A Treaty Election to be Treated as Non-Resident for US Taxes

Treaty Election for US Tax Treatment as a Non-Resident

Unlike almost every other country across the globe, the United States income tax rules are based on U.S. Person status and not residence. This is referred to as Citizenship-Based Taxation — although this term is a misnomer since the rules are not limited to just U.S. citizens. In most countries, the worldwide income tax rules for individuals only apply to residents living within the foreign country (which generally means 183 days or more of residence in a foreign country). When it comes to the United States tax system and individuals, the default rule is that all worldwide income is taxable. Therefore, even if a taxpayer is a Permanent Resident who resides outside of the United States and earns all of their income from foreign sources, the US government still requires US Taxpayers to report their worldwide income just as if they were residing in the United States. Noting, foreign tax credits (FTC) and the foreign earned income exclusion (FEIE) may reduce or eliminate U.S. tax liability on foreign income. Beyond FTC and FEIE, one way that some residents may avoid U.S. worldwide income taxes is if they reside in a treaty country and make a treaty election to be treated as a foreign person for tax purposes. Let’s take a brief look at how this process works and who may qualify.

Tax Treaties

The United States has entered into several different international tax treaties with foreign countries with the overall goal of avoiding double taxation on various types of income. While many of the tax treaties are very similar, each tax treaty is different — and therefore taxpayers have to be careful to make sure that they carefully assess the specific tax treaty they want to rely on in order to make a proper tax treaty-based return reporting disclosure. In general, taxpayers who are in a treaty country may qualify to take a treaty position on various matters. To do so, the US Taxpayer can include a Form 8833 (unless otherwise excluded from the reporting requirement) to make a treaty-based election. Let’s go through the basics of how to qualify for a tax treaty-based return reporting disclosure.

Example of Non-Resident Treaty Election Clause

From the 2016 Model Treaty:

Article 4: RESIDENT

• • • 1. For the purposes of this Convention, the term “resident of a Contracting State” means any person who, under the laws of that Contracting State, is liable to tax therein by reason of his domicile, residence, citizenship, place of management, place of incorporation, or any other criterion of a similar nature, and also includes that Contracting State and any political subdivision or local authority thereof. This term does not include any person whose tax is determined in that Contracting State on a fixed-fee, “forfait” or similar basis, or who is liable to tax in respect only of income from sources in that Contracting State or of profits attributable to a permanent establishment in that Contracting State.

    • 2. The term “resident of a Contracting State” includes:

      • a) a pension fund established in that Contracting State; and

      • b) an organization that is established and maintained in that Contracting State exclusively for religious, charitable, scientific, artistic, cultural, or educational purposes; notwithstanding that all or part of its income or gains may be exempt from tax under the domestic law of that Contracting State.

    • 3. Where, by reason of the provisions of paragraph 1 of this Article, an individual is a resident of both Contracting States, then his status shall be determined as follows:

      • a) he shall be deemed to be a resident only of the Contracting State in which he has a permanent home available to him; if he has a permanent home available to him in both Contracting States, he shall be deemed to be a resident only of the Contracting State with which his personal and economic relations are closer (center of vital interests);

      • b) if the Contracting State in which he has his center of vital interests cannot be determined, or if he does not have a permanent home available to him in either Contracting State, he shall be deemed to be a resident only of the Contracting State in which he has a habitual abode;

      • c) if he has a habitual abode in both Contracting States or in neither of them, he shall be deemed to be a resident only of the Contracting State of which he is a national;

      • d) if he is a national of both Contracting States or of neither of them, the competent authorities of the Contracting States shall endeavor to settle the question by mutual agreement. 11

    • 4. Where by reason of the provisions of paragraph 1 of this Article a company is a resident of both Contracting States, such company shall not be treated as a resident of either Contracting State for purposes of its claiming the benefits provided by this Convention.

