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Tax Court: When Would Foreign Income be Excluded From US Tax?

Dec 1st 2017
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If you work in a foreign country and reside there, you can shield at least part of your income from U.S. tax under the “foreign income exclusion.” However, as evidenced by a recent case, Hudson, TC Memo 2017-221, 11/8/17, you must meet the tax law requirements for residency. Otherwise, the income is fully taxable.

The foreign income exclusion, which is indexed annually for inflation, is increasing to $104,100 for 2018, from $102,100 in 2017. To qualify for this tax exclusion, you must live and work outside the U.S. and either be a bona fide resident of the foreign country or pass a “physical presence” test.

Generally, you’re treated as a bona fide resident of a foreign country if you reside there uninterrupted for an entire tax year. Brief trips outside the country – even to the U.S. — won’t disqualify you. Alternatively, you’re treated as being physically present in a foreign country if you live there for at least 330 full days in any consecutive 12-month period.

The taxpayer in this case was a pilot for Korean Airlines. During the tax years at issue, he was based in Inchon, South Korea and lived in a hotel paid for by Korean Airlines. He received an E5 visa and was a registered alien in Korea.

The taxpayer flew routes to cities throughout Asia, Europe and the U.S. In addition, under the airline’s policy, his layovers between his working flights outside Korea could last for several days. He received nine days off per month, which Korean Airlines typically gave in blocks, and 24 vacation days per year. However, sometimes he would be asked to take flights on his days off. Typically, the taxpayer would request to use vacation days in the same period as his days off.

For his vacations, the taxpayer had the option of traveling, at no expense, to any city where Korean Airlines flew direct. He seldom spent his vacation days in Korea. Instead, he tried to spend all of his time off  — as many as 132 days per year — in the U.S.,  where he owned three homes.

The courts consider a number of factors when determining whether a taxpayer was a bona fide resident of a foreign country. These factors include the following:

  • The intention of the taxpayer.
  • Establishment of his home temporarily in the foreign country for an indefinite period.
  • Participation in the activities of his chosen community on social and cultural levels, identification with the daily lives of the people and, in general, assimilation into the foreign environment.
  • Physical presence in the foreign country consistent with employment.
  • The nature, extent and reasons for temporary absences from the temporary foreign home.
  • Assumption of economic burdens and payment of taxes to the foreign country.
  • Status of resident contrasted to that of transient or sojourner.
  • Treatment accorded income status by the employer.
  • Marital status and residence of family.
  • The nature and duration of the employment, and
  • Good faith in making his trip abroad (i.e., whether it’s for the purpose of tax evasion).

Based on the analysis of these factors, the Tax Court determined that the pilot wasn’t a bona fide resident of South Korea, nor did he meet the physical presence test. Therefore, the exclusion was denied.

Don’t allow your clients to miss the boat on this valuable tax break. Ensure that they meet the requirements for the foreign income exclusion when it is available.

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