EARNED IN RUSSIA
This article addresses the issue of taxation of income earned by American individual in the Russian Federation. Analyses provided hereunder is based on the relevant provisions of the US Internal Revenue Code1, tax laws of the Russian Federation2 and Convention between the United States of America and the Russian Federation for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion With Respect to Taxes on Income and Capital ("the Tax Convention").3
Although this article provides analyses only for taxation of income derived abroad primarily from employment or personal services, general principles of the US taxation of the foreign earned income may be equally interesting not only to American individuals working in Russia, but also those Russians who obtained a US resident status, but still continue to receive their income from the Russian sources.
Russian emerging market today is a very attractive piece of cake for international corporations and this makes them extremely active there. A great number of big American companies have their representation in Russia in different forms.
By year 1995 Russian Emigration Service issued more the 40.000 work permits for foreign individuals, 70% of whom are American citizens.
Following their clients about 60 foreign law firms have established Russian practice through permanent representations. More than 40 of these firms are American. They are growing rapidly and desperately need a labor force.
Due to the political instability, scaring criminal situation and simply "away from home" factors multinational corporations try to attract employees by salaries two to five times as much as those of US employees and by special compensation plans.
Russian authorities in its turn having an understanding that without foreign investments it would be rather difficult to restore a national economy has taken a very tolerant position towards competitive foreign employees. It is rather easy and cheap for the foreign individual to obtain a permit for work in Russia. In accordance with the State Tax Service report from those 40.000 foreign individuals registered by the Emigration Service as foreign labor force, only 3.000 filed tax declarations with the State Tax Service in 1996. Reaction of the tax authorities to this fact was inadequate, only two American citizen in St.Peterburg were asked to leave the country, because of the obvious tax evasion. I would say that there was no reaction at all.
In my estimate, however, this situation of a total "forgiveness" will not last long and one going to work in Russia must estimate his future earnings and tax liabilities based on the law requirements, both US and Russia, rather than on possibility to cheat on taxes.
This paper is aimed at providing a kind of summary guidelines, basic requirements of Russian and US tax regulations for the American individual working in Russia.
In contrast to the Russian tax system US taxes worldwide earned income of its citizens, at the same time providing two mechanisms which allow American citizens to mitigate to some extent double taxation of their income earned abroad and which are supposed to encourage them to work outside US.
Tax Treatment of the Foreign Earned Income in US.
"Export of labor force" has been always one of the ways for the Governments to increase employment opportunities inside country, reduce unemployment and provide stable incoming cash flow. "Affordable" taxes on foreign earned income of US workers reduce the project costs for an employer, thus making his services more competitive on international market, in such industries as construction, oil and gas.
First affords to set forth some incentives for American citizens to work abroad were undertaken by Congress in 1926, when it fully excluded foreign-earned income from taxation in US for citizens and US residents ("American individuals") who lived abroad for at least six month of the taxable year. This incentive worked, however, only when foreign country where American citizen lived, taxed his income at the rates lower than those in US. If the foreign country had higher tax rates American citizen paid more than he would pay in taxes in US.
While this exemption failed to fully reach its target, it became subject to intensive abuse of taxpayers. One could spend half an year in a country with lower tax brackets and tax his income by a lower rates. In respond to this in 1942 the living-abroad period was increased from six months to one year. This requirement was very difficult to comply with. That absolutely discourage short-term workers and deprived a possibility to spend vacations at home of those who actually worked abroad the whole year.
In 1951 Congress introduced amendment which excluded foreign earned income from taxation in the event American citizen was physically present abroad at least 510 full days within eighteen consecutive months. This time income exclusion benefits were used by highly-paid individuals, movie stars for example, who preferred to render their services abroad in order to shelter earnings. Congress reacted with $20,000 limitation for those who qualified physical presence test and full exemption for those who could prove their foreign residence. This rule then was subject to several amendments, however the essence remained the same.
In 1976 with the Foreign Earned Income Act Congress introduced an extremely complicated system of deductions of actual additional expenses incurred by an American individual abroad. This "excess cost living deduction consisted of separate elements for the general cost of living, housing, education and home leave costs".4
In 1981 Congress made an attempt to simplify the Foreign Earned Income Act. By its Economic Recovery Tax Act Congress shorten abroad-presence time and allowed American individual substantial deductions from their foreign earned income for US tax purposes.
