The term “citizenship tax” is abstract and meaningless without context. What does it really mean? In this short post I attempt to describe the defining aspect of US tax residency in simple terms.
The ONLY contextual meaning of taxing based on citizenship is that it allows the US to impose tax on income earned outside the United States by people who live outside the United States.
Here is why …
What exactly is “citizenship taxation”? How/why does citizenship matter? It’s not what the “treaty partner” countries think!
1. Like all countries the United States imposes worldwide taxation on its residents. Individuals living in the United States will meet the “substantial presence” requirements and are therefore taxable on their worldwide income. Citizenship is irrelevant.
2. Like all countries the United States imposes taxation on income sourced in the United States. Generally the United States will have the first right of taxation and has the ability to withhold tax. Citizenship is irrelevant.
3. Like no other country (OK, sort of Eritrea) the United States imposes taxation on the non-US source income of people who do not live in the United States and do live in other countries. The US usually claims this right because those people were “Born In The USA” (making them US citizens). Therefore, the US imposes worldwide taxation on people who live in other countries. Citizenship is relevant because it is why the US claims the right to tax people who don’t live in the US and are residents of other countries.
4. Therefore, the practical meaning of “citizenship taxation” is the United States imposing taxation on the non-US source income earned by people who live in other countries. To be clear: citizenship taxation means that the United States is claiming the residents of OTHER countries as US residents for tax purposes!
5. This means that: Every country in the world who signs a tax treaty with the United States that includes a “saving clause” is agreeing that the United States has the right to tax income earned in the treaty partner country by residents of the treaty partner country. It is obvious that countries signing these treaties have no idea what they are signing. The problem has been further illuminated by the recent US Croatia tax treaty that allows the United States to imposes taxation on Croation residents who ARE and WERE US citizens.
So, US citizenship taxation means that the US can tax the non-US source income of residents of other countries!