12. Canadians who are also U.S. citizens and considering renouncing such citizenship - Some U.S. tax implications By Simon Sturm

Transcription

1 12. Canadians who are also U.S. citizens and considering renouncing such citizenship - Some U.S. tax implications By Simon Sturm Under U.S. tax laws an individual who is either a U.S. citizen or a U.S. resident is subject to U.S. taxation on their worldwide income and their worldwide assets are includible in their U.S. estates. (See Tag #1 and Tag # 16) The only way a U.S. person can lose such U.S. tax status is to formally renounce their U.S. resident and/or citizenship status in a prescribed statutory manner. Such renunciation may create a variety of immigration concerns, but just as ominously it may trigger very significant U.S. tax liabilities immediately at the time of renunciation. In addition, it can result in new unwanted U.S. estate and gift tax consequences down the road. (See discussion below.) Nevertheless, in recent years a very significant number of the estimated 7 million or more U.S. citizens living both in Canada as well as other countries outside the United States have been strongly considering abandoning their U.S. citizenship. According to the U.S. Treasury Department, in the 2015 calendar year 4,279 individuals renounced their U.S. citizenship or U.S. long-term residency status. (For all of 2014, 3,415 U.S. citizens were listed as having expatriated (vs. 2,999 for 2013, and 922 in 2012.) Many of these citizens derived their U.S. citizenship status by virtue of simply being born in the United States or by virtue of being the child of one or more parents who were U.S. citizens. At the same time many foreign nationals acquired U.S. citizenship as a second nationality or obtained a U.S. green-card visa because they believed that it was an advantageous status and now regret their decision. Some of the reasons for such renunciation include the following: 1) the new aggressive enforcement policy of the IRS in pursuing U.S. taxpayers abroad with offshore accounts who have not been filing returns in past years, 2) the possible U.S. taxes due for past years along with interest and penalties that may be imposed by the IRS once returns start to get filed, 3) the excessive administrative time and costs involved in becoming and annually staying U.S. tax compliant (even where no U.S. taxes end up owing due to U.S. allowable foreign income exclusions and as well as foreign tax credits) and 4) the increased intensive scrutiny by the IRS into the offshore accounts of U.S. citizens and green-card holders abroad resulting from the identification of such U.S. taxpayers to the IRS by Canada and other host countries under the recently enacted FATCA regulations. (See Tag #11; see also, Tag #1, Tag #2, Tag #3, Tag #5 and Tag #9.) Individuals seeking to renounce their U.S. citizenship must not only abandon their status for immigration purposes, but more importantly must satisfy the separate conditions required to abandon U.S. citizenship for U.S. tax purposes under Section 877(A)(g)(4) of the Code. U.S citizenship under this

