A Coherent Policy Proposal for U.S. Residence-Based Taxation of Individuals

Article excerpt

ABSTRACT

Taxation of the worldwide income of U.S. citizens has been a feature of the U.S. income tax since the Revenue Act of 1913. This Article proposes that the United States abandon its imposition of income tax based on citizenship and institute a new system for taxing individuals based solely on residence. This includes (1) a revised definition of "residency status" that would be based on physical presence and be monitored through an entry-exit system, (2) a proposal for an exit tax imposed on termination of residence with respect to unrealized appreciation accrued during the period of residence, and (3) new transitional treatment of residents who have left the United States within the past three years but have not yet made a decision to break off residential ties. These proposed rules are designed to achieve more uniform compliance, to reduce the administrative burden for U.S. taxpayers, and to facilitate IRS efforts to enforce U.S. tax obligations.

TABLE OF CONTENTS

  I. INTRODUCTION
 II. THE CURRENT LAW AND THE CASE FOR
     CITIZENSHIP-BASED TAXATION
III. REJECTING CITIZEN-BASED TAXATION
     A. The Taxpayer's Perspective
     B. The IRS Perspective
     C. The Impact on the Case for Taxing
        Based on Citizenship
 IV. A PROPOSAL FOR TAXATION BASED ON RESIDENCE
     A. Defining Residence
     B. How an Individual Becomes a Tax Resident
     C. How an Individual Terminates Residence
        1. The Three-Year Residence
           Retention Rule
        2. Mark-to-Market Tax
  V. CONCLUSION

I. INTRODUCTION

Taxation of the worldwide income of U.S. citizens has been a feature of the U.S. income tax since the Revenue Act of 1913. (1) Moreover, the United States has protected this basis for taxation in its negotiation of bilateral income tax treaties. (2) At the same time, very few countries have followed the U.S. approach of taxing nonresident citizens on worldwide income. (3) And a number of commentators have questioned the wisdom of the approach, in light of the inherent difficulties of enforcing U.S. tax obligations of a nonresident citizen and the inherent potential for overlapping claims of taxation by the United States and the residence country.

This Article advocates eliminating citizenship as a basis for imposing U.S. taxation. Although the equitable arguments for imposing tax burdens on U.S. citizens living abroad have merit, administration of the rule is too difficult and expensive for taxpayers and the IRS, particularly in light of the need for remedies to prevent double taxation resulting from other countries' disparate rules. Citizenship-based taxation should be replaced with a more practical system of residence-based taxation. Residence would be determined largely through days of physical presence, monitored through an electronic entry-exit system at the borders. Residence jurisdiction would generally be deemed to continue during a temporary absence abroad for less than three years; however, an unlimited exclusion for foreign earned income would be permitted in this case. A taxpayer whose residence terminates would be taxed on the unrealized appreciation that accrued on the taxpayer's worldwide assets during residence.

Part II will begin by briefly describing the current rules for taxing U.S. citizens and residents and the arguments that have been made in favor of retaining citizenship-based taxation. Part III will then explain the rationale for eliminating citizenship-based taxation. The remainder of the Article will describe a proposed new system of taxation for individuals based solely on residence and the considerations entering into its design.

II. THE CURRENT LAW AND THE CASE FOR CITIZENSHIP-BASED TAXATION

The United States imposes tax on the worldwide income of every U.S. citizen and every alien classified as a "resident alien" under [section] 7701(b) of the Code. (4) Under that provision, an alien is classified as a resident alien if the alien "is a lawful permanent resident" (i. …