Barron's International Tax Service

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A Question of Compliance

Some years ago an American expatriate residing in Iberia attended a luncheon of the American Club. The main speaker was speaking jubilantly about a tax treaty designed to eliminate double taxation between the United States and a treaty country. What double taxation meant was that American expatriates could, lacking such a treaty, be taxed on the same income both by their country of origin and country of residence.

The United States taxing authority known as the Internal Revenue Service (IRS) already mandated that American citizens wherever they reside report and pay taxes on their world-wide income. At the same time foreign countries could require that residents (citizens and expatriates) pay taxes on world-wide income, residents often being described as anyone expatriated in the foreign country for over 183 days.

My American expatriate friend was not pleased with what appeared to be an intrusion into his privacy. Until now he had always reported his U.S. source income to IRS and his foreign income to the country wherein he resided. He thought he understood that by reporting both his U.S. and foreign source income to his country of origin (United States) that IRS would apply allowable tax credits against income reported to and taxed by the foreign country. That seemed ok. However, up until now, the foreign country had not actually required him to report his U.S. income. So what was the point of a tax treaty?

In 2003 he received a tax notice from the foreign country taxing authority in which he was assessed €2,800 in taxes and interest against some €9,000 in U.S. dividend income, which he had reported only to IRS on his 1999 federal income tax return. Back in 2000 when he was filing his 1999 U.S. and foreign tax returns, several tax advisors where he resided advised him not to report this dividend income. One said that the law only applied to citizens of the foreign country. Another insisted that the country did not tax dividends. Still another declared that the country lacked the expertise to apply the law. Now, in spite of this advice, my friend found himself being scrutinized by a highly trained tax auditor who was fully apprised of those dividends he had failed to report to the foreign country.

Today double taxation treaties have proliferated between many countries, facilitating collaboration between taxing authorities. As a result, anyone who derives income from, or owns property in, one or more foreign countries must carefully negotiate an often perplexing maze of international tax filing requirements so as not to run awry of the law. To mitigate the confusion and avoid audits, timely compliance is essential. IRS mandates that American expatriates pay their 2004 income taxes by 15 April 2005, even though the deadline for actually filing the 2004 tax return is 15 June 2005. At the same time, estimated tax payments on 2005 income must be paid quarterly, starting on 15 April 2005.

Fines can apply for failing to pay taxes or file a tax return on time. IRS assesses interest charges up to 25% of unpaid taxes. A minimum penalty of $100 or 100% of taxes owed will also be charged for failure to file a tax return by the due date. American expatriates who do not report any foreign earned income may also be denied the foreign earned income exclusion, and consequently find themselves taxed on this same income by both their countries of citizenship and residence, despite the existence of a tax treaty. Concerning compliance IRS on their website states: ‘When individuals make deliberate decisions to not comply with the law, they face the possibility of a civil audit or criminal investigation which could result in prosecution and possible jail time.’