2 provision is lost only upon the issuance by the U.S. Department of State of a Certificate of Loss of Nationality, usually after an individual has renounced nationality before a diplomatic or consular official. Accordingly, loss of U.S. status for immigration purposes does not automatically enable an individual to lose such status for U.S. tax filing purposes. There are separate tests involved. For individuals seeking to give up their U.S. green card visas, the date of termination of their long term residency status for U.S. tax purposes occurs on (1) the date voluntarily abandon their status by filing a Record of Abandonment of Lawful Permanent Resident Status (Form 107,) or (2) the date they become subject to a final administrative order for removal from the United States or (3) for individuals who are dual residents, the date they commenced to be treated as a resident of a foreign country under the provision of a tax treaty that country has with the U.S. and gave notice to the Secretary of such treatment. For U.S. tax purposes, individuals seeking to renounce either U.S. citizenship or U.S. green-card status will have to certify that they have been in full U.S. tax compliance for the five years prior to their planned renunciation. (See tax compliance test discussed below.) As a result, from a practical standpoint in most cases expatriation is not a very good strategy for easily solving past U.S. noncompliance problems. The IRS insists that the U.S. taxpayer first let all cats out of the bag before it will allow him to leave the country and avoid future U.S. tax liabilities on income earned abroad. Such revelations if made, may entail in the imposition by the IRS of very considerable civil, and possibly even criminal, penalties unrelated to the act of expatriation. In order to get a better sense of the U.S. tax laws presently governing individuals living abroad and seeking to renounce their U.S. citizenship status, a little historical perspective is useful. Prior to 2008 individuals who gave up their U.S. citizenship or terminated their long term U.S. lawful resident status (i.e. those with green card visas for at least 8 of the 15 years prior to expatriation) were subject to a 10 year alternative tax regime on their U.S. source income. This meant essentially that any income earned by such individuals from U.S. sources, including the sale of securities issued by a U.S. entity or the sale of U.S. real estate during the 10 years after they left, was subject to U.S. income tax. However, the tax would only be triggered by the occurrence of a taxable event involving the actual disposition of an asset owned at the time citizenship was renounced. Furthermore, on the death of such expatriate during the 10 years after abandoning U.S. citizenship, their U.S. estate would include not only their property which had a U.S. situs but also in very limited circumstances shares of certain foreign entities held as of the date of death Such expatriate was subject to gift taxes of U.S. situs tangible or intangible property for a 10 year period. (See discussion below.) Under the law in effect until 2008 for the purpose of both the U.S. income and estate and gift tax provisions to be applicable to an expatriate, all the IRS had to do was show that it was reasonable to believe that the expatriate had a principal reason (it was not simply a secondary motive) of tax avoidance when they gave up U.S. citizenship. On making this case the burden of proof shifted to the renouncing taxpayer to prove otherwise if they sought to avoid the 10 year shackles imposed by the IRS.

3 After 2008 this method for taxing those who abandon their U.S. citizenship changed considerably. The U.S. laws now impose a deemed exit tax on the global assets of a U.S. person surrendering their U.S. citizenship (and possibly U.S. green-card status.) For a Canadian individual who is also a U.S. citizen but wishes to renounce such status this means that provided they qualify as covered expatriates as defined further below, there would be immediate U.S. as well as long term U.S. tax consequences. Under present U.S. tax laws a covered expatriate (not all expatriates) would be required to recognize any appreciation in value attributable to any and all of their worldwide assets including, but by no means limited to, U.S. and Canadian securities, other tangible and intangible assets and real estate. This expatriate tax is imposed through a new mark-to-market evaluation of the individual s global assets (including interests in grantor-trusts, gifts and bequests). Gains representing a form of phantom income are calculated based on a deemed sale of the covered expatriate s worldwide assets on the day prior to the date that U.S. citizenship is renounced or the day they cease to be a lawful U.S. permanent resident. Valuation of property considered as owned for mark-to-market purposes could in many circumstances require a formal evaluation. In effect such individual would be forced to have their unrealized gain treated as recognized gain, and therefore subject to immediate U.S. taxation at the time they formally renounce their U.S. citizenship under U.S. immigration laws. In connection with any gains, there is an exclusion of (US) $ 668,000 (in 2015) discussed below which is allocated proportionately among all the assets subject to the exit tax. Any net gains (long-term) realized above the excludible amount will generally be subject to the U.S. capital gains tax rate of 20%. A covered expatriate to whom the mark-to-market tax regime applies would be an individual seeking to give up their (i) U.S. citizenship or (ii) long term permanent resident status. (Such long term permanent resident status generally applies to individuals holding a U.S. green-card visa for parts of at least 8 out of the previous 15 years, not including years where they filed as non U.S. residents by virtue of being residents of another country under a treaty.) Such individuals could be treated as covered expatriates if they meet ANY of the following tests by virtue of either (a) having an average net income tax liability over the five year period before they expatriated of more than (US) $160,000 (in 2015, $161,000 in 2016 Tax liability test ) or (b) having a net worth based on their worldwide assets at the time they relinquished their U.S. citizenship in excess of (US) $2,000,000 ( Net worth test ) or (c) failing to formally to certify on Form 8854 that they had complied with all U.S. tax filing obligations for the five years preceding the date of their expatriation ( the Compliance test. ) However, this mark-to market tax will only apply to a covered expatriate where after calculations are concluded using estate tax valuation principles for the appraisal of their assets, the deemed realized net gains from such assets in the year of abandoning their U.S. citizenship exceeds the minimum threshold amount in 2015 of (US) $ 690,000. Where the phantom income realized in the year

