The array of challenges faced by US citizens residing in New Zealand be summarized in the simple term of "tax residency tied to citizenship." This principle is applied by only three countries worldwide: North Korea, Eritrea, and the United States. Despite their vast differences, they share the commonality that their citizens are deemed tax residents of their respective countries, regardless of their global whereabouts.
This impacts not only migrants who have moved to New Zealand from the USA but also "accidental Americans" – New Zealanders who acquired US citizenship at birth (some without even visiting the USA).
The United States' laws are delineated in the "US Code," with all taxation laws found in Chapter 26 of the code. The foundation of citizenship-based taxation lies in the US definition of a "US Person," which is outlined in Chapter 31, CFR § 560.314. This code section designates a US person as any citizen, permanent resident, or entity organized in the US. For reference, a permanent resident is commonly known as a Green Card holder. All US tax laws subsequently refer to the taxation of US persons, irrespective of their location – inside or outside the USA.
By constructing the US tax system around the taxation of US Persons rather than just tax residents, the US can levy taxes on its citizens globally, without considering tax residency.
But how does this affect US Persons residing in New Zealand? This necessitates a heavy reliance on the Double Taxation Agreement (referred to as "the treaty") to prevent the US from taxing Australian income as if it were earned in the US. For US persons living in New Zealand, they must file annual tax returns to the Internal Revenue Service (IRS), with substantial penalties for non-compliance.
While some form of citizenship-based taxation has existed in the US since the Civil War, it only became enforceable and realistic with the introduction of the Foreign Account Tax Compliance Act (FATCA) legislation under President Barack Obama's administration.
FATCA
After meticulous planning, the Foreign Account Tax Compliance Act (FATCA) was enacted and became US law on March 18, 2010. Through various changes to the tax code, a new chapter (chapter 26) of the Internal Revenue Code was established.
The advent of FATCA revolutionized US citizenship-based taxation. Previously unenforceable, two pivotal elements of the FATCA legislation made it nearly impossible to evade the filing obligations set by the United States.
These changes manifested in two forms: firstly, 26 U.S. Code § 6038D, which necessitated US citizens to report their non-US bank account interests, subject to specific thresholds. This alone might not have been effective in enforcing citizenship-based taxation, as it only added to the existing requirements that many were already ignoring or unaware of.
However, the significant change occurred with another code section, 26 U.S. Code § 1471. This section was the crux of the FATCA legislation. Under this provision, US payors of income were obligated to withhold a 30% tax rate on foreign financial institutions that didn't identify their US citizen customers.
Although this code section contained various clauses, its essence forced foreign banks to identify and report the existence of accounts belonging to US citizens. This was clearly delineated in section § 1471(b)(1)(E), which mandated that foreign banks "comply with requests by the Secretary for additional information with respect to any United States account maintained by such institution."
While groundwork was laid to identify the non-US bank accounts of US citizens, this still required foreign countries to waive or breach local data privacy laws in order for foreign banks to adhere to this US requirement.
At this juncture, the US established agreements with nearly all countries having sizeable US expatriate populations. These agreements allowed local data privacy laws to be bypassed for FATCA compliance purposes. Some argue that each country had little choice, as a 30% withholding tax on all USD transactions could harm their financial sectors, prompting a US strong-arm approach.
In New Zealand, FATCA laws were enacted on 1st July, 2014, under the Agreement between the Government of the United States of America and the Government of New Zealand to Improve International Tax Compliance and to Implement FATCA.
In essence, this agreement compelled Kiwi banks to register as Foreign Financial Institutions for FATCA purposes. It also mandated automated data sharing of US citizen clients' information with the IRD, which would, in turn, share it with the IRS.
This system provided the IRS with a straightforward avenue to identify US citizens' non-US accounts. This information could be used to swiftly impose penalties on non-compliant individuals, with the assistance of the Australian federal government and financial sector.
From a once unenforceable system, the regulatory infrastructure to identify, track, and penalize non-compliant US citizens overseas was now established.
The final outcome was that US persons needed to annually declare their interest in any non-US financial account to the USA, including accounts on which they are signatories or have indirect interests. Notably, this also encompasses business accounts over which a US person has authority.
Implications for US Persons Residing in New Zealand
In a way, the implications of FATCA for US persons in New Zealand can be simplified to a single point: file annual tax returns to the IRS. However, this barely scratches the surface.
As of the beginning of the 2021 tax year, the US tax code spanned 75,914 pages. The result is a highly intricate tax system, laden with thousands of regulations and requirements, some of which may even contradict each other. Complying with these regulations is a daunting task for most US persons in New Zealand. This has led to a number of US tax compliance firms now operating in New Zealand.
The US tax return entails reporting worldwide income, calculating applicable US taxes, and applying Foreign Tax Credits (FTC) for New Zealand taxes paid. Other methods to exclude foreign income essentially have the same outcome but are best explored in a separate discussion.
