By Anthony Diosdi
Foreign investors generally have the same goal of minimizing their tax liabilities from their U.S. real estate and other U.S. investments, as do their U.S. counterparts, although their objective is complicated by the very fact that they are not domiciled in the U.S. The U.S. has a special estate and gift tax regime that is applicable to foreign investors that are not domiciled in the U.S. Sometimes, with proper planning, foreign investors can avoid U.S. estate and gift taxes. This article discusses the special provisions of the U.S.-France estate and gift tax treaty foreign investors should consider when planning to avoid or mitigate U.S. estate and gift taxes.
An Overview of the Estate and Gift Tax
U.S. Federal law imposes a transfer tax upon the privilege of transferring property by gift, bequest or inheritance. During an individual’s lifetime, his transfer tax takes the form of a gift tax. For gift tax purposes, a gift is defined as the transfer of property for less than adequate and full consideration in money or money’s worth, other than a transfer in the “ordinary course of business.” No U.S. gift tax would be owed on a gift to a beneficiary until the gifts made to the beneficiary in a calendar year exceed an applicable exclusion amount for that year ($17,000 for calendar year 2023). Upon an individual’s death, the tax takes the form of an estate tax. The tax is measured against a tax base that includes all the assets owned at death.
The U.S. estate and gift tax is assessed at a rate of 18 to 40 percent of the value of an estate or gift. A unified credit is available to minimize the impact of the transfer tax. The unified credit gives a set dollar amount that an individual can gift during their lifetime and pass on to beneficiaries before a gift or estate taxes apply. U.S. citizens and resident individuals are permitted a unified credit that exempts $12.92 million (for the 2023 calendar year) from the estate tax. This means that U.S. citizens and residents can pass $12.92 million to their heirs without being assessed a gift or estate tax. The unified credit is significantly smaller for foreign individuals that are not domiciled in the U.S. The current unified credit for non-domiciliaries is equivalent to a $60,000 exemption, unless an applicable treaty allows a greater credit. In addition to its smaller size, the unified credit available to non-U.S. citizens and non-U.S. domiciliaries cannot be used to reduce their U.S. gift tax. The credit can only be used by their estates upon their deaths to reduce U.S. estate tax. See IRC Section 2505(a).
There are also significant differences as to how the estate and gift tax is calculated for individuals domiciled in the U.S. compared to individuals not domiciled in the U.S. The worldwide estate of a decedent is subject to U.S. estate tax only if the individual was either a U.S. citizen or resident at the time of death. See IRC Sections 2001(a) and 2031(a). In contrast, the estate of an individual not domiciled in the U.S. is subject to estate tax solely on his or her U.S. situs assets. Similarly, all property gifted by a U.S. citizen or domiciliary is subject to U.S. gift tax regardless of where the property is situated. However, in the case of a donor who is neither a U.S. person nor a U.S. domiciliary, only gifts of real property or tangible personal property situated in the U.S. are subject to U.S. gift tax.
Determining Domicile for U.S. Estate and Gift Tax
Because individuals domiciled in the U.S. are permitted a unified credit of $12.92 million, for most U.S. citizens, the estate and gift tax is not an issue. This situation is different for foreign persons who are not domiciled in the U.S. Instead of a unified credit that would shelter up to $12.92 million in lifetime gifts, individuals not domiciled in the U.S. are only provided a credit equivalent to an exemption of just $60,000 against the estate tax. Given the differences in the way the U.S. estate and gift tax is calculated, it is crucial to understand when an individual can be classified as being domiciled in the United States. An individual is presumed to have a foreign domicile until such domicile is shown to have changed to the United States. A person acquires a U.S. domicile by living here, potentially even for a brief period of time, with no definite present intention of leaving. To be domiciled in the U.S. for estate and gift tax purposes, an individual must physically present in the U.S. coupled with the intent to remain in the U.S. indefinitely or permanently. For U.S. estate and gift tax purposes, an individual can only be domiciled in one country. The term “domicile” for estate and gift tax purposes should not be confused with the terms “resident” or “residence” used in the income tax context. A foreign investor may be characterized as a resident of the U.S. for income tax purposes through either the green card test or substantial presence test. Just because a foreign person is classified as a U.S. resident for U.S. federal income tax purposes, does not mean the individual is domiciled in the U.S. for estate and gift tax purposes.
