A. In response to well-publicized expatriations of U.S. citizens as a tax avoidance technique, Congress added amendments to section 877 with the Health Reform Act (hereinafter HRA of 1996):
1. To presume a tax avoidance purpose for certain wealthy or high-income individuals;
2. To expand the resourcing rules of section 877 of the Internal Revenue Code (26 USC hereinafter IRC); and
3. To extend the rule to U.S. estate and gift taxes.
Coupled with this new tax law on expatriation is section 352 of the 1996 Immigration Reform Act that adds expatriation to avoid tax as a new grounds for excluding former U.S. citizens from entry into the United States.
B. The difference in the federal tax structure for U.S. citizens and residents and the tax structure for nonresidents allows for tax planning opportunities particularly related to ownership of shares in U.S. corporations.
1. U.S. citizens and residents are subject to U.S. income tax on worldwide income, while nonresidents are subject to U.S. income tax on U.S. source income and income effectively connected with a U.S. trade or business.
2. A nonresident who spends less than 183 days in the United States in the calendar year is not subject to U.S. income tax on capital gains from sales of stock in U.S. corporations and debt of U.S. entities, individuals, or federal, state or local governments.
C. To prevent U.S. citizens who surrendered U.S. citizenship from avoiding the recognition of significant capital gains, Congress adopted section 877 of the Internal Revenue Code in 1965 subjecting certain expatriating U.S. citizens to an alternative tax at ordinary graduated rates or at the rates of alternative minimum tax rates.
1. The alternative tax applies for a 10-year period following expatriation to former U.S. citizens who were found to have surrendered U.S. citizenship with the principal purpose of avoiding U.S. tax.
2. The alternative tax is based on resourcing rules that apply to tax gains from sales or exchanges of stock in U.S. corporations or debts of U.S. entities, individuals, and federal, state and local governments and sales or exchanges of property (other than stock or debt obligations) located in the United States.
3. This alternative tax does not apply to non-U.S. citizens who terminate U.S. residency with a tax avoidance purpose.
4. This alternative tax does apply, however, to resident aliens who terminate U.S. residency and then resume U.S. residency before the close of the third calendar year after ceasing to be a U.S. resident. The purpose of this rule is to prevent eliminate U.S. tax advantages for non-U.S. citizens who leave the tax system for a short period of time. No tax avoidance purpose is required in this situation.
II. INDIVIDUALS PRESUMED EXPATRIATING FOR TAX AVOIDANCE
A. An individual is treated as having a principal purpose to avoid tax if:
1. The individual's average net income tax liability for the five tax years ending before expatriation is greater than $100,000; or
2. If the individual's net worth on the date of expatriation is $500,000 or more.
After 1996 these amounts will be increased by annual cost-of-living adjustments and rounded to the nearest $1,000.
B. The new tax law is effective for U.S. citizens surrendering citizenship and certain long-term U.S. lawful permanent residents who cease being U.S. lawful permanent residents after February 5, 1995.
1. A long-term U.S. resident is an individual who is a U.S. lawful permanent resident in at least 8 out of 15 tax years ending with the tax year of expatriation.
2. A U.S. lawful permanent resident is not treated as a U.S. lawful permanent resident during any taxable year that the individual is treated as a resident of another country under the residency tie-breaker rule of an income tax treaty with that country and the individual fails to waive the benefits of the treaty.
C. The prior law requiring proof of a tax avoidance purpose continues to apply to other expatriating U.S. citizens and to non-U.S. citizens who terminate U.S. residency and regain U.S. residency before the end of the requisite three-year period.
D. U.S. citizens who officially renounce citizenship and who are determined by the Immigration and Naturalization Service (INS) to have renounced citizenship for the purpose of avoiding U.S. taxation are excludable from the United States.
1. Under the prior section 877 if the Treasury Department establishes that it is reasonable to believe that the expatriate's loss of citizenship will result in a substantial reduction in U.S. tax, the former citizen has an opportunity to rebut the presumption with proof that the loss of citizenship did not have as one of its principal purposes the avoidance of U.S. tax.
2. The new tax law provides a rebuttable presumption of a tax avoidance purpose for renouncing U.S. citizenship. However, the grounds for rebutting the presumption are very narrowly defined in the statute as described below. All other former U.S. citizens satisfying the presumption may be determined to be excludable with no actual finding of a tax avoidance purpose, a situation that poses significant due process issues.
3. An INA § 212(d)(3) waiver may be available for a former citizen to enter on a nonimmigrant visa. However, no waiver exists for entering as an immigrant.
4. Tax avoidance as a grounds for exclusion applies to renunciations of U.S. citizenship occurring after September 30, 1996.
5. No similar grounds for exclusion apply to long-term residents who are presumed to terminate residency for a tax avoidance purpose under the new tax law. Therefore, such a long-term resident could conceivably enter at some future time and become an immigrant and even a U.S. citizen. This opportunity is not available to former citizens.
