By: Jerald David August
Chair, International Taxation and Wealth Planning Group
Set of Expatriation Blog Posts
This is the second in a series of blog posts on the US income and wealth tax implications of expatriation. This post sets forth the U.S. approach to the expatriation of a U.S. citizen and long-tern resident prior to the effective date of the Heroes Act of 2008 which applied to expatriations occurring after June 16, 2008. The succeeding post will summarize the existing law under the Heroes Earnings Assistance and Relief Act of 2008 which introduced the “mark-to-market” tax regime.
The U.S. Approach to the Expatriation of a U.S. Citizen and Then Long-Term Resident Prior to the Heroes Act in 2008
Before the enactment of the Foreign Investors Tax Act of 1966, when an individual renounced her U.S. citizenship or green card status and to become a nonresident, no realization event was imposed under the tax law which stands in marked contrast to the income realization event imposed, subject to exception, under present Section 877A. In addition, the U.S. expatriate would no longer be subject to tax on her worldwide income, only income sourced within the United States. By 1960, Congress became concerned that the state of the law at that time encouraged expatriation since it allowed the expatriate to avoid the graduated income tax rates on her U.S. investment income, e.g., FDAP and U.S. gift and estate tax on worldwide holdings. The response was the enactment of the Foreign Investors Tax.
Under new Section 877 under the Foreign Investors Tax Act of 1966 (“FITA”), a U.S. citizen who renounced her U.S. citizenship would remain subject to U.S. income tax on such individual’s ECI and any other U.S. source income at regular income tax rates for a period of 10 years from the taxable year in question (and after March 8, 1965) provided that one of the principal purposes of the expatriation was the avoidance of U.S. income, estate, or gift taxes, and further provided such rule did not result in a lower income tax impact than would otherwise follow. If the individual expatriate passed away within the 10-year period, a special estate tax rule applied.
Under FITA, Congress introduced an alternative income tax rule applied under Section 877(b) should the alternative regime produce a greater amount of tax. Section 877(b) included as U.S. source income, gains from the sale or exchange or property (other than stock or debt obligations) located in the United States, and gains on the sale or exchange of stock of a domestic corporation or debt obligations of U.S. persons or of the United States, a State or political subdivision, or the District of Columbia, regardless of where the sale or exchange occurs or title is transferred. Deductions were allowed only to the extent properly allocable to the gross income of the expatriate, determined under the above-described provisions (except that the capital loss carryover provision is not to apply). For federal transfer tax purposes, under Section 2017, in the event a U.S. expatriate died within 10 years following expatriation, such individual’s U.S. taxable estate would include, in addition to U.S. situs property otherwise subject to estate tax in the case of a nonresident (non-domiciled) individual, shares of stock held at the date of death reflecting ownership, whether direct or indirect, of 10% or more of a foreign corporation treated as owned more than 50% by the decedent. Constructive ownership rules under Section 958 were applied.
Under Section 2501(a)(3), also amended by FITA, the general gift tax exclusion for transfers by gift of intangible property made by a nonresident (nondomiciled) alien was not applicable for transfers by gift made within 10 years after expatriation by a U.S. citizen. Accordingly, an expatriate was subject to gift tax on transfers of U.S. situs intangible property during the 10-year post-expatriation period. It should be noted that under FITA, “a” principal purpose test was applied separately for income tax purposes versus U.S. transfer tax purposes.
After the Foreign Investors Tax Act of 1966 Came The Health Insurance Portability and Accountability Act of 1996 in Reforming the Rules Applicable to Expatriation
Twenty years later, in The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”), Congress expanded the expatriation rules for long-term residents who relinquish their green cards. HIPAA revised the “a principal purpose” of tax avoidance prerequisite by setting forth a statutory presumption that such purpose was present where an expatriate individual satisfied an average tax liability and net worth tests. Where the statutory presumption test was met, the expatriate in many cases would need to request a favorable private letter ruling from the IRS within the one-year period beginning on the date of the loss of United States citizenship that a principal purpose was not avoidance of taxes.
Other changes were introduced in HIPAA including special anti-avoidance sourcing rules with respect to: (i) gains from the sale of property other than stock or debt; (ii) gains from the sale of stock issued by a U.S. corporation; (iii) gains on debt obligations of a U.S. person or government; and (iv) gains from a CFC where the expatriate owned 10% or more of the voting power and at least 50% of the total value of that corporation’s stock.
Next Change by Congress: The American Jobs Protection Act of 2004
In The American Jobs Protection Act of 2004 (“AJCA”),Congress decided it was time to abandon the “a principal purpose” test in trying to determine the subjective intent of the taxpayer. While the presumptions based on average income tax liability or net worth thresholds reflected objective facts, the presumptions were still rebuttable. Moreover, the subject test still applied to expatriates who did not meet either statutory presumption test. Congress noted that the level of reporting by individuals after an expatriation was spotty and undesirable. Many in Congress wanted the tax benefits of citizenship relinquishment or residency termination denied until an individual provides information necessary for the IRS to properly administer the alternative tax regime. ACJA enacted major reforms to the expatriation provisions. First, it repealed the subjective intent test and provided objective standards for applying the alternative tax regime for the requisite 10-year period. In order to avoid being subject to the alternative tax provisions, the former U.S. citizen or green card holder would need to: (i) establish that her average annual net income tax liability for the five preceding years does not exceed $124,000 (adjusted for inflation after 2004) (now $168,000 in 2019); (ii) establishes her net worth does not exceed $2 million (without inflation adjustment), or alternatively satisfies limited, objective exceptions for dual citizens and minors who have had no substantial contact with the United States; and (ii) certifies under penalties of perjury that she has complied with all U.S. Federal tax obligations for the preceding five years and provides such evidence of compliance as the Secretary of the Treasury may require.
ACJA also announced a notification of the expatriate’s renunciation of citizenship or green card status had to be noticed with the Office of Homeland Security and until such notice is provided, such individual is still treated as a U.S. citizen or permanent resident for U.S. federal tax purposes until such individual provides such notice and files a statement required under Section 6039G. Another AJCA reform was that the expatriate remains subject to full U.S. taxation on her worldwide income where such expatriating individual is present in the United States for more than 30 days in the calendar year ending in such taxable year within the 10-year window. Should the expatriate die within a taxable year in which she is present in the United States for more than 30 days, she is treated as domiciled in the United States and subject to U.S. estate tax on her worldwide gross estate less applicable deductions. Similarly, if an individual subject to the alternative tax regime is present in the United States for more than 30 days in any year during the 10-year period following citizenship relinquishment or residency termination, the individual is subject to U.S. gift tax on any transfer by gift of assets regardless of Sections 2104 or 2105 of the Section. This rule is referred to as some commentators as the anti-gaming the system rule.
Well, the introductory post and this second blog post on the background leading up to the mark-to-market tax and inheritance tax under our current set of expatriation provisions in the Internal Revenue Code are set out in broad terms. The next posts will address current law and in some detail.
This post is for informational purposes and may not be relied upon as legal advice issued by Fox Rothschild LLP or Jerald David August. If you have questions on expatriation please seek the advises of your legal counsel, including your lawyer at Fox Rothschild LLP or Mr. August.