U.S. expats facing tax 'sticker shock'
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You could say American expatriates were ambushed in May 2006, when the U.S. Congress passed a new tax law - retroactive to the previous January - that raised the tax bracket on anything U.S. expats earned overseas beyond a fixed amount, and put a cap on expat housing allowances.
While some Americans who work overseas and filed U.S. tax returns in 2006 have already felt the pain, it appears that 2007 will be the year of "sticker shock," according to Steven Horton, a certified public accountant practicing in Paris, whose clients include a roster of long-term expats.
Horton described a client who is an executive for a large French company and has lived in France for 20 years. As the sole working member of a family with a child and paying child support to a former spouse while earning the equivalent of $195,000, the client has never paid U.S. taxes because his French tax credits canceled out his U.S. obligations. "I had to tell him that next year, for the first time he will have to pay U.S. taxes," Horton said.
The United States is one of the few countries that taxes on the basis of citizenship rather than residence. In order to keep U.S. workers abroad competitive with other international workers, it excludes from taxation a fixed amount of money earned abroad, known as the foreign earned income exclusion. For 2007, that amount was $85,700. That sum is free of U.S. taxes whether someone works in a high-tax country like Austria or Denmark, or a low- or no-tax country like Hong Kong or Saudi Arabia.
Anything beyond $85,700 is subject to U.S. tax, unless the expat is paying taxes at an equal or higher rate elsewhere. If paying higher taxes abroad, he can use a foreign tax credit to offset his U.S. tax liability. If there are low or no taxes overseas, then according to the 2006 law, the first dollar of compensation above $85,700 is taxed at the rate it would be taxed at as if the person were living in the United States. Previously it had been taxed as if it were the first dollar earned, at the lowest rate.
Today in Americas
But while 20 years ago U.S. citizens who worked in high-tax places like France or Austria were able to use their tax credits to offset all U.S. taxes, these days many countries' tax systems are becoming more competitive, and their top rates have fallen.
In France, where the top rate used to be more than 50 percent, it is now 40 percent. In Germany, the maximum tax rate has been falling 1 to 2 percentage points a year and now stands at 42 percent. Slovakia's maximum personal income tax rate is a mere 19 percent.
What is more, some countries give taxpayers a lot more deductions than the United States. While the French top tax rate of 40 percent is still higher than the U.S. top rate of 35 percent, the French permit taxpayers to deduct large social security payments that cover medical insurance and other obligatory social payments from gross income. The United States does not. The French also allow deductions for child support and support of aged parents, and credits for housekeeping help if done within the legal framework. In the United States, there are no tax benefits for these expenditures.
The bottom line is that in some cases, despite higher nominal tax rates, the tax liability overseas may actually be lower than the U.S. tax liability.
And because of the dramatic slide in the dollar over the past year, middle-income expat workers paid in foreign currencies who previously earned less than the foreign earned income exclusion may now earn more than the exclusion in U.S. dollar terms, and be liable for U.S. taxes.
While individuals abroad have been hit with higher U.S. tax bills, the law appears to have had little effect on the international employment plans of top U.S. companies. "The surprise is it hasn't slowed any of the international assignment activity," said Kent Klaus, partner in the global employees services practice at Deloitte Tax in Chicago.
Klaus observed that most of his corporate clients were actually increasing the number of people they are sending overseas, as many U.S. companies experience more growth outside the United States. But he acknowledged that his viewpoint was limited to Fortune 500 companies, and he questioned whether higher tax bills might be prohibitive to smaller growth companies.
Even large companies, he said, are putting tax reimbursement arrangements with overseas employees under a microscope. While many large companies offer overseas employees tax equalization programs to ensure they will pay no more in taxes than they would for a similar salary at home, increasingly companies are looking at whether they can "localize" employees. That means if an employee is on foreign assignment for an indefinite period, and is making a career in a foreign location, corporations may not offer tax equalization plans. Previously some companies had policies limiting tax equalization periods, but they were not as eager to enforce them, Klaus said.
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