer that have different functional currencies, including treating post-1986 remittances from each QBU as having been made on a pro rata basis out of the QBUs post-1986 accumulated earnings. Notwithstanding the broad grant of regulatory authority provided by Section 987(3), no generally applicable regulations have been issued to date. The only currently effective regulations under Section 987 are Treas. Reg. §§ 1.987-5 and 1.989(c)-1, which provide certain transition rules related to the Tax Reform Act of 1986, but those rules apply only to QBUs that were in existence on December 31, 1986.

The IRS issued proposed regulations under Sec. 987 in 1991, which were withdrawn when a new set of proposed regulations were issued in 2006. However, the IRS has indicated that the methodology under the 1991 proposed regulations is considered a reasonable method for applying Sec. 987. This summary sets forth the rules under the 1991 proposed regulations.

In general, IRC Sec. 987 requires that a gain or loss be recognized when a QBU makes a remittance to the taxpayer. A remittance is considered a transfer of cash or other property from the QBU to the taxpayer for personal use. As mentioned above, to be treated as a QBU, separate books and records tracking income and expenses of the rental property must be maintained in the functional currency of the QBU. This means that the income and expenses related to the rental property are segregated from the

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other funds of the taxpayer. A remittance will occur when any of the funds that have been segregated within the rental property are used by the individual taxpayer for any personal reason.

When a remittance occurs, Section 987 gain or loss is realized and must be recognized in the taxable year of the remittance. It is considered an ordinary gain or loss, and is sourced based on the source of the income giving rise to the gain or loss. Generally, in the case of a foreign rental property, the source of the gain or loss will be foreign source.

Under the approach of the 1991 proposed regulations, Section 987 gain or loss is determined with reference to the equity or net assets of a QBU. Under Prop. Reg. Sec. 1.987-2(a)(1) (1991), a taxpayer maintains an equity pool and a basis pool in each QBU. The equity pool is maintained in the functional currency of the QBU, while the basis pool is maintained in the functional currency of the taxpayer.124 The equity pool of a QBU generally consists of the undistributed capital and earnings of such QBU,125

and the basis pool generally reflects the taxpayer’s basis in the undistributed capital and earnings contained in the equity pool.126 When a QBU makes a remittance to the taxpayer, Section 987 gain or loss is computed as the difference between the value of the remittance translated into the taxpayer’s functional currency at the spot rate on the date of the remittance, less the portion of the basis pool attributed to such remittance.127 A remittance is defined generally to mean the net amount of property (measured in the functional currency of the QBU) that is transferred from a QBU to the taxpayer, to the extent that the aggregate amount of such transfers during the taxable year does not exceed the positive year-end balance of the equity pool.128

Example • Taxpayer uses €5,000 from his rental property for personal purposes in year 3 of operations• Originally purchased property for €100,000, when exchange rate was $1.2:€1• Income in each of first three years was €10,000 per year, and exchange rate each year was

$1.25 : €1• On the date of remittance, the spot rate was $1.3 : €1

124 Prop. Treas. Reg. § 1.987-2(c) (1991).

125 Prop. Treas. Reg. § 1.987-2(c)(1)(ii) (1991).

126 Prop. Treas. Reg. § 1.987-2(c)(2)(ii) (1991).

127 See generally, Prop. Treas. Reg. § 1.987-2(d)(1) (1991).

128 See generally, Prop. Treas. Reg. § 1.987-2(b)(4) (1991). 63


Equity Pool (Maintained in €)

Exchange rate to US$ Basis Pool (Maintained in $)

€100,000 1.2:1 $120,000

€10,000 1.25:1 $12,500

€10,000 1.25:1 $12,500

€10,000 1.25:1 $12,500

Balance

€130,000 $157,500

• When remittance occurs, gain/loss is computed as the difference between (1) the value of the remittance translated into the taxpayer’s functional currency at the spot rate on the date of the remittance, less (2) the portion of the basis pool attributed to such remittance.• (1) €5,000 * $1.3 = $6,500• (2) Amount of remittance (in functional currency) * Balance in US$

Balance in EQ pool (in functional currency) basis pool

€5,000 * $157,500 = $6,058€130,000

• Net gain of $442, foreign source, ordinary income

4. Conclusion An evaluation of each foreign rental property will be required to determine whether it meets the definition of a QBU. However, if it does, the income, expenses and depreciation should be tracked in the foreign functional currency and then translated into dollars based on the average exchange rate for the year. Special attention must be given to the overall accounting and treatment of income and expenses throughout the period of rental, with particular focus on any remittances made to the individual taxpayer, to ensure that proper reporting is completed on the tax returns.

VII. Social Security and Self-Employment Tax Totalization Agreements

Totalization agreements cover both employees and self-employed individuals. In general, if an employee of a U.S. company is seconded to a foreign country with which the U.S. has entered into a totalization agreement for a less-than-specified period (e.g., a period not to exceed five years for the U.S./UK agreement), the individual may continue to pay U.S. social security and not the foreign

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country’s contributions. A certificate of coverage must be obtained from the U.S. authorities. Totalization agreements cover the countries in which the individual is resident and employed and not the countries to which the individual may from time to time travel to perform services. Self-employed individuals residing in a country with which the U.S. has entered into a totalization agreement are generally subject to the social security system of the country of residence. However, foreign countries have different interpretations of ‘residence’ for these purposes. Thus, it may be possible for a self-employed individual to continue to pay U.S. self-employment tax. The specific agreement for the country must be referred to in all cases. Self-employed individuals who are subject to self-employment tax in the foreign country will be exempt from U.S. self-employment tax. A certificate of coverage must be obtained from the country of residence. Schedule SE should be included in the U.S. tax return with a statement that the individual is exempt from U.S. tax as a result of the totalization agreement. Revenue Procedure 84-54, 1984-2 C.B. 489, amplifying Revenue Procedure 80-56, 1980-2 C.B. 851, lists the procedures for securing statements regarding coverage in those countries with which the U.S. has a totalization agreement in effect.

See page 20 above for a complete list of totalization agreements. A list is also available on the Social Security Administration website (www.ssa.gov).

VIII. Retirement Plan Deductions

A. IRA Deductions

Traditional and Roth IRA contributions are limited to the lesser of 100 percent of compensation included in gross income or the following amounts:

$5,000 for 2009 and 2010 ($6,000 if 50 or older);

An expatriate who wishes to make any contribution to a traditional or Roth IRA must have U.S. gross income (not including any income excluded by section 911) in an amount equal to or greater than the amount to be contributed.

Where spouses file a joint return, the limitation is computed separately for each spouse, but the lower-earning spouse’s compensation is deemed equal to the higher earners.

Traditional IRA contributions are deductible if the taxpayer and the taxpayer's spouse, if they file a joint return, are not active participants in a U.S. qualified retirement plan (See Form W-2, box 13). An expatriate who is an active participant, or whose spouse is an active participant, is entitled to a full deduction only if adjusted gross income (AGI), including amounts excluded by section 911, falls below the level specified in section 219(g). The AGI threshold for full deductibility for unmarried individuals is $55,000 in 2009 and $56,000 in 2010. For married individuals filing joint returns, it is $89,000 in 2009 and 2010 where both spouses are active participants in a qualified plan. Where one spouse is an

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active participant in a qualified plan and the other spouse is not, the threshold is $166,000 in 2009 and $167,000 in 2010 for the spouse who is not an active participant. For married individuals filing separate returns, it is zero, unless they live apart for the entire year, in which case they are treated as unmarried for this purpose. The deduction phases out ratably as AGI increases beyond the threshold. It is reduced to zero if AGI is $10,000 or more above the threshold ($20,000 for married individuals filing joint returns in 2007 or later).

