October 16, 2022
The US is the only country other than Eritrea that taxes its citizens on their income regardless of their residence. Whether they know it or not, American citizens living abroad, their families, descendants, and the corporations they control face a very real threat of substantial US tax. The 2010 Foreign Account Tax Compliance Act (FACTA) and the 2017 Tax Cuts and Jobs Act, the latter of which implemented the Global Intangible Low-Taxed Income (GILTI) regime, have strengthened the taxing power of the US, and there is little indication of any future weakening.
Does renouncing US citizenship, also known as expatriation, eliminate the tax consequences of US citizenship? Expatriation may have tax consequences, though not as substantial as those of US citizenship. The following outlines (1) the potential tax consequences of expatriation; (2) some tax planning concepts; and (3) the expatriation procedure.
Expatriation Tax Consequences
There are three major tax consequences of expatriation:
- Mark-to-market tax;
- Withholding tax on deferred compensation items; and
- Withholding tax on receipts from non-grantor trusts.
The above taxes only apply, with some exceptions, to expatriates who:
- Have an average annual net income tax for the five years preceding expatriation of more than USD$172,000 for 2021;
- Have a net worth greater than or equal to USD$2,000,000 on the date of expatriation; or
- Have failed to comply with US tax obligations for any of the five years preceding expatriation
The IRS refers to expatriates who meet any of these criteria as “covered expatriates”. You do not want to be categorized as a covered expatriate.
Mark-to-Market Exit Tax
The IRS taxes as income any capital gain on the deemed sale of covered expatriates’ worldwide assets, with some exceptions, at fair market value on the date of expatriation. Covered expatriates cannot claim a foreign tax credit for the tax. A maximum of unrealized capital gain equal to USD$744,000 may be excluded from the tax. This means no exit tax if your accrued gains are less than $744,000. Covered expatriates may defer the tax by posting adequate security to the IRS and paying interest during the deferral period.
Withholding Tax on Deferred Compensation Items
This tax and the tax described below are not subject to the mark-to-market tax.
The IRS generally construes the following, amongst others, as deferred compensation items:
- Qualified US pensions;
- 401(k) plans;
- Other profit-sharing plans;
- Simplified Employee Pension plans;
- Any interest in a non-US pension plan or similar retirement arrangement or program; or
- Any property, or right to property, (e.g., stock) receipt of which is in connection with the performance of certain services.
The IRS levies a 30% withholding tax on income received by covered expatriates from deferred compensation items for which the payor is a US person, and covered expatriates cannot claim a foreign tax credit for the tax.
Withholding Tax on Non-Grantor Trust Receipts
The IRS levies a 30% withholding tax on income received by covered expatriates from non grantor trusts, which are trusts for which the covered expatriate is not considered to be the owner under section 617 through 679 of the Internal Revenue Code. Covered expatriates cannot claim a foreign tax credit for the tax, but they may avoid withholding tax by electing to be treated as having received the value of their interest in the trust as of the day before their expatriation date, and to pay tax on that value. Electing covered expatriates must receive a ruling letter from the IRS as to the valuation of the trust interest before making the election.
Tax Planning Concepts
It is important to analyze and plan around the three criteria for being considered a covered expatriate. There are several different tax planning opportunities regarding gifting assets to spouses or others prior to commencing the expatriation process. It is also imperative to be compliant with US income tax returns by filing Form 1040 for at least the last five years. Additional problems to consider include planning for bequest of a covered expatriate’s estate to children or grandchildren who are US citizens.
Expatriation must be completed in person before an official at an embassy or consulate outside the US. If you intend to expatriate, we will prepare the necessary papers and schedule an interview appointment at the consulate on your behalf. We generally schedule appointments at the consulate in any of the cities in Canada that will have the shortest delay, but we may also schedule an appointment for you in the city of your choice.
The objective of the interview is to ensure that you are voluntarily expatriating, that you understand the consequences of doing so, and to record your reasons for doing so. We will counsel you on the expatriation process, the questions asked, and the appropriate responses to provide, at the consulate. There are no legal restrictions to the reasons for expatriation, but a 1996 statutory amendment to US immigration law called the Reed Amendment provides that expatriates may be permanently refused entry to the US after expatriation if the reason for expatriation was to avoid US tax liability. Our understanding is that this amendment was enforced only twice since its enactment. The expatriates in these instances instigated enforcement by explaining that tax liability was the reason for their wanting to expatriate.
The consulate official will forward the required paperwork to Washington, D.C. for final approval after your interview. You remain a US citizen until Washington issues you a Certificate of Loss of Nationality. The official will also forward your name to the IRS to be published in the Federal Register under a quarterly list of expatriates.
All expatriates must file a US tax return for the year of expatriation that includes Form 8854. They must also file Form 8854 for tax years following expatriation under certain circumstances. The IRS refers to the form to determine whether expatriates are subject to the above taxes and whether to audit.
Covered expatriates must provide each payor of deferred compensation items and non grantor trust receipts, amongst other payors, with Form W-8CE for their records. The form notifies the payors of an expatriate’s status as a covered expatriate, and it instructs the payors as to their responsibilities in respect of withholding income from, or providing information to, the expatriate.
The IRS may impose a $10,000 penalty for failure to properly file Form 8854.
Should you wish for further information, please contact David Altro or Eric Miller.
This is not a tax or legal opinion. The views expressed herein are not binding on the CRA, the IRS, the courts, or any party, and any party may successfully challenge the matters discussed herein.
This article is for general reference. Any conclusions herein are dependent upon our understanding of the information referenced herein, and the continued accuracy of all such factual understandings, statements and representations. Any inaccuracy herein, or factual change or development that would cause such statements or representations to cease to be accurate or to be incomplete may result in a different conclusion or conclusions.