Tax Optimization for USC R2Ier. MFJ ? MFS ?

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KRV
Posts: 255
Joined: Tue Jan 16, 2007 10:55 pm

Tax Optimization for USC R2Ier. MFJ ? MFS ?

Post by KRV »

Folks,

I searched in the new forum for related threads but could not find any. In the most recent issue of The Economist (dt. Feb. 24-March 2, 2007), there is a special section on Offshore Finance. Interesting to read how this once arcane and often abused part of personal finance has become part of a legitimate personal and corporate tax planning strategy in its own right.

The section mentions, among other things, that Britain is one of the best personal tax havens in the world. Most of its "resident non-domiciles" who derive income outside of U.K. pay no tax to U.K. Other the other hand, The Economist continues, U.S. taxes people on worldwide income and assets because U.S. does not tax non-residents' financial deposits in U.S. This is the main driver for nearly $2.5 trillion in U.S. bank deposits held by foreigners, more than twice what is held by the best known offshore haven for individuals (including crooks!), Switzerland.

Do the gurus (bobus and others) know if Indian citizens are taxed similarly on global income as well, just like U.S.? If so, the choice between INC and USC is not that attractive, especially if some wealthy USCs have a choice of settling in more favorable tax havens (like UK, Singapore?). On the other hand, by retaining INC (and having bulk of one's assets in US) if one can save U.S. taxes (because of US non-resident relaxations, per The Economist) and also save Indian taxes (if India follows British resident non-domicile rules), then getting USC is may not be attractive from a tax view point! Gurus, please opine!
nand
Posts: 447
Joined: Thu Jan 25, 2007 6:38 am

Tax Optimization for USC R2Ier. MFJ ? MFS ?

Post by nand »

Kindly look at this thread where I have attempted to summarize the problems of a USC living in India as a ROR.

http://www.r2iclubforums.com/clubvb/showthread.php?t=899

When you live in India as a ROR, you are also taxed on global income like in the US. In spite of DTAA, there is a double whammy effect in that tax shelters in US are taxable in India and vice-verca. For example 401K accruals are taxable by India, Indian mutual funds, in spite of not having LTCG on debt funds, come under very punitive PFIC rules of IRS etc. DTAA provides relief only where both geographies tax.

If you R2I with say < 200K it is not that much of a problem, since your income in India is exempt under foreign earned income exclusion. Say you have 500K or more in net worth, you will end up ramming your head looking for ways to minimize tax. What I have learned from this forum as possible solutions:

1. Buy the biggest house you can in India, holding for more than 3 yrs will give you LTCG exemption in India (subject to conditions) as well as primary home exclusion by IRS
2. Avoid PFIC by using MINDX other emerging mkts funds in US to get exposure to India (more expensive) or Nifty replication strategies
3. IRA treatment - refer the excellent threads on roth conversion, rrk limits etc., withdrawal strategies to minimize accruals in ROR phase etc.
4. Benami holdings in mama, papa, chacha, chachi, didi, saala's names (they can bolt with the money or blow it on bunty ki shaadi too:eek: )
5. If you are MFJ with 2 kids up to 40K in US is almost tax free (due to deductions, credits etc.). Arrange yearly withdrawals accordingly
6. Maybe live in Dubai or Singapore and jump over the ponds to India if you have too much moolah (2 mill plus??)
7. If you have 5 mill plus, do you need USC? Give it up if you want to R2I or LIA and visit India 10 times a year or whatever. Then it is kar lo duniya muthi mein.

If am only looking at legal means. Even benami, if properly gifted is not illegal in letter, though maybe in spirit. Illegal means, to me are not worth it in terms of lost sleep and watching your back always.

Please post your suggestions as well.
KRV
Posts: 255
Joined: Tue Jan 16, 2007 10:55 pm

Tax Optimization for USC R2Ier. MFJ ? MFS ?

Post by KRV »

This is a good summary to start with, thanks for putting this together.

Aside from emotional and visa-free travel benefits, there seems to no other advantage to taking USC instead of INC. However, given how much "emotional" my other half gets, getting USC may be driven by the mere fact that I can and not because whether I should!

The problem is, after one gets USC, giving it up in India regaining INC still does not make you clean from IRS perspective. IRS can go back past 10 years of tax returns to ensure that you are not giving up USC just to save US taxes. Otherwise, they can slap you with "expatriation" tax.
nand
Posts: 447
Joined: Thu Jan 25, 2007 6:38 am

Tax Optimization for USC R2Ier. MFJ ? MFS ?

Post by nand »

KRV

What you said is correct about USC, except that for people with lower net worth or prospective R2I retirees with low to moderate net worth (for whatever reason, maybe they live life large and more power to them) then USC may be beneficial. My back of envelope says over 5-600K is the inlfection point. Assuming 8% return on this money, that is 40-50K. That is just the point in income where IRS starts charging taxes (dues to deductions, MFJ + 2 kids can go up to 40K tax free). Just as you said, it does not make sense to me, yet I am taking it for some unknown reason.

