The 12 Bona Fide Residence Test Factors
US citizens and residents are subject to tax on worldwide income regardless of the location of their permanent home. Expatriates and Americans who are continuously living overseas are still required to file US income tax return and pay any taxes due. Because of the immense burden on taxpayers, Section 911 of the Tax Code was enacted to heave a sigh of relief. The current language of the statute has its roots back to 1942 when Congress considered it necessary to encourage, promote and stimulate international trade, by providing foreign earned income exclusion. The exclusion is capped at $100,800 for 2015 and $101,300 for 2016 tax year. Foreign earned income is defined as income derived from or attributable to services performed in a foreign country. But what is the definition of a foreign country?
The term "foreign country" means any territory under the sovereignty of a government other than that of the United States, including its airspace and territorial waters, determined under the US law. For example, in Arnett v. Commissioner, 473 F.3d at 797 (2007), the US Court of Appeals for the 7th Circuit, affirmed the Tax Court conclusion that Antarctica is not a foreign country for the purposes of the foreign earned income exclusion. Same treatment applies to income attributable to services performed in international waters or airspace. In Rogers v. Commissioner, 783 F.3d 320 (2015), the Court of Appeals for the District of Columbia lined up with the Tax Court's conclusion that crew-members cannot exclude income earned in international airspace under Section 911. To sum up, income earned in territories that do not belong to any country, including the international airspace and waters, does not qualify for exclusion under Section 911.
Once a determination of the foreign earned income is made, the law requires a "qualifying individual" to make an annual election to exclude income by filing Form 2555. A qualifying individual is defined as a US citizen who meets either the Bona Fide Residence Test or the Physical Presence Test. A US permanent resident, such as a Green Card holder, is required to pass the Physical Presence Test. The Bona Fide Residence Test applies to US permanent residents only if there is a tax treaty between the host country and the USA.
The Physical Presence Test is straight forward as it requires a mere presence in a foreign country for at least 330 days in any 12-month period. Thus, a US citizen or resident who is physically present in one or more foreign countries for at least 330 days in any 12-month period that starts or ends within the tax year will be a qualifying individual. On the other hand, the Bona Fide Residence Test is a complicated matter as the Tax Code provides no clear requirements or an exact definition. Next, we appeal to the court cases for more guidance. In Sochurek v. Commissioner, 300 F.2d 34, 38 (1962), the Court of Appeals for the 7th Circuit enumerated the 12 most essential factors that determine residency.
The intention of the taxpayer is of great significance. The establishment of residency comes with certain degree of permanence and good faith intentions. Mere presence in a foreign country is generally not sufficient to establish residency. Therefore, long periods of stay in a given country are supporting argument but not a panacea. The taxpayer's good faith intentions towards the foreign country matter most.
Establishment of a home temporary in the host country for an indefinite period. The courts made clear that the meaning of "residency" may vary according to context, as a person may have only one permanent home, but may be a resident of multiple places or countries at the same time. The type of accommodation is also important and distinction is made between a dormitory or hotel facilities and rented apartment or the purchase of a home. At any case, residency requires far less than domicile as the latter implies an intention to make a fixed and permanent home. By following this principle, the courts concluded that an individual should establish a home in a foreign country for a period that is long enough to consider the home as a residence. In fact, the Tax Code specifically requires a bona-fide residence in a foreign country for an uninterrupted period of at least one full calendar year. A special exception applies only to taxpayers whose presence abroad has been limited by acts of war or other similar conditions beyond their control.
Participation in the activities of the chosen community on social and cultural levels. The social interaction with the local community is another factor evaluated by the courts. A taxpayer who becomes a member of a local club or church, or participates in the social and cultural life of the local community is a step closer to the status of resident. In a similar vein, the courts concluded that individuals who assimilate with the foreign environment show good faith intention to maintain residency abroad. Consequently, factors such as relationships with locals, friendships, networking, observing local traditions and believes are also in support to bona-fide residency.
Nature, extent and reasons for temporary absences from the foreign home. The character and duration of absences from the taxpayer's home is another factor that deserves consideration. For instance, long absences from the foreign country could be interpreted as abandonment of residency in a real and substantial sense. The reasons for the absence are vital as exceptions apply to temporary absence borne by business arrangements and vacation or due to medical condition or education.
