01 July 2007

Stop Press - Proposed Revision of the Tax Rules on Expatriation


Jay H. Rubinstein
Partner | Switzerland

In General

The House Ways and Means Committee approved a proposal (the “Proposal”) that would tax certain U.S. citizens who relinquish their U.S. citizenship and certain long-term U.S. residents who terminate their U.S. residence.[1]  The tax would be on the net unrealized gain in their property as if such property had been sold (the “deemed sale”) for its fair market value on the day before his “expatriation date“[2] (the “mark-to-market tax”).  Gain from the deemed sale would generally be taken into account to the extent otherwise provided in the Internal Revenue Code.  Any net gain on the deemed sale would be recognized to the extent it exceeds $600,000.[3]

The Proposal would affect U.S. citizens who relinquish citizenship or long-term residents who terminate their residency on or after the date of enactment.  However, the portion of the Proposal relating to covered gifts or bequests would be effective for gifts and bequests received from former citizens or former long-term residents (or their estates) on or after the date of enactment, regardless of when the transferor expatriated. 

Similar provisions have been proposed several times over the last several years.  None have been enacted.  However, unlike past proposals, the House Ways and Means Committee approved the current Proposal.  Therefore, we believe that this Proposal or a similar proposal has a better chance of passage into law than prior proposals.

Individuals Covered

The mark-to-market tax would apply to any U.S. citizen who relinquishes his citizenship[4] and any “long-term resident” who terminates U.S. residency who (i) has an average net income tax liability of greater than $136,000[5] for the five (5) year period prior to expatriation; (ii) has a net worth of $2,000,000 or more; or (iii) fails to certify under penalties of perjury that he has complied with all U.S. Federal tax obligations for the preceding five (5) years or fails to submit such evidence of compliance as the Secretary may require (the “covered expatriate”).[6] 

Deferral of Mark-to-Market Tax Payment

Under the Proposal, an individual may elect to defer payment of the mark-to-market tax imposed on the deemed sale of property until the return is due for the taxable year in which the property is disposed.[7]  Interest is charged for the period the tax is deferred at the rate normally applicable to individual underpayments.  This election is irrevocable and is made on a property-by-property basis. 

The deferred tax attributable to a particular property is the amount that bears the same ratio to the total mark-to-market tax as the gain taken into account with respect to such property bears to the total gain from the deemed sale.  In order to defer payment, the individual must provide adequate security with respect to such property and he must consent to the waiver of any treaty rights that would preclude the assessment or collection of the tax. 

Rules for Deferred Compensation Items, Specified Tax Deferred Accounts and Trust Interests

Deferred Compensation Items

Under the Proposal, certain deferred compensation items will be subject to the mark-to-market tax.  For purposes of this calculation, an amount equal to the present value of the covered expatriate’s accrued benefit is treated as having been received on the date before the expatriation date.  No early distribution excise tax shall apply by reason of this treatment and appropriate adjustments shall be made to subsequent distributions from the plan to reflect such treatment.  Other qualifying deferred compensation items would not be subject to the mark-to-market tax; however, the payor must deduct and withhold a tax of thirty percent (30%) from any taxable payment to a covered expatriate.[8]  A taxable payment is subject to withholding to the extent it would be included in the gross income of the covered expatriate if such person were a U.S. citizen or resident. 

Specified Tax Deferred Accounts

Under the Proposal, the mark-to-market tax will apply to certain specified tax deferred accounts.  In the case of any interest in a specified account held by a covered expatriate on the day before the expatriation date, the expatriate is treated as having received a distribution of his entire interest in the account on that date.  Appropriate adjustments are made for subsequent distributions to take into account this treatment.  These deemed distributions are not subject to additional tax. 

Trust Interests

1.   Grantor Trusts

The Proposal makes a distinction between grantor trusts and non-grantor trusts.  A grantor trust is ignored as a taxable entity for U.S. federal income tax purposes.  The “owner” of the trust must include in computing his tax liability the items of income, deduction and credit that are attributable to the trust.  Therefore, in the case of the portion of any trust for which the covered expatriate is treated as the owner under the grantor trust provisions, the assets held by that portion of the trust are subject to the mark-to-market tax. 

2.       Non-Grantor Trusts

The mark-to-market tax does not apply to non-grantor trusts.  Rather, in the case of any direct or indirect distribution from the trust to a covered expatriate, the trustee must deduct and withhold from the distribution an amount equal to thirty percent (30%) of the distribution portion that would be includable in the gross income of the covered expatriate if he were subject to U.S. income tax.  The covered expatriate is treated as having waived any right to claim any reduction in withholding under any treaty with the U.S.  The Proposal does not provide an explanation as to how the withholding will be enforced against a non-U.S. trustee of a trust.

In addition, if the non-grantor trust distributes appreciated property to a covered expatriate, the trust recognizes the gain as if the property were sold to the expatriate at its fair market value. 

If a trust that is a non-grantor trust becomes a grantor trust for which the covered expatriate is treated as the owner, such conversion is treated as a distribution to the covered expatriate and will trigger the thirty percent (30%) withholding. 