The expatriation taxes thing is new to me, can you point me to a link on it? Coz, if I hit it big in India, I would certainly be inclined to think about it.
KRV
Posts: 255
Joined: Tue Jan 16, 2007 10:55 pm

Tax Optimization for USC R2Ier. MFJ ? MFS ?

Post by KRV »

Nand,

Here's the IRS link to expatriation tax for those considering to give up USC but have significant wealth. For the 2005 tax year, it specifically points to those with $2 mill.+ in net worth (rare for R2I candidates) or earning $127K+ (not so rare given the high Indian salaries these days). This rule allows the IRS to examine your financials for 10 years after you give up USC to determine if you gave up USC to avoid US taxes and whether you should be slapped with the expatriation tax.

I am curious as to how you came up with "$500-600K inflection point" for USC assets to R2I. Per my analysis, most USC R2Iers who intend to work in India will pay the highest marginal tax rate to GOI if they live in India and may claim that under Foreign Earned Income Exclusion/DTAA to avoid paying any taxes to IRS. If you are a INC R2Ier intending to work at upper or senior management level in India, you will be in the highest Indian marginal rate anyway.

Investments in Indian MFs can be reasonably replicated by creating an portfolio of individual equity holdings, as RRK, Bobus and you have mentioned. This avoid PFIC rules and so, I don't see this as a major disadvantage for USCs in India.

Beyond that, unless the income or asset levels cross the IRS threshold for expatriation tax, is there any additional tax that a USC has to contend with? From US perspective, USC R2Iers have estate tax benefits if they intend to keep significant assets in US, because US charges estate tax (can be as high as 40%, gulp!) for NRAs with US assets over $60-70K, which most R2Iers may have. For USCs, the limit is over $1.5 million (or $2 million recently?) as I understand. Estate tax may not be the principal driver for the decision but it is good to consider this as well, which favors USC.
DosaiLvr
Posts: 1069
Joined: Wed Jan 10, 2007 11:40 pm

Tax Optimization for USC R2Ier. MFJ ? MFS ?

Post by DosaiLvr »

nand;9314Kindly look at this thread where I have attempted to summarize the problems of a USC living in India as a ROR.

http://www.r2iclubforums.com/clubvb/showthread.php?t=899

...tax shelters in US are taxable in India and vice-verca...

...DTAA provides relief only where both geographies tax. [/quote]

nand,

Thank you for posting your thoughts regarding tax issues that RORs must be aware of. It has been very helpful.
nand
Posts: 447
Joined: Thu Jan 25, 2007 6:38 am

Tax Optimization for USC R2Ier. MFJ ? MFS ?

Post by nand »

KRV

Look at this example:

CASE 1:

Assume my networth is 1 million USD (4.4 crores all inclusive)
Assume I am NRA and not USC/GC

I can invest this 1 million as follows to minimize tax in India:
1.Real estate + land than I hold long term and avoid taxes on it
2.equity mutual funds long term - again tax avoided
3. PPF, other schemes again tax deffered/sheltered

On all of these no or less taxes in India.

Now assume same 1 million USD networth and USC ROR
Each of the items 1,2,3 are taxable in US

Furthermore let us say I have muni/tax free bonds in US, or money in 401K (accruals taxable by GOI), these are all taxable in India. Therefore you cannot really use any tax shelter effectively, whereas if you were LIA or NRA youwould. DTAA does not provide adequate releif in this case.

This is the downside of USC

CASE 2:

Assume my net worth is 250K, and I am USC ROR and I arrange my investments in India such that:

1. I buy land, houses and hold them long term. I can avoid indian taxes upon sale by buying infra bonds etc.
2. I can avoid taxes on Indian equity MF's and indian stocks as before.

So why does having a USC not impose a penalty? - On 250K say the total return on your portfolio is 10% - 25K and you are MFJ with 2 kids, Your tax on this 25K is close to 0 or very less. Your income comes under foreign earned income exclusion anyway. Even with TIPRA rules you are not going to be hurt much.

ergo - 500-600K as the inflection point - 50-60K in portfolio return will result in positive tax in US even though you can take advantage of Indian tax free conditions like mentioned above.

KRV;9469Nand,

Here's the IRS link to expatriation tax for those considering to give up USC but have significant wealth. For the 2005 tax year, it specifically points to those with $2 mill.+ in net worth (rare for R2I candidates) or earning $127K+ (not so rare given the high Indian salaries these days). This rule allows the IRS to examine your financials for 10 years after you give up USC to determine if you gave up USC to avoid US taxes and whether you should be slapped with the expatriation tax.

I am curious as to how you came up with "$500-600K inflection point" for USC assets to R2I. Per my analysis, most USC R2Iers who intend to work in India will pay the highest marginal tax rate to GOI if they live in India and may claim that under Foreign Earned Income Exclusion/DTAA to avoid paying any taxes to IRS. If you are a INC R2Ier intending to work at upper or senior management level in India, you will be in the highest Indian marginal rate anyway.