How the Estate Tax and Gift Tax is Computed for a Decedent Not Domiciled in the U.S.
The estate tax for a decedent that was not domiciled in the U.S. is only assessed on its gross estate. The gross estate is made up of property or assets situated in one of the U.S. states or the District of Columbia at the time of death. This is often referred to as U.S. situs assets or property. The gross estate is composed of revocable transfers, transfers taking effect on death, transfers, with a retained life interest or (to a limited extent) transfers within three years of death are includible in the U.S. gross estate if the subject property was U.S. situs property at either the time of the transfer or the time of death. In the case of corporate stock, the stock of a U.S. corporation is U.S. situs and stock of a foreign corporation is foreign situs, regardless of place of management or location of stock certificates.
The rules for determining gift tax for an individual not domiciled in the U.S. differ from the estate tax. As a general rule, the gift tax applies only if transfers of tangible property (real property and tangible personal property, including currency) are physically located in the United States at the time of the gift. The gift tax does not apply to intangible property such as stock in U.S. or foreign corporations even though such property is includible in the U.S. gross estate for federal estate tax purposes. Since the gift tax is not assessed on the transfer of securities, non-domiciliaries often transfer securities to heirs prior to death for planning purposes.
Introduction to U.S.- France Estate and Gift Tax Treaty
The United States imposes its estate tax on estates of individuals who were U.S. citizens or U.S. domiciliaries at the time of their death, and on assets of nondomicilies where the assets are situated in the United States at the time of their death. The United States imposes its gift tax on gifts made by U.S. citizens and U.S. domiciliaries regardless of where the property which is the subject of the gift is located, and also on gifts made by nondomiciliaries where the property which is the subject of the gift is tangible property in the United States at the time of the gift.
France imposes its succession duty on estates of individuals who were domiciled in France at the time of their death, or on the assets of persons not domiciled in France where the assets were situated in France at the time of their death. The French gift duty is imposed on gifts made by persons who were domiciled in France at the time the gift was made, and on gifts made by persons not domiciled in France where the property was situated in France at the time of the gift.
Since each country has its own definition of domicile in that country, it is possible that the definition of domicile, it is possible that the definition of domicile in the two countries could overlap resulting in double taxation. This could result in double estate and gift taxation. The U.S.-France estate and gift tax treaty was enacted to avoid double taxation.
Elimination of Double Taxation
The U.S.-France treaty is designed to alleviate double taxation on gifts and estates of U.S. citizens and domiciliaries and French domiciliaries in some situations by allowing only one country to impose its tax and in others by allowing both countries to impose a tax but requiring one of the countries to allow a credit against its tax for the taxes paid to the other country.
In most situations, the treaty allows the country of domicile to assert primary tax jurisdiction. However, the situs country is given priority taxation in the case of real property, tangible personal property, and business assets which are located in that country.
Estate, Gift, and Taxes Covered
The treaty applies to estates of decedents who were domiciled in France at the time of their death and to estates that are subject to tax in the United States because the decedent was a citizen or domiciliary of the United States at the time of his death. With respect to gifts, the treaty applies to gifts made while the donor was a domiciliary of France and to gifts which are subject to tax in the United States because the donor was a citizen or domiciliary of the United States when the gift was made. Generation-skipping transfers which are subject to tax in the United States because the transferor was a U.S. citizen or domiciliary are also covered. The treaty applies to the French succession duty and the French gift duty. The succession duty is imposed on the world-wide assets of persons domiciled in France at the time of their death, and on property of nondomiciliaries of France where the property is located in France at the time of their death, France imposes a gift duty on all gifts made by persons domiciled in France, and on property of nondomiciliaries that is located in France at the time of the gift.
Below, this article will discuss select provisions of the U.S.-France estate and gift tax treaty.
The concept of domicile is important under the treaty because the country of domicile has, under the treaty, primary tax jurisdiction on all property other than the property subject to situs taxation. Under the Internal Revenue Code, an individual is considered a domiciliary of the United States for purposes of the federal estate and gift tax if the person was residing in the United States and had the intent to remain in the United States indefinitely. A person is considered domiciled in France if his main establishment is in France. In general, a person’s main establishment is where he physically resides and intends to live permanently.
To provide relief from double taxation where the individual is considered domiciled in both countries under their domestic laws, the treaty provides a series of rules designed to establish a single country of domicile for the individual for purposes of the taxes covered by the treaty. The country so selected will then have the primary tax jurisdiction with respect to the worldwide estate of the decedent or his worldwide gifts, other than with respect to real property, business assets of tangible property situated in the other country.