Last result of Congress activity in this field appeared in 1986. Congress limited foreign-earned income exclusion by $70,000 and reduced the list of countries to which this exclusion could not be applied.
Now Congress considers a possibility to increase retroactively the exclusion limit from 70,000 to $98,000.
We may speak about two major benefits provided by Congress for Americans working abroad. The first one is set forth in the Section 901 of the Internal revenue Code. It allows to credit income tax imposed on individual by a country where he derived his income, against income tax imposed under US Internal Revenue Code ("IRC.") The second benefit, introduced by the Section 911 provides for an exclusion from US taxation (i) of the foreign earned income, and (ii) housing cost amounts.
In addition to the benefits and requirements set forth by IRC there is another major document which must be taken into account while making tax estimates. This is the Tax Convention between the United States and Russia. The Tax Convention, does not have substantial impact, or I would say that there is no impact at all on US side of the American employee tax planning, as US internal requirements are more restrictive than those in Convention.5
Russian taxation of foreign individuals and in our analyses American individuals are now fully in compliance with the Tax Convention. Sometimes Russian tax authorities try to take a more restrictive position than that set forth in the Tax Convention, but every time, under the pressure of both US and Russian Governments, tax authorities have to obey the Tax Convention provisions.6
US-Russia Tax Convention was one of the first documents of this kind of the new Russian, not Soviet Union any more, Government. This Convention was copied from the old US-Soviet Union Convention. At that point of its history Russian Government did not fully understand the demands and needs of emerging "market" economy in their international aspect and did not have any experience in this field (application of US-Soviet Union Tax Convention did not resulted in any experience, because that Convention was dead from the moment of its birth, due to the absence of serious tax relations between US and Soviet Union), moreover young Russian Government at the time of the Convention adoption badly needed international support and in exchange for friendship it without any bargaining approved the documents.
Now situation has changed dramatically. Russian Government experiences a pressure of new economic forces, like local corporations and banks. US-Russian relationship is not so friendly now as it was in 1992, due to the certain international political disagreements. But the Tax Convention along with Protocol7 is still alive and that causes the quiet anger of the State Tax Service. This aspect must be also taken into account as becoming an ordinary Russian taxpayer an American individual has to deal with the tax inspector, who usually knows nothing about tax treaties and appealing to the upper level tax authorities that individual should be ready to receive a negative reaction of the Tax Inspectorate.
The Tax Convention defines general terms like: "competent authority", "resident of a contracting state", "permanent establishment" and sets forth some requirements depending on which income will be tax in one or another contracting state.
Russian Tax Regulations
The third major source of regulations which must be considered while making tax planning is the Russian Law "On Personal Income Tax". The Law, however, provides for only general outline of the Governmental policy towards taxation of individuals, including foreigners. More detailed requirements and procedures are set forth in the Instruction of the State Tax Service No.35 "On Application the Law of the RF "On Personal Income Tax" ("the Instruction"). The Section 5 of the Instructions regulates taxation of the foreign individuals who have permanent presence in Russia and the Section 4 provides for requirements to foreign individuals who temporarily live in Russia.
1. Tax Regime under the Tax Convention
Article 14(1) of the Tax Convention establishes the rule under which salaries, wages, and other similar remuneration derived by a resident of US in respect of an employment shall be taxable in Russia, if the employment exercised in Russia. Further, paragraph 2 of Article 14 provides that the remuneration of the US individual may be exempt from taxation Russia if all of the following conditions are met: (i) US individual is present in Russia for a period not exceeding in the aggregate 183 days in the calendar year concerned, (ii) the remuneration is paid by, or on behalf of, an employer who is not a Russian resident, (iii) the remuneration is not borne by a permanent establishment or fixed base which the foreign employer has in Russia.
The Convention also exempts from the Russian taxation income derived by (i) the members of ship or aircraft crew, (ii) employees of business representation which is not a permanent establishment in terms of this Convention, who are present in Russia for a period not exceeding 12 consecutive months, (iii) technical specialists for the services connected with the application of a right of property giving rise to royalty.
Careful study of all these conditions shows that there is a chance for certain categories of the foreign employees to avoid Russian taxation.