Roth IRA contributions are not deductible. They are limited to the amounts stated above (reduced by the amounts of any contribution made to any traditional IRAs that year). This limit is subject to a phase-out based on AGI, including amounts excluded from income under section 911(a). For 2009, the phase-out begins at $166,000 for taxpayers filing joint returns, $105,000 for unmarried individuals, and zero for married individuals filing separate returns (except those who live apart throughout the entire year). The limit is reduced to zero at AGI of $176,000 for joint return filers, $120,000 for unmarried individuals, and $10,000 for married individuals filing separately. For 2010, the phase-out begins at $167,000 for taxpayers filing joint returns, and $105,000 for unmarried individuals. The limit is reduced to zero at AGI of $177,000 for joint return filers, and $120,000 for unmarried individuals. For married individuals filing separately, the 2010 phase-outs are the same as 2009.

Both Roth and traditional IRA contributions must be made no later than April 15 of the year following the tax year for which the contribution is made, regardless of whether a taxpayer is out of the country at the time.

Some companies factor in an IRA contribution deduction in computing the employee’s hypothetical tax for the year. If this is true of your taxpayer’s employer, there may be a current tax advantage to the employee in making contributions to an IRA regardless of whether a deduction is actually claimed. This will be the case if such amounts are converted to Roth IRAs, as will be possible in 2010. Please refer to the tax equalization section of the Supplemental Engagement Memoranda for a given client for further information.

B. Keogh Contributions/Deductions

“Keogh” or “HR-10” plans are qualified retirement plans that cover self-employed individuals. The rules for determining deductible contributions differ between sole proprietors and partners, and between defined benefit and defined contribution plans.

1) Sole Proprietors

Section 401(c) treats a sole proprietor as both an employer (for purposes of establishing a plan and an employee (for purposes of participating in a plan). A sole proprietor's “compensation” for plan purposes is determined under section 401(c)(2) and equals net earnings from self-employment, as defined by section 1402 for the trade or business with respect to which the plan is established, reduced by items excluded from gross income (such as earnings excluded by section 911), the contributions made in his behalf to the plan (other than elective deferrals under a section 401(k) plan) and the deduction allowed by section 164(f) for self-employment tax. The compensation taken into account for plan purposes may not exceed the limitation specified in section 401(a)(17) ($245,000 in 2009 and 2010).

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The minimum required and maximum deductible contributions for a defined benefit plan are calculated annually by the plan’s actuary. Section 404(a)(8) limits the deduction to net earnings calculated in accordance with section 401(c)(2). The minimum required contribution must be made, even if it is not fully deductible. Nondeductible contributions are ordinarily subject to a 10 percent excise tax under section 4972, but section 4972(c)(4) provides an exception for self-employed individuals who make minimum required contributions.

The maximum deductible contribution to a defined contribution plan is 25 percent of the participant's aggregate compensation, as defined by section 401(c)(2) and limited by section 401(a)(17), except that elective deferrals under section 401(k) plans are deductible without limitation. In addition, the allocation to each participant’s account is limited to the lesser of a dollar maximum ($49,000 in 2009 and 2010) or 100 percent of compensation, defined as in section 401(c)(2), except that income excluded by section 911 is included.

Because the mechanics of calculating the proper amount of deduction are somewhat complex (involving a definition of “earned income” that carves out plan contributions on behalf of the self-employed and the deduction for self-employment tax) the IRS provides worksheets in Publication 560, available at www.irs.gov.

2) Partners

The rules described above apply in the partnership context; however, the deduction limit is determined at the partnership level while the partner takes the portion of the deduction attributable to contributions on his behalf on his individual return. The partnership is considered to be the “employer” and is the entity that maintains the plan. The individual partners are “employees” for plan purposes.

The steps to determine a partnership contributions and partner deductions under a defined contribution Keogh plan are as follows:

1. Determine the aggregate compensation, as defined in section 401(c)(2) and limited by section 401(a)(17), of all participants in the plan. Contributions are deductible up to 25 percent of that amount, except that elective deferrals under a section 401(k) plan are deductible without limitation.

2. Determine the maximum contribution that can be allocated under section 415(c) to each participant’s account, which is the same as the limitation described above for sole proprietors.

3. Deduct on the partnership return contributions made in behalf of non-partner employees of the partnership.

4. Deduct on each partner’s individual return the contributions allocated to his own account. This deduction may not exceed the partner's section 401(c)(2) compensation derived from the partnership. Any nondeductible portion is not subject to excise tax under section 4972, because deductibility for that purpose is determined at the partnership rather than the partner level.

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http://www.irs.gov/

A specialist should be consulted for determining deductible contributions for a partnership defined benefit plan.

IX. Miscellaneous

A. Timely Filing Requirement

1) Timely Filed Section 911 Elections Treasury reg. section 1.911-7(a)(1) provides that the elections under section 911 must be filed with one of the following:

A timely filed income tax return, including extension, An amended return for a timely filed return, or An original return filed within one year after the due date (without extension) for the first

taxable year for which the election is to be effective. The following example illustrates the due dates using the automatic relief: 2009 Tax Year Reg. section 1.911-7

Due Date (1) Original/Extended Rtn. 01/30/11 (2) Late Return 04/15/11 (3) Amended Return 06/15/13

The Original and Extended due dates assume that the taxpayer will qualify as a bona fide resident using 2010 as the qualifying period and filing Form 2350 (Application for Extension of Time to File U.S. Income Tax Return) to extend the due date until January 30, 2011. The Late Return date assumes that section 911 exclusion is elected on an original return which is filed late. The Amended Return example assumes the taxpayer timely filed his original return by the automatic two-month extended date without the section 911 exclusion. The IRS has issued final Treasury reg. section 1.911-7(a)(2)(i)(D), which permits the late election of the exclusion for tax years beginning after 12/31/81 provided:

The taxpayer owes no federal income tax after taking into account the exclusion and files Form 1040 with Form 2555 or a comparable form attached either before or after the Internal Revenue Service discovers that the taxpayer failed to elect the exclusion; or

The taxpayer owes federal income tax after taking into account the exclusion and files Form 1040 with Form 2555 or a comparable form attached before the Internal Revenue Service discovers that the taxpayer failed to elect the exclusion.

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Chief Counsel Advise Memorandum 200226010, issued on March 20, 2002, defines tax liability for purposes of the above rule by providing that:

[T]ax examiners should apply any payments, such as withholding tax, estimated tax, tax credit, balance due, etc. to offset any federal income tax liability, to determine whether the taxpayer “owes no federal income tax.”

The intent of this regulation section is to allow a taxpayer whose only income at issue is excluded foreign earned income to file a late section 911 election. If a taxpayer has a refund or no balance due, the taxpayer “owes no federal income tax” under section 1.911-7(a)(2)(i)(D)(1) and (2), and does not need to request a private letter ruling from us.

