U.S. EXPATRIATE TAXES IN CHINA
U.S. Federal Income Tax Obligations For U.S. Expatriates Living/ Working in China
The Basics – China
China, whose capital city is Beijing and largest city is Shanghai is officially known as the People’s Republic of China (PRC), is a country in East Asia. China stretches five (5) time zones and has a coast that fronts on the Yellow Sea, the East China Sea, and the South China Sea. It is elsewhere bounded on the east by Russia and North Korea, on the north by Russia and Mongolia, on the west by Tajikistan, Kyrgyzstan, Kazakhstan, Pakistan, and Afghanistan, and on the south by India, Nepal, Bhutan, Myanmar, Laos, and Vietnam.
It is the world’s most populous country and largest by area. As a one-party state led by the Chinese Communist Party (CCP), it exercises jurisdiction over 22 provinces (Anhui, Fujian, Guangdong, Guizhou, Hainan, Hebei, Henan, Hubei, Hunan, Gansu, Jiangxi, Jiangsu, Qinghai, Shaanxi, Shandong, Shanxi, Sichuan, Yunnan, Zhejiang, and, in the northeast (Manchuria), Heilongjiang, Jilin, and Liaoning), five autonomous regions (Tibet, the Inner Mongolian Autonomous Region, the Ningxia Hui Autonomous Region, the Guangxi Zhuang Autonomous Region, and the Xinjiang Uygur Autonomous Region), and four government-controlled municipalities (Beijing, Chongqing, Shanghai, and Tianjin). The country officially divides itself into 23 provinces, numbering Taiwan as its 23d. Hong Kong became a special administrative region of China in 1997, and Macao achieved this status in 1999.
The Qing Empire, was China’s last dynasty. The Chinese monarchy (Dynasty’s) collapsed in 1912 with the Xinhai Revolution, when the Republic of China (ROC) replaced the Qing dynasty. China was invaded by the Empire of Japan during World War II. The Chinese Civil War resulted in a division of territory in 1949 when the CCP led by Mao Zedong established the People’s Republic of China (PRC) on mainland China, while the Kuomintang-led ROC government retreated to the island of Taiwan. The PRC is sometimes referred to as Mainland China or the Mainland to distinguish the ROC from the PRC. Although 1949 the PRC has tried to assert ownership and control over the now thriving democracy of ROC Taiwan, having led to much friction in the East China Sea and with the United State Taiwan’s main backer.
China is the largest economy in the world by PPP since 2014 and the second-wealthiest nation in the world.
Since the introduction of reforms in 1978, the economy of China has produced numerous significant achievements. They include the country being the world’s fastest-growing major economy, the continuation of the world’s fastest rise in GDP per capita recorded from 1960 to 2018, the world’s highest amount of exports, the world’s fastest-growing consumer market, the world’s largest banking sector with assets of $40 trillion and the world’s top four largest banks. Having four of the world’s top ten most competitive financial centers (Shanghai, Hong Kong, Beijing and Shenzhen) in the 2020 Global Financial Centers Index more than any other country.
China is a unitary one-party socialist and communist republic and is one of the few nominally socialist states left worldwide. As such it is very much isolated form a ideological point of view. Political dissidents and human rights groups have denounced the Chinese government for widespread human rights abuses, including political repression, suppression of religious and ethnic minorities, censorship, mass surveillance, and their response to protests, notably the 1989 Tiananmen Square protests. The country is a recognized nuclear weapons state and has the world’s largest standing army, the People’s Liberation Army, and the second-largest defense budget. The PRC is a permanent member of the United Nations Security Council since replacing the ROC in 1971. China has been characterized as the new superpower directly opposite of that of the United States, as a result of of its economy, rapid infrastructural development, and military.
China comprises a total area of 3,705,407 sq miles is the 3rd/ 4th largest country in the world by area, has a population of 1,400,050,000 people 1st in the world and a GDP of 24.2 trillion U.S. dollars. The China’s currency is the is the RMB/ CNY, the China ‘s five (5) time zones stretch far but its standard time zone is +8 UTC, China ‘s country telephone dialing code is + 86, it’s internet TLD is “.cn” and it operates on a 220 volt electrical grid.
The U.S. and China share no common language or heritage, it’s opposing political ideology make them bitter competitors and enemies, however China’s massive economy make China a popular destination for Americans to reside and work. As a U.S. citizen or resident alien (U.S. Expat) living in China, however, there is always the possibility of “double income taxation,” i.e., having to pay taxes to both China and the U.S. on the same income you earned in China. The good news is that there are rules in place to avoid double taxation.
Knowing your obligations as a U.S. Expat are important. The Internal Revenue Code’s (IRC) rules are, however, quite complex, and while this is a simplified, broad overview to familiarize you with your filing obligations and how to avoid double taxation, you should consult a Certified Public Accountant (CPA) expert in U.S. Expat income taxation to learn more. U.S. Expat income taxes are a highly complex niche area of taxation that most CPA’s are not aware of.