1.1. Permanent Establishment
A lot of foreign companies at initial stage8 of entering into the Russian market prefer to carry out their activities "of auxiliary character" through a representative office, while conducting major commercial activities taxable in Russia through Russian legal entities (subsidiaries.) This structure allows the foreign company to avoid an exposure to the Russian taxation. Although the Russian tax law9 provides for a sweeping definition of "permanent establishment", the application of this definition, however, may be limited by the Convention which contains a list of activities that are excluded from the definition of permanent establishment, thus providing a "safe harbor" for those US companies which undertake only such specified types of activities. "Auxiliary clause" in this list allows the companies to fight successfully Russian Tax Inspectorate attempts to place them within the permanent establishment definition. If a representative office by which an American individual is employed works within the limits of the "safe harbor", and the remuneration of this individual is not considered as born by permanent establishment. Thus, one of the requirements of the Article 14(2)(c) of the Convention is satisfied.
1.2. Non-Resident Employer Requirement
Another provision of the Article 14(2)(b) requires that remuneration be paid by, or on behalf of, an employer who is not a Russian resident. It is not difficult to satisfy this requirement. In the case of representative office, which is not considered a legal entity under the Russian law, employer would always be a non-resident.
1.3. 183 Days Requirement
This requirement is really difficult to bypass. The only industry which may turn this requirement to its advantage is a construction and may be oil and gas industry, where people are scheduled to work in shifts. If within calendar year the number of a presence-in-Russia days of the worker in question does not exceed 183 days, the income of that foreign individual is not subject to the Russian tax provided that other above-mentioned requirements have been met. Please note, that calendar year term allows to structure shifts in such a way that employee may spent 182 days in the second half of an year one and 182 days in the first half of an year two and still satisfy the requirement of presence not exceeding 183 day.
Summarizing analyses of the Tax Convention, we may say that only a certain, narrow group of American employees may be protected under this document from the Russian tax liability. These individuals must be employees (scheduled to work in shifts for nor more that 183 days in a calendar year) of a foreign (non-Russian) company which is involved in Russia in a building site or construction, installation or assembly project, or an installation or drilling rig or ship used for exploration or exploitation of natural resources for period not exceeding 18 months (these activities do not create a permanent establishment for the foreign company under the Article 5(4) of the Tax Convention, which means that the remuneration of the employees "is not born by the permanent establishment" and the company does not incur a status of Russian resident.)
2. Russian Income Tax
2.1. General Approach
Presume that American individual can not use the benefits of the Tax Convention and has to pay income tax in the Russian Federation. Current income tax law requires that foreign citizen who is present in Russia for a period exceeding 183 days must declare his income and pay income tax determined in accordance with the following table:
If taxable income10 is:
Not over $2,00012%
over $2,000 but not over $4,000$240 plus 20% of the excess over $2,000
over $4,000 but not over $6,000$640 plus 25% of the excess over $4,000
over $6,000 but not over $8,000$1,140 plus 30% of the excess over $6,000
over $8,000 $1,740 plus 35% of the excess over $8,000
Tax must be paid within a taxable year in four installments in accordance with future income estimate made by the foreign citizen at the beginning of a tax year. Amount of the final installment must be adjusted in accordance with income actually received by a taxpayer.11
Thus, we may see that Russian tax rates are a little bit lower than those in US, however, income thresholds for application of higher rates are high enough to totally eliminate lower rate advantage for certain category of taxpayers.
2.2. Russian Income Tax Benefits
American individual present in Russia for more than 183 days may exclude from his taxable income (i) amounts assigned by the employer to the US Social Security Fund , (ii) amounts of the compensation for renting a living accommodations and maintaining a motor vehicle for business purposes, (iii) amounts of travel expenses incurred in connection with individuals work.
2.3. Taxation of American Individual Who Is Present in Russia for Less than 183 Days
Foreign individuals who are not permanently resident in Russia (their presence does not exceeds 183 days) are not obligated to declare their income in Russia, however, their income received in Russia in form of wage or salary, or as a compensation for other personal services will be subject to withholding tax, at applicable tax rate (see table above). The payer of this income, in our case it is most likely an employer, must withhold the amount of income tax and transfer it to the Tax Inspectorate.12
This order is applied unless the relevant tax agreement between the individuals resident country and Russia stipulates otherwise. Unfortunately, the Tax Convention does not stipulate otherwise with respect to the income from this type of employment.
It would be troublesome for an American individual to claim a US credit for the amounts of Russian income tax withheld by his employer in Russia, as an employer being a tax collecting agent for the Russian Tax Inspectorate in this case, is not authorized to issue to the American individual a confirmation of the taxes collected, or it would be true to say that such a confirmation, even issued by an employer, would not serve a sufficient evidence to the US Internal Revenue Service. Practically, it is possible to obtain such a confirmation from the Russian Tax Inspectorate, however, this procedure is not clearly established in the tax regulations.