2) Timely Filed Returns — Foreign Postmarks Revenue Ruling 80-218, 1980-2 C.B. 386 states that federal tax returns mailed by taxpayers in foreign countries will be accepted as timely filed if they bear an official postmark dated on or before midnight of the last date prescribed for filing, including any extension of time for such filing. In Pekar v. Comm’r, the Tax Court imposed penalties under section 6651(a)(1) for failing to file a timely return.129 The Service acquiesced, in result only, to the Tax Court's opinion in Pekar, on March 14, 2002, and filed a motion requesting the Tax Court modify its opinion to follow Revenue Ruling 80-218. The tax court upheld its original opinion. A separate position exists with respect to refund claims. The Second Circuit held that the “mailbox rule” applies to refund claims, and that a refund claim is deemed filed on the date it is postmarked.130

3) Foreign Delivery Services A taxpayer who sends his/her tax return to the IRS from abroad via the local mail service or the foreign private delivery services should be aware the IRS may consider these tax returns as late filed if they are not timely received. The section 7502(f) authorizes the Secretary to designate certain private delivery services as an acceptable means for “the timely mailing as timely filing/paying” rule. The most recent list was updated in December of 2004.131

1. DHL Express (DHL): DHL Same Day Service, DHL Next Day 10:30 am, DHL Next Day 12:00

pm: DHL Next Day 3:00 pm, and DHL 2nd Day Service;

2. Federal Express (FedEx): FedEx Priority Overnight, FedEx Standard Overnight, FedEx 2 Day, FedEx International Priority, and FedEx International First; and

3. United Parcel Service (UPS): UPS Next Day Air, UPS Next Day Air Saver, UPS 2nd Day Air, UPS

129 113 T.C. 158 (1999), acq. in result, 2002-10 I.R.B. 606.

130 Weisbart v. United States, 222 F.3d 93 (2nd Cir., 2000), acq. in result, 2000-48 I.R.B. 515.

131 Notice 2004-83, 2004-52 IRB 1030.69


http://www.lexis.com/research/buttonTFLink?_m=19736eb83e03fb0ba796c75e21171806&_xfercite=%3Ccite%20cc%3D%22USA%22%3E%3C!%5BCDATA%5B113%20T.C.%20158%5D%5D%3E%3C%2Fcite%3E&_lexsee=SHMID&_butType=3&_butStat=254&_butNum=22&_butInline=1&_butinfo=%3Ccite%20cc%3D%22USA%22%3E%3C!%5BCDATA%5B2002-10%20I.R.B.%20606%5D%5D%3E%3C%2Fcite%3E&_fmtstr=FULL&docnum=1&_startdoc=1&wchp=dGLbVtz-zSkAb&_md5=137de2b82b75de5c740c9193103b2b4a

2nd Air A.M., UPS Worldwide Express Plus, and UPS Worldwide Express.

4) Timely Filed Refund Claims A taxpayer must file a claim for a credit or refund of an overpayment within three years from the time of filing the relevant return, or two years from the time of the payment of the tax, whichever period expires later. However, section 7503 only provides for the automatic extended due date to the next business day if the due date of an original return falls on a Saturday, Sunday, or legal holiday. If the last day to file returns falls on a Saturday, Sunday, or a legal holiday, this extension due to the weekend or holiday does not also extend the designated period for filing a refund claim. For example, a taxpayer timely files a 2006 return on March 1, 2007. The last day to file a return for tax year 2006 is Monday, April 16, 2007, because April 15, 2007 falls on a Sunday. A taxpayer would have to file a refund claim by April 15, 2010 (even if this date was a Saturday, Sunday, or legal holiday) in order for the claim to be valid. B. Treaty-Based Return Positions — Disclosure and Penalties Taxpayers are required to disclose when tax return positions are taken in which a treaty overrules or modifies any provision of the Code. Disclosure is necessary regardless of whether a tax return is otherwise required to be filed. The regulations indicate that the disclosure requirement covers, but is not limited to, any income tax treaty, estate and gift tax treaty, or friendship, commerce, and navigation treaty. Disclosure is accomplished by completing Form 8833, Treaty-Based Return Position Disclosure Under section 6114 or section 7701(b), and attaching it to the return. Disclosure is specifically required if:

A nondiscrimination provision of a treaty precludes the application of any otherwise applicable Code section,

A treaty reduces or modifies the taxation of gain or loss from the disposition of a United States real property interest,

A reduced rate of withholding applies to fixed or determinable annual or periodic income received from a related party that was not properly reported on Form 1042S,

Effectively connected income of a nonresident alien is not attributable to a permanent establishment or a fixed base of operations in the United States and, thus, is not subject to U.S. tax on a net basis,

The source of income or deduction is altered, or A foreign tax credit is granted that would not otherwise be allowed under the Code. Residency is determined under a treaty and apart from the Code (Treasury reg. section

1.7701(b)-7(c))

Treasury reg. section 301.6114-1 specifically requires disclosure for the following in addition to the above named items:

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1. Cases where a treaty exempts from tax, or reduces the rate of tax on income subject to withholding that is received by a foreign person that is the beneficial owner of the income and the beneficial owner is related to the person obligated to pay the income within the meaning of sections 267(b) and 707(b) and the income exceeds $500,000;

2. The foreign person meets the requirements of the limitation on benefits article of the treaty; and

3. A treaty imposes any other conditions for the entitlement of treaty benefits, for example as a part of the interest, dividends, or royalty article, that such conditions are met.132

The above list is not intended to be all-inclusive. Any treaty-based position not specifically exempted from the reporting requirements must be disclosed.

Disclosure is specifically not required if:

A reduced rate of withholding applies on payments between unrelated parties; Income derived from dependent personal services, pensions, annuities, social security and other

public pensions, or income derived by artists, athletes, students, trainees or teachers is modified or reduced (disclosure specifically called for on Form 1040NR);

A Social Security Totalization Agreement or a Diplomatic or Consular Agreement reduces or modifies the taxation of income derived by the taxpayer; or

The income of an individual is re-sourced for purposes of the foreign tax limitation under a treaty provision relating to elimination of double taxation.

Where payments or income items otherwise reportable under this section are received during the course of the taxable year and they do not exceed $10,000, disclosure is waived. A $1,000 penalty may be assessed for each separate failure to disclose a treaty-based return position.133

The penalty can be imposed more than once for a single tax year, if more than one treaty positions is taken and not properly disclosed. In the event the failure to disclose was not due to willful neglect, the penalty may be waived, in whole or in part. It is strongly recommended that required disclosures be made with the appropriate tax returns because waiver of the penalty is often difficult to obtain. Revenue Procedure 2003-77, 2003-2 C.B. 964 provides that disclosure must be made on forms in a clear manner and in accordance with their instructions. In the case of treaty-based return positions, disclosure must be made on Form 8833, and no additional disclosure of facts is necessary. Any money amounts entered on the forms must be verifiable, meaning that upon audit, the taxpayer can demonstrate the origin of the number and show good faith in entering that number on the applicable form. The revenue procedure also provides guidance for other forms and the required disclosure to support numbers entered there.

C. Changes in Penalty Standards of Tax Return Preparers

132 See Treasury Reg. §1.6114-1(b)(4)(ii)(C) and (D). Notice 2001-43, 2001-2 C.B. 72, sets forth certain changes that will be made to the regulations.

133 Treas. Reg. §301.6712-1(a). 71


Section 6694(a) imposes a penalty on a tax return preparer who prepares a return or claim for refund with respect to which any part of an understatement of liability is due to “an unreasonable position.” Changes made during 2007 had raised the standards applicable to tax return preparers to a level higher than those applicable to taxpayers under the accuracy-related penalty provisions in section 6662. The Tax Extenders and Alternative Minimum Tax Relief Act of 2008 (“the 2008 Act”) returned the standards to the same levels applicable to taxpayers for positions other than those attributable to tax shelters (as defined in section 6662(d)(2)(C)(ii)) or reportable transactions to which section 6662A applies (this includes any (i) listed transaction or (ii) other reportable transaction if a significant purpose of such transaction is the avoidance or evasion of Federal income tax) (hereinafter, “6662A transactions”). Treasury Regulations under section 6694 and Notice 2009-5 also provide guidance on these new tax return preparer standards.

