The tax gap issue from offshore ‘non-reported’ money is largely concerned with non-reported portfolio investment. In general, an American foreign-resident earns a salary that is taxable in the country of residence at a tax rate comparable or higher than the corresponding US tax rate.
More Americans live in high-tax Europe than in zero-income tax jurisdictions such as the Cayman Islands or Saudi Arabia. For the rare non-taxable exception, the earned income exclusion before the US tax rate, as it applies for 2017, is US$102,100. After this foreign exemption for income and exemption for foreign housing, and the foreign tax credit, more likely than not a de minimis US income tax liability remains (if any at all on foreign employment income). To drive this point home, according to the 2014 Taxpayer Advocate annual report, for the 2011 Offshore Voluntary Disclosure Initiative, the media account size for the middle 80 per cent of taxpayers was US$183,993 with a median additional tax for 10 years of US$5,845 – approximately US$585 a year.
Regarding investment income, many taxpayers for the years 2007, 2008 and 2009, because of the financial crisis and ensuing ‘Great Recession’ lost asset value and investment income. By examples, over this period the Dow, the S&P 500, and the NASDAQ each lost more than 50 per cent of their respective values. Property funds and most bond funds also lost significant value. Investment and retirement accounts that invest in these securities correspondingly lost substantial value. In 2010 securities markets began a slow recovery, but greatly accelerated in 2012 through 2016. Most US taxpayers only returned to their 2007 position in late 2012 or in 2013.
Generally speaking, the effective tax rate on investment income such as capital gains and dividends is preferential in the US. Instead of the ordinary income tax rates, it is usually half. The same divergence of rates is generally not true for foreign countries. Thus, for most upper middleclass and high net wealth Americans, passive income will normally attract a 15 per cent rate if not held in a tax favourable vehicle such as a retirement savings account or from a tax preference investment like a municipal bond. A portfolio manager will configure a client’s asset exposure for a mixture of non-taxable income like municipal bonds, preferentially taxed capital gains, preferentially taxed dividends, and preferential partnership distributions such as Real Estate Investment Trusts and Master Limited Partnerships. Moreover, a high net wealth individual can to some extent borrow tax free against portfolio holdings to further reduce the effective annual tax rate.
A US taxpayer that attracts a greater effective tax rate upon the income generated from foreign non-reported assets than the applicable US tax rate will report the income for which the foreign tax credit will exceed the US tax liability. By example, if the effective US rate was 13 per cent on a portfolio, and the investor is attracting 20 per cent foreign tax on the portfolio’s income, then the foreign tax credit will exceed the US tax due on the income. In fact, the investor would be worse off with ‘hidden’ assets because of the additional administration fees for maintaining noncompliant foreign holdings and the additional noncompliant risks such as not being able to report financial mismanagement. Note that in the Great Recession years of no income or of losses, a US taxpayer has either no tax liability or a loss to carry back two years or to carry forward 20 years. By example, the tremendous investment income losses of 2007 through 2009 may carry back to the income tax liability generated in 2005 and 2006, perhaps eliminating the income tax liability associated with investment income for those years. In 2011 and 2012 taxpayers experienced renewed bull markets, clawing back lost ground and generating investment income. But the tax years of 2006 through perhaps 2012, after losses are taken into account from amending returns, are probably dismal.
How much asset value is necessary to generate US$150 billion in ‘hidden’ annual taxable income, the oft reported figure originating with the 2009 Senate UBS hearings? Taking into account a 15 per cent tax rate on investment income, these ‘hidden’ assets would need to generate one trillion dollars of annual income to generate US$150 billion of tax revenue. Using a nearly impossible average annual return of 10 per cent, it would require US$10 trillion of hidden assets of US taxpayers to generate a US$150 billion annual tax gap.
Is it plausible that Americans have hidden US$10 trillion dollars in the global financial system? Probably not because it is reasonably estimated that globally every investment fund, every retirement account, and all the bank accounts combined have an asset value of approximately US$75 trillion. Thus, to generate this illusionary US$150 billion in lost tax dollars, US tax evaders would need to own and have hidden more than 10 per cent of global wealth.
