Everything you wanted to know about US expat taxes but were too afraid to ask
Last Update: January 2023It is no wonder that many U.S. expats choose Australia as their new home abroad. Australia consistently dominates the Organization for Economic Development and Cooperation (“OECD”) Better Life Index, scoring high marks in the areas of life satisfaction, safety, health, and environment, as well as other factors related to well-being.
The Australian income tax system is fundamentally similar to the U.S. federal income tax system although there are significant differences. For instance, similar to the U.S. system, Australia taxes its residents on their worldwide income (i.e., whether the income is earned within our without Australia). Non-resident individuals are generally only required to pay tax on Australia source income. Unlike the U.S., individuals that become residents for a short time may be eligible for temporary resident tax exemptions on their foreign income and capital gains.
Like the U.S., Australia employs a marginal tax rate based on a progressive tax system, where tax rates for an individual increase as income rises. The current highest marginal tax rate for residents is 45%, not including an additional 2% Medicare levy. Unlike the U.S., income taxes in Australia are imposed at the federal but generally not at the state or local level.
Also similar to the U.S., Australian taxpayers are required to file an income tax return annually. Unlike the U.S., the tax year is not based on the calendar year ending December 31, but rather on Australia’s fiscal year ending June 30. Australia’s individual income tax return must be “lodged” (i.e., filed) by October 31, although extensions are available.
Principle #1 - Your Obligation Endures
Your U.S. Tax Filing Obligation Endures Even After Moving Abroad
Our first principle is of particular importance because U.S. expats so often mistakenly believe that once they have moved abroad their U.S. tax obligations cease to exist.
In fact, as a basic rule, U.S. citizens, even those residing outside the United States, are considered to be U.S. residents for tax purposes and are therefore subject to U.S. tax reporting on their worldwide income. Expats must annually report all of their income to the IRS, just as they did prior to moving to abroad, whether the income is U.S. source or foreign source, and whether that foreign source is Australia (e.g., employment in Australia) or any other foreign country.
Principle #2 - New Filing Obligations
You’re Likely Subject to New Information Reporting Obligations
U.S. expats who hold accounts or other assets overseas are subject to a number of specific filing requirements in the form of informational forms. Some of these forms are submitted to the IRS as attachments to the personal income tax return (Form 1040), while others are submitted to other governmental departments. The failure to file any of these forms can result in severe civil penalties, such as a $10,000 penalty per form per year. Additionally, in certain extreme cases, criminal penalties, including fines and incarceration, may apply if the reporting delinquency is shown to be willful.
Some of the more common forms include:
- Foreign Bank and Financial Account Report (FBAR)
The FBAR is not a tax form and it is not filed with the IRS. Instead, it is an informational form that is submitted with the U.S. Treasury Department. A U.S. account holder (person or entity) with a financial interest in or signature authority over one or more foreign financial accounts, with more than $10,000 in aggregate value in a calendar year, must file the FBAR annually with the Treasury Department.
- Form 8938, Statement of Specified Foreign Financial Assets (FATCA Reporting)
If you reside outside the U.S. and have a bank account or investment account in a foreign financial institution, you are generally required to include FATCA Form 8938 with your U.S. federal income tax return if you meet certain monetary thresholds.
Principle #3 - New US Tax Considerations
Your Activities in Australia Have Important U.S. Tax Implications
With each item of income that an expat earns and with each foreign asset that is owned or acquired, special considerations need to be addressed. The following are examples of common activities in Australia and their potential U.S. tax implications.
The Australian Trust Entity
While the registered company remains a very common and well-understood entity for carrying on a business in Australia, the trust entity has become an increasingly popular business vehicle because of its combination of business advantages (e.g., asset protection and limitation of liability) and tax benefits (e.g., capital gains on sale of assets may be eligible for 50 percent discount). The two main types of trusts that are utilized in Australia are unit trusts (where beneficiaries have a fixed entitlement to income and capital based on the proportion of units they hold in the trust) and discretionary trusts (where the trustee has discretion to distribute income and capital to one or more beneficiaries of the trust as the trustee sees fit).
For all the advantages that the trust entity offers under Australian law, the U.S. expat should be aware that utilization of this type of entity may not necessarily be sound planning from a U.S. tax perspective. For instance, an entity that is characterized as a trust for Australian tax purposes can be classified as a business entity for U.S. tax purposes that is akin to a corporation if the trust operates a business. Such characterization under U.S. tax law may trigger the U.S. anti-deferral regimes, such as the “controlled foreign corporation” regime, the new “global intangible low-taxed income” regime, or the “passive foreign investment company” regime, all of which are generally designed to prevent taxpayers from deferring U.S. tax by shifting income to foreign entities. Careful planning is often needed to ensure that these regimes do not subject your income to highly punitive U.S. federal tax rates.
