It has been almost four years since the current expatriation tax laws under Internal Revenue Code ("IRC") §877A, came into effect. The main modification introduced in 2008 was the mark-to-market tax imposed on the worldwide assets of individuals who relinquish their U.S. citizenship or terminate their long-term U.S. residency. Prior to 2008, the expatriation tax laws under IRC §877 had the effect of taxing such individuals for a period of ten years after expatriation on an expanded definition of U.S.-source income. This article focuses on the basic rules associated with the current expatriation tax rules and its implications for individuals on U.S. assignment from Japan.
The U.S. expatriation tax provisions apply to U.S. citizens who relinquish their citizenship and U.S. lawful permanent residents (i.e., green card holders) who surrender their green card after they have held it in at least 8 out of the 15 tax years ending with the date of expatriation. In applying the 8-of-15-year test, it should be noted that holding a green card for as little as one day in a particular year causes that year to be counted for purposes of this test. Therefore, an individual who holds a green card for as little as six years and a few days could satisfy the eight year requirement and thus, be subject to the expatriation provisions.
In determining if an individual has satisfied the eight year holding requirement to be subject to the expatriation provisions, it is possible to exclude the time an individual was treated as a resident of a foreign country under tie-breaker provision of a tax treaty, provided the individual has not already met the 8-of-15-year test.
U.S. permanent resident status is terminated for purposes of the expatriation tax on the earliest date of the following actions taking place:
- Voluntarily filing Form I-407, Abandonment of Lawful Permanent Resident Status, to Homeland Security, or
- A final administrative order of removal from the United States under the Immigration and Nationality Act, or
- Commencing to be treated as a resident of a foreign country under the tie-breaker provision of a United States income tax treaty.
An individual who gives up U.S. citizenship or terminates green card status after meeting the 8-of-15-year test described above will be a "covered expatriate", and therefore subject to expatriation tax rules if he or she meets any of the following tests:
- The average annual net income tax liability for the five preceding years ending before the date of relinquishment of U.S. citizenship, or termination of permanent residency exceeds $151,000 (for 2012; this amount is adjusted annually for inflation);
- The net worth of the individual is $2 million or more on the date of expatriation (this amount is not adjusted for inflation); or
- The individual fails to certify compliance with all U.S. federal tax obligations for the preceding five years, or fails to submit such evidence of compliance as the U.S. Internal Revenue Service may require.
Certain narrow exceptions in relation to tests 1 and 2 above apply to those individuals who became dual-citizens at birth or who give up U.S. citizenship before the age of 18½.
Any individual who gives up U.S. citizenship or terminates green card status after meeting the 8-of-15-year test must file Form 8854, Initial and Annual Expatriation Statement, with his or her individual tax return for the year of expatriation. Individuals who do not meet the tax liability or net worth tests must still file Form 8854 to certify their compliance with their U.S. tax obligations for the prior five years. Failure to file Form 8854 where required may result in a penalty of $10,000 for that year unless it is shown that such failure is due to reasonable clause and not willful neglect.
Covered expatriates are subject to the mark-to-market tax. Under this tax, they are treated as if they had sold their worldwide assets (subject to certain exceptions described below) at fair market value on the day before their expatriation date. The gains from the deemed sale are taken into account without regard to other exclusions under the IRC. The gains are considered taxable to the extent that they exceed an exclusion amount of $651,000 for 2012 (which is adjusted annually for inflation). Any loss from the deemed sale is also taken into account; however the wash sale rules, which disallow deductions for losses in certain situations, do not apply. Any gains or losses realized on the sale of property in subsequent years would be determined after adjusting the basis of the property by the gain or loss arising from the prior deemed sale. However, due to the time lag between the deemed sale and the actual sale, when a covered expatriate subsequently sells property that was subject to the mark-to-market tax, it is likely that the individual will be subject to tax on the actual gain in the foreign country in which he or she is resident, and would not be entitled to claim foreign tax credits for the expatriation taxes paid in the United States on the deemed sale. Thus, the mark-to-market tax may impose a significant tax burden of double taxation on the covered expatriate.
