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Lowtax Expat Briefing – Gone But Not Forgotten!

By Lowtax Editorial
15 November, 2011

Imagine a situation in which you owe back taxes to another country even though you no longer live there, work there or haven’t earned so much as a dime there in several years, and then, to add insult to financial injury, you were required to pay swingeing non-compliance penalties on top of these. Most people would respond that, if there was any natural justice in the world, such a scenario would not be allowed to happen. But, as many American expats in Canada are discovering to their horror, it most certainly is, and such cases highlight the lengths to which nationals of some countries must go to finally sever ties with the tax man in the land of their birth.

US citizens are in a uniquely horrible position as expatriates, wherever they reside, since the US is just about the only major nation which taxes its citizens regardless of their residential status, and US citizens and resident aliens who are outside the United States (and its possessions) have the same requirements to file tax returns as anyone living in the United States.

Legislation in recent years has done nothing to improve the situation, and with the Obama administration determined to pass ever more draconian tax and reporting laws on individuals and companies stationed offshore in an effort to narrow the federal deficit, this is becoming a worrying issue for US-born expats everywhere, but especially in Canada, where it is estimated that about one million people hold dual nationality.

If you pay foreign taxes, it may be possible to offset these against US taxes if there is a double tax treaty with the country in which you are resident. For many Americans in Canada, this means that they will actually owe little or no tax in the US. What many US expats do not seem to be aware of however, is that they must still file a tax return with the IRS, even if they theoretically owe no tax in the US, and there have been a number of reports in the Canadian media in recent months of US expats facing potentially severe financial penalties as a result of not knowing these rules.

During a speech to the Canadian Club in Ottawa in October, the US Ambassador to Canada, David Jacobson, said that the US would view such cases sympathetically, and urged those who could be in breach of US tax rules to “sit tight”.

“We are not unreasonable. We are not unsympathetic. We are not irresponsible,” he assured listeners.

"There are so many dual citizens, typically by birth, probably more than a million. So this issue is much more common here than in any other country in the world,” he noted, before somewhat unreassuringly adding that “the penalties — at least in a theoretical sense — can be quite severe."

Jacobson’s words will be of cold comfort to those US expats, potentially numbering in the hundreds of thousands, who hadn’t bargained on getting a nasty financial surprise from the US tax man, and it remains to be seen just how sympathetic the overspent US government is when it comes to the crunch. There was one crumb of comfort recently though, from the Canadian government, which is becoming increasingly concerned about the impact of US tax reporting rules on Canadians, including those with dual nationality.

In a letter to several US publications in September, Finance Minister Jim Flaherty wrote that the IRS is overstepping its jurisdictional reach with its Foreign Bank Account Report rules and the soon-to-be-introduced Foreign Account Tax Compliance Act.

Most individuals targeted by such rules hold only distant links with the US, Flaherty said, and therefore, because they are not deliberately evading US taxes, they do not represent a threat to the US Treasury.

"Because they work and pay taxes in Canada, they generally do not owe any taxes in the United States in any event,” he wrote. “Their only transgression is failing to file the IRS paperwork they were never aware they were required to file."

Flaherty believes that, as these individuals are "not high rollers with offshore bank accounts", they are rather "people who have made innocent errors of omission that deserve to be looked upon with leniency".

Instead, the prospect of having to comply with such regulations will impact on the lives of Canadian people, according to Flaherty. He says that the threat of prohibitive fines for simply failing to file a return they were unaware they had to file, "is a frightening prospect that is causing unnecessary stress and fear among law abiding hardworking dual citizens".

Flaherty also took the opportunity to make known his apprehensions about the impact that FATCA will have on Canadiantaxpayers and he reiterated his desire to see Canada's financial institutions exempt from the legislation when it becomes effective on January 1, 2013, because Canada and the US already possess a tax information exchange agreement.

The FATCA legislation, passed in March, 2010, requires foreign financial institutions to report US citizens holding more than USD50,000 in a depository or custodial account to the IRS, and failure by a foreign financial institution to disclose such information would result in a requirement on non-US financial intermediaries to withhold a 30% tax on US-source income. Flaherty, in common with many other foreign governments and banks, believes that these rules would result in "unnecessary red tape" for financial institutions. However, of more concern are FATCA’s “far-reaching extraterritorial implications,” which would effectively “turn Canadian banks into extensions of the IRS”, raising significant privacy concerns for Canadians”, Flaherty warned.

