A Closer Look at the U.S.- U.K. Estate and Gift Tax Treaty

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.- United Kingdom or (“U.K.”) 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.- U.K. 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.

The U.K. imposes a capital transfer tax on estates of individuals who were domiciled in the U.K. at the time of their death or on the assets of persons not domiciled in the U.K. where the assets were situated in the U.K. at the time of their death. The U.K. capital transfer tax is imposed on gifts made by persons who were domiciled in the U.K. at the time the gift was made and on gifts made by persons not domiciled in the U.K. where the property was situated in the U.K. 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- U.K. estate and gift tax treaty was enacted to avoid double taxation.

Elimination of Double Taxation

The U.S- U.K. estate and gift tax treaty is designed to alleviate double taxation on gifts and estates of U.S. citizens and domiciliaries and U.K. 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 U.S.-U.K. estate and gift tax treaty applies to any person who is subject to the U.S. gift and estate tax, including the tax on generation-skipping transfers, or the U.K. capital transfer tax. Thus, the treaty will apply, in general, to estates of decedents who were domiciled in the U.K. at the time of their death and to estates that are subject to tax in the U.S. because the decedent was a citizen or domiciliary of the U.S. at the time of his or her death. The treaty also applies to estates of decedents who had property situated in the U.S. or the U.K. at the time of their death. With respect to gifts, the treaty applies to gifts made while the donor was a domiciliary of the U.K. and to gifts which are subject to tax in the U.S. because the donor was a citizen or domiciliary of the U.S. when the gift was made. The treaty also applies to gifts of property where the property was situated in the U.S. or the U.K. at the time of the gift.

Below, this article will discuss select provisions of the U.S.- U.K. estate and gift tax treaty.

Fiscal Domicile

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 domiciled in the U.K. for purposes of the capital transfer tax if:

1. He or she was domiciled in the U.K. within three years preceding the date of death or the date the gift was made:

2. He or she was a resident in the U.K. in not less than seventeen of the twenty income tax years which end with the income tax year in which the person died or which the gift was made; or

3) He or she became, and has remained, a domiciliary at the Channel Islands or the Isle of Man, and he was a U.K. domiciliary immediately prior to that.

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 U.K. imposes an inheritance tax on the estate of decedents domiciled in that country. U.K. inheritance tax is typically levied at a rate of 40 percent on the decedent’s worldwide estate with values in excess of 325,000 British Sterling Pounds (approximately $402,000). In contrast, individuals domiciled in the U.S. are provided with a far more generous $12.92 million exclusion from U.S. estate tax.

Given the more favorable tax treatment under U.S. law, an individual who can be classified as domiciliaries of both countries solely as a U.S. domiciliary in accordance with the U.S.-U.K. estate, gift, and generation-skipping tax treaty. In so doing, a dual domiciliary can break his or her U.K. domiciliary status and potentially avoid the assessment of U.K. inheritance tax on U.S. situs assets.  

Set forth in Article 4 of the treaty are tie-breaker rules, ranked in order of priority, to determine the domiciliary status of a dual domiciliary. First, a dual domiciliary will be deemed solely a domiciliary if the individual is not a U.S. citizen and did not reside in the U.S. for at least 7 out of the previous 10-year period. Otherwise, the dual domiciliary will be deemed solely a U.S. domiciliary if the individual is a U.S. citizen (but not a U.K. national) and did not reside in the U.K. for at least 7 out of the previous 10-year period. If neither rule applies, a dual domiciliary will be deemed solely the domiciliary of the country where the individual’s permanent home, “centre of vital interest,” or habitual abode is located. If no such location exists (or if there are multiple places for these locations), then the dual domiciliary will be a U.S. domiciliary. If the individual is a U.S. citizen or a U.K. domiciliary if the individual is a U.K. national. If none of the rules apply, the U.S. and U.K. taxing authorities will make the domiciliary determination by mutual agreement.         

If the facts and circumstances of the particular case warrant, in certain cases, utilizing the treaty to break U.K. domiciliary in favor of being classified a U.S. domiciliary may significantly reduce an individual’s exposure to the U.K. wealth transfer tax. Each case needs to be carefully examined to determine if this strategy is beneficial from a global tax perspective. 

The Taxation of Property

The U.S.- U.K. estate and gift tax treaty provides the immovable property (real property) is one of two types of property over which the situs country has primary tax jurisdiction over the country of domicile. The other type is assets of a permanent establishment or fixed base. Under these articles, domiciliaries of the U.K. 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, partnership, and trusts to avoid U.S. transfer taxes.

Under Article 5 of the U.S.- U.K. estate and gift tax treaty, tangible personal property, cash, U.S.-situs debt obligations, and U.S. corporation stock owned by a U.K. domiciliary will likely only be taxed by the U.K. However, Article 5 of the treaty also seems to provide special rules applicable to certain trusts. In light of Article 5, caution is recommended for any tax advisor that utilizes the planning techniques discussed above for U.K. domiciliaries with U.S. based investments.