Investments in Indian MFs can be reasonably replicated by creating an portfolio of individual equity holdings, as RRK, Bobus and you have mentioned. This avoid PFIC rules and so, I don't see this as a major disadvantage for USCs in India.

Beyond that, unless the income or asset levels cross the IRS threshold for expatriation tax, is there any additional tax that a USC has to contend with? From US perspective, USC R2Iers have estate tax benefits if they intend to keep significant assets in US, because US charges estate tax (can be as high as 40%, gulp!) for NRAs with US assets over $60-70K, which most R2Iers may have. For USCs, the limit is over $1.5 million (or $2 million recently?) as I understand. Estate tax may not be the principal driver for the decision but it is good to consider this as well, which favors USC.[/quote]
KRV
Posts: 255
Joined: Tue Jan 16, 2007 10:55 pm

Tax Optimization for USC R2Ier. MFJ ? MFS ?

Post by KRV »

Nand,

Thanks for following up. I understand your examples but you are making some assumptions that may not hold true in all cases.

Consider a USC with substantial portion of assets in taxable accounts vs. tax-deferred (since these may be withdrawn during RNOR period). This may be true in many R2I cases because of "RRK contribution limits" that many may follow to ensure that all withdrawals from tax-deferred accounts are completed within RNOR period.

For the sake of analysis, let's say a USC R2Ier has 20% in tax-deferred accounts and 80% in taxable accounts. Based on the above, assume the 20% is withdrawn within 2 years of RNOR and invested in a replicated index portfolio of individual Indian stocks. The remaining 80%, let's say, are mostly in tax-efficient index mutual funds based in US, generating a low dividend/cap gain yield, which gets reported in 1099 each year.

A USC R2Ier will need to report this 1099 in both 1040 and Indian tax return and pay the higher of the two taxes and claim the Indian tax (likely to be larger) to eliminate the US tax. This is no different than NRA R2Ier.

Assume all real estate investments are held by the NRA spouse of USC R2Ier, which is the same as far as India is concerned as a NRA R2Ier holding the same RE investments. So, the tax situation is largely neutral for real estate.
PPF and other tax-deferred investments may also be neutral as long as the total earned income in India is within the $80K foreign earned exclusion.

In the above sceniaro, how is a USC R2Ier much worse off than NRA R2Ier from a total tax perspective?
sgh
Posts: 17
Joined: Mon Feb 05, 2007 12:18 pm

Tax Optimization for USC R2Ier. MFJ ? MFS ?

Post by sgh »

Nand,

The following assumption is incorrect :-

>>> On 250K say the total return on your portfolio is 10% - 25K and you are MFJ with 2 kids, Your tax on this 25K is close to 0 or very less. Your income comes under foreign earned income exclusion anyway. <<<<

It is true that MFJ+2kids can get 25K tax free income; however you cannot club this with Foreign Earned Exclusion with the NEW Law Change which happened (search the forum for that). Say you have about 17 Lakhs/year ($40k) of Earned Income in India. While as per the law all of it would get excluded but your additional income would be taxed at an appropriate slab. So in this case for an Indian Earned Income of 17L/y + an US Income of 25K, assuming MFJ+2, you would end up in the 15% tax bracket for the 25K i.e. you would be paying a tax of $3750. :emangry:

And BTW if that 25K is as a result of IRA distribution do not forget to add an additional 10% tax :( (unless you are trying to shield that under Roth).
nand
Posts: 447
Joined: Thu Jan 25, 2007 6:38 am

Tax Optimization for USC R2Ier. MFJ ? MFS ?

Post by nand »

sgh - you are correct. The new TIPRA rules will make you cough up the additional amount. Thanks for pointing this out. I think one way out that we can explore is filing MFS if spouse is not working and arranging for all the investments under spouse name.

sgh;10550Nand,

The following assumption is incorrect :-

>>> On 250K say the total return on your portfolio is 10% - 25K and you are MFJ with 2 kids, Your tax on this 25K is close to 0 or very less. Your income comes under foreign earned income exclusion anyway. <<<<

It is true that MFJ+2kids can get 25K tax free income; however you cannot club this with Foreign Earned Exclusion with the NEW Law Change which happened (search the forum for that). Say you have about 17 Lakhs/year ($40k) of Earned Income in India. While as per the law all of it would get excluded but your additional income would be taxed at an appropriate slab. So in this case for an Indian Earned Income of 17L/y + an US Income of 25K, assuming MFJ+2, you would end up in the 15% tax bracket for the 25K i.e. you would be paying a tax of $3750. :emangry:

And BTW if that 25K is as a result of IRA distribution do not forget to add an additional 10% tax :( (unless you are trying to shield that under Roth).[/quote]
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