It remains to be seen whether FATCA is workable in practice. However, many Americans are not waiting to find out, and are voting with their feet in increasingly large numbers in a bid to escape Uncle Sam’s all-encompassing tax net by taking the dramatic step of renouncing their citizenship. This in itself can be a costly and bureaucratic exercise, and recent legislation and IRS regulations have made it harder for those seeking to terminate their US citizenship, such as the 2008 HEART Act, which imposed an ‘exit tax’ on such individuals. Recent figures, however, certainly point to an emerging trend: US government data indicates that the total number of Americans handing back their passports in 2009 was three times higher than in 2008 and grew further, to over 1,500 in 2010.

The UK is another country from which it is difficult to escape the clutches of the tax man, and the recent conclusion of a long-running court case highlighted the complexity of that country’s residency rules.

An individual is deemed to be tax resident when he or she spends a total of more than 183 days of the tax year in the UK or visits the UK on a regular basis and spends an average of 91 days per year in the UK, calculated over a four-year period. Further, close ties to the UK, such as a permanent home there, or where a person’s lifestyle indicates, for example, business, family and/or social connections with the UK, can also be taken into account when deciding his or her tax residence status (referred to as “ordinary residence”).

A person’s domicile may also affect tax liability where he or she receives foreign-source income or gains. However, the rules are complex, as illustrated by the dispute between international businessman Robert Gaines-Cooper and the UK tax authority, HM Revenue and Customs (HMRC), which went all the way to the UK’s highest court earlier this year, and which hinged on the interpretation of the phrases "residence" and "ordinary residence" for the purposes of an individual’s liability for UK income and capital gains tax.

Gaines-Cooper migrated to the Seychelles in 1976, and spent less than 91 days each year in the UK in accordance with non-domicile residency rules. He owns a house in England, which is occupied by his second wife and son. He keeps classic cars and a collection of paintings at the property, and sent his son to a British public school. He also had his will drawn up under English law.

It was Gaines-Cooper's links with England that led the Court of Appeal in an earlier ruling in favour of the tax authority to find that the UK remained Gaines-Cooper’s “centre of gravity of his life and interests” – a decision which has prompted tax experts to accuse HMRC and the courts of moving the goalposts.

However, explaining the reasoning behind its 4-1 majority decision in favour of HMRC, the Supreme Court said last month that while guidance on how to achieve non-residence "should have been much clearer", the guidance, when taken as a whole, informed taxpayers that one would need to leave the UK permanently, indefinitely or for full-time employment, and do more than to take up residence abroad and relinquish ‘usual residence’ in the UK. Information was also provided that subsequent returns to the UK had to be no more than ‘visits’ and that any property retained in the UK by the taxpayer for their use could not be used as a place of residence.

The case ultimately boiled down to whether expats could rely upon guidance issued by HMRC on the subject of residency, which Gaines-Cooper argued contained a more "benevolent" interpretation of the circumstances in which an individual becomes non-resident and not ordinarily resident in the UK than did the ordinary law. However, it also underlined a more fundamental shortcoming in the way UK law treats the area of residency and domicile for tax purposes, which is widely seen as antiquated and way out of step with the fast pace of the global economy in which people frequently move around the world for work and investment purposes.

As Alex Henderson, partner at PwC observed: "The case highlights that the century old tax code on residency has not kept pace with modern life. It rests on case law based on Edwardian lifestyles rather than internationally mobile individuals and businesses. Part of the problem is that it's an 'all or nothing' rule: once you're resident all your worldwide income can be taxed.”

With the UK also battling to raise tax revenues as part of its deficit reduction strategy, the Gaines Cooper ruling may have been viewed by HMRC as a significant triumph as it aggressively targets tax avoidance and evasion, and especially those with ‘offshore’ links. However, it has come somewhat late in the day given that the government is due to introduce a statutory residence test next April. What’s more, the case could merely serve to underline the growing perception in sections of the business community both domestically and abroad that the UK is becoming increasingly hostile to internationally-mobile entrepreneurs at a time when the country needs to attract them more than ever, and therefore could be considered as something of a hollow victory.

“There's room for debate on how to achieve the balancing act of enhancing tax contributions without scaring people off,” Henderson notes. “The UK needs these wealth creators."

“Ultimately residency is a question of fact and it's obviously enormously helpful for people to know clearly where they stand," he adds.

The new residency test is expected to greatly simplify UK law in this area and the government therefore has a good opportunity to bring these laws into the 21st century. However, given the on-going fiscal crises that continue to confound governments and legislatures in many countries, including the US, don’t expect to escape the tax man’s net for long!



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