Marital Deductions

U.S. tax law, U.S. allows an unlimited deduction for property passing from a decedent to his or her surviving spouse. Referred to as the unlimited marital deduction (or “UMD”), this deduction is the most important deduction available to married couples wishing to minimize transfer taxes on their property. The martial excludes from U.S. estate and gift taxes all the property transferred by one spouse to another. However, in order to take the UMD, the spouse receiving the transferred property must be a U.S. citizen. Whether or not the receiving spouse is domiciled in the U.S. is irrelevant for purposes of this deduction.

In the case of gifts made to a spouse who is not a U.S. citizen, the annual gift tax exclusion amount is increased from $17,000 to $175,000 (for calendar year 2023). In the case of passing property upon the death to a surviving spouse who is not a U.S. citizen, the marital deduction can be available if the property is transferred to a qualified domestic trust or (“QDOT”). The QDOT arrangement allows the estate to postpone payment of the decedent’s estate tax, generally until the surviving spouse’s death. The postponed tax is imposed on the QDOT property revalued at the time of taxation at the decedent’s top marginal estate tax rate and the property held in the QDOT is taxed as if it had been included in the decedent’s gross estate.

There are a number of treaties that abrogate these rules. For example, the United Kingdom estate, gift, and generation-skipping tax treaties provide for an unlimited marital deduction for property which would have been eligible for such a deduction had the decedent been domiciled in the U.S. at his death.

The United KIngdom’s estate and gift tax treaty with the United States provide for a marital deduction which would have been eligible for such a deduction had the decedent been domiciled in the U.S. at his death. Under the U.S.- U.K. estate and gift tax treaty, individuals domiciled in the U.K. can claim a marital deduction for purposes of U.S. estate or gift taxes as if they were domiciled in the U.S. This offers a significant planning opportunity for mitigating the consequences of the U.S. estate and gift tax. In essence, the U.S.- U.K. estate, gift, and generation-skipping tax treaty exempts most if not all U.S. situs assets from the U.S. estate and gift tax in connection with interspousal transfers. That is, as long as the worldwide assets of the transferor U.K. domiciled spouse does not exceed the applicable unified credit ($12.92 million for 2023).

Claiming a Treaty Position to Reduce or Eliminate the U.S. Estate Tax

The taxation of non-U.S. domiciliaries can be harsher than that of U.S. domiciliaries. Non-U.S. domiciliaries are subject to estate tax on their U.S. situs assets and are not allowed an exemption of only $60,000. The treaty provides a pro rata unified credit to the estate of an individual domiciled in the U.K. (who is not a U.S. citizen) for purposes of computing the U.S. estate tax. The pro rata portion is based upon the ratio that the U.K. resident’s gross estate situated in the United States at the time of his death bears to his worldwide gross estate. Below, please see the example below which discusses how pro rata unified credit is computed.

Example

Let’s assume a United Kingdom domiciliary dies while owning U.S. real estate valued at $125,000. Since the U.K. domiciliary died owning U.S. situs property worth more than $60,000, the U.K domiciliary’s estate would typically be subject to the U.S. estate tax. However, Article 8, paragraph 5 of the U.S.-U.K. estate, gift, and generation-skipping tax treaty states “Where property may be taxed in the United States on the death of a United Kingdom national who was neither domiciled in nor a national of the United States and a claim is made under this paragraph, the tax imposed in the United States shall be limited to the amount of tax which would have been imposed had the decedent become domiciled in the United States immediately before his death, on the property which would in that event have been taxable.”

In order to determine if the estate of a U.K. domiciliary owes a U.S. estate tax, it will be necessary review the decedent’s worldwide assets at the date of death and calculate a hypothetical estate tax on the decedent’s worldwide assets as if the decedent were domiciled in the U.S. In this example, let’s assume that the U.K. domiciliary owed U.K. assets valued at $1,356,939 which she died in 2023. Since she owed U.S. situs assets valued at $125,000, the U.K. domiciliaries total worldwide estate was valued at $1,481,939. The estate tax exemption in 2023 is $12.92 million. The U.S. assets comprised 16% of the total worldwide assets ($125,000/$1,356,939). Under the estate tax treaty between the U.S. and the U.K., the estate is able to take a pro rata credit of $2,007,520. The estate tax on $1,481,939 is approximately $592,775 ($1,481,939 x 40% = $592,775) which is offset in full by the unified credit, leaving a U.S. estate tax of zero.

Filing Requirements

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.

Conclusion

This article is intended to acquaint readers with some of the principal U.S. estate and gift tax considerations that can come into play when investors who are not U.S. citizens or residents invest in a business or real estate in the United States. This area is relatively complex and is constantly evolving with Congress entertaining new tax laws, the IRS issuing new regulations and interpretations and courts rendering new rulings in this area. As a result, it is crucial that non-U.S. investors consult with a qualified international tax attorney when planning to invest in a U.S. business or real estate. This is to ensure that the proposed investment is appropriate given the investor’s tax circumstances and that no developments have arisen in the area that can impact the investment’s tax objectives. With careful, individualized planning, non-U.S. investors may be able to substantially reduce the U.S. estate and gift tax consequences of their U.S. investments that affect not only themselves but their heirs and beneficiaries as well.

We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in cross-border tax planning and compliance. We have also  provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.

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 adiosdi@sftaxcounsel.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.