4 of expatriation does not exceed this minimum amount, there will be no exit tax/income tax consequences of U.S. expatriation. However, where the expatriating party meets the qualifications for being a covered expatriate there will remain long-term U.S. estate and gift tax consequences of expatriation which effectively remain forever as discussed further below. There is a possible exception to the applicability of covered expatriate status based on the net asset or tax liability tests in the case of (i) individuals who had dual U.S.-Canada citizenship at birth and who had not lived in the United States for more than 10 of the preceding 15 years and (ii) those under age 19½, who had not met certain statutory U.S. substantial presence tests prior to expatriating. (See Tag # 15) However, even these individuals would have to meet the Compliance test described above if they sought to avoid the potentially fearsome U.S. tax consequences of covered expatriate status. For those who had in previous years failed to file U.S. returns, if they qualify to do so, they may consider filing for the preceding three years under the IRS Streamlined Procedures ( see Tag #7.) They could then proceed to file separate U.S. returns for the ensuing two years, thereby meeting the Compliance test s five year filing requirement. In this way they would avoid covered expatriate treatment regardless of the level of their U.S. tax liabilities or worldwide assets in preceding years. Where a U.S. exit tax is applicable, the IRS has established a set procedure enabling an expatriating U.S. citizen to avoid immediate payment of the tax under the mark-to-market regime. This can be accomplished by a covered expatriate electing at the time they renounce their U.S. citizenship to defer payment of the tax to a future date when an asset they own at the time their U.S. citizenship status is actually eventually sold. This can be done on an asset-by-asset basis. Such tax deferral would be permitted by the IRS but only where the expatriate provided adequate and acceptable security and irrevocably waive the benefit of any U.S. tax treaty that might otherwise prevent the assessment of a U.S. tax on the asset at a later date. The election ends with respect to any property covered by such security when the taxpayer dies if by then the property was not previously sold, or when the IRS determines that the security provided at the time of expatriation is no longer adequate. The IRS has complete discretion to determine whether it will agree to enter into a tax deferral arrangement with a covered expatriate. Where a U.S. expatriate had elected to defer payment of the mark-to-market tax, a Form 8854 would have to be filed by them annually in subsequent years until the tax is in fact eventually paid provided such election has been approved by the IRS. Despite the fact that tax is deferred, interest at the normal rate applicable to underpayment of taxes accrues on the deferred taxes. Certain special rules not discussed here apply to deferred compensation arrangements. All other U.S. tax non-recognition deferrals are terminated as of the day before expatriation. Furthermore, as discussed in the following paragraph on receipt by a U.S. person of a gift or bequest from a covered expatriate, there is an estate and gift tax imposed on them. However, no such tax would apply to transfers entitled to the benefits of the U.S. marital deduction or a charitable deduction. Furthermore, in determining whether a recipient is a U.S. person for these purposes the criteria is whether their factual circumstances indicate that they were domiciles in the United States rather than whether they would be considered U.S. taxpayers for U.S. income tax purposes.