Thus, the 2008 Act establishes the following definitions of “an unreasonable position” under section 6694:

1. For undisclosed positions other than those attributable to tax shelters or 6662A transactions, a position is unreasonable unless there is or was substantial authority for the position.

2. For disclosed positions other than those attributable to tax shelters or 6662A transactions, a position is unreasonable unless there is a reasonable basis for the position.

3. For positions that are attributable to tax shelters (as defined in section 6662(d)(2)(C)(ii)) or 6662A transactions, a position is unreasonable unless it is reasonable to believe that the position would more likely than not be sustained on its merits.

1) Adequate Disclosure of Positions (other than those attributable to tax shelters and section 6662A transactions)

For positions with reasonable basis and not attributable to tax shelters or section 6662A transactions, Treasury Regulations under section 6694 provide that no penalty will be imposed if the position is adequately disclosed.

Signing Tax Return Preparers

For a signing tax return preparer, disclosure of a position is adequate if:

a. The position is disclosed in accordance with Treas. Reg. section 1.6662-4(f), which requires disclosure on a Form 8275 or Form 8275R as applicable, or on the tax return in accordance with the annual revenue procedure described in Treas. Reg. section 1.6662-4(f)(2);

b. The tax return preparer provides the taxpayer with the prepared tax return that includes the disclosure in accordance with Treas. Reg. section 1.6662-4(f); or

c. For returns or claims for refund that are subject to penalties pursuant to section 6662 other than the accuracy-related penalty for a substantial understatement of tax under

72


section 6662(b)(2) and (d), the tax return preparer advises the taxpayer of the penalty standards applicable to the taxpayer under section 6662 and contemporaneously documents the advice in the tax return preparer’s files. Treas. Reg. section 1.6694-2(d)(3)(i).

Nonsigning Tax Return Preparers

In the case of a nonsigning preparer, disclosure of a position other than a position with respect to a tax shelter or section 6662A transaction that satisfies the reasonable basis standard is adequate if disclosure is in accordance with Treas. Reg. section 1.6662-4(f). In addition, disclosure of a position other than a position with respect to a tax shelter or section 6662A transaction is adequate if the nonsigning preparer advises the taxpayer of any opportunity to avoid penalties under section 6662 that could apply to the position, if relevant, and of the standards for disclosure to the extent applicable. If a nonsigning preparer provides advice to another tax return preparer, disclosure is adequate if the tax return preparer advises the other tax return preparer that disclosure under section 6694(a) may be required. In either instance, the nonsigning preparer must contemporaneously document the advice in his or her files.

2) New Interim Rules Regarding Tax Shelter Positions

Notice 2009-5 contains interim penalty compliance rules for tax shelters. “Tax shelters” are defined in section 6662(d)(2)(C)(ii) to include any partnership or other entity, plan, or arrangement if a significant purpose of such partnership, entity, plan, or arrangement is the avoidance or evasion of Federal income tax; however, neither the term “tax shelter” nor “significant purpose” are currently defined in the Treasury Regulations under sections 6662 or 6694. Notice 2009-5 contains interim penalty compliance rules for tax shelters that provide, in effect, a “speech rule” similar to the rule in Notice 2008-13. The interim compliance rules in the Notice do not apply to 6662A transactions.

Under Notice 2009-5, a position with respect to a tax shelter will not be deemed an “unreasonable position” if there is substantial authority for the position and the tax return preparer advises the taxpayer of the penalty standards applicable to the taxpayer in the event that the transaction is deemed to have a significant purpose of federal tax avoidance or evasion. The tax return preparer must contemporaneously document the advice in his or her files. This advice to the taxpayer must explain that, if the position has a significant purpose of tax avoidance or evasion:

1. There needs to be at a minimum substantial authority for the position; 2. The taxpayer must possess a reasonable belief that the tax treatment was more likely than not the

proper treatment in order to avoid a penalty under section 6662(d); and,3. Disclosure in accordance with Treas. Reg. section 1.6662-4(f) will not protect the taxpayer from

assessment of an accuracy-related penalty if section 6662(d)(2)(C) applies to the position.

If a nonsigning tax return preparer provides advice to another tax return preparer regarding a position with respect to a tax shelter, the position will not be deemed an “unreasonable position” if there is

73


substantial authority for the position and the nonsigning tax return preparer provides a statement to the other tax return preparer about the penalty standards applicable to the tax return preparer under section 6694. The nonsigning preparer must contemporaneously document this advice.

3) Penalty standards for tax return preparers related to state tax returns

Certain states have enacted their own provisions regarding paid tax return preparers. Professionals should be aware of the provisions that would impact them based on the state in which they are perform services and the state for which the services with respect to the client are being performed. Particular questions should be addressed with a respective state tax expert.

D. State Returns Barring unusual circumstances, expatriates who are expected to be on foreign assignment for 2 years or more and whose families have moved abroad with them should be treated as having terminated their residence in the U.S. for state income tax purposes. Therefore, for the year of the move, a part-year resident return should be filed. During the non-resident period, only income relating to trade or business activity in the former state of residence is to be reported. Due to the variety of rules among the various states, care must be taken to insure proper compliance. Please refer to the State Tax Guides for further guidance. These are located in Innosphere.

E. Currency Exchange Rates A mean or average exchange rate covering the period of foreign employment should be used to convert income earned ratably throughout the year. The same mean or average exchange rates should also be used in converting foreign tax withholding for purposes of completing Form 1116. For nonperiodic compensation (e.g., school fees, bonuses, etc.) and for direct payments of foreign tax obligations, the exchange rate on the date of payment should be used. Many times this conversion has been done by the employer since the payment is recorded in payroll records. Whenever possible, the U.S. dollar equivalent of the foreign tax payment should be the same for purposes of computing the foreign tax credit as it is for the reporting of compensation. F. Underpayment Penalties not Reduced by Foreign Tax Credit Carrybacks Underpayment penalties may not be eliminated due to the reduction in taxes from a foreign tax credit carryback. In Fluor Corp,, the Court of Appeals for the Federal Circuit reversed the decision of the Federal Court of Claims, concluding under the then existing law that there was no clear legislative intent to allow taxpayers to avoid interest on deficiencies that are later eliminated by foreign tax credit carrybacks.134 Section 6601(d) now requires payment of interest on deficiencies that are eliminated by foreign tax credit carrybacks.

134 Fluor Corporation v. United States, 126 F.3d 1397 (Fed. Cir. 1997) cert. denied, 522 U.S. 1118 (1998). 74


X. Expatriation Provisions

A. Individuals subject to the tax

Long-term permanent residents who terminate U.S. residency or who commence to be treated as residents of another country pursuant to a treaty and who fail to waive treaty benefits are subject to the expatriation tax provisions in the same manner as U.S. citizens who lose U.S. citizenship. A long-term permanent resident is an individual who is a lawful permanent resident (i.e., greencard holder) of the U.S. for at least part of 8 of the 15 years preceding termination of residency. The American Jobs Creation Act of 2004 (AJCA) changed U.S. tax law applicable to expatriating individuals and applies to all persons expatriating on or after June 4, 2004.135 Further changes were made to the expatriation rules in 2008. The Heroes Earning Assistance and Tax Relief Tax Act (HEART) changed the individual expatriation rules for all persons expatriating on or after June 17, 2008. The following summary covers the rules that apply to all expatriating individuals in each of the now three categories.

B. Expatriation prior to June 4, 2004

The expatriation tax will be imposed if one of the principal purposes of terminating residency was tax avoidance.136 The expatriation tax on income applies for tax years ending within 10 years of the date of the termination of residency.

