Spain is becoming a trendy destination for teleworking. Apart from the traditional international assignees, we are experiencing an ever-growing number of relocations related to the so-called digital nomads, who move to live in our country while working for foreign employees or clients. Americans are no exception.
Surely, most inpatriates did some tax research and know the basics of Spanish tax system. Others might have been lucky enough to receive a more specific advice from the company’s tax advisors. However, these analyses are usually focused on the tax treatment of current personal and economic situation in the destination country, not intended for long-term residency and planning.
By now, you must already know that, as an American living in Spain, you must file Spanish taxes and reports in Spain, but also those required by the U.S., including income taxes, gift and estate taxes, and foreign assets reporting. Our experience from working with Americans allowed us to identify hot issues arising from this double tax filing obligations which are often overlooked. This post addresses three advanced tax-smart issues you should be covering in your research and New Year’s tax-planning as an American living in Spain.
Foreign currency exchange gains and losses
Despite the euro being the currency in your economic environment, the one you habitually use in your daily transactions, as an individual, all your U.S. tax liabilities must to be translated into U.S. dollars. There are different rules to determine the currency exchange rate applicable depending on the type of income, capital gain or report to be made.
But having U.S dollar as the currency of reference (functional currency) has an important and often overlooked consequence: you will have to report gains and losses realized because of changes in exchange rates between the dollar and the euro on the date of acquisition and before the date of disposition. In addition, this gain or loss will not receive the beneficial capital gain treatment for U.S. tax purposes but will be considered ordinary income. In other words, for U.S. tax purposes, if you buy a house in Spain and then sell it, you will have a gain or loss on the sale of the house, plus a gain or loss (ordinary income) on the fluctuation of the dollar against the euro from the date of investment to the date of sale. Same if you invest in stock in euros or any other currency, or if you take on a mortgage on your house. In these situations, you may be able to offset your U.S. tax liability with the taxes paid in Spain upon the sale of the asset (house, stock, bonds, etc.) but there is no way to offset the liability on a gain or loss on the currency exchange.
Beware of PFICs
Investing in mutual funds and ETFs is usually a good strategy in Spain taxwise, since your realized gains will be tax-free as long as your proceeds are directly reinvested in another mutual funds. However, there are two U.S. tax consequences of your investment you should be aware of.
On the one hand, your Spanish tax-free transfer between mutual funds will not enjoy the beneficial treatment in the U.S. and capital gains will have to be reported.
On the other, your non-U.S. mutual funds and other European pooled investment vehicles qualify as Passive Foreign Investment Companies (PFIC). U.S. tax treatment for PFICs is extremely complex and punitive:
- Capital gains deriving from the disposition of a PFIC are ordinary income, must be allocated over the holding period on a daily basis and taxed at individual’s maximum tax rate for year (currently 37%).
- Dividends distributed exceeding 1.25% of the average dividends received in the three previous years will be taxed as described above.
- Each PFIC shall be reported individually in Form 8621 and filed together with your income tax return.
- PFICS shall also be reported in NFBAR.
If you decide to take advantage of the beneficial tax-free transfer between funds in Spain, it will be very difficult to even mitigate the PFIC’s punitive treatment and may be facing double taxation upon liquidation of your interest in the funds.
The rationale behind this punitive tax treatment is to avoid deferment of U.S. taxation by investing in foreign mutual funds so, apparently, the easy way to overcome this treatment would be to invest in U.S. mutual funds. However, FATCA has made it very difficult for Americans not living in the U.S. to invest in U.S. mutual funds all together.
Optimizing your Foreign Tax Credit
Although Americans must make a double filing, it does not necessarily mean double taxation. Americans living in Spain are entitled to offset their U.S. tax liability by deducting Spanish taxes paid on income included in the U.S. filing, technically called Foreign Tax Credit (FTC).
Applying the rules to quantify the credit for Spanish taxes paid can be complex, but we would like to call your attention on the election to the method. As you may well be aware of, Americans report their income on a cash basis: you report income and pay your taxes as you receive the income. Similarly, as a general rule, you will be allowed to deduct taxes paid in the year of reporting; i.e., you can deduct taxes actually paid during the year under report.
Contrary to U.S persons, Spanish tax residents do not have to make estimated payments to cover for their annual tax liability before the end of the year in Spain. However, most types of income are subject to withholdings. Any balance of tax due exceeding the amount of withholdings shall be paid upon filing (April to June next year), with no interests or penalties. This implies that, if the income is not subject to withholding, the year in which you receive the income and pay the corresponding tax will be different. This happens, for instance, with rental income and most capital gains. So if you have any of these chances are you will not be entitled to the foreign tax credit in the year in which you report your income in the U.S.
However, a cash-basis American taxpayer can make an election to calculate foreign tax credit based on foreign taxes accrued. This election will allow the American living in Spain the possibility to timely adjust deduction of foreign taxes paid with income reporting in the same year. This election is not always available, so you should consult your U.S. tax preparer to confirm.
Because being exposed to the tax rules of two countries complicates your tax preparation, international tax experts should be consulted to avoid both inefficiencies and unpleasant surprises. You can trust our team of tax lawyers specialized in U.S. and Spanish tax law to achieve the peace of mind you need when dealing with tax matters and optimize your tax liabilities in both countries. You can contact them here.
Director in Tax Department