Bob Ward, mentor and colleague, continues his work on the ways in which the IRS might detect delinquent foreign 1040 filers with the help of DHS here:
A very respected and experienced colleague has recently published this brief article in Bloomberg about the ways in which foreign taxpayers might get caught when failing to file a U.S. income tax return. It's worth a read even if you are not a foreign taxpayer.
Some countries in which you may be posted as a member of the Foreign Service do not refund Value Added Taxes (VAT) to U.S. diplomats despite the requirement to do so under the Vienna Convention for Diplomatic Relations. If you are posted to such a country, you may have wondered if there is a way for you to deduct those taxes on your federal income tax return. The 2016 AFSA Tax Guide briefly addresses the deductibility of some state, local and foreign taxes you might pay. The relevant portion reads:
"Deductible Taxes: There are only four kinds of deductible non-business taxes: (1) State, local and foreign income taxes; (2) State and local general sales taxes; (3) State, local and foreign real estate taxes; and (4) State and local personal property taxes. The taxpayer must itemize (using 1040 Schedule A) and must have been charged and actually paid the taxes to be entitled to these deductions."
So the question may arise, may I deduct the foreign VAT I pay while abroad. Those are just like state income taxes, right? Unfortunately, that logic is not supported by the IRS regulations related to the portion of the law that allows for these deductions (IRC Section 164). Consequently, claiming an income tax deduction for a foreign VAT from which you are not exempt is an aggressive tax position. I would not recommend doing so unless you invest in some up front legal research to support your position and anticipate defending position in an audit and/or federal district court.
Value Added Taxes are taxes, so the starting point for deductibility is IRC Section 164. It begins:
"(a) ... the following taxes shall be allowed as a deduction for the taxable year within which paid or accrued:
(1) State and local, and foreign, real property taxes.
(2) State and local personal property taxes.
(3) State and local, and foreign, income, war profits, and excess profits taxes.
(4) The GST [Generation Skipping Tax] tax imposed on income distributions."
Notice that sales taxes are not even mentioned. However Section 164(b)(5) includes a special rule allowing a taxpayer to elect to deduct state sales taxes in place of state income taxes in place of the (a)(3) state and local income taxes. It does not include a similar provision allowing foreign sales taxes to be deducted in lieu of foreign income taxes.
This interpretation is supported by the Code of Federal Regulations (written by the IRS). Section 1.164-3(f), which specifically states "No foreign sales tax is deductible under section 164(a)..." It also clarifies that another part of the 1.164 regulations, in which the service explains that state or local sales taxes may be deducted, do not include foreign sales taxes. In short, the most direct way of deducting a foreign sales tax (in this case a VAT tax) is specifically prohibited.
So what about a deduction for unreimbursed business expenses instead? Foreign Service Officers who end up paying foreign VAT taxes are only doing so because the State Department requires it, right? Not so fast.
Claiming foreign VAT taxes as a business expense deduction on your federal return amounts to going around Tax Reg 1.164-3(f) by way of IRC Section 162. That is the law allowing for a deduction of "ordinary and necessary" expenses incurred when "carrying on a trade or business." This deduction means that only "new" money will be taxed. So a salesperson who spends $10 in gas while at work when he travels to sell a widget for $20 will only pay taxes on $10. That is because his transportation expenses on his way to make the sale is an "ordinary and necessary" expense incurred when "carrying on" a sales business. A salesman, like any person, will have many expenses. These include his food, clothing, house, and maybe also business cards. IRC 162 does not allow him to deduct his food, clothing, or house because these are not business expenses. They may be ordinary and necessary, but they are personal expenses, which are generally not deductible. The cost of the business cards is deductible because those are business expenses (advertising). Similarly, sales tax on the salesman's food, clothing, and house are not deductible (absent some provision like IRC Section 164) because those taxes are levied on personal expenses. The sales tax you pay on your personal expenses in a country that does not refund your VAT will not be deductible for the same reason.
It may be possible to find a way to deduct VAT taxes from your federal income tax liability. However, if you hope to safely take this position on your taxes, you'll need to hire some extensive legal research into the issue. The result will be a professional legal opinion letter that you keep with your return(s). If you get audited, you'll produce it to explain why you deducted those taxes. The auditor may be convinced and allow the deduction. If not, the auditor will assess a deficiency with interest against you (the opinion letter may help you out of a penalty). You would then need to decide whether to pay the deficiency and/or which court to which you should appeal.
Finally, as an aside, the Office of Foreign Missions information on the State Department website states, "Not all foreign missions and their personnel are entitled to tax exemption, because this privilege is based on reciprocity and not all foreign countries grant such tax exemption to American Embassies and personnel." So if you are in a country that does not refund the VAT taxes you pay (as it should under the Vienna Convention for Diplomatic Relations), rest assured that the U.S. is probably not refunding the sales taxes that country's diplomats must pay in the U.S.
Circular 230 Notice: Pursuant to U.S. Treasury Department Regulations, all tax advice herein is not intended or written to be used, and may not be used, for the purposes of avoiding tax-related penalties under the Internal Revenue Code or promoting, marketing or recommending advice on any tax-related matters addressed herein.
The EFM Lawyer.