Presumption of tax-avoidance motive

A tax avoidance motive will be presumed if either of the following apply:

The individual’s average annual net income tax for the five years preceding the termination exceeds $122,000 for 2003 and 124,000 for 2004; or

The individual’s net worth equals at least $608,000 for 2003 and $622,000 for 2004.137

The presumption of tax avoidance motive could have been rebutted by certain citizens and long-term residents who filed a ruling request with the Secretary of the Treasury within one year of the termination, and who received a positive or good faith ruling.138 In order to be eligible to submit a ruling request, a person must have fallen into one of the following categories:

1. Expatriating Citizens: The individual was born with dual citizenship and retains citizenship in the other country; The individual becomes a citizen of the country of the individual’s birth, the birth country of a

spouse, or the birth country of either parent; The individual terminates citizenship before age 18 ½; or

135 American Jobs Creation Act of 2004, Pub. L. 108-357, §804.

136 I.R.C. §877(a)(1), amended by Pub. L. 108-357, §804(a)(1) (6/3/2004).

137 I.R.C. §877(a)(2) amended by Pub. L. 108-357, §804(a)(1) (6/3/2004).

138 I.R.C. §877(c)(1)(B) amended by Pub. L. 108-357, §804(a)(2) (6/3/2004). 75


The individual was present in the United States for less than 30 days in each year of the 10-year period ending with expatriation.

I.R.C. section 877(c)(2) amended by Pub. L. 108-357, section 804(a)(2) (6/3/2004).

2. Expatriating long-term residents: The individual becomes a citizen of the country of the individual's birth, the birth country of a

spouse, or the birth country of either parent, and the individual becomes fully liable for income tax in such country by reason of the individual’s residence;

The individual was present in the United States for less than 30 days in each year of the 10-year period ending with expatriation;139 or

The individual terminates residency status before reaching age 18 ½.140

Expatriating individuals who “narrowly failed” to satisfy the above categories were also eligible to submit ruling requests. The IRS considered all factors in determining whether to grant the ruling.

Treaty relief is not available for U.S. citizens who revoke citizenship if section 877 applies as all U.S. treaties contain provisions in the saving clause that override the treaty with respect to former U.S. citizens. However, long-term residents who revoke their green cards may be able to rely on treaties for relief from section 877. Although section 877 specifically overrides all existing treaties, some treaties were ratified after section 877 was enacted and do not have provisions in the saving clause that include former U.S. green card holders. Therefore, section 877 would be overridden by the treaty in such a case but only for persons expatriating before June 4, 2004. The income tax treaties which do not include former long-term residents in the savings clause are as follows:

Country Effective Date Austria 2/1/1998 France 12/30/1995 Ireland 12/17/1997 Kazakhstan 12/30/1996 Luxembourg 12/20/2000 Portugal 12/18/1995 Sweden 10/26/1995 Switzerland 12/19/1997 Turkey 12/19/1997 Ukraine 6/5/2000

However, it is important to note that the favorable saving clauses contained in the above income tax treaties apply for income tax purposes only. This means that sections 2107 and 2501 still apply unless

139 I.R.C. §877(c)(2)(B) amended by Pub. L. 108-357, §804(a)(2) (6/3/2004).

140 I.R.C. §877(c)(2)(C) amended by Pub. L. 108-357, §804(a)(2) (6/3/2004).76


overridden by a separate estate or gift tax treaty. In the absence of such a treaty override, the expatriation provisions for estate and gift tax purposes will still apply to former greencard holders for whom the above income tax treaties override section 877. Of the countries listed in the above chart, the U.S. has estate or estate and gift tax treaties with Austria, Ireland, Switzerland, France and Sweden. However, only the estate and gift tax treaty with Sweden contains a saving clause which is limited in application to residents, citizens, and former citizens and which does not apply to former residents. Therefore, former residents of the U.S. covered by the income tax treaties included in the above chart are subject to the estate and gift expatriation provisions of sections 2107 and 2501.

For additional information on the pre-AJCA expatriation provisions, see section 877, Notice 97-19, 1997-1 C.B. 394, and Notice 98-34, 1998-2 C.B. 29. Information Reporting Individuals who lost citizenship and long-term residents who terminated residency under the pre-June 4, 2004 rules were required to file an initial statement on Form 8854 that included identifying information, foreign residence, and assets and liabilities. The penalty for failure to file the required statement equals the greater of 5 percent of the expatriation tax or $1,000 for each tax year in which the failure continues. In addition, if the individual did not receive a positive or good faith ruling (as discussed above) Form 1040-NR must be filed for the 10-year period following expatriation, regardless of whether the individual is otherwise required to file such form (i.e., regardless of whether the individual earns U.S.-source or effectively connected income). On such form, the individual must disclose worldwide income for informational purposes in addition to reporting and paying tax on any U.S.-source or effectively connected income.

C. Expatriation on or after June 4, 2004

The AJCA replaced the subjective determination of tax avoidance as a principal purpose for expatriation with objective rules.141 Under the AJCA, a former citizen or former long-term resident would be subject to the expatriation tax for a 10-year period after relinquishing citizenship or terminating residency, unless the former citizen or long-term resident:

For calendar year 2008 establishes that his or her average annual net income tax liability for the five preceding years is less than $139,000142 (amount indexed for inflation) or

His or her net worth is less than $2 million,143 or alternatively Satisfies limited, objective exceptions for dual citizens and minors who have had no substantial

contact with the U.S.; AND Certifies under penalties of perjury that he or she has complied with all U.S. federal tax

obligations for the preceding five years and provides such evidence of compliance as the

141 H.R. REP. NO. 108-755.

142 I.R.C. §877(a)(2)(A).

143 I.R.C. §877(a)(2)(B).77


Secretary of the Treasury may require.144

The monetary thresholds under the new legislation replace the inquiry into the taxpayer’s intent. In addition, the legislation eliminates the process of filing IRS ruling requests in order to rebut the presumption of a tax avoidance motive.145

The presumption of a tax avoidance motive may be rebutted by a citizen or long-term resident who was born with dual (i.e., U.S. and non-U.S.) citizenship, retains non-U.S. citizenship after expatriation, and meets the following additional criteria:146

Was never a resident of the U.S. (as defined in Section 7701(b)), Has never held a U.S. passport, and Was not present in the U.S. for more than 30 days during any of the 10 calendar years

preceding the individual’s loss of U.S. citizenship.

The presumption of tax avoidance may also be rebutted in the case of a minor child if:147 The child became a U.S. citizen at birth, Neither parent was a U.S. citizen at the time of the child's birth, The child relinquishes U.S. citizenship before reaching age 18 ½, and The child was not present in the U.S. for more than 30 days during any of the 10 calendar

years preceding the loss of U.S. citizenship.

1) Termination of U.S. citizenship or long-term residency status for U.S. Federal income tax purposes

An individual continues to be treated as a U.S. citizen or long-term resident for U.S. Federal tax purposes, until the individual:

Gives notice of an expatriating act or termination of residency (with the requisite intent to relinquish citizenship or terminate residency) to the Secretary of State or the Secretary of Homeland Security, respectively; and

Provides a statement in accordance with section 6039G on Form 8854.148 Until these steps are taken, the individual remains taxable on worldwide income as well as subject to U.S. estate and gift tax laws.

2) Sanctions for individuals subject to the expatriation tax regime who return to the U.S. for extended periods

The expatriation tax does not apply for any tax year during the 10-year period following expatriation if the individual is present in the U.S. for more than 30 days in the calendar year. Such individual will be

144 I.R.C. §877(a)(2)(C).

145 H.R. REP. NO. 108-755.

146 I.R.C. §877(c)(2)(B).

147 I.R.C. §877(c)(3).

148 See Notice 2005-36, 2005-1 C.B. 1007.78


treated as a U.S. citizen or resident for such year and, as such will be subject to:

Income tax on worldwide income, Estate tax on worldwide assets if the individual dies during that taxable year, and Gift tax on any gifts of worldwide assets (both tangible and intangible property) during that

taxable year.

