INCOME TAX COMPLIANCE BY U.S. CITIZENS AND U.S. LAWFUL PERMANENT RESIDENTS RESIDING OUTSIDE THE UNITED STATES AND RELATED ISSUES TABLE OF CONTENTS Executive Summary ......................................................... iv I. Summary of Current Law ................................................1 A. General Provisions ...............................................1 B. Foreign Earned Income Exclusion and Foreign Tax Credit (Code Sections 911 and 901) .......................................................2 C. Expatriation to Avoid Tax (Code Section 877) ..........................4 II. Compliance Measurement and Improvement .................................7 A. Demographic Study of Overseas Compliance ...........................7 B. Efforts to Improve Compliance .....................................8 C. Factors Limiting Efforts to Measure and Improve Compliance .............13 III. Sharing of Information Between Agencies ..................................15 A. Information from Department of State Regarding U.S. Citizens and Former U.S. Citizens Living Abroad .......................................15 1. Individuals Who Retain Citizenship ............................15 a. Passport Data (Code Section 6039E) .....................15 b. Department of State Restrictions on Additional Information ...19 2. Individuals Who Lose Citizenship (Code Section 6039G) ...........21 B. Information from INS Regarding Lawful Permanent Residents Living Abroad .23 1. Individuals Who Retain Green Card ...........................23 a. Green Card Data (Code Section 6039E) ..................23 b. INS Databases ......................................25 2. Green Card Holders Whose Status is Revoked/Determined to Be Abandoned .......................................................26 IV. Definition of Individuals Subject to U.S. Taxation ............................27 A. Definition of U.S. Citizen for Tax Purposes ...........................29 1. Modification of Nationality Law Definition ......................35 2. Modification of Tax Law Definition ...........................36 a. Elimination of Retroactive Effect of Citizenship Loss .........36 b. Relief for “Unknowing” or “Restored” Citizens .............38 B. Definition of Lawful Permanent Resident Subject to Tax .................42 V. Conclusion and Recommendation .........................................44 iii EXECUTIVE SUMMARY This report responds to section 513 of the Health Insurance Portability and Accountability Act, Pub. L. 104-191, which directs the Secretary of the Treasury to prepare a report that describes income tax compliance by U.S. citizens and lawful permanent residents residing outside the United States and that recommends measures to improve such compliance, including improved coordination between executive branch agencies. As suggested in the House Ways and Means Committee report accompanying the legislation, the report also reviews the process through which the Department of State determines when U.S. citizenship has been lost, and discusses possible changes to that process in light of its significance for tax purposes. See H.R. Rep. No. 104-736, at 329-330. Part I of the report summarizes the current law regarding the taxation of U.S. citizens and lawful permanent residents living abroad and the income tax filing requirements placed on such persons. Part I also describes the tax regime that applies to former U.S. citizens and long-term permanent residents whose loss of such status had for one of its principal purposes the avoidance of U.S. taxes. Part II details initiatives the Internal Revenue Service has undertaken to measure and improve compliance by U.S. taxpayers living overseas, including a discussion of Internal Revenue Service’s successful Middle East Compliance Initiative and a discussion of a demographic study the Internal Revenue Service is currently conducting that will allow it to more effectively apply its enforcement resources. Part II also discusses factors currently limiting compliance enforcement. Part III of the report discusses the extent to which the Department of State and the Immigration and Naturalization Service collect information that might aid the Internal Revenue Service in determining and improving compliance. The discussion suggests ways in which the Department of State and the Immigration and Naturalization Service could make the information currently collected more useful to the Internal Revenue Service, describes the information those agencies are not currently collecting that could aid the Internal Revenue Service in determining and improving compliance, and notes the changes to those agencies’ information disclosure policies and information disclosure constraints that might be necessary for information that the agencies now collect to be made available to the Internal Revenue Service. Part IV of the report describes the current law regarding the definition of “U.S. citizen” for income tax purposes and discusses possible changes to the definition that might allow the Internal Revenue Service to more effectively allocate its resources to identify certain non-complying U.S. taxpayers living overseas and to better prevent tax avoidance by U.S. citizens who expatriate to avoid U.S. taxes. The inclusion in the report of these possible changes (like the inclusion in Section I.C of possible changes to the expatriation taxation rules) is intended to serve as a basis for discussion, and not as a legislative recommendation. Part V concludes that directed application of the Internal Revenue Service’s proven compliance-improvement methods, such as were used in the Internal Revenue Service’s successful Middle East Compliance Initiative, discussed in Section II.B, is the most cost-effective way to improve overseas compliance and concludes that the Internal Revenue Service should continue to pursue its demographic study, discussed in Section II.A, to provide that direction. It is therefore the recommendation of this report that the Internal Revenue Service draw upon its extensive compliance- improvement experience, combined with the results of its demographic study, to appropriately allocate its resources to projects and initiatives that properly balance the goals of efficient revenue collection with the legitimate privacy and other interests of Americans living and traveling overseas. Such projects and initiatives should include: analysis of local information sources, such as local financial news media, and Department of State and Department of Labor data, to identify employers of U.S. citizens, organizations with U.S. citizenship membership, education resources for U.S. citizens or dependents and any other data that would aid in targeting education and compliance projects; identification of local tax practitioners used by U.S. citizens to provide such practitioners with the resources and education necessary to improve compliance with U.S. tax laws; identification of local media outlets accessed by U.S. citizens and development of specialized media releases to educate U.S. citizens regarding identified areas of non-compliance; development and implementation of market segment education and compliance projects; conducting outreach and informational seminars; and pursuing appropriate individual examinations and investigations. See Section II.B. The Internal Revenue Service’s demographic study, which should provide information that can help guide the application of these projects and initiatives, is scheduled for release in draft form later this summer. v I. Summary of Current Law A. General Provisions In general, U.S. citizens are required to file U.S. tax returns and to pay taxes on their worldwide taxable income, regardless of whether they reside inside or outside the United States. The United States also imposes a special tax regime on former citizens (and former long-term lawful permanent residents) whose loss of such status had for one of its principal purposes the avoidance of U.S. taxes.1 See Section I.C, infra. The determination of who is a citizen for tax purposes, and when such citizenship is lost, is governed by the Immigration and Nationality Act (“INA”). See Treas. Reg. § 1.1-1(c) (referencing INA, 8 U.S.C. § 1401 et seq.); see also Section IV.A, infra. A non-U.S. citizen generally is taxed in the same manner as a U.S. citizen, and is subject to the same filing requirements, if the individual is a “resident alien,” as that term is defined in section 7701(b) of the Internal Revenue Code of 1986 (the “Code”). The term includes a person who is a lawful permanent resident of the United States (sometimes referred to as a “green card holder”) at any time during the calendar year. Code § 7701(b)(1)(A)(i); see also Treas. Reg. § 301.7701(b)-1. A citizen or resident alien need not file a tax return unless his or her gross income equals or exceeds certain minimum amounts.2 Code § 6012(a). Even if a citizen or resident alien is required to file a return, two provisions of the Code -- the foreign earned income exclusion (and housing expense exclusion and deduction) and the foreign tax credit -- allow many U.S. citizens or resident aliens who reside abroad to reduce or eliminate their U.S. tax liability. 1In addition, the Immigration and Nationality Act (“INA”) provides that the Immigration and Naturalization Service (“INS”) may deny entry to the United States to any former U.S. citizen who officially renounces U.S. citizenship and who the Attorney General determines renounced citizenship for the purpose of avoiding U.S. taxation. INA § 212(a)(10)(E),