Introduction
The United States has a peculiar tax system requiring U.S. persons to declare their worldwide income to U.S. income tax regardless of where they live or where they earn their income. Tax returns are required to be filed with the Internal Revenue Service (IRS) under the United States Department of Treasury.
More often than not, taxpayers take a plea of ignorance of law and therefore do not report global income/file taxes in the U.S. However, the IRS does not consider ignorance of law as an excuse to not report worldwide income. Therefore, non-compliance could be considered a serious breach of conduct and attract high penalties.
Determining U.S. Person Status for Tax Purposes
The distinction between a "U.S. person" and a "U.S. citizen" is crucial in understanding the United States' unique approach to taxation, which is based on worldwide income, also known as Citizen-Based Taxation (CBT).
Who is Considered a U.S. Person?
For tax purposes, the category of U.S. persons includes:
1. U.S citizens.
2. Legal permanent residents (Green Card Holders).
3. Foreign nationals meeting the substantial presence test.
4. Former legal permanent residents who did not properly expatriate.
What Income is taxable?
Income subject to taxation includes interest and dividend income, agriculture income , salary and wages, capital gains, rental income, business income, royalties and fees, pension and retirement distributions, earnings from Public Provident Fund (PPF), mutual fund investments, and life insurance policies. Even if certain income is tax-exempt in India, it may still be subject to taxation in the US.
Double-taxed income and foreign tax credit
U.S. persons may pay tax on income in India and in the U.S., thus resulting in double-taxation of the income. Therefore, the Government allows certain individuals to claim foreign tax credit on taxes paid in India. Foreign tax credit (‘FTC’) is a tax benefit available to offset income tax paid in foreign countries. FTC can be used to reduce federal tax liability and in certain cases excess credit can be carried forward. It is pertinent to note that the amount of FTC is not a dollar-to-dollar credit, there is a complex calculation by way of which permissible credit is derived and unused credit is carried forward for 10 years.
IRS Form 1116 is used to calculate and claim credit for individuals, estates or trusts and Form 1118 for corporations.
Compliances for foreign income/asset reporting
In addition to reporting all income on the tax returns (1040/1041/1120), the taxpayer is also required to file certain necessary forms with the IRS. Some of these forms may include:
- Form 8621 on Information Return by a shareholder of a Passive Foreign Investment Company (‘PFIC’) or a Qualified Electing Fund (‘QEF’),
- Form 114 – Report of Foreign Bank and Financial Accounts (‘FBAR’) is required to be e-filed with the Financial Crimes Enforcement Network (FinCEN), which is a bureau of the Treasury Department, if a US person has a financial interest in or signature authority over foreign financial accounts. FBAR must be filed if the aggregate value of the foreign financial accounts exceeds $10,000 at any time during the calendar year,
- Form 8938 for Statement of Specified Foreign Financial Assets to report specified foreign financial assets exceeding certain threshold.
Penalty for Non-Compliance
Failure to report foreign income from India on a U.S. tax return can result in various penalties, including failure to file and pay penalties, which can reach up to 25% of unpaid taxes, and interest on the overdue amount.
More severe penalties include a 20% accuracy-related penalty for negligence, a 75% fraud penalty for deliberate underreporting, and substantial penalties for not filing FBAR and FATCA reports, which can be $10,000 for non-willful violations and up to 50% of the account balances for willful violations.
In extreme cases, non-compliance can lead to criminal prosecution.