Days of physical presence — An individual is treated as present in the U.S. on any day if he or she is physically present in the U.S. at any time during the day. Certain individuals may disregard days spent in the U.S. if they are performing services in the U.S. on such day for an unrelated employer (within the meaning of sections 267 and 707(b)). No more than 30 days may be disregarded during any calendar year under this rule.

3) Gift of certain closely-held foreign corporation stock

The new legislation subjects expatriating individuals to U.S. gift tax on certain gifts of closely-held foreign stock during the 10-year period following expatriation.

4) Information Reporting

Individuals who relinquish citizenship and long-term residents who terminate residency in the United States are required to file an annual return for each year they are subject to the alternative tax regime. The annual return is required even if no U.S. federal income tax is due. The following information is required on the annual return:

Taxpayer’s TIN, The mailing address of the individual’s principal foreign residence, The foreign country in which the individual resides, The foreign country of citizenship, Information detailing the income, assets, and liabilities of the individual (including

foreign stock potentially subject to the special estate tax rule of section 2107(b) and the gift tax rules),

The number of days during any portion of which the individual was physically present in the U.S. during the taxable year,

Under the new legislation, the penalty for failure to file the required statement will be $10,000.

D. Expatriation on or after June 17, 2008

The HEART Act repealed the expatriation rules mentioned above.149 However, for an individual who expatriated prior to the enactment of the HEART Act, the old rules will still apply. The rules for who will be subject to the expatriation rules remain the same as under the AJCA (with the income tax threshold continuing to be indexed for inflation, $145,000 for 2009 and 2010). The individual would have to meet one of the three tests mentioned above, the net income test, the net worth test, or the certification test. An

149 Notice 2009-85, issued on October 15, 2009, provides guidance on 877A.79


individual who is subject to the expatriation rules contained in the HEART Act is referred to as a “covered expatriate.”

Per Sec. 877A(g)(2), a citizen or long-term permanent resident is considered to have expatriated either on the date that a citizen relinquishes his/her citizenship or when a permanent resident ceases to be a resident under sec. 7701(b). Under prior law, Form 8854 also had to be filed. That form is no longer required to effect a tax expatriation (although the form is being modified by the IRS to handle the computation of deemed sale discussed below).

There are two key components that result from the HEART Act: A mark to market deemed sale of all assets as of the day before expatriation for the covered

expatriate, and A tax on the receipt of gifts or bequests to a U.S. person from an individual who expatriated on

or after June 17, 2008.

1) Mark to Market Deemed Sale

An individual will be deemed to have sold all assets on the day before the date of expatriation for fair market value. Losses may be taken into account, but only to the extent of gains; therefore, application of the expatriation rules may not result in a loss for tax purposes. The first $600,000 of net gain is excluded for each expatriating individual; this $600,000 amount will be indexed annually. For 2009, this amount is $626,000, and for 2010, it is $627,000. Note that this exclusion is not applicable with respect to certain deferred compensation assets, certain interests in foreign trusts, and specified tax-deferred accounts.

A basis adjustment will be applied to all property subject to the deemed sale provisions; such adjustment will ensure that an actual sale at a future date would not result in double taxation due to the prior application of the deemed sale rules.

For purposes of determining the basis of property subject to the deemed sale rules, property that was held by an individual on the date the individual first became a resident of the U.S. shall be treated as having a basis equal to the fair market value of such property on the residency start date. An individual may elect not to have this step-up in basis apply. Basis of property acquired after the residency start date would be computed under the “standard” basis rules.

2) Special Rules for certain deferred compensation assets, interests in foreign trusts, and specified tax-deferred accounts

Special rules apply to certain deferred compensation assets, certain interests in foreign trusts, and specified tax-deferred accounts. In general, deferred compensation includes all types of employer retirement plans including foreign plans, qualified retirement plans, and nonqualified retirement plans. In addition, it includes property transfers or the right to future property transfers that an individual is entitled to receive in connection with the performance of services to the extent that amounts have not been previously included in taxable income. Tax-deferred accounts include individual retirement plans, qualified tuition plans, Coverdell education plans, health savings accounts, and Archer MSAs.

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Eligible Deferred Compensation Items and Interests in Nongrantor Trusts:

For eligible deferred compensation items and nongrantor trusts from which a distribution is made to a covered expatriate subsequent to his or her expatriation date, a withholding mechanism may be elected, which permits deferral of tax at the time of expatriation and requires that U.S. withholding take place at the time of a distribution to the covered expatriate subsequent to the expatriation date. In order to be eligible to make this election, the plan administrator or trustee must agree to withhold U.S. tax at the rate of 30 percent on the taxable portion of a distribution. As mentioned, this withholding tax at the time of distribution is imposed in lieu of the application of the deemed sale rules on the day before the expatriation date. For grantor trusts, the mark-to-market rules apply and this special withholding rule is not applicable.

Tax-Deferred Accounts and Other Deferred Compensation:

For other deferred compensation and tax-deferred accounts, the account will be treated as having been distributed on the day before the expatriation date. With respect to property transfers or the right to transfers, amounts are assumed to have been transferred and not subject to a substantial risk of forfeiture on the day before the expatriation date. The deemed distribution will be subject to income tax at ordinary income rates, but the penalties that normally apply to early withdrawals from such accounts will not apply to a deemed distribution under the expatriation rules. A basis adjustment will be made to reflect the taxation incurred as a result of the deemed distribution under the expatriation rules.

What is eligible deferred compensation?

Eligible deferred compensation is any deferred compensation item with respect to which:

(1) The payor is either a U.S. person or certain non-U.S. persons who elect to be treated as a U.S. person for purposes of withholding and

(2) The covered expatriate notifies the payor of the covered expatriate status and irrevocably waives any claim to withholding reduction under any U.S. treaty.

3) Tax on Gifts and Bequests

A U.S. person who receives a gift or bequest from a covered expatriate is subject to U.S. tax on the receipt of such gift. The total value of the gift is first reduced by the available annual exclusion ($13,000 in 2009), and tax is then assessed at the highest applicable gift tax rate at the time of the gift (in 2009, the top gift tax rate is 45 percent). Marital and charitable deductions are available for transfers to a U.S. citizen spouse or a qualified charity. In Notice 2009-85, the IRS declared a temporary moratorium on reporting and collection of tax on the receipt of gifts or bequests from a covered expatriate, until such time as regulations or other guidance is issued.

4) Deferral of Tax

A covered expatriate may elect to defer the tax resulting from the application of the deemed sale rules

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(but not the special withholding tax rules for deferred compensation, tax-deferred accounts, or nongrantor trusts) until the later of:

(1) The due date of the tax return for the year in which a particular asset for which the deferral election was made is actually sold or otherwise disposed of or

(2) The due date of the individual’s final income tax return in the case where the covered expatriate dies owning property for which the deferral election was made.

Interest is charged during the period the election is in place with respect to the deferred gain, and security must be posted as collateral.

The deferral election may be made for all assets subject to the deemed sale rules or only for certain select assets. The election to defer tax under the HEART Act expatriation rules may compromise the ability of a covered expatriate to take certain treaty positions. Note that the deferral election is not applicable with respect to deferred compensation, specified tax accounts, and foreign trust rules.