In determining the domicile of an individual under the treaty, each country will first determine whether the individual is considered a domiciliary under its law. If the individual is a domiciliary of only one country then that will be the individual’s country of domicile for purposes of the treaty. However, if the person is determined to be a domiciliary of both countries the treaty provides a series of rules by which an exclusive domicile for the individuals will be determined.
Under Article 4 of the U.S.-France estate and gift tax treaty, the first rule that is applied consists of two separate tests which apply to persons who are citizens of only one of the two countries. Under the first test, such a person will be considered domiciled in the country of which he is a citizen if he was domiciled in the other country for less than 5 years during the 7-year period which ends with the year of his death or the year the gift was made, and he was in that country because an assignment of employment or because he was spouse or dependent of a person who was in that country for such a purpose. Under the second test, the person will be considered a domiciliary of the country of which he is a citizen if he was domiciled in the other country for less than 7 years during the 10-year period which ends with the year of his death or the year the gift was made, and he was in that country because of a renewal of an assignment of employment or because he was the spouse or dependent of a p;erson who was in that country for such a purpose.
A second rule, which is similar to the first in that it applies to persons who are domiciliaries of both countries and citizens of only one of the countries, applies if domicile cannot be resolved under the first rule. Under the second rule such a person will be considered a domiciliary of the country of which he is a citizen if he had a clear intention to retain his domicile in that country and he was domiciled in the other country for less than five years during the 7-year period which ends with the year of death or the year the gift was made.
If the duel residency problem remains, the individual will be considered a domiciliary in the country 1) in which he maintained his permanent home, 2) in which his personal relations were the closest (center of vital interests), 3) in which he had a habitual abode, or 4) in his country of citizenship. In cases where an individual’s domicile cannot be determined under these rules, the competent authorities of the countries are to settle the question by mutual agreement.
The Taxation of Property
Under Articles 5, 6, and 7 of the U.S.-France estate and gift tax treaty, immovable (real) property is one of three properties over which the situs country has primary tax jurisdiction rather than the country of domicile. The other two are assets of a permanent establishment or fixed base. Under these articles, domiciliaries of France who own U.S. real property could be subject to the U.S. estate or gift tax on the value of the U.S. situs property. Many foreign investors utilize planning techniques to avoid the U.S. estate and gift tax. One such planning option is to contribute U.S. real property to a corporation, limited liability company, or partnership to avoid U.S. transfer taxes.
The U.S.-France estate and gift tax treaty rules, in effect, appear to limit such planning techniques. Under Article 5 of the U.S.-France estate and gift tax treaty, corporate stock or other interests in entities that constitute intangible property should be taxable if the assets of such entities, directly or indirectly, are at least 50% attributable to “real property situated in one of the Contracting States or of rights pertaining to such property.” As a result, an interest in a corporation, limited liability company, or partnership, at least 50% of which comprises U.S. situs real property or related “rights” should be considered U.S. situs property for treaty purposes. See Estate and Gift Taxation of Nonresident Aliens in the United States, Florida Institute of CPAs by Leslie A. Share and Michael Rosenberg. Individuals who are domiciled in France should be able to own shares of U.S. entities and shield underlying assets from the U.S. estate tax. However, as discussed above, Article 5 of the U.S.-France estate and gift tax provides a specific exception of real property. In light of Article 5, extreme caution is recommended for any tax advisor that utilizes the planning techniques discussed above for French domiciliaries.
The estates of individuals not domiciled in the United States are generally not entitled to a marital deduction for U.S. estate tax purposes. Marital deductions refers to exceptions to gift and estate taxes for transfers made to spouses. Almost all property qualifies for this deduction and there is no limit. The deduction does not avoid transfer taxes completely, but rather, the spouse receiving the property must pay the eventual estate taxes. The marital deduction for non-U.S. citizens is limited to an annual exclusion of $175,000 for the 2023 calendar year.