3. Taxation of the Foreign Earned Income in US
3.1. Exclusion of the Foreign Earned Income
3.1.1. Foreign Earned Income
Section 911 of the Internal Revenue Code grants a qualifying taxpayer the right to exclude from his US gross income (i) up to $70,000 of the foreign earned income, and (ii) housing cost amount.
Foreign earned income of an individual in terms of this exclusion means the amount received by the individual from the sources within a foreign country or countries which constitutes earned income attributable to services performed by such individual during his presence abroad. This income may include wages, salaries, professional fees and other amounts received for personal services actually rendered.
In order to qualify for the benefits of the Section 911 American individual must have a "tax home" in a foreign country and:
1) be present in this country or countries for no less than 330 full days within 12 consecutive months, or
2) must "establish a satisfaction of Secretary that he has been a bona fide resident of a foreign country or countries, for an uninterrupted period which includes an entire taxable year."13
3.1.2. Tax Home
Under the both tests American individual must establish a "tax home" in a foreign country. Section 911 defines the term "tax home" as an "individual's home for purposes of Section 162(a)(2)(relating to traveling expenses while away from home.)
Although, Federal Tax Regulations define a tax home as a "regular or principal ... place of business", of an American individual, for the purpose of application of the exemption under the Section 911 these regulations set forth an additional limitation which states that "an individual shall not, however, be considered to have a tax home in a foreign country for any period for which the individual's abode is in the United States."14
Tax home requirement precludes American individual from using the exemption in the event he lives abroad within the required period (330 days within 12 months), but avoids to pay the foreign income tax staying in different foreign countries for the period not exceeding 183 days (for example live in Russia for not more than 182 days, than in Ukraine for another 182 day). This requirement is also crucial for those American individuals who seek to deduct business travel expenses "while away from home." If an individual establishes "tax home" abroad it enables him to apply the Section 911 exemption, however, deprives him the right to claim certain traveling deductions, which would be allowable if the individual's "tax home" were in US.
The case law history defines "abode" as individual's home, habitation or place of dwelling. Applying "abode" requirement of the section 911 the courts pay a particular attention to the taxpayer's ties to the Unites States. If courts considers that taxpayer's ties to the United States are stronger than those to the foreign country it usually decides that the taxpayer's "abode" is in US and he may not apply an exemption. The recent court rulings in Jones case15, however, have introduced a new approach to the "abode" concept. Jones was an American pilot transferred to work from Alaska to Japan due to the service necessity. His wife stayed to live in US at the place of his prior service. In Japan Mr. Jones lived in hotel, rather than in apartments. Commissioner found that these facts, as well as some other circumstances clearly indicated that Mr.Jones' "abode" was in US. The court, however, disagreed with the Commissioner, pointing out that due to equalization of opportunities for men in women in society, Jones' wife had right to stay in US to continue her business career. "Today, husbands and wives have the right to separate careers."16
With regard to Jones' living in a hotel, the court found that "economic realities of Japan lead him to choose to live in a hotel rather than rent an apartment or buy a home."17 In addition, the court supported its position of Jones Japanese "abode" by the facts indicating that pilot incurred additional expenses for his vocational travel to US, additional expenses for meal and housing while not in Japan, additional costs of paying Japanese income taxes.
Experts in this field of law have noted that this case introduced a lot of confusion. Indeed, it is very doubtful, that "separate careers" rights of wives and husbands have developed to that point when they can live so separately, that even court fails to find ties between husband and wife (for "abode" determination purposes), but it is considered that their relations still constitute a family. Jone's ties to his service turned out to be stronger than those to his wife.
3.1.3. The 330-Day Test
The 330 days of foreign presence requirement for the first test is very precise and simple and even gives a chance to American citizen to have 35-day vacation in US. Formality of the test, however, requires that individual keep a record of the days spent abroad and provide a sufficient evidence that these days actually were spent abroad.
3.1.4. "Bona Fide Foreign Residency Test"
If an American citizen fails to meet the requirements of the first test due to improper recordkeeping or lack of formal evidence of his 330 days presence abroad it may use more fluid "bona fide foreign residency test."
