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for the Global Tax Citizen

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Sec. 877A Tax Bomb for Expatriates 

Thousands of US citizens (“USC”) and green card holder (lawful permanent residents, “LPR’s) live outside the US. Many do not even know they are a USC. 

In a globalized economy, especially one where the US is taking on a diminished role, for many with significant foreign ties, the likelihood that careers and family matters will take one outside the US, perhaps permanently, is high. 

In the author’s experience most expatriates are not packing their bags and fleeing a large tax bill. They already live abroad; most of their personal and fiscal ties are outside the US, all they are doing is simplifying their lives in view of increasingly onerous IRS reporting requirements ($10,000 is the baseline penalty for failure to file a single information form timely). 

"Exit tax” legislation (Sec. 877 and now Sec. 877A) first passed in 1966, targeted the very wealthy whose expatriation was clearly tax motivated in a subjective sense. “Tax motivation” evolved into an objective standard tied to net worth or income with a limited opportunity to refute through a ruling process. 

The exit tax was limited to US source income realized within 10 years of expatriation. 

The exit tax was modified significantly in 2008 and now presents a serious problem for potential expatriates whose net worth exceeds $2 million (or whose annual tax liability exceeds prescribed thresholds) as the tax liability is triggered by a mark to market artificial tax event. 

You are deemed to have sold all your property, yes even personal property, and liquidated in full all retirement plans – all on the day before the legal expatriating event.

The IRS “softens” the blow by allowing you to defer payment of tax provided security is provided (a bond) and interest accrues. The IRS also requires that you waive the benefit of an available tax treaty (the author advises against this).

Greencards (Lawful permanent residents “LPR’s) – The Special Risk

LPR’s are more likely to have tenuous ties to the US and can find themselves as the target of the Exit Tax without formally terminating their LPR status.  

An LPR may take advantage of a tax treaty to claim residence in a foreign country or they may simply spend too much time in a foreign country under conditions wherein US immigration authorities can claim he has “abandoned” his LPR status. In either case, the Exit Tax would kick in. 

The Exit Tax only applies to LPR’s who have held their green cards in eight calendar years, that can include two partial years. Therefore, one can be an LPR for as little as six years a couple of months and be subject to this punitive tax regime.

The Artificial Tax Event

Expatriation after June 16, 2008 results in deemed sale of global assets the day before you lose your green card or citizenship. This can be a problem, to say the least, for many. You are allowed a $600,000 exemption, gains in excess of that amount fall into your final tax return. Just from an administrative standpoint, this can be a nightmare. 

The task of determining the US dollar gain of your global estate (this goes beyond real estate and marketable investments to include personal property such as clothing, furniture, jewellery).  In addition, you are also considered to have liquidated your retirement schemes on that same day (the $600,000 exemption does not work here). The IRS faces serious practical difficulties in enforcing all of this.

The IRS recognizes that a deemed sale does not provide liquidity for payment of tax – and graciously they allow for deferred payment if you pay an interest charge and offer security.  However, crystallizing values based upon an artificial taxable event is problematic and unfair.  

As previously stated, the decision to leave the US tax and legal system is, for most, based upon simplifying one’s personal affairs. There has not been an economic decision to sell one’s assets. To assess tax based upon a fictional sale when in an unsettled world values and exchanges rates can change dramatically is not equitable tax policy, especially when a tax haven is not implicated.

The exit tax is particularly damaging to retirement planning. The goal with pensions is to maximize the tax deferral. The Exit Tax creates a “deemed” a 100% lump sum distribution and then levies a tax. This is particularly punitive and undermines one of the fundamental objectives of international tax treaties (see Sec. 877A defences, below).

Double Taxation

The goal of the international tax treaty network is to prevent double taxation in order to facilitate international trade. However, the Sec. 877A Exit Tax is likely to produce double taxation. 

First off, the tax may be on property that is situated in the country of residence and a tax credit will not be allowed for a foreign tax on gain sourced to its jurisdiction. 

In addition there is the problem of timing and amount. When the property is actually sold values and exchange rates are likely to differ from those of the artificial tax event. The country of residence may not allow a credit, even if the subject property is foreign source, for a foreign tax paid years earlier.

Tax treaties are typically the vehicle to solve double taxation problems, but to date, they have not been drafted to accommodate this type of tax (see discussion below). 

Possible Defenses to Sec. 877A Taxation

The IRS requires that you waive treaty benefits when requesting deferred payment of the Exit Tax. This tells you something, as the Treaty network may provide some help.  Each tax treaty is very specific in that regard. For example, the US-UK Treaty (the “Treaty”) in Article 24 provides some re-sourcing rules that offer some protection from double taxation inherent in the Savings Clause and its application to former citizens. 

The problem with the Treaty is that it deals with double taxation resulting from the predecessor exit tax regime (US claw back taxation for up to 10 years on certain US source income) and not the worldwide immediate taxation arising from Sec. 877A. 

One may consider taking the position that Sec. 877A violates the fundamental spirit of the Treaty, specifically Article 24 Double Taxation and Article 25 Non-Discrimination. This would have to be disclosed on your tax return and should not be done without professional advice. 

Assuming you are going forward with your decision to expatriate and you do not have access to a helpful tax treaty there is little to do except keep your net worth less than $2 million or manage unrealized gains so that they fall within the $600,000 exemption. Consider gifts if they otherwise make sense or how best to own property with a spouse who is not legally connected to the US. 

If you choose to remain in the US legal system, you should do so in an informed and diligent manner. In the author’s experience, for most with tenuous ties to the US they or their advisors simply fail to pay attention to the issues and reporting requirements that invariably arise and then it is too late. 

The best defensive strategy to avoid problems with your US legal connections is to remain aware of the relevant rules and comply on a timely basis. This will keep the $10,000 penalty regime away and minimize professional fees.

 

The material provided in this website is for informational purposes only and does not constitute tax or legal advice. Such advice can only be provided with full knowledge of your particular facts and circumstances.

 

George Hayduk - Hayduk Law
US IRS Tax Law
UK  Inland Revenue Taxation
Canadian Tax Law, Green Cards, Expat Tax
Pensions & Estate Planning