    • 5. Where by reason of the provisions of paragraph 1 of this Article a person other than an individual or a company is a resident of both Contracting States, the competent authorities of the Contracting States shall by mutual agreement endeavor to determine the mode of application of this Convention to that person.

Should You Make the Election?

In general, for taxpayers who qualify for this election — it may significantly reduce or eliminate US taxes on a significant portion of their income. Moreover, it may also help taxpayers avoid an exit tax if they are approaching the long-term lawful permanent resident threshold and instead files Form 8833 to be treated as a non-resident for tax purposes so that any year the election is made it is not applied towards that eight-year of 15-year long term permanent resident rule.

One important factor to consider is that for taxpayers who have already met the long-term lawful permanent resident definition, by filing form 8833 in making this type of election it may be seen as the expatriating act. Thus, the taxpayers who are approaching or are already at the eight-year mark must be careful before making such an election.

What About FBAR Reporting?

When a Taxpayer is considered a US person, that means that they are required to report their worldwide income on their US tax return. They are also required to report their global assets on various international information reporting forms, such as the FBAR (Foreign Bank and Financial Account Reporting Form aka FinCEN Form 114), FATCA (Foreign Account Tax Compliance Act, aka Form 8938) Form 3520 Foreign Gift and Trust Reporting – and several other invasive IRS tax forms. When a taxpayer is a resident of a treaty country, they may qualify to make a treaty election that they want to be treated as a foreign resident for US tax purposes, in a situation in which they have significant contacts with a foreign country.  If a person is considered a foreign resident for tax purposes under a treaty election, are they exempt from filing the FBAR?

The IRS Says a Treaty Election Does Not Eliminate FBAR

The IRS’ position is that even if a US person qualifies to make a treaty election in order to be treated as a foreign resident for tax purposes, so they would file a form 1040-NR instead of a 1040—they are still required to file the FBAR.   Recently, in 2022, the US government updated its FBAR reference guide and Practice Unit provided the following example:

FBAR Practice Unit

• • • “CAUTION: U.S. tax treaty provisions do not affect residency status for FBAR purposes.

      • The federal tax treatment of a USP does not determine whether the person must file an FBAR. FBARs are required under the BSA provisions of Title 31 of the United States Code (USC) not under any provisions of Title 26 of the USC. Entities that are USP and are disregarded for tax purposes may be required to file an FBAR. This statement is derived from an example provided by IRM section 4.26.16.2.1(2) Example (11-06-2015).”

FBAR Publication 5569

• • • “Kyle is a permanent legal resident of the U.S. Kyle is a citizen of the United Kingdom. Under a tax treaty, Kyle is a tax resident of the United Kingdom and elects to be taxed as a resident of the United Kingdom. Kyle is a U.S. person for FBAR purposes. Tax treaties with the U.S. do not affect FBAR filing obligations.“

2023 Litigation Update (Aroeste v US)

There is currently a very important case brewing at the federal court level (Aroeste v US) involving a nuanced FBAR foreign account penalty conundrum. In general, there are three categories of individual taxpayers who have to file FBAR: US Citizens, Lawful Permanent Residents, and Foreign Nationals who meet the Substantial Presence Test. But what happens if a taxpayer resides overseas and makes a treaty election to be treated as a foreign person so that they are not considered a US person for tax purposes? In other words, if someone is a permanent resident of the United States but claims treaty benefits to be treated as a foreign person, are they still considered a US person for FBAR filing purposes?  This is the challenge taxpayer makes as to whether the US/Mexico tax treaty will overrule the IRS’ position on treaty elections and FBAR.

Treaty Elections are Complicated

In general, taxpayers should carefully consider the pros and cons of making a treaty-based election before doing so. That is because the election can increase the chance of an audit or examination—depending on the category and type of election. Moreover, the election will carry forward for many years to come, and if a taxpayer later wants to unwind the election, it could become a very complicated and cost-intensive exercise.

International Tax Lawyers: Golding & Golding

Golding & Golding specializes exclusively in international tax and specifically, IRS offshore disclosure. 

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