Citizenship-Based Taxation

Citizenship-based taxation is a system in which a country taxes people because of their nationality rather than because of where they live or where their income arises. A United States citizen is taxed on worldwide income for every year of citizenship, whether they live in Ohio or Osaka, and the same is true of lawful permanent residents (green card holders). Most of the world uses residence-based taxation, under which a country taxes only the people who actually live there, or territorial taxation, under which it taxes only income earned inside its borders.

The system is unusual to the point of being nearly unique. Setting aside the United States, the only country generally described as taxing its citizens regardless of residence is Eritrea, which levies a flat diaspora tax. That rarity is why the arrangement surprises so many Americans who move abroad and assume, reasonably, that leaving the country ends their tax relationship with it.

The historical root is the Civil War. Congress first reached citizens living abroad in the Revenue Act of 1862 and the principle was upheld by the Supreme Court in Cook v. Tait in 1924, on the theory that citizenship itself confers benefits and protection that justify taxation wherever the citizen resides. Whatever one makes of the rationale, the rule has been settled law for a century, and it is written into the definition of who is subject to tax rather than into any single deductible provision.

The practical consequence is double exposure, which the code then partly relieves. A US citizen who lives and works in Germany is taxed by Germany as a resident and by the United States as a citizen, so without relief the same salary would be taxed twice. Three mechanisms exist precisely because citizenship-based taxation creates that overlap. The foreign earned income exclusion lets a qualifying person leave a capped amount of foreign wages out of US gross income. The foreign tax credit offsets US tax dollar-for-dollar with income tax already paid to another country. And income tax treaties reallocate taxing rights and reduce withholding. None of the three eliminates the duty to file; they reduce or erase the amount owed.

Reporting survives even when tax does not. Because the reach is based on status, the filing requirements are broad and apply regardless of whether any US tax is ultimately due. A citizen abroad may owe nothing after the exclusion and the credit and still be required to file a Form 1040, report foreign accounts, and in some cases file additional information returns. Penalties for failing to file those information returns can be severe even when the underlying tax is zero, which is the trap that catches people who reasoned that no tax meant no filing.

Leaving the system is a deliberate legal act with its own tax. Because the obligation attaches to citizenship, the only way to end it is to renounce citizenship or, for a long-term green card holder, to abandon that status. For people above certain income or net-worth thresholds, doing so can trigger the expatriation tax, a mark-to-market charge treating most assets as sold on the day before expatriation. So the exit from citizenship-based taxation is itself taxed for the wealthiest who take it.

The mechanism is a matter of who is defined as a taxpayer. The Internal Revenue Code imposes tax on the taxable income of every individual, and the regulations define the citizens and residents it reaches without any carve-out for those who live abroad. So the starting point for a US citizen anywhere in the world is the same worldwide income a resident would report, after which the relief provisions are applied in order.

A hypothetical example. Marcus is a US citizen who moves to Portugal and earns the equivalent of $90,000 in salary there, paying Portuguese income tax on it. On his US return he still reports the full $90,000 as worldwide income. He then applies the foreign earned income exclusion, which for the year covers up to $132,900, so the salary is excluded from his US taxable income. Even though his US tax on the wages comes to zero, he must file the return to claim the exclusion, and he must separately report his Portuguese bank accounts if they cross the reporting thresholds. Had he instead earned investment income that the exclusion does not reach, he would have used the foreign tax credit for the Portuguese tax on it to avoid being taxed twice.

Citizenship-based taxation is a feature of law rather than a choice, so the honest framing is what it does and does not accomplish, not whether to use it.

Arguments made for it

• It ties the benefits of citizenship, including consular protection and the right to return, to a continuing obligation, which is the rationale the Supreme Court accepted in 1924.
• It is difficult to escape by simply moving abroad, which limits residence shopping as a way to avoid tax.

Arguments made against it, and the burdens it imposes

• It exposes the same income to two tax systems, relieved only partially by the exclusion, the credit, and treaties, and never relieved of the duty to file.
• It imposes filing and foreign-account reporting on millions of people who owe no US tax, with penalties that can exceed any tax at stake.
• It creates "accidental Americans," people who are US citizens by birth but have never lived in the country, who face filing duties they often do not know exist.
• Foreign banks, wary of the reporting rules that accompany it, sometimes decline to open accounts for US citizens at all.