Under the "bona fide residency of a foreign country" test American citizen must prove that within a taxable year in question he established a residency in a foreign country and his income was subject to the income tax of that country. This test is a very useful for those American individuals who actually have established a "tax home" in Russia, but in course of business have to travel often to US. Apparently, it will be difficult for them to provide accurate and persuasive records, but under the "bona fide test" they are given a chance to prove on the fact and circumstances basis that they were an income tax payers of the foreign country.
Although the wording of the test itself is not very precise, the case law has developed a pattern "under which numerous factors have been considered as bearing on the determination of bona fide foreign residence."18
Among these factors are: (i) intention of the taxpayer, (ii) establishment of home in the foreign country for indefinite period, (iii) participation in social and community life at the place of the taxpayer establishment, (iv) necessity to stay abroad due to the employment requirements, (v) residence of the taxpayers family, (vi) good faith in traveling "away from foreign home", (vii) assumption of foreign economic burdens, (viii) nature of the taxpayers establishment and living conditions abroad, etc.
In the case of Jones v. Commissioner the court has reviewed the approach to the "bona-fide test" developed on previous occasions and ruled in favor of Jones, to the great dissatisfaction of IRS. The court in this case absolutely disregarded participation in social life test (the pilot failed to assimilate into the Japanese cultural life), residence of the taxpayers family test (Jone's wife stayed in US, pursuing her personal career), living conditions abroad (Jones did not rent an apartment and lived in a hotel) and, as it was noted above, the court gave a new color to the meaning of "the abode within the United States" term (see above.) The main emphasis in this case was made on the intention factor.
3.2. Housing Cost Exclusion
3.2.1. Employer Compensated Housing Expenses
It is very often in Russia that an employer provides compensation for the housing expenses incurred by its foreign employee in Russia. The amount of this compensation may be rather substantial19 due to the necessity to ensure an employee's personal security20 and to maintain an American style of living.
Section 911(c)(3)(D) reminds that in general (without regard to exemption provided under this section) compensation of housing expenses, including "any amount paid or incurred on behalf of the individual by the individuals employer, must be included in the individual's gross income for the taxable year."
Section 911 allowing exclusion of "housing cost amounts", however, sets forth upper and lower limits on housing cost exclusion.
Lower limit amount, which is not excluded from the gross income is "16 percent of the salary (computed on a daily basis) of an employee of the United States who is compensated at a rate equal to the annual rate paid for step 1 of grade GS-14, multiplied by ... the number of days"21 the qualified individual resided in a foreign country.
The upper limit is determined by application of "reasonable expenses test". "Housing expenses shall not be treated as reasonable to the extent such expenses are lavish or extravagant under the circumstances."22
Thus, within these limits are the amounts of "expenses attributable to housing (such as utilities and insurance.)" Due to the low personal security standards in Russia, it is conceivable that under the Section 911(c)(2)(B) American individual will be allowed to include in his housing expenses costs for the second household maintenance for his family (spouse and dependents) if "they do not reside with the taxpayer because of living conditions which are dangerous, unhealthful, or otherwise adverse."
3.2.2. Housing Expenses Not Provided by Employer
In the event the housing expenses are not compensated by an employer, Section 911(c)(3)(A) allows to deduct them from the gross income of the qualified individual. The amount of this deduction, however, may not exceed the balance of the foreign earned income remained after $70,000 exclusion. In the event of such an excess, section 911(c)(3)(C) permits to carryover the amounts of housing expenses not allowed for deduction in the current year to the 1-st succeeding year, provided that the income received by an employee in that year is big enough to do this.
It must be noted that under the Russian tax law, an American individual is also entitled to the housing expenses deduction in computing his taxable income, which may save him amounts equal to 35 per cent of his Russian housing expenses.
3.3. Taxation of Non-Excluded Income
New tax rates 36% and 39,6% introduced in 1992 affected more Americans working abroad. Exclusion granted by the Section 911 gives a little protection against US taxes, because American employee compensation in Russia are often higher than that of US employees due to the special allowances that normally accompany a work abroad (compensation for hardship and personal risks, compensation for maintenance an American style of living, educational benefits for dependents, vacation pay and moving allowances, etc.) In average an aggregate amount of salary and compensations of the American employees in Russia is about $100,000.