On the surface, the US-NZ Double Taxation Agreement (DTA) is a commendable document, shielding US persons in Australia from facing dual taxation by the IRD and the IRS. However, delving deeper reveals that the US leaves room for double taxation in the treaty. Specific taxes in the US can still apply here in New Zealand, on self-employed individuals and those making a capital gain.
At the beginning of the document in Article 1(3) is the "Savings Clause," which permits the US to tax its citizens as if the DTA didn't exist. While this article isn't frequently invoked by the IRS, its presence has to be considered by tax professionals, assuming the IRS can and will tax any income it's entitled to. Most tax professionals indeed are required to treat sections of the treaty as inapplicable, due to the savings clause. Despite this clause, the IRS acknowledges FTC claims for New Zealand taxes paid for substantially identical taxes.
Penalties for Non-Compliance
The penalties associated with US persons failing to fulfill their US tax obligations are punitive, intended to deter non-filers rather than recover lost tax revenue.
For individual tax returns, penalties are discretionary but can reach as high as 125% of gross income for the year.
For trust and business information returns, set penalties of $10,000 per form are in place and often imposed. If a US citizen’s ownership value of a New Zealand trust is less than $10,000USD, then the penalty is limited to their investment. In practice, using a KiwiSaver worth $8000, this would mean the entire KiwiSaver value being used as a penalty.
Regarding FATCA compliance (bank information reporting), penalties amount to $10,000 per unreported account per year, or a maximum penalty of 50% of the account's value.
Criminal prosecution is a possibility in any of the above scenarios, however it should be noted that this is rare, as it stands..
KiwiSaver
The complex issues arise with KiwiSaver. Although now rare, in the past some online tax sources has made contrary claims that KiwiSaver is non-taxable. The IRS addressed this themselves in recent years, through a private letter ruling (an analysis by the IRS of its own laws) and we can conclude that the DTA doesn't shield KiwiSaver from US taxation; the IRS views it as fully taxable.
Pensions and Superannuation are addressed in Article 18 of the DTA, providing exemptions from US taxation for two types of superannuation:
(1) Pensions and similar compensation paid to an individual who is a resident of one Contracting State for past employment are only taxable in that State, subject to Article 19 (Governmental Remuneration).
Misunderstood at times, the above article permits US persons in New Zealand to exclude from US taxation any pension paid out when the individual is resident of New Zealand. However, the savings clause mentioned previously comes into place here, and instead we must still consider US taxation (albeit with a credit for NZ tax paid).
(2) Social Security payments and other public pensions paid by one Contracting State to an individual who is a resident of the other Contracting State or a US citizen are only taxable in the first-mentioned State.
The second article, excluding pensions from taxation above, pertains solely to Social Security-type payments. In broad terms, this makes NZ Government Superannuation and US Social Security non-taxable by their opposing taxing authorities (ie Social Security non-taxable in NZ).
KiwiSaver however is treated differently, with growth and withdrawals considered taxable income by the IRS. While only limited tax is paid on growth and contributions in New Zealand, there is minimal FTC available in the US tax return to prevent its taxation. The result is that KiwiSaver owned by US persons will be taxed by the IRS, without considering the tax status of superannuation in New Zealand
Though not necessarily double taxation due to the favourable tax status of KiwiSaver in New Zealand, this comes as an unwelcome surprise for many expat US persons.
It's crucial to note that this is reciprocal; US-based retirement funds are also deemed taxable by the IRD, disregarding their home country's tax benefits.
New Zealand Trusts
As is often publicised, New Zealand has amongst the highest rates of trust ownership worldwide. Trusts are an incredibly common method to own homes, businesses, rental properties amongst other assets. Whether this continues given New Zealand tax changes in recent years, remains to be seen.
To understand US taxation of KiwiSaver, one must first comprehend how the US treats foreign trusts. Trust reporting in the US is intricate and costly. US persons are required to disclose their interest in a foreign trust, detailed on Form 3520 and 3520-A. Generally, the entity isn't required to file a tax return; instead, an information return is necessary for the US person owner.
Two types of foreign trusts exist for US tax purposes:
Foreign grantor trust (explained below)
Foreign non-grantor trust (no US ownership but potentially US beneficiaries)
While it's reasonable to assume that trust reporting is needed for Family trusts, this can also apply to KiwiSaver
Starting with US Code Section 26 U.S. Code § 679, a "United States person who directly or indirectly transfers property to a foreign trust (except a trust described in section 6048(a)(3)(B)(ii)) is treated as the owner for their taxable year of the trust portion attributed to the property, if there's a United States beneficiary of any part of that trust for that year."
This means that contributing to a foreign trust, from which one may benefit in the future, designates the contributor as an owner of that trust. An owner is termed a grantor of a foreign trust in US tax terms, and grantors are subject to stringent filing obligations. Subsequently, any trust with a US owner/grantor is referred to as a Foreign Grantor Trust.