Article 11 of the U.S.-France estate and gift tax treaty allows a marital deduction in connection with transfers satisfying each of five conditions. First, the property transferred must be “qualifying property.” Second, the decedent must have been, at the time of death, domiciled in either France or the United States, or a citizen of the United States. Third, the surviving spouse must have been, at the time of the decedent’s death, domiciled in either France or the United States. Fourth, if both the decedent and surviving spouse were domiciled in the United States at the time of the decedent’s death, at least one of them must have been a citizen of France. Finally, the executor of the decedent’s estate is required to waive the benefits of any estate tax marital deduction that would be allowed under U.S. domestic law, on a U.S. Federal estate tax return filed by the deadline for making a qualified domestic trust election under Internal Revenue Code Section 2056A(d).
In order for property to be “qualifying property,” it must pass to the surviving spouse (within the meaning of U.S. domestic law) and be property that would have qualified for the estate tax marital deduction under U.S. domestic law if the surviving spouse had been a U.S. citizen and all applicable elections specified by U.S. domestic law had been properly made.
The treaty states in effect that interspousal transfers are excluded from a qualifying decedent’s gross estate for U.S. tax purposes to the extent that their value does not exceed 50% of the value of all property included in the U.S. taxable base. However, the marital deduction is limited to the amount that would reduce the U.S. tax due to that would apply using rates applicable to U.S. residents. The estate would then be subject to U.S. tax in the lower amount of: a) the figure determined using the marital deduction; or b) that generally imposed upon an individual not domiciled in the U.S. under U.S law.
The following examples (taken from the Technical Explanation of the 2004 Protocol which amended the U.S.-France estate and gift tax return) illustrate the operation of the pro rata unified credit and the marital deduction. Unless otherwise stated, assume for purposes of illustration that: H, the decedent, and W, his surviving spouse, are French citizens residents in France at the time of the decedent’s death; h dies in 2005, when the unified credit for estate tax purposes under Section 2010 of the Internal Revenue Code is $555,800 and the applicable exclusion amount under Section 2010 is $1,500,000.
H has U.S. real property worth $4,000,000, all of which he bequeaths to W. The remainder of H’s estate consists of $6,000,000 of French situs property.
Pursuant to Article 11 of the U.S.-French estate and gift tax treaty equals $2,000,000 (the amount by which the $4,000,000 of U.S. real property bequeathed to W exceeds $2,000,000 (50% of the total value of U.S. property taxable by the United States under the Convention)). H’s worldwide gross estate equals $8,000,000 plus $6,000,000 of French situs property).
The $2,000,000 U.S. gross estate is reduced by the $1,500,000 marital deduction of Article 11 of the U.S.-French estate and gift tax treaty, resulting in a $500,000 U.S. taxable estate. The tentative tax on the taxable estate equals $155,800. H’s estate would also be entitled to the pro rata unified credit allowed by Article 12 of $138,950 ($55.800 (the full unified credit) multiplied by a fraction equal to the $2,000,000 U.S. gross estate over the $8,000,000 worldwide gross estate). Thus, the total U.S. estate tax liability is $16,850 ($155,800 – $138,950).
The facts are the same as in Example 1, except that H bequeaths $1,200,000 of his U.S. real property to W and $2,800,000 of his U.S. real property to C, H’s child.
The $2,800,000 of U.S. real property bequeathed to C is included in H’s U.S. gross estate. Pursuant to Article 11 of the U.S.-France estate and gift tax treaty, none of the U.S. real property bequeathed to W is included in the gross estate, because such property would be included only to the extent of its value (i.e., $1,200,000) exceed 50% of the $4,000,000 total U.S. situs property taxable under the treaty. H’s worldwide gross estate equals $8,800,000 ($2,800,000 plus $6,000,000 of French situs property).
Because none of the U.S. situs property bequeathed to W is included in the U.S. gross estate, the property is not “qualifying property,” and therefore no marital deduction is allowed with respect to that property under Article 11 of the U.S.-France estate and gift tax treaty. The tentative tax on the $2,800,000 gross estate equals $1,156,800. H’s estate would also be entitled to the pro rata unified credit allowed by Article 12 of the U.S.-France estate and gift tax treaty which equals $176,845 ($555,800 (the full unified credit), multiplied by a fraction equal to the $2,800,000 U.S. gross estate over the $8,800,000 worldwide gross estate). Thus, the total U.S. estate tax liability is $979,955 ($1.156,800 – $176,845)
If an individual nondomiciliary or decedent that was not domiciled in the U.S. would like to take a treaty position, this treaty position must be disclosed on Form 8833 which must be attached to either a U.S. estate or gift tax return.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or email@example.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.