XI. Reporting Requirements of Foreign Bank and Financial Accounts

The Treasury has authority to require U.S. persons to report transactions with foreign financial institutions. Form TD F 90-22.1 (Report of Foreign Bank and Financial Accounts, or “FBAR form”) is used to disclose this financial account information. The FBAR form is NOT a tax return. It is therefore preferable not to prepare this form for taxpayers. Where the form must be prepared as part of the engagement, due care must be taken when completing it and appropriate disclosures must be communicated to the client.

Because the FBAR form is not a tax return, it must be prepared by each person who holds signature authority over a foreign financial account. For a married couple with joint financial interest in an account may report that account on one form. If the only reportable accounts of the spouse are the joint accounts, the spouse does not need to file a separate report. However, if the spouse has a financial interest in other accounts, the spouse should file a separate report for all accounts including those reported as jointly owned on the first spouse’s FBAR form.

Under Treasury Regulations, each person subject to the jurisdiction of the U.S. having a financial interest in, or signature or other authority over a bank, securities, or other financial account in a foreign country must report such relationship for each year in which such relationship exists.

U.S. taxpayers filing Form 1040 are required to check a box on Schedule B, Part III, indicating whether they own an interest in a financial account in a foreign country. For purposes of this checkbox, the instructions for Schedule B provide that a taxpayer must check “yes” if:

The taxpayer owns more than 50 percent of the stock of any corporation that owns one or more foreign bank accounts; or

At any time during the year the taxpayer had any interest in or signature authority over a financial account in a foreign country (such as a bank account, securities account, or other financial account).

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However, if the combined value of the accounts was $10,000 or less during the entire year, the box may be checked “no.” If the box is checked “yes,” Form TD F 90-22.1 must be filed by June 30 following the calendar year for which the interest in a foreign account is reported. The deadline for filing the form may not be extended; therefore, June 30 is always the deadline regardless of whether the taxpayer’s income tax return is extended. (See below for further discussion regarding recent clarification to these rules in Notice 2010-23 and Announcement 2010-16).

The form is not submitted to the IRS, but instead must be mailed to:

Department of the TreasuryP.O. Box 32621

. Detroit, MI 48232-0621

The form may also be hand-delivered to any local IRS office for forwarding to Treasury. The FBAR form is NOT to be attached to any tax return.

An updated and much more expansive form was released in October, 2008. The instructions also updated several of the definitions in the rules. Under the new definitions, a U.S. person means a citizen or resident of the U.S., or a person in and doing business in the U.S. A person is defined as an individual, a corporation, a partnership, a trust or estate, a joint stock company, an association, a syndicate, joint venture or other unincorporated organization or group, an Indian Tribe (as that term is defined in the Indian Gaming Regulatory Act), and all entities cognizable as legal personalities. For future years, further clarification is still to come from the IRS regarding who is included as a person in and doing business in the U.S.

Nevertheless, in Announcement 2010-16 (released on February 26, 2010), the IRS has suspended the requirement to file the FBAR for 2009 and earlier years for any person who is not a US citizen, resident or domestic entity. All persons may rely on the definition of a US person found in the July 2000 version of the FBAR instructions, and can disregard the current instructions that include a person in and doing business in the US. Under the July 2000 version of the instructions, a US person is defined as (1) a citizen or resident of the US, (2) a domestic partnership, (3) a domestic corporation or (4) a domestic estate or trust. Again, this applies for 2009 and earlier years. All other requirements of the 2008 version of the FBAR form remain in effect.

A U.S. person has a financial interest if an account is maintained in which a U.S. person is the owner of record or a U.S. person has legal title, regardless of whether the account is maintained for the benefit of the U.S. person or for the benefit of others, including non-U.S. persons. If the account is maintained in the name of two persons jointly, or if several persons each own a partial interest in an account, each U.S. person has a financial interest in the account. A financial interest also includes:

An account for which the owner of record or holder of legal title is acting as an agent, nominee, attorney, or in some other capacity on behalf of a U.S. person,

A corporation in which a U.S. person owns directly or indirectly more than 50 percent of the total value of shares of stock or more than 50 percent of the voting power for all shares of stock,

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A partnership in which a U.S. person owns an interest in more than 50 percent of the profits (distributive share of income) or more than 50 percent of the capital of the partnership, or

A trust in which a U.S. person either has a present beneficial interest, either directly or indirectly, in more than 50 percent of the assets, or from which such person receives more than 50 percent of the current income.

Finally, a financial interest includes any bank, securities, or other financial account in a foreign country for which the owner of record or holder of legal title is a trust, or a person acting on behalf of a trust, that was established by such U.S. person and for which a trust protector has been appointed.

When a U.S. person can control the disposition of money or other property in an account via his/her signature (or together with another person), the U.S. person is considered to have signature authority over a financial account.

Notice 2010-23 (released on February 26, 2010) extends the deadline for completing the FBAR for accounts where the individual has signature authority over the financial account, but does not have a financial interest in that account. The deadline for filing the FBAR to report these accounts is extended until June 30, 2011 for the 2010 year and all prior years. If the only foreign account that a taxpayer has is one of these accounts, they should answer the question at the bottom of Schedule B as “no”. See discussion above.

Financial accounts include any bank, securities, securities derivatives or other financial instrument accounts. Financial accounts also include savings, demand, checking, deposit, time deposit, and any other account maintained with a financial institution or other person engaged in the business of a financial institution. Such accounts generally also include any accounts in which the assets are held in a commingled fund, and the account owner holds an equity interest in the fund (including mutual funds). In Notice 2010-23, the IRS clarified that persons with a financial interest or signature authority over a foreign commingled fund that is a mutual fund are required to file an FBAR, unless subject to some other exception. However, the IRS will not interpret “commingled fund” as applying to any funds other than mutual funds with respect to FBARs for 2009 and prior years. Therefore, for 2009 and prior years, there is no filing obligation to file an FBAR for a financial interest or signature authority over a foreign hedge fund or private equity fund.

U.S. foreign countries include all geographic areas located outside the U.S., Guam, Puerto Rico, and the Virgin Islands. Accounts maintained at an affiliate of a U.S. bank or other financial institution that is located in a foreign country must be reported. However, accounts maintained with a branch, agency, or other office of a foreign bank or other financial institution that is located in the U.S., Guam, Puerto Rico, or the U.S. Virgin Islands need not be reported.

XII. Trust/Gift Positions

A. Foreign Trusts 150

150 For more information on the US taxation of foreign trusts, refer to the pamphlet in TaxShare under the Lead Tax Services portal.

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The Small Business Job Protection Act of 1996 implemented several rules applicable to inbound grantor trusts to eliminate the ability of U.S. beneficiaries to avoid U.S. tax on distributions from a trust by treating a foreign grantor as the owner of a foreign trust. Under the Act, the grantor trust rules generally apply only to the extent that they result in amounts being currently included in the income of a U.S. person. This rule does not apply to revocable trusts, trusts that can make distributions solely to the grantor or the grantor’s spouse during the lifetime of the grantor, or certain compensatory trusts.

Generally, transfers to foreign trusts by U.S. persons are treated as a sale or exchange of the property at its fair market value. The transferor is subject to tax on any gain (i.e., the excess of the fair market value of the property over the transferor's basis). This rule does not apply if the trust is a grantor trust under the grantor trust rules (sections 671-679).151 Note that Sec. 684 was modified effective 1/1/2010; the "new" Sec. 684 provides that the owner must be US in order for the deemed sale rule not to apply. Previously, the trust could be grantor to either a US or non-US person.

