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Beware The US Expatriation Tax

Expat Briefing Editorial Team
13 February, 2015


For those citizens and long-term residents of the United States quitting the country in protest at its increasingly onerous taxes – and recent statistics suggest that there are record numbers of these people – one final tax surprise awaits in the form of the US expatriate tax.


US Expatriation Tax

The expatriation tax provisions under Internal Revenue Code (IRC) sections 877 and 877A apply to US citizens who have renounced their citizenship and long-term residents who have ended their US resident status for federal tax purposes.

Since June 16, 2008, the expatriation rules apply if any of the following situations apply:

  • Your average annual net income tax for the 5 years ending before the date of expatriation or termination of residency exceeds a certain amount, which is adjusted annually for inflation. For 2014, this is USD157,000.
  • Your net worth is USD2m or more on the date of your expatriation or termination of residency.
  • You fail to certify that you have complied with all US federal tax obligations for the 5 years preceding the date of your expatriation or termination of residency.

If you meet any of these rules, then you are known as a "covered expatriate."

IRC 877A imposes a mark-to-market regime, which generally means that all property of a covered expatriate is deemed sold for its fair market value on the day before the expatriation date.  Any gain arising from the deemed sale is taken into account when calculating tax liability for the year in which the deemed sale took place. The tax is equivalent to the 15 percent capital gains tax.

A certain amount can be excluded from the gain, which is also adjusted annually for inflation. In 2014, the exclusion amount was USD680,000. Note, however, that the gain from the deemed sale cannot be reduced below zero.

At USD10,000, the penalty for failing to inform the Internal Revenue Service (IRS) you are expatriating or terminating your residency is pretty steep. Failure to file or not including all the information required by the form or including incorrect information could also lead to a penalty.

It should be noted that different rules apply to expatriations that took place prior to June 16, 2008.


The Rising Cost OF Renouncing Citizenship

It's not only the expatriate tax that those handing in their US passports must be aware of, however.

Last year, the State Department – without any fanfare – hiked the fees payable for processing expatriation applications by 422 percent with effect from September 12, 2014.

The State Department put the "adjustment" in the application processing fee for renunciation of US citizenship, from USD450 to USD2,350, down to "the findings of a recent Cost of Service study to ensure that the fees for consular services better align with the costs of providing those services."

The fee hike took place a month after Treasury Department statistics disclosed that a record number (at that point) of US taxpayers (1,577) gave up their passports in the first half of 2014.

The acceleration in the number of individuals giving up their citizenship has come as actions being taken by the Treasury and the IRS to trace American undeclared assets and income held abroad have gathered pace – particularly with the operation of the Foreign Account Tax Compliance Act, intended to ensure that the IRS obtains information on accounts held abroad at foreign financial institutions by US taxpayers, from July 1, and the agreement of Swiss banks to participate in a US tax regularization program. US expatriates are also finding it more challenging to open an account abroad due to FATCA.

It has also been said that more Americans living abroad are becoming aware of their US tax reporting obligations – for example, the requirement to file a Report of Foreign Bank and Financial Accounts – due to the US "worldwide" tax code, which subjects all of an individual's earnings to US taxation.

The State Department has noted that application demand for the renunciation of citizenship has increased substantially, and that, as the process involves a costly use of foreign consular time in processing cases, it should be charged at its cost.

However, Kevyn Nightingale, who is a Partner with the MNP accountancy practice in Toronto, pointed out that the Department's service was free until 2010, and that, calculated at its present "charge-out" rate of USD135 per hour, it now "means that each expatriation is supposed to take over 17 hours of time. Sure, there's some back office work, but 17 hours?" he questioned.

"There are a lot of Americans living abroad who find the US tax system oppressively complicated and difficult," he added. "It's already expensive to comply. So many of [those] who owe no US tax (which is to say most of them) want to get out of the system. This fee has just made it that much nastier. Stay in – get dinged. Leave – get dinged."


The Political Clamour For Tougher Rules

If you decide to cut your ties with the United States for tax reasons however, you are going to be very unpopular with a lot of people, including some influential figures in Congress – on both sides of the aisle – who are attempting to make the expatriation rules even tougher.

In 2012, the US Speaker of the House of Representatives John Boehner, one of the most senior Republicans in Congress, surprisingly came out in favour of a bill introduced in the Senate by two Democrats aimed against those who renounce their American citizenship to avoid paying taxes.

This followed the political furore over the decision of Facebook co-founder and partial owner Eduardo Saverin to give up his US citizenship in order, it was said, to avoid taxes on profits he expected to collect after the social-networking company went public. Saverin has lived in Singapore since 2009 and had dual citizenship, but then renounced his US citizenship in September 2011.

Estimates of the amount of tax saved by Saverin as a result of his expatriation vary. But the so-called Ex-PATRIOT Act would not only re-impose taxes on such expatriates, it would also bar those individuals from re-entering the country until they had paid their taxes in full. It would also subject expats to a 30 percent withholding tax on capital gains from US investments.

It should be pointed out that Saverin himself has denied that he has renounced his US citizenship to avoid paying taxes. In a statement he stressed that his decision "was based solely on my interest in working and living in Singapore."

"I am obligated to and will pay hundreds of millions of dollars in taxes to the US government," he stated. "I have paid and will continue to pay any taxes due on everything I earned while a US citizen. It is unfortunate that my personal choice has led to a public debate, based not on the facts, but entirely on speculation and misinformation."

Luckily for Saverin and others targeted by this proposal, the legislation died at the expiry of the 112th Congress later that year. Similar proposals were added as an amendment to a major immigration bill in June 2013, but were not present in the final version passed by the Senate.

It is probably merely a matter of time though before they rear their head in US Congress once again.

It is unclear how such a law would be enforced. The US Government has shown with FATCA that it can convince foreign authorities to apply US tax laws affecting American citizens with financial interests overseas. But ultimately, it probably doesn't matter. The members of Congress who supported these proposals so vocally were tapping into popular anger about wealthy and "unpatriotic" tax dodgers, and so some political capital was earned if nothing else.


The Pendulum Swings Too Far?

Some members of the US legal community on the other hand think that the Government now has far too much power to entrap expatriating individuals, and are calling for the expatriation tax rules to be weakened rather than made more stringent.

In December 2013, the Taxation Section of the American Bar Association wrote a letter to Congress containing proposing options for the reform that will make international tax provisions for individual taxpayers easier to understand and follow.

"Unfortunately," it said, "some of these provisions have proven to be 'traps for the unwary' and in some cases create compliance burdens that cannot reasonably be met. In addition, concern with US taxpayers expatriating for tax purposes has resulted in laws that we anticipate will be difficult to enforce and that can result in significant double taxation."

In its plan, the Section also includes changes to the expatriation tax provisions under sections 877 and 877A of Internal Revenue Code, applying to US citizens who have renounced their citizenship and long-term residents who have ended their US resident status for federal tax purposes.

For example, it proposes that Congress considers amending the definition of long-term resident to require a longer period of residence, such as 17 of 20 years, consistent with the United Kingdom residence standard for inheritance tax purposes; to count a year toward residence only if the individual was resident during 183 days of that year; and to take into account any year of residence for US income tax purposes (not just years of lawful permanent residence).

It is further suggested that, to account for inflation, Congress considers making annual adjustments to the USD2m net worth threshold required for application of section 877A, and that an expatriate should be allowed to exclude the mark-to-market gain on the deemed sale of a residence to the same extent as an actual sale of that residence.

Given the mood in Congress and among the wider tax-paying American public though, it seems unlikely that these proposals will be taken up any time soon.




 

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