E. An expatriating U.S. citizen meeting one of the following criteria may submit a request for a ruling from the Internal Revenue Service (IRS) within one year of loss of citizenship for a determination that there was no tax avoidance purpose for surrendering citizenship:
1. The individual was born with dual citizenship and retains only the non-U.S. citizenship;
2. The individual became a citizen of the country where the individual, the individual's spouse, or one of the individual's parents was born;
3. The individual was present in the U.S. for no more than 30 days during any year in the 10-year period immediately before the loss of citizenship;
4. The individual relinquished U.S. citizenship before reaching age 18 1/2; or
5. The individual is in a category of individuals as prescribed by regulations.
This is the only section of the law that applies only to U.S. citizens. All other references to U.S. citizens in the amended section 877 of the IRC apply also to long-term permanent residents under IRC § 877(e).
F. Congress stated in the Committee Report that in making a determination as to the presence of a tax avoidance purpose, the IRS should take into account the substantiality of the former citizen's ties to the United States including:
1. Ownership of U.S. assets before expatriation,
2. The retention of U.S. citizenship by the individual's spouse,
3. The extent to which the former citizen is subject to tax in his or her country of residence.
G. The IRS may issue regulations exempting certain categories of individuals from these rules and for situations in which an alien individual becomes a resident of the U.S. during the 10-year period following termination of U.S. lawful permanent residency.
III. ACTS OF EXPATRIATION
A. Loss of U.S. citizenship occurs when the individual performs one of the following acts:
1. The individual renounces U.S. citizenship before a diplomatic or consular officer of the U.S. under the Immigration and Nationality Act, § 349(a)(5);
2. The individual furnishes to the State Department a signed statement of voluntary relinquishment of U.S. citizenship confirming the performance of an act of expatriation under the Immigration and Nationality Act, § 349(a)(1)-(4);
3. The State Department issues the individual a Certificate of Loss of Nationality; or
4. A U.S. court cancels the individual's Certificate of Naturalization.
B. The act of expatriation of a long-term resident occurs when:
1. The individual relinquishes, revokes, or abandoned U.S. lawful permanent resident status within the meaning of section 7701(b)(6);or
2. When the U.S. lawful permanent resident commences being treated as a resident of another country and the individual is treated as a resident under the residency tie-breaker rule of an income tax treaty between that country and the United States and the individual fails to waive treaty benefits.
IV. REPORTING REQUIREMENTS
A. The HRA of 1996 requires individuals who expatriate to file an information statement that includes the individual's:
1. Taxpayer identification number;
2. Mailing address at his or her principal foreign residence;
3. New foreign country of residence;
4. New foreign country of citizenship;
5. Information detailing his or her assets and liabilities if the individual's net worth is at least $500,000; and
6. Any other information requested by the IRS.
B. A U.S. citizen must file the statement with the State Department or other U.S. government agency involved in the relinquishment on or before the date that the citizenship is treated as relinquished. A special transition rule applies to any U.S. citizen who committed an expatriation act before February 6, 1995 and who did not submit such a statement.
C. A U.S. lawful permanent resident must file the statement with the tax return for the year in which residency is terminated.
D. Failure to submit the statement will result in the imposition of a penalty for each year of the 10-year period that begins on the date of expatriation that is equal to the greater of 5 percent of the individual's section 877 tax liability or $1,000. The penalty can be waived if the failure is due to reasonable cause and not to willful neglect.
E. The State Department and federal agencies involved in the act of expatriation are required to provide the IRS with copies of the statements, or the names and other information on individuals refusing to submit such statements, and other government documents evidencing the loss of U.S. citizenship or U.S. lawful permanent resident status.
F. The IRS is required to publish the names of expatriates in the Federal Register within 30 days of the close of each calendar quarter unless the individual is one of a class of individuals determined by regulation to be exempt from such reporting.
G. Procedures for the notification to INS by the IRS of individuals expatriating for tax avoidance purposes can be expected to be automatic. Once INS is notified of such individuals, these persons can then be added to the INS and State Department watch lists for exclusion purposes.
V. EXPANDED RESOURCING RULES
A. If the expatriation rule applies, U.S. tax is imposed on the following items of U.S. source income:
1. Gains on the sale or exchange of stock in a U.S. corporation;
2. Gains on the sale or exchange of debt of U.S. entities, U.S. citizens and residents, or of the federal, state, or local governments;
3. Gains on the sale or exchange of property (other than stock or debt obligations) located in the U.S.; and
4. Income or gain from stock in certain foreign corporations, but only:
a. If with respect to an individual, within the 2-year period prior to expatriating, the individual is considered to own more than 50 percent of the corporation by vote or value by applying the attribution rules of IRC § 958(b), and
b. To the extent such income or gain does not exceed the earnings and profits attributable to such individual before the expatriation event and during which the ownership requirements are met.
B. To avoid U.S. taxation of pre-U.S. residency period appreciation, property held by a long-term resident on the date the individual first became a resident is treated as having a basis equal to the fair market value of the asset on such date unless the individual irrevocably elects otherwise.
