The Trump Tax Reform - what does this mean for US Expats?
Introduction of a new "foreign branch income" basket for determining the allowable foreign tax credit - implications for expats.
President Trump signed H.R.1 into law on December 22, 2017. This 185 page document is considered the biggest revision of the US tax code since 1986, amending various individual and corporate tax laws, but the question that most US citizens abroad would like to know is – What is the impact for the US expat community?
Among all the changes, introduction of a new foreign branch income basket is what we expect to have the most impact on US residents abroad.
In general, under IRC Section 904, a taxpayer is permitted to claim a foreign tax credit for taxes paid in a foreign country against the US tax liability. Under the previous law, the allowable credit is determined separately for the taxpayer's "general basket" and "passive basket" income. The Act adds as a new basket "foreign branch income," which is defined as the business profits of a U.S. person that are attributable to one or more qualified business units in one or more foreign countries.
We at Taxential believe that this provision would have the most significant impact the US citizens abroad more than anyone else, especially those who receive rental income in the country they live.
To illustrate, let’s look at the following scenario which is quite typical for the average US citizen abroad:
Melissa is a US citizen who lives in the UK. She bought her house a few years ago with a mortgage which she pays monthly and in addition, she has another place that she rents. Due to the recent depreciation of the UK pound, with every monthly mortgage payment Melissa realizes a significant foreign exchange gain which is taxable as foreign passive income on her US tax return. We explained how that gain on foreign exchange works in a previous article that you can read by clicking here.
In addition, she receives dividend income from some UK stocks that as well as some interest from her cash ISA account. From UK tax point of view, the dividend income falls within her non-taxable allowance of £5,000, and the income from the ISA account is tax free in the UK. However, from a US tax point of view, the interest, dividends as well as the gain on foreign exchange are all taxable, and they all fall within the passive category income basket.
To illustrate the impact on the new law, let’s consider that Melissa also receives rental income from a UK based rental property, and pays tax on that rental income in the UK. She generates foreign tax credit that she can use to offset the US tax liability not only on the rental income, but also on any other passive category income, including the gain that she realizes on her mortgage repayment and the diffident and interest income that are tax free in the UK. Due to the differences in methodology in determining net taxable rental income for US and UK tax perspective, and most notably due to the more generous allowance for cost recovery in the US, it is very common that the rental income in the UK is actually a loss when reported on the US tax return. Consequently, the entire amount of tax paid in the UK with respect to that rental income is available to offset the US tax liability on other income items as long as they are in the same category also called “passive income basket”.
Under the previous law, rental income fell under the passive category income. However, under the newly enacted law, the rental property will likely be considered a qualifying business unit (QBU), and the UK tax paid on the rental income would only be available against the US tax liability on income from other QBU’s and not against passive income items such as interest, dividends and foreign exchange gains on personal loans.
If you think that the situation described above relates to you, or if you would like to discuss other implications of the tax law changes and how those may impact you, we are here to assist. Get in touch with your Taxential advisor now!
Disclaimer: The content of this page does not constitute legal advice, and should not be relied upon for tax avoidance purposes. The facts and circumstances specific to your situation are the ones that ultimately determine the application of the rules. The text above is based on Taxential's interpretation of the US tax law from a general perspective only.