Prior to 1993 high-compensated individuals were taxed at higher rates on non-excluded income, as if the exclusion did not apply. Example: If the foreign earned income of the individual in 1992 was $100,000 with $33,940 of the Russian income tax and a taxpayer for the US income tax purpose excluded $70,000 under the Section 911, the US income tax assessed on $30,000 of excess would be $9,300 (difference between $26,522 - tax amount assessed on $100,000 and $17,222 - tax assessed on $70,000).23
However, with the addition of the 36 and 39,6 percent brackets any amount of exclusion under the Section 911 comes "off the top", which may allow a taxpayer's income to fall within a lower tax brackets. Example: the same as above, however, American individual calculated his tax in 1993. Income tax on exceeding $30,000 would be $5,527 vs. $9,300 assessed on a prior year. This allowance gives a significant tax saving effect, which should be seriously considered while making a tax planning.
4. Tax Credit
4.1. General Approach
Declaring his world wide income for taxation in US American citizen has a right to credit the "amount of income ... taxes paid or accrued during the taxable year to any foreign country".24 Apparently that this rule covers both cases (i) when American individual was present in Russia for more than 183 days (resident in Russia for the tax purposes) and (ii) when this individual has not established tax residence abroad (was present in Russia less 183 days.) Income taxes paid by this individual in Russia may be claimed for credit against US income tax in either case.
The foreign income taxes paid by an American individual may be credited against US income tax, in the same proportion which foreign income of the American individual bears to his entire taxable income.25 Thus, in the event American citizen has other sources of income, besides the foreign earned one, credit is subject to this limitation. This provision precludes American taxpayer from offsetting the amounts of foreign-paid taxes against US tax on income derived from other sources, in the event tax brackets in the foreign country are higher than those in US.
4.2. Disallowance of the Foreign Tax Credit
A portion of the foreign income tax related to the income excluded under the Section 911, may not be credited against US income tax.26
Thus, if an American citizen has chosen to use benefits provided by the Section 911 (exclusion of the foreign-earned income up to $70,000 and housing expenses,) he may credit a foreign paid income tax only in the part properly allocated to the foreign earned income in excess of the amount deducted under the section 911. Federal Tax Regulations do not provide a clear method for determination of that portion of the tax amount which is disallowed for credit, although proper allocation, however, is not that simple. We may distinguish the following methods of allocation:
Mr.R.Feischreiber in his book "International Tax Planning" proposes a formula, applying which a taxpayer may apportion foreign taxes "between excluded and non-excluded foreign source income in proportion to the US graduate tax rate schedule. This is the proposed formula:
D = F x ------
Where:D is the amount of foreign taxes disallowed;
F is the amount of foreign taxes paid;
T is the US tax on the excluded income;
L is the foreign tax credit limitation."27
For example, if the foreign earned income is $100,000 with $33,940 of the foreign income tax and a taxpayer for the US income tax purpose excludes $70,000 under the Section 911, he then, may credit that part of the foreign paid tax which relates to the excess of the foreign income over excluded $70,000. In our case that part of the foreign paid tax allowed for credit is $22,515.
As an authority to the formula proposition Mr.R.Feischreiber refers to a technical corrections bill to The Tax Reform Act of 1976.28
This approach might be correct at the time when this formula was proposed, as the amount of income in excess of the exclusion was taxed at higher rates, as if the exclusion were not applied. However, as we have said above, after 1992 the excluded amount under the Section 911 comes "off the top" of the foreign earned income, thus, allowing to tax a remainder of the foreign income at the lower tax brackets. That may mean that there is no need any more to allocate foreign paid tax in proportion "to the U.S. graduated tax rate schedule", at least Section 911(d)(6) does not require to do so.
Simple allocation of the foreign tax amounts ($33,940) between excluded ($70,000) and not excluded income ($30,000), without regard to the US graduated tax schedule, gives, in example above, a disallowed amount of $23,758 (vs. $11,425 under the formula), and only remained $10,182 of the foreign paid tax may be claimed for credit, against US income tax of $5,527.
In the event American individual along with $70,000 excludes his housing cost amounts, he may claim a credit only for the taxes properly allocated to the excess of sum of $70,000 and housing cost amounts. Example: if in our example above the housing cost amount is $10,000 and American individual elects to exclude both $70,000 and $10,000 from his gross income. In order to avoid application of double benfits under 911(d)(6) the amount of tax must be apportioned between the amount of exclusion - $80,000 and remained balance of the foreign income - $20,000. In this case a portion of tax allowed for credit is $6,788.
This is, however, only a general approach. In the event American individual enjoys the housing expenses exclusion granted under the Russian tax law29, thus reducing Russian income tax, he may not use the same benefit for the second time and exclude his housing cost amount from his gross income in US.30 In this situation American individual, apparently, has a choice which exclusion apply, Russian or US one.