C. During the 10-year period following expatriation, an individual must recognize gain on exchanges that would otherwise be from a nonrecognition transaction if income from the property changes from U.S. source to foreign source.
1. Gain is measured as if the property were sold at fair market value on the date of the exchange.
a. Gain is recognized in the taxable year in which the exchange occurs.
b. The property receives a step-up in basis to the extent of gain recognized.
2. The IRS can extend the rule by regulation to 15 years to include exchanges occurring five years before the act of expatriation.
3. The IRS may apply this rule by regulation to the removal of appreciated tangible assets such as artwork and collectibles from the U.S. without the recognition of unrealized gain.
4. Immediate recognition of gain can be avoided by entering an agreement with the IRS to recognize income or gain from the property acquired in the exchange as U.S. source income for the 10-year period.
a. The agreement is terminated if the property exchanged by the individual is disposed of by the person acquiring the property.
b. Any gain not recognized because of the agreement will be recognized on the date of the disposition.
D. The running of the 10-year period is suspended with reference to any property for any period during which the expatriating individual's risk of loss in the property is substantially diminished by:
1. The holding of a put for the property;
2. The holding by another person of the right to acquire the property; or
3. A short sale or any other transaction.
E. During the 10-year period following the expatriation event, if property is contributed to certain foreign corporations and income from the property is or would have been U.S. source, then any income or gain received or accrued from the property by the corporation during the 10-year period is treated as received or accrued by the individual.
1. A corporation is covered by this rule if, but for the expatriating event, the corporation would be a controlled foreign corporation (CFC) and the individual would be a U.S. shareholder.
a. A corporation is a CFC if 50 percent or more by vote or value of the corporation's stock is owned directly, indirectly, or constructively by U.S. Shareholders.
b. An individual is a U.S. shareholder if he or she is, or would have been, in this case a U.S. citizen or resident and the individual owns directly, or indirectly based on the attribution rules of section 958, at least 10 percent shareholder of the stock in the corporation.
2. If stock of the corporation is disposed of while the property is held by the corporation during the 10-year period, the disposition is treated as a pro rata sale of the property.
F. The expatriation tax is reduced by a foreign tax credit allowed for foreign taxes paid on any income taxed under the expatriation rules. The foreign taxes paid cannot be used to offset other U.S. taxes.
G. The IRS is expected to review existing tax treaties for conflicts with the expatriation tax rules and to renegotiate affected treaties. On the tenth anniversary of the enactment of the HRA of 1996, conflicting treaty provisions will precede the expatriation tax provisions.
VI. U.S. EXPATRIATE GIFT TAX
A. U.S. citizens are subject to U.S. gift tax on the fair market value of worldwide gifts subject to certain exceptions and the application of the unified credit.
B. Only gifts of U.S. situs property by non-U.S. citizens not domiciled in the United States are subject to U.S. gift taxes. Intangibles such as stock in U.S. corporations and debt of U.S. entities and individuals and debts of federal, state and local governments are not included in the definition of U.S. situs property for U.S. gift tax purposes.
C. Prior § 2501 of the IRC imposed U.S. gift taxes for a period of 10 years on gifts of intangible property by U.S. citizens determined to have surrendered citizenship with the principal purpose of avoiding tax.
D. The HRA of 1996 extends U.S. gift taxes to intangible gifts made by wealthy or high income former U.S. citizens and former long-term residents presumed to have expatriated for tax avoidance as defined under the above rules.
E. A credit against the gift tax is available for any foreign gift tax paid.
VII. U.S. EXPATRIATE ESTATE TAXES
A. The worldwide assets of U.S. citizens and non-U.S. citizens domiciled in the United States at death are subject to U.S. estate taxes.
B. Only U.S. situs property is includable in the U.S. estates of non-U.S. citizen decedents not domiciled in the United States. U.S. situs property for U.S. estate tax purposes includes shares of stock in U.S. corporations and debt of U.S. entities and individuals and debt obligations of federal, state and local governments.
C. The gross estate of a former wealthy or high income U.S. citizen or long-term resident decedent who dies within 10 years of an expatriation act may include a portion of the value of the stock in a foreign corporation if the decedent owned more than 50 percent of the vote or value of the corporation at the time of death.
D. A credit for foreign death taxes paid, with certain limitations, is allowed against the expatriate estate tax.
VIII. CONCLUSION
A. Congress has effectively blocked the short-term tax savings from surrendering U.S. citizenship. Careful planning is required for those citizens planning expatriation for long-term tax benefits.
B. Wealthy or high income U.S. lawful permanent residents who change their country of residence need to be advised on these matters to avoid unexpected U.S. estate and gift taxes.
C. The real danger under the new tax and immigration laws is that a U.S. citizen may renounce U.S. citizenship, discover that the renunciation fails to accomplish the desired tax objective and find him or herself excludable from the United States.