As mentioned above, in calculating the gain from this deemed sale (i.e. the current fair market value minus the basis), covered expatriates may use a "stepped-up" basis, not the actual cost, for assets held on the date they first became U.S. residents. Such assets would be treated as acquired for their fair market value on that date.
The mark-to-market tax would apply to all assets held by covered expatriates, with exceptions for certain categories of property described below:
1. Eligible deferred compensation items:
Eligible deferred compensation items include the following: 1) certain qualified pensions such as 401(k) and profit sharing, SEP and SIMPLE plans; 2) foreign pension plans or similar retirement arrangements or programs; 3) certain deferred compensation such as phantom stock arrangements and other such compensation that represents an unfunded and unsecured promise to pay money or other compensation in the future; 4) any property that the covered expatriate is entitled to receive in connection with the performance of services.
These eligible items will generally be subject to thirty percent withholding tax upon distribution as long as the payor is either a U.S. person or a foreign person who elects to be subject to the U.S. withholding rules. The covered expatriate is required to irrevocably waive any rights to claim any withholding reduction under income tax treaties in relation to the deferred compensation income. Form W-8CE, Notice of Expatriation and Waiver of Treaty Benefits, should be timely filed by the covered expatriate to notify the payor the special tax treatment on the earlier of (a) the day before the first distribution on or after the expatriation date or (b) thirty days after the expatriation date.
The withholding tax would not apply to deferred compensation attributable to services performed outside the U. S. while the covered expatriate was not a U.S. citizen or resident. Therefore, for example, a Japanese assignee who was a long-term resident and surrendered his green card would not be subject to the mark-to-market tax on contributions to a Japanese deferred compensation plan made while the individual was working in Japan before he became a green card holder.
2. Ineligible deferred compensation items:
Any deferred compensation items other than eligible deferred compensation items above will be treated as having been distributed to the covered expatriate at present value on the day before relinquishment. Form W-8CE should be timely filed by the taxpayer so that the payor can advise the covered expatriate within 60 days of receipt of the form of the present value of the individual’s accrued benefits in the deferred compensation.
3. Tax Deferred Accounts:
Amounts held by covered expatriates in tax deferred accounts such as certain individual retirement plans, qualified tuition program, Coverdell education savings accounts, health savings accounts and Archer medical savings accounts will be treated as if the funds were distributed on the day before relinquishment (but not subject to early distribution penalties). Again, Form W-8CE should be used to obtain the interest value in the account from the payor.
4. Non-grantor Trusts:
A non-grantor trust can be defined as any trust in the U.S. or foreign country that the individual is not considered as the owner of the trust assets. Distributions from non-grantor trusts to covered expatriates will generally be subject to a 30-percent withholding tax.
Any gain or loss from the deemed sale under the mark-to-market rule is calculated on Form 8854, then transferred to the appropriate line or schedule of Form 1040, U.S. Individual Income Tax Return, depending on the type of income. After applying the exclusion amount pro-rata to the items that give rise to gain, the covered expatriate is required to pay expatriation taxes along with regular income tax by the tax return due date. The character of each gain or loss remains the same; thus long-term capital gain would be taxed at the preferential tax rate of 15% for 2012, and short-term gain or deferred compensations are taxed at graduated tax rates from 10% through 35% for 2012, along with all other income normally reported on the individual income tax return.
Under a special tax regime also introduced in 2008, any U.S. taxpayer who receives a gift or bequest from a covered expatriate would be required to pay tax on the transfer at the highest applicable rate of gift or estate tax (35 percent for 2012) to the extent any such receipt is in excess of the annual gift exclusion amount ($13,000 for 2012).
The expatriation tax rules are highly complex, and complicated administrative matters are involved. Therefore, it is strongly recommended that any individual potentially subject to these rules consult with a KPMG tax specialist for professional advice before taking any actions in relation to relinquishing U.S. citizenship or surrendering a green card.
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
The views and opinions are those of the author and do not necessarily represent the views and opinions of KPMG LLP. All information provided is of a general nature and is not intended to address the circumstances of any particular individual or entity.