There is no doubt that US citizens living abroad are feeling the brunt of recent efforts to enforce tax rules around foreign assets and income. Unlike any other developed nation, the US continues to impose income tax filing requirements on its citizens, regardless of where in the world they make their homes.
For most Americans in Canada, tax compliance stateside has long been little more than an exercise in paperwork. High Canadian tax rates, combined with relatively generous rules around excluding foreign income and a Treaty-supported foreign tax credit regime, has meant that actually having to pay tax to the US was a rarity. This likely contributed to the situation that many find themselves in – US citizens resident in Canada for decades and have never filed returns in the US.
Unfortunately, in the past ten years, the US government has enacted new laws, such as the Foreign Account Tax Compliance Act (FATCA), which increases the administrative and financial burden on its foreign resident taxpayers, while diminishing their chances of remaining below the Internal Revenue Service (IRS) radar.
As a consequence, more and more expats are considering renouncing their US citizenship – not because of the tax liability, but to escape the headaches and professional fees associated with maintaining compliance. The focus here is on the implications for those who have not maintained compliance over the years.
Expatriation and Loss of Citizenship
According to the US Immigration and Nationality Act, US citizenship can be lost through the commission of an ‘expatriating act.’ The simplest of these acts is to attend a consulate abroad and swear an oath of renunciation. Such an oath, if approved by the Department of State in Washington D.C., will result in a Certificate of Loss of Nationality (CLN) for the expatriate, confirming the date of loss of citizenship.
In addition, other conduct can also result in the relinquishment of citizenship, such as swearing an oath of allegiance to a foreign state, or serving in the military of another country. US courts have, over the past several decades, required that such expatriating acts be done voluntarily and with the intention of relinquishing US citizenship, intending to protect citizens from inadvertent loss of citizenship.
Prior to these court rulings, dual citizenship for American-born people was not possible – US citizenship was simply lost upon naturalization elsewhere. However, in the intervening years, new tax legislation has been passed that complicates this story considerably.
In 1996, Congress passed a law that imposed the first requirement to notify the IRS of expatriation. This statute provided that a person would be subject to US tax until notice was provided in what came to be Form 8854, but the law was clear that the expatriation tax rules would not apply if the expatriate could satisfy the government that he had lost citizenship prior to the passage of these rules.
However, in 2008, a new version of the expatriation tax regime was implemented, which defines the ‘Expatriation Date’ as the date of notification to the IRS of loss of citizenship, with no allowances for those who had quietly relinquished in past years.
This presents a conundrum for many, which is best examined through an example. Mr. Smith was born in the US in 1950, and came with his parents to Canada at age 10. Upon reaching age 18, he applied for Canadian citizenship, which was granted in 1969. He has not returned to the US to live, and has never applied for a US passport or social security number. Needless to say he has never filed a US income tax return.
Mr. Smith, according to US citizenship laws probably lost his citizenship upon naturalization in Canada. In the 1960s, it was not possible to retain US citizenship, and it was standard practice in Canada to advise new citizens of this fact. However, even absent express notice to the new Canadian, the courts had not yet read the intentionality test into the law.
As a consequence, Mr. Smith could likely succeed in an application to the Consulate for a CLN certifying that he lost his US citizenship in 1969 upon naturalization in Canada.
However, if he sought that determination from the Consulate in 2015, then he would have expatriated in that year according to the new rules (found in Section 877A of the Code). With an ‘expatriation date’ in 2015, he is obliged to file Form 8854, to determine whether he is a ‘covered expatriate’ under the tax rules, and figure his expatriation tax, if any.
The real challenge Mr. Smith faces in this situation is that he will automatically be considered a covered expatriate (regardless of his net worth or annual tax liability) because he cannot certify compliance with the tax rules in the five years prior to his ‘expatriation date.’
Therefore, Mr. Smith is left with a choice (ideally, made before seeing the consulate for his CLN). If he files the five years of income tax returns that would allow him to certify compliance and avoid covered expatriate status, he is effectively conceding that he has been delinquent in his tax filings all these years. This may open him up to penalties for non-filing, and dramatically increases his cost to expatriate.
Alternatively, if he simply seeks the CLN without tax filings, he is left in a similarly tricky situation. On the one hand, the State Department would likely agree that he lost his citizenship in 1969. Simultaneously, however, the IRS would expect him to file the Form 8854 (because State sends copies of all CLNs to the IRS each quarter). However, with no tax filing records, Mr. Smith could be subject to dramatic and lifelong US tax implications as a ‘Covered Expatriate.’
A strong case could be made that Mr. Smith could challenge the IRS on Constitutional grounds in the event that he was assessed a tax bill on the facts above. US courts have approved some retroactive tax legislation, but not to this extent or severity. Of course, Mr. Smith is also unlikely to want to take his case on the long and expensive route of tax litigation against the US government.
Altro LLP routinely assists clients with fact patterns similar to those of Mr. Smith above. We can assess both the risks and rewards of different compliance and expatriation pathways, to help clients make decisions based on both complex law and personal risk tolerances. Please contact us for a consultation.