4.3. Carryover, Carryback of Foreign Paid Income Taxes
In the event the amount of the income taxes paid by an American individual to the foreign state exceeds the amount of tax allowed for credit in US for the income tax purposes, such an excess may be carried two years back and five years forward. Carried back and forward amounts of foreign paid taxes are allowed only for credit against US income tax and may not be merely deducted from gross income.
American individual going to work to Russia should take into account carryover benefit while making a tax planning. As a general rule, Americans prefer to work in Russia not more than two years and in the event certain amounts of the Russian paid taxes are not allowed for credit in US in the current year, the individual may effectively use carry forward device for reduction of his taxes in future, upon his return to US.
4.4. Credit vs. Exclusion
The exclusion granted by the Section 911 may be particularly beneficial for an American individual if a foreign country where he works has lower tax rates than in US. That is not the case with Russia. Although, the maximum tax rate is 35% vs. 39,6% in US, the thresholds for the progressive rates application are much lower than those in US, and this totally eliminates the benefit of 4,6% rate difference for certain category of taxpayers. Example31: If a foreign taxable income of a US citizen is $100,000 he will pay $33,940 with Russian taxes. While in US the taxes assessed on this income will be $26,522. Simple computation indicates that Russian lower tax rate will benefit only if the amount of income of American individual earned in Russia exceeds $500,000. Thus, if an American citizen earns less than $500,000 he may find it more tax effective to take an advantage of tax credit under the Section 901, which allows him to discharge US tax liability and carry the balance of the foreign taxes in excess of the credit limitation two years back and five years forward. In our example it will be amount $7,418.
American individual may also make a computation applying both income and housing cost amount exclusion and crediting foreign paid taxes in part allocated to the income in excess of exclusion. Example: In 1997 American individual has a Russian income $100,000, employer provided housing cost compensation of $10,000 and has no other income to include in his US gross income. He elects to exclude his foreign earned income up to $70,000 and not to exclude housing cost compensation for calculation of the Russian income tax. Thus, his gross Russian income is $110,000 and Russian tax assessed on this amount is $37,440. After exclusion of $80,000 from his Russian-earned income, US income tax assessed on the balance is $5,527. Having apportioned amount of the Russian tax to non-excluded income, we come with the $27,229 of the amount of the foreign tax disallowed for credit. The rest of it - $10,211 may be credited against $5,527 in the current tax year, and the remainder $4,684 may be carried two years back and five years forward.
If a taxpayer elects merely to credit his foreign paid taxes against US income tax, in our example it will be $37,440 of a Russian tax against $29,622 of the US income tax, the difference of $7,818 may be carried back and forward. The latter method seems to be more beneficial for the American taxpayer than complicated combination of exclusions and credit.
It is very difficult within framework of simple analyses of this paper to provide a tax estimation for all possible tax situations which may happen in real life, as they depend on amount of income earned in Russia, housing cost amounts provided by employer, method of mitigation of US tax burden (simple credit, exclusions or combination of credit and exclusions). Moreover, there is no rational to make all possible and precise estimations, as Russia remains a country with an unstable legal system where income tax brackets have been substantially changed two times within last three years and now Russian legislative body considering to change them once again.
General observations, however, may be made:
1) Exclusions provided by the section 911 are absolutely useless in the Russian case for the low and mid compensated American employees, because even in combination with credit of taxes on income in excess of exclusions, these exclusions can not provide additional benefit for the taxpayers, due to the low thresholds of tax brackets in Russia.
3) In contrary to the said above, exclusions provided by the Section 911 may be used as an additional benefit for highly compensated American employees working in Russia. It was indicated above that lower Russian tax rate results in lower taxes only when the amount of income exceeds $500,000 (at this level 4.6% difference between US and Russian top tax rates overrides low Russian thresholds.) Those who earn even more may exclude from their foreign earned income allowed $70,000 and housing cost amounts, thus realizing Russian lower tax rate effect and reducing US tax burden. For example: American individual has $1,000,000 of Russian earned income and taxes paid on this amount - $348,940. US income tax on $1,000,000 is $369,772. Applying the section 911 exclusion of $70,000 the taxpayer may reduce the taxable income to $930,000 and income tax on this amount to $349,052. After extracting from the Russian paid tax an amount allocated to the exclusion the taxpayer has $343,887 of Russian taxes against which he is allowed to credit US income tax of $349,052. The difference of $5,165 is still due to be paid as US income tax, however, the exclusion saved to the taxpayer $20,720.
