A recent decision of the US Tax Court illustrates the surprising tax results that can ensnare US expatriates as a result of the United States’ worldwide tax regime.
Unlike most countries, the United States imposes tax on the income of US citizens no matter where their income is earned. However, it provides a handful of relief measures that US expatriates rely on to reduce their US tax burden: They can take a credit or deduction for taxes paid on foreign income and, if they qualify as overseas residents, can elect to exclude their foreign earned income and housing costs from gross income under Sec. 911 of the Internal Revenue Code.
The definition of “foreign earned income” was at issue in recent litigation in the US Tax Court, and the result was not favourable for a US citizen who lives in Hong Kong and works as a flight attendant on international flights.
The Tax Court held that the flight attendant could not claim 100% of her wages were excludable under the foreign earned income exclusion (Rogers, T.C. Memo. 2013-77). The court also upheld an accuracy-related penalty under Sec. 6662, pointing to the taxpayer’s earlier Tax Court case in which she had made the same claim of 100% exclusion under the same facts (Rogers, T.C. Memo. 2009-111).
The taxpayer, who worked for United Airlines on flights between Hong Kong and Vietnam, Hong Kong and Chicago, Hong Kong and San Francisco, and San Francisco and Japan, received pay statements from the airline apportioning her flight time within or over the United States, over international waters, and in or over foreign countries. Flight time was counted from the time an aeroplane’s handbrake was released at the airport until it was set again at the destination. The taxpayer was not separately compensated for time spent working before and after the flight. The taxpayer excluded 100% of her income on her 2007 tax return, classifying it all as foreign earned income. (Her income was below the 2007 exclusion amount of $85,700, and she was a “qualified individual” under Sec. 911.)
Sec. 911(b)(1)(A) defines “foreign earned income” to generally mean amounts earned “from sources within a foreign country.” Treasury Regulations Sec. 1.911-2(h) defines “foreign country” as “any territory under the sovereignty of a government other than that of the United States.” The Tax Court held, therefore, that only her wages earned while in or flying over foreign countries qualify as foreign earned income, and wages earned while in international airspace or over the United States do not qualify.
The taxpayer also tried to claim that 100% of her vacation and sick pay should be excluded under Sec. 911. The court, however, concluded that it must look to where the services were performed, not where the compensation was paid or where the taxpayer was when it was paid, to determine whether compensation is treated as income from sources within a foreign country. The labour agreement between United and the union based the accrual of sick and vacation time on hours worked. Therefore, the court held it was appropriate to apportion this income based on where the taxpayer was when she earned it, not where she was when she went on holiday or took sick leave.
—Sally P. Schreiber (firstname.lastname@example.org) is a CGMA Magazine senior editor.