Under code section 26 U.S. Code § 671, the income of a foreign grantor trust is treated as the grantor's direct income (essentially disregarding the trust). US individuals with an interest in a foreign trust must report their share of trust income on their individual tax returns, as if they had earned the income themselves. Despite this disregard, the obligation to file Form 3520 & 3520-A for the trust remains.
Ownership of the foreign trust is determined through various tests. The tax code outlines conditions such as the US person's control over the trust and their ability to enjoy trust assets. The most common method to ascertain trust ownership percentage is by reviewing cumulative contributions since inception.
For instance, if two newlyweds each contribute a property of equal value to a jointly-owned trust, the trust is considered 50/50 owned. If one spouse contributes a $400,000 property and the other contributes $600,000, ownership becomes 40/60. Income from the trust is then reported on the US person's tax return based on this ratio.
Reporting
This brings us to the complexity of US persons reporting KiwiSaver in their annual tax returns. Given that the US tax code spans nearly 76,000 pages, it's not surprising that tax returns can be equally intricate. Separate schedules or tax returns often need filing for foreign entities on behalf of US person owners/shareholders.
KiwiSaver
How does this relate to KiwiSaver? Firstly, its important to note that UniSaver, KiwiSaver and most other Superannuation products in NZ are organised with the same financial structure, albeit slightly different NZ tax treatment. All New Zealand Superannuation products are structured as trusts under the Kiwisaver Act 2006. Consequently, contributing to a KiwSaver can trigger a requirement to file an annual trust tax return.
Tax professionals have long petitioned the IRS on this requirement, which led to an obligation for US persons to file for superannuation but didn't align with the intent of US Code Section 679 (designed for ordinary/family trusts).
In early 2018, a Private Letter Ruling (PLR) from the IRS was published, outlining the IRS stance on the matter. A PLR is a private analysis of the US tax code, obtainable from the IRS, albeit at a high cost (often up to $181,000 USD).
Whilst the PLR was related to an Australian Super Scheme, the precedent was set for any financial structure similar to the scheme described in the PLR.
This PLR sought favorable treatment for an Australian Superannuation scheme, aiming to classify it like an employees' trust described under § 402(b) of the Internal Revenue Code. Such classification would exempt it from reporting requirements while not necessarily eliminating the tax obligation upon withdrawal. The IRS assessed the issue and concluded that when an employee contributes over 50% of the total historical contributions to a super, it's treated as a Foreign Grantor Trust, mandating stringent reporting. This calculation is straightforward, comparing voluntary contributions by an employee to employer contributions.
Unfortunately, New Zealand’s KiwiSaver contribution system results in almost all holders being above this 50% threshold. The reason for this, is that an employee’s 3% contribution enters the fund before tax, meaning the full 3% from their salary is deposited. However, the employer’s 3% is after tax (PAYE taken), resulting in less than the actual 3% being deposited in the account. In this instance, virtually all contributors are over the 50% threshold.
Hence, most KiwiSaver funds are considered Foreign Grantor Trusts.
In this instance where a KiwiSaver primarily employee-funded, substantial additional reporting, including trust and PFIC (Passive Foreign Investment Company) reporting, becomes necessary.
Upon withdrawal, the entire withdrawal is taxable beyond the pre-taxed amount (the tax that has been paid on an annual basis on the growth).
Passive Foreign Investment Companies (PFIC)
A Passive Foreign Investment Company is defined by the IRS under 26 U.S. Code Section § 1297. Created in response to the request of major US brokerage and mutual fund companies in the late 1980s, a PFIC is any foreign company deriving over 75% of its income from passive sources or having at least 50% of assets held for passive income production.
While the terminology refers to companies, the IRS applies PFIC regulations to any entity resembling a company in structure, such as a unit trust.
Most index funds, managed funds, or investment funds are considered PFICs by the US tax code, including ASX100-type investments or Global Equity funds.
Holding a PFIC has severe implications and punitive consequences, coupled with costly and time-consuming reporting.
Introduced as part of the Tax Reform Act of 1986, PFIC regulations were designed to make investing in foreign investment funds challenging and costly. PFICs are taxed under three regimes: § 1291, § 1296, and a QEF (qualified electing fund). PFIC income is subject to a top tax rate of 39.6%, with gains calculated using a complex algorithm necessitating calculations for every individual transaction between the US person and the fund, annually (e.g., sale, purchase, dividend, tax). Due to the complexity, an amount of income is determined, subject to tax at a rate based on the income level.
Unfortunately, PFICs can't be grouped under a single Form 8621; instead, each fund shareholding must be reported separately once a combined PFIC investment value of $25,000 USD is met.
Summary
US persons living in New Zealand or elsewhere abroad must be aware of and compliant with the intricate and extensive US tax system. Filing annual tax returns to the US is essential to avoid severe penalties.
Amnesty programs are currently available for those previously unaware of their obligations, but these may close with little notice.
Comments