Conversely, if a grantor trust becomes a non-grantor trust after the individual expatriates, it appears under the Proposal that the mark-to-market tax would apply to assets in the grantor trust and the thirty percent (30%) withholding requirement will not apply to the trust once it becomes a non-grantor trust.  This is an important point because the act of expatriating commonly converts grantor trusts into non-grantor trusts.

Treatment of Gifts and Bequests from a Former Citizen or Former Long-Term Resident

Finally, the Proposal provides for a special transfer tax for certain “covered gifts or bequests“[9] received by a U.S. citizen or resident.  The tax is calculated as the product of (i) the highest marginal rate of tax specified in the table relating to estate tax or, if greater, the highest marginal rate of tax specified in the table relating to gift tax, both as in effect on the date of receipt of the covered gift or bequest; and (ii) the value of the covered gift or bequest.  The tax applies only to the extent that the covered gifts and bequests received by the taxpayer exceed $10,000 during any calendar year and is reduced by the amount of any gift or estate tax paid to a foreign country with respect to such covered gift or bequest.  There does not appear to be any allowance for the one million dollar ($1,000,000) exemption from U.S. gift tax or the two million dollar ($2,000,000) exemption from U.S. estate tax normally granted to U.S. persons.  In fact, the Proposal does not seem to provide for a marital or charitable deduction either.

In the case of a covered gift or bequest made to a U.S. trust, the tax applies as if the trust were a U.S. citizen and the trust would be required to pay the tax.  In the case of a covered gift or bequest made to a foreign trust, the tax applies to any distribution, whether from income or corpus, made from such trust to a recipient that is a U.S. citizen or resident, in the same manner as if such distribution were a covered gift or bequest. 

The date that determines whether someone is a “covered expatriate” is the date of the gift or bequest.  Thus, it is possible that this particular provision will apply to a person who has expatriated in the past should he make a gift or bequest to a U.S. person.

Effective date

The effective date of the Proposal is the date on which it is enacted.  Therefore, as currently proposed, the mark-to-market tax will not apply to those individuals who expatriate prior to its enactment.  However, the Proposal may have a major impact on those who expatriate prior to enactment, and, in fact, those persons who expatriated long ago, as any gifts or bequests to U.S. persons after the date of enactment will be subject to an equivalent of the U.S. estate and gift tax.

Conclusion

In light of the Proposal, individuals who are considering expatriation should consider examining their expatriation time frame.  In addition, those individuals who expatriate prior to the enactment date (including those who expatriated years ago) and who are considering making gifts or bequests to U.S. persons in the future should review their planning. 


[1] The term “long-term resident” means any individual (other than a U.S. citizen) who is a lawful permanent resident of the United States in at least eight (8) taxable years during the period of fifteen (15) taxable years ending with the taxable years during which he ceases to be a lawful permanent resident or commences to be treated as a resident of a foreign country.

[2] An individual’s expatriation date is defined as the date on which he relinquishes U.S. citizenship, or, in the case of a long-term resident of the U.S., the date on which he ceases to be a lawful permanent resident of the U.S.

[3] The $600,000 amount is increased by the cost of living adjustment factor in future years. 

[4] For purposes of the mark-to-market tax, an individual is treated as having relinquished his citizenship on the earliest of four possible dates:  (i) the date on which he renounces his U.S. nationality before a diplomatic or consular officer of the U.S.; (ii) the date on which he furnishes to the U.S. Department of State a signed statement of voluntary relinquishment of U.S. nationality confirming the performance of an expatriating act; (iii) the date on which the State Department issues a certificate of loss of nationality; or (iv) the date on which a U.S. court cancels a naturalized citizen’s certificate of naturalization. 

[5] The $136,000 amount is increased by the cost of living adjustment factor in future years.

[6] An individual is excluded from the definition of “covered expatriate” where:  (i) he was born with citizenship both in the U.S. and in another country, provided that (a) as of the expatriation date he continues to be a citizen of, and is taxed as a resident of, such other country, and (b) he has been a resident of the U.S. for not more than ten (10) taxable years during the fifteen (15) year taxable period ending with the taxable year of expatriation; or (ii) he relinquished U.S. citizenship before reaching the age of eighteen and a half (18½), provided that he was a resident of the U.S. for not more than ten (10) taxable years before relinquishment. 

[7] The deferral of the mark-to-market tax may not be extended beyond the due date of the return for the taxable year which includes the individual’s death.

[8] This payment is in lieu of any withholding requirement under present law. 

[9] Defined as any property acquired (i) by gift directly or indirectly from an individual who was a covered expatriate at the time of such acquisition; or (ii) directly or indirectly by reason of the death of an individual who was a covered expatriate.  The definition excludes (i) any property shown as a taxable gift on a timely filed gift tax return by the covered expatriate, and (ii) any property included in the gross estate of the covered expatriate for estate tax purposes and shown on a timely filed estate tax return of the estate of the covered expatriate. 

Jay H. Rubinstein Partner | Geneva

Category: Article