What is a “Foreign Country” for Income Tax Purposes?

United States citizens are subject to tax in the U.S. on their worldwide earnings and income. This includes wages earned for work performed in foreign countries.

There are exceptions to this treatment, such as the provisions of tax treaties. The other exception involves the foreign-earned-income exclusion. This exclusion allows individual taxpayers to exclude income earned in certain foreign countries. 

This begs the question as to whether a taxpayer working outside of the U.S. is in a foreign country if he is working in an area that is not governed by the equivalent of what we think of as a government.  Is a foreign government required? Is there a difference between a “foreign country” and a “foreign land?” The court addresses this in Arnett v. Commissioner, 06-1934 (7th Cir. 2007) in the context of whether Antarctica is a “foreign country” for tax purposes.

Facts & Procedural History

Arnett is a U.S. citizen.  He was stationed in and worked in Antarctica.  He was employed by a U.S.-based employer. 

Arnett filed his U.S. tax return and claimed a Section 911 foreign earned income exclusion for amounts that he earned while stationed in Antarctica.

The IRS audited the tax return and assessed a deficiency for the excluded income, arguing that Antarctica is not a “foreign country”as defined in the regulations.  The taxpayer then filed a petition in the U.S. tax court.

The Foreign Earned Income Exclusion

The 911 foreign earned income exclusion is a provision of the U.S. tax code that allows U.S. citizens and resident aliens who work and earn income abroad to exclude a certain amount of that income from their U.S. federal income tax.

The purpose of the exclusion is to reduce the tax burden on U.S. citizens working abroad and to make them more competitive with foreign workers who may have lower tax liabilities.

The amount of the exclusion is adjusted each year for inflation and for tax year 2021, the maximum exclusion amount is $108,700.

To qualify for the exclusion, the taxpayer must have a tax home in a foreign country and meet either the bona fide residence test or the physical presence test.

To pass the bona fide residence test, the taxpayer must be a bona fide resident of a foreign country for an uninterrupted period that includes an entire tax year. The taxpayer must also have established a closer connection to the foreign country than to the U.S.

The physical presence test requires the taxpayer to be physically present in a foreign country for at least 330 full days in a 12-month period. The 12-month period does not need to coincide with the calendar year, and the taxpayer does not need to be present in the foreign country for a full year.

What is a Foreign Country?

The regulation defines the phrase “foreign country” to mean a territory under the sovereignty of a foreign nation. But how do you determine if a territory is under the sovereignty of a foreign nation?  Who makes this determination?  

One significant factor to consider is the perspective from which the determination is made. In the case before the U.S. Tax Court, the court looked to U.S. law to make its determination. Under U.S. law, Antarctica is not recognized as the sovereign territory of any foreign government, and is instead considered ungoverned land. As a result, the U.S. Tax Court concluded that Antarctica does not qualify as a “foreign country” for tax purposes.

But What is a Foreign Country, Really?

The concept of a “foreign country” may seem straightforward, but in the world of taxation, its definition can be more complex than one might expect.

The ambiguity of this phrase was brought to light in a case that made its way to the Seventh Circuit Court of Appeal. The case involved the interpretation of the term “foreign country” in Section 911, which relates to the exclusion of foreign-earned income. The definition of “foreign country” is critical in this context, as it determines whether an American worker is eligible for the exclusion while working abroad.

The U.S. Tax Court had previously determined that Antarctica did not qualify as a foreign country for purposes of Section 911. This decision was based on the U.S. government’s stance that it did not recognize Antarctica as the sovereign territory of any foreign government, and instead considered it ungoverned land. However, on appeal, the Seventh Circuit Court of Appeal found the term “foreign country” to be ambiguous in Section 911 and therefore used statutory construction principles to discern its definition.

In its analysis, the appeals court considered the purpose of Section 911, which is to allow U.S. companies to deploy Americans overseas on a more competitive basis, given the higher taxes Americans pay while working abroad. The court concluded that Antarctica’s status as an ungoverned land meant that the issue of taxation did not arise, as there was no government to impose taxes. Therefore, the appeals court affirmed the U.S. Tax Court’s decision that Antarctica is not a “foreign country” for purposes of Section 911.

The Takeaway

Understanding the definition of a “foreign country” is crucial in determining a U.S. citizen’s tax liabilities on worldwide earnings and income. While tax treaties and foreign-earned-income exclusions provide exceptions, the definition of a “foreign country” can be complex and subject to interpretation. As illustrated in Arnett v. Commissioner, the ambiguity of this phrase can lead to disputes and require tax planning and analysis of factors such as the perspective from which the determination is made and the purpose of the relevant tax provision. Therefore, seeking guidance from expert tax attorneys and staying up-to-date with changes in tax law is crucial for individuals and businesses with international operations.