Australian Pension Plans
Foreign pension plans, including Australian pension plans, generally do not qualify for the beneficial tax-deferral treatment afforded to certain U.S. pension plans under Section 401 of the U.S. Internal Revenue Code (e.g., a 401(k) plan). As such, employer contributions and plan earnings may be subject to U.S. tax on a current basis and required to be reported on the individual’s U.S. income tax return, even though these items may not be currently subject to Australian tax. In the case of a foreign pension plan that qualifies as an “employees’ trust” within the meaning of Section 402(b) of the Internal Revenue Code, employer contributions are taxed currently but plan earnings may be tax deferred until retirement assuming certain conditions are met.
In this regard, over 90 percent of employed Australians currently have savings in a superannuation pension account – employment contributions to these accounts may be tax deferred in Australia but are generally currently taxable in the U.S. Further U.S. tax and reporting implications may arise depending on whether the superannuation fund is a public super fund or a self-funded super fund. In some instances, a self-funded super fund may be viewed as a “foreign grantor trust” for U.S. tax purposes, which may trigger additional reporting obligations, such as the requirement to file a foreign trust form (IRS Form 3520). For these and many other reasons, it is essential that U.S. expats participating in a superannuation or other pension fund understand the full U.S. tax and reporting implications associated with plan participation.
U.S. Tax Reporting Considerations
It is important to keep in mind that in addition to the substantive U.S. tax implications associated with the above activities, additional tax reporting obligations may also arise as a result of such activities. Some of the common forms associated with investment or other financial activities abroad include:
- Form 3520: must be filed to report transactions with foreign trusts and receipt of certain foreign gifts
- Form 5471: must be filed by certain shareholders of foreign corporations
- Form 8621: must be filed by certain shareholders of passive foreign investment companies (such as foreign mutual funds)
- Form 8865: must be filed for each controlled foreign partnership in which the taxpayer is a 10% or more partner
Principle #4 - US Tax Benefits
U.S. Tax Benefits Are Available to You
The good news for expats living in Australia is that both U.S. domestic tax law and U.S.-Australia bilateral agreements contain a number of provisions that are designed to prevent “double taxation,” or taxation on the same income in both countries.
These provisions, in many cases, can reduce or even eliminate the U.S. federal income tax that would otherwise be due by the expat taxpayer. Keep in mind, however, that even if no U.S. tax is owed, a U.S. tax return still generally must be filed and the failure to do so can result in severe penalties.
Domestic law provisions, such as the foreign earned income exclusion (“FEIE”), foreign housing exclusion (“FHE”), and foreign tax credit (“FTC”) are designed specifically for taxpayers living abroad.
Foreign Earned Income Exclusion
Provided an individual is able to establish that his tax home is outside the U.S. (by satisfying either the “bona fide residence” test or the “physical presence” test), such individual can exclude from income a portion of their income earned overseas. The FEIE amount is adjusted annually for inflation. For tax year 2022, the maximum exclusion is $112,000 per person ($224,000 for a married expat couple).
In order to claim this exclusion, an individual must file a U.S. federal income tax return (Form 1040). To claim the FEIE, an individual must file Form 2555 with their U.S. federal income tax return.
Foreign Housing Exclusion/Deduction
In addition to the FEIE, a U.S. expat can also exclude or deduct from their gross income their housing cost amount in a foreign country provided they qualify under the bona fide residence or physical presence tests. The exclusion is applicable whenever an individual has wages. The deduction is applicable whenever the individual is self-employed. In order to claim the foreign house exclusion/deduction, an individual must file Form 2555.
However, the housing cost amount is subject to certain limitations that are adjusted based on geographical location. Without any adjustments to the limitations, the maximum foreign housing exclusion for 2022 is $15,680. Adjustments vary from city to city and are based on the cost of living in each city. Such adjustments apply specifically to the following Australian cities: Darwin, Northern Country, Melbourne, Perth, and Sydney.
Foreign Tax Credits
As an alternative to (and for higher income earners, in complement to) the FEIE and foreign housing exclusion/deduction, a U.S. expat can claim a foreign tax credit (“FTC”) for foreign income taxes paid. The amount of foreign tax credits that may be taken is limited to the amount of foreign source taxable income and cannot be used to offset U.S. source income.
