Taxation of Accidental Americans - FATCA - Cause or effect?

By Michael Lewis, Director, Mark Allsopp, Senior Tax Manager

When discussing why someone should file a US tax return the topic of FATCA (The Foreign Account Tax Compliance Act) is often incorrectly cited.

Evidence of how FATCA and its relevance is so misunderstood was demonstrated back on 1 October 2019 when Martyn Dan MP in correspondence to the Chancellor of the Exchequer asked;

"what recent representations he has made to his counterpart in the US Administration on the creation of the accidental Americans through the US Foreign Account Tax Compliance Act".

Of course, FATCA does not cause someone to have a US filing requirement nor does it 'create' Accidental Americans but this kind of mistake is all too regularly made, with many commentators getting completely confused between cause and effect.

Cause

An Accidental American is an individual who holds citizenship outside of America but who also holds US citizenship (often unknowingly) by virtue of being born in the US or simply having a US parent and resultingly being a US citizen by 'accident', i.e. through no action or expectation of their own.

There are many Accidental Americans throughout the world, most do not realise they are US citizens until told so by a professional advisor, for example when trying to open an investment account.

Being an accidental American (or more simply; a US citizen) comes with many tax obligations. Most people would assume that if they do live in the US that there are no US tax issues to consider but this is unfortunately not the case for US citizens.

A major principal of the US tax system (in force since the US began imposing income taxes in 1913) is that it imposes tax (and complex reporting requirements) on its Citizens irrespective of where they live. In addition, the US of course also taxes habitual residents within the country such that the US can tax both citizens and non-citizens alike.

The default system of 'US citizenship taxation' means that those US citizens who are based aboard, regardless of whether they feel any affiliation to the US or not, have an annual obligation to Uncle Sam.

Effect

As set out an Accidental American must file tax returns annually to the IRS. Period.

This rule applies almost irrespective of liability, worldwide income or economic status. Someone who earns below the US standard deduction would technically be exempt from having to file but this threshold is so low that it is almost completely unhelpful e.g. the deduction in 2017 was only $6,350 for individuals (in addition for students under the age of 24 with a US parent the deduction may be worth even less).

But the obligations of US citizens is not just to file a tax return but also to provide very detailed information on their non-US investments. Non-US investments above a certain threshold including bonds, shares, pensions and trusts need to be reported on form 8938 while US citizens with significant business interests outside the US will have some very complex reporting.

Of course when discussing reporting obligations one cannot not mention form FINCEN-114 - more commonly referred to as an FBAR (short for Foreign Bank Account Reporting form). This form applies where someone has more than $10,000 in non-US accounts at any point in the calendar year. If it applies then all accounts owned, or on which signature authority is held will need to be disclosed (including the maximum balance each account in the year). Substantial penalties apply for non- compliance with this reporting obligation.

FATCA

As set out above FATCA did not cause people to be US Citizens or create the rules requiring them to file US tax returns (such rules applying since 2013!).

Rather the Foreign Account Tax Compliance Act, 2010 (FATCA) was introduced to help enforce the rules which already existed. It did this in two ways - firstly by increasing the burden on the individual reporting of non-US investments by the taxpayer (through form 8938) but more importantly by introducing a reporting obligation on financial institutions, wherever they are based, to disclose details on their US citizen/resident clients.

The implementation (or should we say 'Imposition) of FATCA by the US onto the rest of the world created a significant ripple in the financial system. Many Financial institutions (FIs) became queasy at the thought of maintaining or establishing relationships with US Citizens due to the reporting requirements to the US and subsequent fines for lack thereof. The impact being some US citizens were dropped from the books of many institutions around the world. In a number of cases governments realised that that financial institutions in their country would be unable to apply the FATCA rules due to data protection restrictions. To deal with this these countries (which includes the UK) negotiated bilateral reciprocal treaties with the US effectively incorporating the FATCA rules into domestic law

Although FATCA has not created any new tax rules but rather it has created more burdensome reporting rules - both on the individual and on institutions. The cost of implementing FATCA is estimated to far exceed any tax which it has helped recover/save but since the cost is borne by someone else it is not something the US government has been very concerned about.

While there are some well-publicised campaigns being run which look to challenge the validity of the FATCA rules we would not bet on their success. Regardless, however, of whether such campaigns succeed or not fundamentally the requirement on US citizens to file a tax return applies irrespective of FATCA.

Summary

While FATCA increased significantly the volume of information available to the IRS and Treasury through additional annual reporting obligations on both Financial institutions and US taxpayers it didn't create the core tax filing obligation applicable for Accidental Americans.

If FATCA didn't exist, Accidental Americans and indeed any US Citizens outside of the US would certainly find financial institutions a lot more welcoming but would nevertheless still be required to file returns to the IRS.

The direct impact of FATCA especially as a result of the response by Financial institutions (and governments) has been to put a spotlight on Accidental Americans - highlighting their obligations. While it has created many new frustrations it certainly has caused many US citizens to become US tax compliant.

FATCA has arguably has also created an environment where the global sharing of tax information has become much more acceptable. Without FATCA it is unlikely for instance that we would have the Common Reporting Standard (CRS) for the worldwide sharing of information on residents.

The root cause of the tax burden on US Citizens is nothing to do with FATCA but results from both the antiquated US tax rules which impose tax obligations by virtue of citizenship and secondly from the ease with which US citizenship can be acquired (even if not wanted!). While the ending of citizenship taxation in the US has often been discussed we believe that it will be around for many years to come. The issue of 'Accidental Americans' is therefore not going to go away any time soon!