5 On renouncing U.S. citizenship, the taint of covered expatriate status never ends and has long term U.S. estate and gift tax consequences. After expatriation any subsequent gift by a covered expatriate or a bequest distribution from the estate of a covered expatriate to a U.S. beneficiary would require payment of taxes by the beneficiary at the highest applicable estate and gift tax rate on the amount received (in 2015,at the rate of 40%.) It would also require the recipient of a covered gift or bequest to file a new Form 708, which is at this point only in a proposed stage and has not yet been finalized. This would apply whether the covered expatriate acquired the property being transferred prior to expatriation or even at any time afterward. The tax would apply to direct or indirect transfers to a U.S. beneficiary, including transfers made to a U.S. beneficiary from a non-u.s. trust. In addition, where a covered expatriate has control over property in a trust through the general power of appointment over property held by a trust, the exercise, release or a lapse of the power would be considered to represent a covered gift or bequest to a beneficiary. (The annual gift tax exemption for gifts of up to $14,000 per person would still apply.) Under the proposed regulations there is a rebuttable presumption that any gift received from a former U.S. person is treated as a gift from a covered expatriate taxable at the 40% rate unless the recipient can prove otherwise. The U.S Treasury Department in September 2015 has proposed a complex set of Regulations covering covered gifts and covered bequests which is expected to be finalized and adopted in 2016, but there are likely to be considerable modifications yet in store for the present form of this proposed form. A U.S. taxpayer considering renouncing their U.S. status should consider these new rules carefully before renunciation. Even if after doing the calculations such U.S taxpayer would not incur significant U.S. income tax consequences as a result U.S. expatriation, ( and there are concededly a considerable number of other advantages described above of doing so, ) if a U.S. citizen spouse or U.S. citizen/resident children remain in the picture after expatriation. Any covered gifts or bequests as well as any possible transfer of property to them in years ahead could only be accomplished at an exceedingly high 40% U.S. tax cost to be paid by the U.S. beneficiary. At the same time, the retention of U.S. tax status, with all its failings, might avoid such cost by virtue of the (US) $ 10,860,000 unfied estate/gift tax exemption (in 2015) available to married U.S. taxpayers (See Tag #16.) All U.S. citizens seeking to renounce their citizenship formally must submit to the IRS a Form 8854 (Expatriation Information Statement). This essentially requires that the person intending to expatriate certifies under penalty of perjury that he or she has fully complied with income tax and information disclosure filing requirements. If in fact no returns had been filed, such expatriate would be required to proceed to file all required U.S. income tax and information disclosure returns, including FBARs, covering the preceding 5 year period. This would result in the full disclosure of their worldwide assets. Additionally, they would be required to certify that they have complied with all federal tax obligations and paid all taxes due over the course of the preceding five years. Any taxpayer who fails to submit this certificate of five year tax compliance would be subject to the mark-to-market effective exit tax described above, irrespective of whether they met the income tax liability or net worth conditions normally required to trigger such tax. The recent spate of proposed legislation relating to U.S. expatriates suggests very clearly that there is not a great deal of sympathy accorded in Washington to the many U.S. citizens abroad now

6 considering expatriation. This is the case despite the fact that the recent rapid increase in the number of U.S. citizens abroad renouncing their U.S. citizenship is generally not a political statement in reaction to any American domestic or foreign policies. Rather, it is fundamentally a reaction by them not only to the high U.S. tax costs of dual citizenship, but the extensive administrative burdens of filing so many different required U.S. tax and asset information returns along with the new aggressive policy by the IRS in seeking to collect taxes and penalties from U.S. persons abroad. (See Tag #3, Tag #4, Tag #5 and Tag#11.) U.S. citizens considering giving up their U.S. citizenship status and expatriating should also be made aware of the existence of the Reed Amendment enacted in The amendment prohibits reentry to the United States of U.S. citizens who in the opinion of the Attorney General expatriated for a principal tax avoidance purpose. The amendment has never really been implemented and enforced by Department of Homeland Security. Individuals considering renouncing their U.S. citizenship should, nevertheless, be aware of the fact that the amendment is still on the books. It may, at the very least, be a disturbing element which should be confronted prior to making a final and irreversible formal decision to surrender U.S. citizenship. DISCLAIMER: Any U.S. federal tax advice included in this article or in any articles on this web site is not intended to be used and may not be used by you or any other person for the purpose of avoiding penalties that may be imposed by the Internal Revenue Code or marketing or recommending to another party any tax related matter addressed in this article or on this web site. The information provided here is intended as a general guide for Canadians with no direct U.S. ties as well as those who may be U.S. citizens or residents.however, it should not be relied on as a basis for making decisions or taking action affecting possible U.S. tax obligations including annual U.S. income tax and/or financial disclosure returns. Canadians subject to such filings who have not complied with such filing requirements in past years are generally advised to voluntarily come forward and become U.S. tax compliant. No representation is made with regard to the correctness or timeliness of the information presented. Canadians concerned with the possibility of U.S. tax obligations should consult directly with a lawyer or international tax professional with U.S./Canada cross-border tax expertise. This article is for general information purposes only and is not intended to represent legal or tax advice