This is the first of a highly detailed examination of cross-border tax issues for individuals living overseas and often using multiple jurisdictions.
The cross-border taxation of people who live “globally mobile lives” is a major concern of private banks and wealth managers. It is a way that “globalisation” manifests itself. To discuss these questions is Withers, the law firm. The authors of this article are Naomita Yadav, partner; Lara Crompton, special counsel, and Emma Cooper-Hedges, senior associate. This article is over two parts, given its length. This is the first part. The editors of this news service are pleased to share this detailed and important analysis. The usual editorial disclaimers apply and as always, readers are welcome to respond. Email firstname.lastname@example.org
Part I - Talking income taxes
Much has been written about how the pandemic disrupted the way people thought about where they live, primarily by divorcing physical presence from productivity. Locations that could offer the elusive combination of space and access to amenities became much more desirable. Many individuals took advantage of the shifting priorities to move across cities, states, and even countries. One such couple were the Sussexes, who relocated to Santa Barbara, California in August 2020 (1).
Taxes are likely not top-of-mind considerations when moving to a different country. However, the circumstances of the Sussexes’ move provide a particularly interesting fact pattern regarding if, when, and where they may be subject to tax. For US and UK practitioners, they represent the perfect case study for exploring tax issues connected with citizenship, domicile, and residency.
US tax liability
Generally, all US citizens are subject to US federal income tax on worldwide income. For non-US citizens, US federal income tax liability is based on residence. At the state level, California also applies a residency test to determine if an individual is subject to California income tax on their worldwide income.
As a US citizen, Meghan would be generally subject to US federal income tax on her worldwide income. Harry, a non-US citizen, may be subject to federal income tax depending on his residency. IRC section 7701(b) provides that non-US citizens who are lawful permanent residents (that is, green card holders), or individuals who meet the requirements of a substantial presence test, are generally treated as resident aliens. It seems that Harry has not applied for a green card. Therefore, the critical test for him would be the substantial presence test, and if he meets those requirements, the next question is whether he can qualify under a treaty exception.
An individual satisfies the substantial presence test if:
He or she has been present in the U.S. on at least 183 days during a three-year period that includes the current year. For the purposes of this test, each day of presence in the current year is counted as a full day. Each day of presence in the first preceding year is counted as one-third of a day and each day of presence in the second preceding year is counted as one-sixth of a day (2).
Some non-US citizens who satisfy the substantial presence test are able to claim non-resident status under a “closer connection” exception (3). However, this exception requires that the individual spends fewer than 183 days in the US in the year for which the exception is claimed (4). Based on media coverage, it appears that Harry and Meghan spent more than 183 days in the US every year starting in 2020 (5).
The Heritage Foundation’s Oversight Project recently filed a Freedom of Information Act request and further sued the Department of Homeland Security over Harry’s US visa status (6). Although this lawsuit is focused on immigration laws and procedures, it has a direct bearing on Harry's tax status. Whilst the substantial presence test generally depends on counting the number of days an individual is physically present in the US (7), days of presence as a “foreign government-related individual” are not counted (8).
Foreign government-related individuals include those with full-time diplomatic or consular status, or full-time employees of designated organisations under the International Organizations Act (9). This means that if Harry is present in the US on certain visas (for example, certain subcategories of A or a G visa), he will not be considered a resident under the substantial presence test. Conversely, if his presence is based on the spousal visa (the K visas for non-immigrant spouses) or categories available to authors, actors, etc. (for example, an O visa), he would likely have met the substantial presence threshold.
Certain types of diplomatic visas may not qualify for foreign government-related individual status for tax purposes. Treasury regulations require the individual to intend to “engage primarily in the official activities for that foreign government while in the US (11).” Given that the Sussexes have stepped down as working royals, it is unclear if they can engage in official activities for the UK government, or even if they could, whether it could rise to the level of Harry’s being primarily engaged in official activities for the UK government.
Harry’s residence for tax purposes has critical implications for
the couple - any income earned worldwide after he is treated as a
US resident, including royalties on the publication of his
memoir, Spare, or from Netflix, would be fully taxable in the US,
likely as trade or business income. If he were considered a
non-resident, withholding tax under section 1441 would apply to
payments made by US payers, subject to treaty exemptions
Like the federal government, California also taxes residents on their worldwide income (13). Cal. Rev. & Tax. Code section 17014(a) defines an individual resident as one who (1) is in California for other than a temporary or transitory purpose, or (2) is domiciled in California, but who is outside the state for a temporary or transitory purpose. Compared with the federal tests for income tax residency, the California standard is less formulaic and fact-dependent. Residence of a spouse and children (14) or maintaining a California home (15) generally tend to establish tax residency in the state. Given the public proclamations of Santa Barbara being “home” for the couple, it is difficult to see how the Sussexes would not qualify as California tax residents.
A peculiarity of the US tax system is that state income taxes are not covered by international tax treaties. Though some states conform to federal definitions of income and therefore allow treaty exemptions, California is among a handful of non-conforming states (16). This means that even if a treaty position may be available to exempt some income from federal taxes, that benefit is unlikely to be available for California taxation, leaving the couple subject to worldwide taxation at one of the highest state taxation rates in the country (17).
Another important aspect of a move to California is the
possibility of attribution of income under community property
laws. In the absence of a prenuptial agreement that satisfies
California standards, income from all sources earned while in
California could be attributable 50 per cent to Meghan, who is a
US citizen and California resident (18). If this were the case,
then it would operate as another mechanism by which a share of
all worldwide income could be fully taxable in the US and