How Many Americans Report Foreign Tax Credits and Seek the Foreign Income Exclusion?
In 2014, approximately 8.5 million US taxpayers with foreign exposure filed a US tax return and disclosed their foreign income. For 2007, the number was approximately eight million. The foreign income exclusion is elected by a US taxpayer who resides in a foreign country for at least 330 days in a calendar year. The exclusion allowed for the sheltering of employment income of US$92,900 for 2011 and US$100,800 for 2015. IRS tax statistics disclose that taxpayer returns claiming the foreign-income exclusion increased by 60,000 taxpayers after the Foreign Account Tax Compliance Act (FATCA) in 2011 and 2012, but then dropped by 22,000 taxpayers the following two years.
A US taxpayer may claim a tax credit for foreign tax paid on foreign income that also attracts US tax. These taxpayers have earned income from a foreign country and have paid tax to the foreign country, offsetting the US tax liability with the foreign tax already paid. In 2007, 7.6 million US taxpayer individuals claimed a foreign tax credit. However, the number of US taxpayers claiming the foreign tax credit fell to 6.7 million in 2008 and again to 6.3 million in 2009. The number gradually increased to 6.9 million in 2011, 7 million in 2012, and 7.4 million in 2013. Not until 2014 did the number surpass that of 2007, increasing to 7.9 million for US$21.6 billion. In 2007, 7.6 million filers sought foreign tax credits for tax paid on foreign source income, thus acknowledging foreign asset or at least income exposure. In 2014, well after FATCA and the Offshore Voluntary Disclosure Programs, the number increased by only 300,000 taxpayers, to 7.9 million. In the same stead, if FATCA had been responsible for the increase in the filings for the foreign income exclusion, then the number of filings should not have declined in 2013 and 2014.
Table 1. Foreign Tax Credit Filings & Foreign Income Exclusions (in Billions)
The 2015 Taxpayer Advocate annual report to Congress noted that the data does not demonstrate that substantial amounts of tax evaders are reacting to FATCA. Instead, the report notes that the burden of FATCA falls on US taxpayers who likely would be compliant regardless. On 26 April 2017, the House Committee on Oversight and Reform reviewed the unintended consequences of FATCA. During the hearing, two American US Citizens living abroad testified to how they were denied partnership or promotion in business, unable to secure business financing, or to how these consequences required these and other Americans to renounce their US citizenship. Mr Bupp, legal counsel for an established American entrepreneur, testified that in the wake of FATCA, “[m]any foreign banks have stopped serving US citizens, and record numbers of Americans have renounced their citizenship.”
What is unexplainable is that so few Americans file FATCA Form 8938 of the Report of Foreign Bank and Financial Accounts (FBAR). The Taxpayer Advocate found that US taxpayers who must file Form 8938 are generally as compliant as the overall US taxpayer population. Yet, as of December 2015, only approximately 300,000 taxpayers had filed Forms 8938 for tax year 2013, while about 283,000 had filed in 2014. The Taxpayer
Advocate noted that of the taxpayers filing Forms 8938 for 2013, approximately 38 per cent also filed FBAR forms. Further analysis needs to be explored to understand the discrepancy among reporting for the foreign tax credits, foreign income exclusion, Form 8938 and FBAR. But it is likely not the result of Americans wilfully seeking to hide assets, much less US$10 trillion to plug the imaginary ‘offshore’ tax gap.
Professor William Byrnes
Professor William Byrnes is the Executive Professor of Law and Associate Dean for Special Projects at Texas A & M University School of Law. He developed Texas A & M University Law's International Tax Risk Management curriculum and is the author of Guide to FATCA and CRS Compliance, published annually by LexisNexis, eight other Lexis published tax and financial crimes compliance books, and a 10 volume International Trusts and Company Law Law compliance guide published by Kluwer.