The slight trend in economic stabilization in Russia, growth of income of population and increase in living costs may result in the higher thresholds for the income tax rates, which in its turn will make Russian tax regime more beneficial for American individuals working in Russia.
1 I.R.C. (CCH 1996).
2 The Law of the Russian Federation “On Personal Income Tax” of December 7, 1991,
Instruction No.35 of the State Tax Service of June 29, 1995 “On Application of the Law of the RF “On Personal Income Tax.”
3 “Convention Between the United States of America and the Russian Federation For the Avoidance of Double Taxation and the Prevention of Fiscal Evasion With Respect to Taxes on Income and Capital,” 1992 WL 608527 (Tax Treaty).
4 Mertens, supra note 13, at 45B.02, at 33.
5 The scope of analyses provided in this article is limited to tax implications on income from employment, and does not concern income from capital and other types of income.
6 Russian State Tax Service is considered to be a subdivision of the Federal Government which is fully responsible for the tax collection. Russian Ministry of Finance is a Governmental division which, in general, has more power than the State Tax Service and under the provisions of the Tax Convention it the only Russian body which is authorized to construe the Convention. Pursuing the general course of the Government for attraction of foreign investments and being free of tax collection burden it sometimes construe the Tax Conventions provisions more broadly, than they read and imply, thus triggering negative reaction of the tax authorities.
7 A Protocol accompanies the Convention and forms an integral part of it. The Protocol construes certain provisions of the Convention and internal Russian tax regulations to the benefit of American corporations.
8 At this stage foreign companies usually establish business relations with Russian manufactures, service providers, carry out export-import operations.
9 The Law of the RF “On Profits Tax of Enterprises” and Instruction No.34 of the State Tax Service.
10 All amounts are given in US dollars converted from ruble (official monetary unit of the RF) amount at the rate 6 rubles per one dollar, in accordance with dollar value estimate for year 1998. Please note, that the rate is already adjusted in accordance with provisions of the Russian Monetary Reform Act, which will be in effect from the January 1, 1998.
11 This procedure, except payment by installments, is similar to the US one. It is unusual, however, for Russia, as in ordinary course, income tax is subject to withholding made by the payer of income.
12 Actually, the amount of income tax from individuals is paid to the accounts of the regional (90% of the amount) and federal governments (10%). The Tax Inspectorate only supervise correctness of these payments.
13 I.R.C. # 911(d)(1)(A), (CCH 1996).
14 Federal Income Tax Regulations # 1.911-2(b)(1985).
15 Jones v. Commissioner, 927 F.2d 849 (1991).
16 Id. at 855.
17 Id. At 927.
18 Sochurek v. Commissioner 300 F.2d 34 (1962).
19 Practice and statistics indicate that the amount of compensation may vary from $10.000 to 100,000 per year for an employee.
20 It is alleged that political instability, difficult criminal situation make the foreign employees to live on guarded campuses specifically designed for these purposes. Living standards on these campuses are just the same as in US (schools, communications, houses design.)
21 I.R.C. #911(c)(1) (CCH 1996.)
22 Managing partners and top managers of big American firms and corporations prefer to have their houses permanently guarded by the armed people. These expenses “under the circumstances” are not supposed to be “extravagant.”
23 All examples provided in this article are based on tax assessments for unmarried individual.
24 I.R.C.# 901(b) (CCH 1996.)
25 I.R.C. # 904(a) (CCH 1996.).
26 Section 911(d)(6) of the I.R.C. restricts American taxpayer from claiming a tax credit for the foreign income tax paid on the amounts excludable under the Section 911.
27 R. Feischreiber “International Tax Planning”, at 14 (Panal Publishers, 1977.)
28 The Tax Reform Act of 1976 (H.R. 6715, Sec. 2(q)8.)
29 Instruction No.35 of the State Tax Service of June 29, 1995 “On Application of the Law of the RF “On Personal Income Tax,” section 5.
30 Section 911(d)(6) clearly prohibits exclusion or deduction from gross income or credit against the tax imposed, including any credit or deduction for the amount of taxes paid to the foreign state.
31 Examples provided in this article for simplicity do not count standard deductions and personal exemptions, allowed by the US and Russian tax laws.