Assumption of economic burdens and payment of income taxes to the foreign country. The filing of a nonresident tax return in combination with no income tax obligations in the host country is an automatic disqualifier under the Bona Fide Residence Test. Therefore, a person who claims residency in a foreign country is expected to either pay income taxes to the foreign country or at least not to file a return or statement purporting to be a nonresident of the foreign country. This explicit requirement has been subject to a higher degree of scrutiny by the IRS and the courts. Yet, many countries do not impose income taxes at all or grant special tax exemptions to foreign citizens. Even worse, a country may explicitly require a nonresident return from a foreign person. So, how to approach these situations?
In Frank S. Scott, Jr. v. United States, 432 F.2d 1388 (1970), the United States Court of Federal Claims discussed the scope of immunities and income tax exemptions. The court concluded that a tax exemption provided in the host country laws, a treaty or another international agreement is not in itself the equivalent of a statement by a United States citizen that he is a nonresident of the foreign country. Consequently, if taxpayers enjoy a relief from taxation or an exemption guaranteed by the host country laws or a treaty, they will not be automatically precluded from establishing bona-fide residence. In response to the decision of the court, the IRS issued Rev. Rul. 72-496 and 72-497 to enumerate and contrast various tax immunities and their effect on determination of bona-fide residence.
Nature and extent of any special considerations granted to the taxpayer by the foreign country, which are unavailable to other residents of that country. The courts have also determined that a bona-fide resident should bear the usual obligations and enjoy similar rights and privileges as any other host country citizen or resident. Therefore the nature and extent of any legal or jurisdictional immunities or special considerations that set an individual apart from the general community are subject to a critical review. In Commissioner v. Lyon Tyler Matthew, 335 F.2d 231 (1964), the Court of Appeals for the 5th Circuit determined that Pan Am employees with immunity from the operation of the local judicial system and an exemption from the immigration laws of the host country should not be considered bona-fide residents there. Yet, if certain conditions are met, an exemption, immunity or special treatment afforded by the host country or an international agreement is not an obstacle to bona-fide residency.
Status of resident contrasted to that of transient or sojourner. Transient individuals have no regular place of business and no tax home available to them in any country. Thus, the courts contrasted residency in a particular country with short-term living, work or travelling arrangements to various countries as an indication the individual is transient or sojourner.
Treatment accorded to income tax status by the employer. The nature of tax withholding from remuneration and treatment by the employer is another factor. If the employer treats the employee as nonresident of the foreign country, deducts lower taxes, or no taxes at all, the result is a strong indication that no tax residency has been established. Because bona-fide residence is closely related to tax residence and tax home, such treatment may have adverse effect on bona-fide residency determination.
Physical presence in the foreign country consistent with employment. The consistency of presence abroad with business arrangements is another important consideration. It is accepted that people choose to live in close proximity to the location of their worksite; therefore the taxpayer's presence in the foreign country is expected to coincide with the nature and requirements of employment.
Marital status and residence of family members. The marital status of the taxpayer and the place of residence of the taxpayer's close family members are also relevant. As a rule of the thumb, individuals who relocate with spouse and children are more likely to prove bona-fide resident status in a foreign country. This factor is particularly important if the taxpayer's family members remain in the United States. Yet, the maintenance of a separate home for family members could be an objective defense if borne by adverse living conditions in the host country.
Nature and duration of employment. The courts ruled that the nature of work and its duration, in particular, are closely linked to a status of a resident. If the assignment abroad could be promptly accomplished within a definite or specified time, it generally speaks contrary to bona-fide residency. Same applies if the taxpayer's visa and presence abroad are restricted by the terms of an employment contract or duration of business arrangements.
Good faith in making the trip abroad. The courts also ruled that the taxpayer must have a valid reason to move outside the USA. For instance, a decision to relocate abroad could be driven by employment perspectives, advancement in career, training, education, health, or family reasons. However, if the primary purpose of the relocation is tax evasion, the taxpayer is generally precluded from claiming bona-fide residence in a foreign country.
Finally, the courts do not give preference to any of the factors over the other. The taxpayers are not expected or required to meet all of them to prove bona-fide resident status too. As a consequence, a taxpayer who meets two or three of the criteria may have stronger bona-fide resident indicia, than an individual who falls within six or seven at a time. The courts made clear that each case is unique and must be decided on its merits.