Be Like America, Except For This Bad Tax Policy

Celebrating America’s birthday in the company of foreigners can be great fun. I recently spent the Fourth of July with some British expats who live in Washington, D.C., and love it here.

While awaiting the fireworks, we joked about the many ways our countries’ cultures differ. My guests remarked that we Americans support the wrong kind of football. I countered that the Brits drive on the wrong side of the road. It was a friendly tussle ending in a diplomatic truce about which country does things the better way.

But there is one matter regarding which I encourage the rest of the world not to replicate the American experience: the taxation of citizens who live abroad. A recent blog post from veteran tax attorney Dan Neidle, who runs the London-based think tank Tax Policy Associates, presents the following question: “Citizenship-based taxation: Should all UK citizens pay tax in the UK, even if they live abroad?”

Neidle explains how the United States and the United Kingdom rely on different rules for taxing individuals who live outside their country of origin. The post underscores the conceptual divide between residence-based and citizenship-based taxation. This is an area that’s become increasingly controversial in recent years, in part because of the Foreign Account Tax Compliance Act regime, which makes life burdensome for U.S. citizens who live abroad.

The United Kingdom taxes people according to their residence. If a person lives in the United Kingdom for at least 183 days in a single year, he or she will satisfy the threshold for establishing legal residence and will be taxed accordingly. Seems fair enough. The residence threshold drops to 90 days if the person owns a home in the United Kingdom. That makes nonresident status more difficult to attain because the person must then live outside the country for at least 275 days in a single year. Again, no complaints.

If the person qualifies as a nonresident under U.K. law, they’re generally off the hook for purposes of British taxes. That’s despite being a U.K. citizen. Stated differently, British citizenship alone does not provide a foundational basis for the imposition of U.K. taxing rights. This approach is not some uniquely British anomaly. Residence-based taxation is the international norm. It’s how every country in the world (apart from the United States and Eritrea) goes about things.

The U.S. approach is quite different. It determines tax jurisdiction by considering both residence and citizenship, meaning that U.S. expats and so-called accidental Americans are fully taxable in the United States despite having foreign residency.

The only way they can escape citizenship-based taxation — and the accompanying burdens of FATCA — is to formally renounce their citizenship.

Neidle reflects on residence-based taxation as follows:

The problem with this from some people’s perspective is that it becomes remarkably easy to stop being subject to UK tax. Simply quit the UK. Plenty of wealthy people skip the UK to move to tax havens, often just before making large capital gains. You can be sure we’d see more of that if the UK was about to introduce a hefty wealth tax.

He then makes the point that if a government’s sole consideration is to prevent extremely rich people from fleeing the country and setting up shop in a tax haven, the U.S. model is preferable to the British model. The statement caught my attention because it’s the same argument I routinely hear from U.S. opponents of residence-based taxation.

Despite the observation, and after weighing all the relevant pros and cons, Neidle comes down firmly against citizenship-based taxation. He describes it as “unfair and unjust,” adding that it would be a terrible idea for U.K. policymakers to consider adopting the practice. I couldn’t agree more. No country should follow the U.S. example in this instance.

It was refreshing to hear those thoughts from someone with no particular ax to grind regarding the operation of the U.S. income tax system. Even on a patriotic occasion like the Fourth of July, the perspectives of an outsider (even a Brit) can be a welcome source of objectivity.

Citizenship-based taxation is suboptimal tax policy — with or without the baggage of FATCA.