Three Things About U.S. Taxes Expats in Hong Kong Should Know
Common tax issues for American Living in Hong Kong
Having spent years helping U.S. citizens living and working in Hong Kong to manage their taxes, I have encountered three common misconceptions about foreign tax credits, Hong Kong retirement schemes, and foreign asset reporting. These can lead to costly errors and absurd IRS penalties. Here are three tips to help U.S. citizens living in Hong Kong avoid these common tax mistakes.
1. How Hong Kong taxes are accrued for the foreign tax credit.
Taxpayers in Hong Kong who cannot exclude all their income through the foreign-earned income and housing exclusions should take advantage of the foreign tax credit to prevent double taxation.
The foreign tax credit requires taxpayers to make a major decision: whether to take paid or accrued taxes. For most taxpayers, the consequences of this choice will last a lifetime, as they must use the same tax method for all future years.
Accrued taxes are a straightforward concept: An accrual results when an item has been incurred but not paid for. However, many taxpayers choose this option without being aware of how the IRS determines when taxes accrue. While working in a country with the same tax year as the United States, expats can accrue all the foreign taxes owed for that year. However, in countries with a different tax year, taxpayers cannot split and prorate the taxes that accrue. According to the IRS, foreign taxes cannot accrue until the tax year ends. Therefore, taxpayers in Hong Kong are unable to accrue Hong Kong taxes from April to December, since the Hong Kong tax year ends in March, which is after the U.S. tax year.
Here’s an example: Jim decides he wants to accrue his foreign taxes in Hong Kong for the 20X5 year. He will be allowed to accrue the Hong Kong taxes only from April 20X4 to March 20X5. The Hong Kong tax on income earned from April to December cannot be accrued, since the Hong Kong tax year ends on March 31, 20X6, which is after the US tax year of December, 31 20X5.
Taxpayers who are in their last year in Hong Kong and are accruing foreign taxes also should be aware that they will not get credit for the Hong Kong tax on income earned from April to December. This may mean they need to file an amended return so they can carry back the Hong Kong taxes that will accrue in March of the following year.
2. How your Hong Kong retirement contributions and earnings are taxed.
Many U.S. taxpayers in Hong Kong may be required to participate in the Mandatory Provident Fund (MPF) savings scheme. The MPF accounts could include a mix of employer and employee contributions. U.S. taxpayers should include both types of contributions in their income since MPFs do not qualify as retirement accounts and do not receive tax-deferral benefits under the U.S. tax code. The income in an MPF must be reported on the U.S. annual tax return.
The rules for reporting these types of foreign accounts are complex, and different elections can be made, but most taxpayers will find making a market-to-market election on a Form 8621 the best choice. Taxpayers with MPF accounts will need to track contributions, withdrawals, and the account’s change in market value each year. In most cases, MPF accounts will be subject to the passive foreign investment corporation (PFIC) rules. Congress put these rules in place to prevent U.S. taxpayers from holding investment accounts overseas to defer taxes.
When taxpayers make the market-to-market election, they calculate their MPF’s income and loss as follows. In the first year, the taxpayer adds up all contributions and subtracts them from the MPF’s fair market value (FMV) at the end of the U.S. tax year. If the result is a positive number, the taxpayer will have reportable income taxed at the ordinary rate. In the following year, the taxpayer will start with the FMV of the MPF at the end of the prior year and add up all contributions, then subtract them from the MPF’s fair market value at the end of the U.S. tax year. If the result is a negative number, the taxpayer will have an ordinary loss, but it will be limited to prior income reported. If it exceeds the prior year’s income, it will carry forward. Taxpayers with MPFs who have excess losses can release the losses in the year the MPF is cashed out or disposed of. Keeping detailed schedules of MPF accounts is crucial since the required annual calculation is cumulative.
It is important to note that MPF accounts will not receive special tax rates for long-term capital gains or qualified dividends. Therefore, taxpayers in high tax brackets usually will find MPFs an expensive investment.
Here’s a tip: A taxpayer who works for a U.S. employer that withholds Social Security and Medicare taxes is exempt from making employer MPF contributions. The taxpayer is not required to make employee contributions, but can do so voluntarily. Although making voluntary contributions to an MPF account may seem like a good way to save more for retirement, in most cases, taxpayers benefit more by contributing to regular U.S. brokerage accounts so they can take advantage of preferential long-term and qualified dividend tax rates.
3. Understanding all the informational forms needed to report foreign assets.
In recent years the IRS has greatly increased the amount of information U.S. taxpayers who own certain foreign assets must report. U.S. taxpayers living in Hong Kong may need to consider the following informational reporting forms and disclosures.
FBAR: Taxpayers who own or have signing authority over foreign bank accounts with an aggregate balance above 10K USD during the year must file a FABR disclosure. In prior years, these returns were due at the end of June, but moving forward, the due date will coincide with the due date for individual returns, April 15th. However, taxpayers can extend the due date to October 15th if they file for an extension.
Form 8938: Taxpayers living outside the U.S. may be required to disclose their foreign financial assets on this form if they are unmarried and have above $200,000 on the last day of the tax year, or more than $300,000 at any time during the year. This also applies to taxpayers who are married and have $400,000 on the last day of the tax year, or more than $600,000 at any time during the year. It is important for U.S. taxpayers living in Hong Kong to remember that their MPFs are foreign financial assets and may need to be reported on this form.
Form 5471 and 926: U.S. taxpayers who own 10% or more of a foreign corporation should seek the advice of a tax professional and ask if they need to file a Form 5471 and a Form 926 with their tax return. Taxpayers who fail to file a Form 5471 could be subjected to large penalties, regardless of the size of the foreign corporation. This informational return can be complex, even for small foreign corporations. Hiring a tax professional in this case is highly recommended.
Free Initial Consultation
For U.S. citizens living and working in Hong Kong, preparing taxes is complex and often confusing. If you need assistance preparing your returns, please contact us to request a free consultation.