Filing deadlines and Extensions Living/ Working in China
If you are required to file a U.S. individual income tax return Form 1040, you must file by April 15, however there is an automatic two-month extension until June 15 if you reside in China on April 15 and meet certain requirements. There are other extensions beyond June 15 that U.S Expats can utilize, including the filing a Form 4868- for an automatic six-month extension of time to file until October 15, and an additional and little known about white paper IRS discretionary extension to December 15 if you reside in the U.K., but, again, you have to meet the IRS requirements to use this extensions.
However, no matter how many extensions are utilized, any income taxes owed are still due by April 15, as the extensions are only an extension of time to file not to pay your U.S. income taxes!
How to Report Income and Expenses Living/ Working in China
The U.S. Form 1040 is always expressed in U.S. dollars, using exchange rates as prescribed or otherwise allowed by the IRS. Generally, for income or expense items we use the average Ask rate for the calendar tax year in question, and for gains and losses the daily spot rates.
Avoiding Double Taxation
If you meet the annual income tax filing thresholds referred to above, you are technically required to file and report worldwide income for U.S. income tax purposes on the same income you are also obligated to pay taxes on to China. The good news is that, if you pay income taxes to China on income you earned there, the U.S. IRC has provisions in place to let you avoid double income taxation, using both:
- Use a Foreign Earned Income Exclusion (FEIE) thereby excluding earned income –income earned in China when determining U.S. income taxes and / or
- Obtaining a Foreign Tax Credit (FTC) for the taxes you paid, or have accrued, to China against the taxes you owe to the U.S.
The Exclusions – FEIE
As always, there are certain tests you must meet to be eligible to claim these special exclusions and credits.
If you meet these IRC requirements, the FEIE is claimed on Form 2555, and allows you to exclude “Foreign Earned Income” (FEI) from U.S. Federal income taxes. FEI is essentially wage or self-employment income that you earn while living and residing in China/ outside the U.S.
To qualify to take the FEIE you have to:
- Meet the “Tax Home Test”, (THT) and
- Meet either the:
- “Bona fide Residence Test” (BFR), or the
- “Physical Presence Test” (PPT).
Generally, this means that on a facts and circumstance basis you actually must live and/or work in China and meet certain specific requirements. If you do qualify for the FEIE, it is not unlimited. The IRS sets annually indexed amounts as to how much you can exclude.
The Exclusions – HE and HD
As a U.S. Expat living in China, you may also qualify for the:
- “Housing Exclusion” (HE) if employed or
- “Housing Deduction” (HD) if self-employed.
Both Housing mechanisms referred to above allow U.S. Expats to exclude additional FEI from their U.S. Federal income taxation in reference to actual, qualified, foreign, housing expenses paid for by themselves or by their employers either directly or by reimbursement in China.
Qualified foreign housing expenses can include, but are not limited to such items such as China:
- The fair market value of employer provided housing,
- Furniture rental, and
- Temporary living expenses.
- Real estate/ property taxes
However, to take either the HE or the HD you must first be qualified to take the FEIE, and the IRS sets annual limits- a base or housing Norm/ or Deductible and a Cap- on either of the Housing Exclusions or Deductions, which are determined in reference to the FEIE itself.
The Form 114 FBAR and Form 8938 FFA
Not to forget or marginalize the fact that all U.S. persons must consider their obligation annually to file Form 114 Report of Foreign Bank and Financial Accounts (FBAR) and Form 8938 Statement of Specified Foreign Financial Assets (FFA) , the former of which is specifically referenced on Schedule B – Interest and Dividends- that accompanies Form 1040, the fact that if you are required to file both the FBAR and FFA Forms as a U.S. Expat living and/ or working in China the amounts on both forms must sync and of course that both forms carry a mind boggling non-willful violation penalty of $10,000 per account/ FFA per annum
The Bottom Line
Because China sets income taxes on income at much higher rates than the U.S., if the U.S. income tax compliance is done correctly, in general assuming no U.S. source income- no U.S. passive income and no U.S. workdays- you should never have to pay any additional U.S. Federal Income taxes on income you earned in China.
As you can see, however, the rules are complex, and it is easy to get overburdened if you do not hire the correct CPA firm U.S. Expat specialists.
At Protax, our primary goal and objective is to analyze the interplay of the FEIE, HD, HE and FTC to find the optimum strategy to limit the world-wide taxes you pay. While of course at the same time making sure that you are in full U.S. tax compliance.
Protax is the world’s leading U.S. individual international tax firm, specializing in the delivery of world class professional services to U.S. Expats. For more information, fill out our contact form to speak to one of our expert tax consultants.