Since the Australian tax rate on an expat’s income will generally be higher than the U.S. tax rate, it will often be the case that there is no residual income tax to pay in the U.S. after claiming a foreign tax credit for the Australian tax paid. However, a foreign tax credit cannot be used to reduce the U.S net investment income tax and, as such, residual U.S. tax may result even if the foreign tax credit can otherwise be fully utilized against the earned income tax. The foreign tax credit rules are particularly complex and, as such, require a thorough analysis by a tax expert.
Aside from specific situations, in order to claim a foreign tax credit, an individual must file Form 1116 with their U.S. federal income tax return.
Many countries have signed treaties and other international agreements with the U.S. whereby certain benefits are available to U.S. expats residing in a particular foreign country, for instance in order to protect them from double taxation, both in the U.S. and in their country of residence. U.S.-Australia agreements include:
- U.S.-Australia Income Tax Treaty – This treaty is designed to mitigate the effects of double income taxation. Generally, under an income tax treaty with the U.S., U.S. expats may be entitled to certain credits, deductions, exemptions and reductions in the rate of income taxes of the foreign country in which they reside.
- U.S.-Australia Totalization Agreement – This agreement affects tax payments and benefits under the respective social security systems. It is designed to eliminate dual social security taxation, the situation that occurs when a worker from one country works in another country and is required to pay social security taxes to both countries on the same earnings. It also helps fill gaps in benefit protection for workers who have divided their careers between the United States and Australia.
Principle #5 - Reach of US Government
Due to FATCA and its Supporting International Agreements, the U.S. Income Tax Reach Has Become Wider Than Ever Before
FATCA stands for the “Foreign Account Tax Compliance Act.” FATCA is a relatively new law that was enacted in 2010 as part of the HIRE Act. The objective behind FATCA is to combat offshore tax evasion by requiring U.S. citizens to report their holdings in foreign financial accounts and their foreign assets on an annual basis to the IRS. As part of the implementation of FATCA, starting with the 2011 tax season, the IRS requires certain U.S. citizens to report (on Form 8938) the total value of their “foreign financial assets.”
In order to further enforce FATCA reporting, starting on January 1, 2014, foreign financial institutions (“FFIs”) (which include just about every foreign bank, investment house and even some foreign insurance companies) became required to report the balances in the accounts held by customers who are U.S. citizens. To date, we have seen several large foreign banks require that all U.S. citizens who maintain accounts with them provide a Form W-9 (declaring their status as U.S. citizens) and sign a waiver of confidentiality agreement whereby they allow the bank to provide information about their account to the IRS. In some cases, foreign banks have closed the accounts of U.S. expats who refuse to cooperate with these requests.
It is this renewed effort by the U.S. government to combat offshore tax evasion through FATCA that has led to a recent surge in tax compliance efforts by U.S. expats.
Recently, the IRS announced that the United States had signed a so-called competent authority arrangement (“CAA”) with Australia in furtherance of a previously signed intergovernmental agreement (“IGA”) with Australia, an agreement which is designed to promote the implementation of the FATCA law requiring financial institutions (mainly banks and investment houses) outside the U.S. to report information on financial accounts held by their U.S. customers to the IRS.
The CAA with Australia, along with a simultaneously signed CAA with the UK, are the very first of their kind. These arrangements contain specific provisions regarding exchange of information protocols. For example, under the arrangements, financial institutions and host country tax authorities are required to utilize the International Data Exchange Service (IDES) to exchange FATCA data with the IRS.
This IRS announcement came on the heels of an earlier press release by the Australian Taxation Office (ATO), which stated that it had, for the first time, transmitted FATCA data to the IRS in accordance with its IGA. According to the ATO, more than 30,000 financial accounts valued at more than $5 billion (Australian dollars) were provided to the IRS. In return, the U.S. agreed to provide Australia with information on Australian-owned accounts located in the United States.
These latest developments further signify that efforts by the U.S. to combat offshore tax evasion are being met with support and cooperation by Australia as well as other jurisdictions. We believe this will lead to a further surge in tax compliance efforts by U.S. expats.
If you are a U.S. expat living in Australia, it is essential that you remain compliant with your continuing U.S. tax obligations. Our experts at Expat Tax Professionals are available to help you understand your U.S. tax filing requirements and to assist you with all of your U.S. tax compliance needs.