B. Reporting Requirement for U.S. Beneficiaries of Foreign Trusts Notice 97-34, issued June 2, 1997, provides guidance regarding the foreign trust and foreign gift reporting provisions contained in the Small Business Job Protection Act of 1996 and codified at section 6048. The Act added reporting requirements for U.S. beneficiaries of foreign trusts, extensively revised the civil penalties for failure to file information returns with respect to foreign trusts, and added civil penalties for failure to report certain transfers to foreign entities. Generally, U.S. persons are required to report distributions from foreign trusts or gifts received from foreign individuals on Form 3520 (Annual Return to Report Transactions with Certain Foreign Trusts and Receipt of Certain Foreign Gifts). Failure to file the Form can result in substantial penalties. See below for more details. Section V of Notice 97-34 provides the following guidance regarding the reporting requirements for U.S. beneficiaries of foreign trusts:

“Generally, a U.S. person who receives a distribution, directly or indirectly, from a foreign trust after August 20, 1996, is required to report on Form 3520 the name of the trust, the aggregate amount of distributions from the trust during the taxable year and such other information as the secretary may prescribe. Sec. 6048(c). Reporting is required under section 6048(c) only if the U.S. person knows or has reason to know that the trust is a foreign trust. A U.S. person who fails to report a distribution received after August 20, 1996, will be subject to a 35 percent penalty on the gross amount of the distribution. Section 6677(a).”

There are three determinations that are required to determine if reporting is required. First is that the foreign entity is a trust according to U.S. law, second, whether the trust is a grantor trust or a nongrantor trust, and third, whether a distribution has been made to a US person.

151 See I.R.C. §684 and the regulations thereunder.85


When preparing a U.S. return for U.S. citizens or residents, we must make sure that our clients inform us of all non-U.S. accounts, investments, entities etc. that they own or make transfers to or receive transfers from, and that we be furnished with a copy of the governing documents, if possible, so that we can determine the classification of these assets and entities from a U.S. perspective. This includes investments in non-U.S. mutual funds (which are generally classified as PFICs) or income trusts (which may be classified as trusts under US law). It is quite possible, and in fact, somewhat common, that something called a “trust” in a non-U.S. jurisdiction is not a trust for U.S. purposes. Conversely, something may be classified as a "trust" under U.S. law that is classified in a different way under the law of the local jurisdiction. The U.S. classification will dictate the U.S. filing requirements, even if this is inconsistent with the classification, taxation or filing requirements in the non-U.S. jurisdiction.

Once we have confirmed that the investment vehicle is a trust per U.S. law, we must confirm if a distribution was made. A distribution from a foreign trust includes any transfer of money or property from a foreign trust, whether or not the trust is owned by another person. Loans from a foreign trust to a U.S. person are treated as distributions unless the loan meets the definition of a “qualified obligation”. An obligation is a qualified obligation only if:

(i) The obligation is reduced to writing by an express written agreement;

(ii) The term of the obligation does not exceed five years (for purposes of determining the term of an obligation, the obligation's maturity date is the last possible date that the obligation can be outstanding under the terms of the obligation);

(iii) All payments on the obligation are denominated in U.S. dollars;

(iv) The yield to maturity of the obligation is not less than 100 percent of the applicable Federal rate and not greater than 130 percent of the applicable Federal rate (the applicable Federal rate for an obligation is the applicable Federal rate in effect under section 1274(d) for the day on which the obligation is issued, as published in the Internal Revenue Bulletin);

(v) The U.S. transferor extends the period for assessment of any income or transfer tax attributable to the transfer and any consequential income tax changes for each year that the obligation is outstanding, to a date not earlier than three years after the maturity date of the obligation (this extension is not necessary if the maturity date of the obligation does not extend beyond the end of the U.S. person's taxable year and is paid within such period); when properly executed and filed, such an agreement will be deemed to be consented to by the Service Center Director or the Assistant Commissioner (International) for purposes of §301.6501(c)-1(d) ; and

(vi) The U.S. transferor reports the status of the obligation, including principal and interest payments, on Form 3520 for each year that the obligation is outstanding.152

A distribution from a foreign trust also includes the receipt of trust corpus and the receipt of a gift or bequest described in section 663(a). In addition, a distribution is reportable if it is either actually or constructively received. For example, if a U.S. beneficiary uses a credit card, and charges on that credit card are paid or otherwise satisfied by a foreign trust or guaranteed or secured by the assets of a foreign

152 See Notice 97-34, 1997-1 C.B. 42286


trust, the amount charged on the credit card will be treated as a distribution to the U.S. beneficiary that must be reported under section 6048(c) for the year in which the charge occurs. If a beneficiary writes a check on the foreign trust’s bank or brokerage account or otherwise incurs a debt charged to the foreign trust, the amount incurred will be treated as a distribution to the U.S. beneficiary that must be reported under section 6048(c). Also, if a beneficiary receives a payment from a foreign trust in exchange for property transferred to the trust or services rendered to the trust, and the fair market value of the payment received exceeds the fair market value of the property transferred or services rendered, such excess will be treated as distribution to the U.S. beneficiary that must be reported under section 6048(c). For example, if a U.S. beneficiary receives a payment from a foreign trust purportedly in exchange for the beneficiary’s performance of service as a trustee of the trust, and the payment exceeds the fair market value of the services actually performed by the beneficiary, the excess will be treated as a distribution to the beneficiary. The IRS has developed a simplified reporting regime for taxpayers who hold interests in Canadian registered retirement savings plans (RRSPs) and registered retirement income funds (RRIFs).153 The new reporting regime, which is effective for tax years beginning after December 31, 2002, is in lieu of the filing obligations under section 6048 (Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts, and Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner) that otherwise apply to U.S. citizens and resident aliens who hold interests in RRSPs and RRIFs and to the custodians of such plans. The new simplified reporting regime is designed to permit taxpayers to meet their reporting obligations by using information that is readily available to them.154 Section 6048 (a)(3)(B)(ii) provides that the general reporting requirements do not apply to charitable or deferred compensation trusts as those terms are defined in the Code. This exception is extended to contributions to foreign trusts that provide pension, profit sharing and similar benefits to employees, so that neither the employers nor the employees are subject to the general reporting requirements.155

C. U.S. Recipients of Foreign Gifts Form 3520 is also used to report the receipt of gifts from a foreign individual or entity.

1) Gifts from foreign individuals and foreign estates

A U.S. person is required to report the receipt of gifts from a nonresident alien or foreign estate only if the aggregate amount of the gifts from that nonresident alien or foreign estate exceeds $100,000 during the taxable year. In determining whether the $100,000 threshold has been met, gifts from persons related to each other are aggregated. Once the $100,000 threshold has been met, Form 3520 requires the donee to separately identify each gift

153 Notice 2003-75, 2003-50 I.R.B. 1204.

154 See Notice 2003-75, Revenue Procedure 2002-23, 2002-1 C.B. 744, U.S. Tax Alert 03043 and the Global Employer Services competency group’s Tax Technical Positions Memo for Foreign Nationals.

155 See Treas. Reg. §16.3-1(d)(4).87


in excess of $5,000, but does not require the identification of the donor.

2) Purported gifts from foreign corporations or foreign partnerships

A U.S. person is required to report the receipt of purported gifts from foreign corporations and foreign partnerships if the aggregate amount of purported gifts from all such entities exceeds $14,139 (in 2009; this amount is annually modified by cost-of-living adjustments under section 6039F(d)) during the taxable year). Once the $14,139 threshold has been met, Form 3520 requires the donee to separately identify all purported gifts from a foreign corporation or foreign partnership, including the identity of the donor entity. Purported gifts from foreign corporations or foreign partnerships are subject to recharacterization under new section 672(f)(4).

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2009 expatriate tax technical positions version 1

Documents