By Anthony Diosdi
Introduction
An individual who terminates citizenship or long-term residence could be subject to an expatriation tax. In part, an expatriate individual is automatically subject to an expatriation tax if the individual’s average annual tax burden exceeds $171,000 for the preceding five years or if they have a net worth of over $2 million when they expatriate. In many cases, individuals seeking to expatriate from the United States have spouses that are not U.S. citizens or residents. It is not uncommon for these individuals to own shares in foreign corporations. Recently, Congress enacted sweeping changes to Internal Revenue Code Section 958 “attribution rules.” Under Internal Revenue Code Section 958, stock owned directly or indirectly by a U.S. Person’s spouse is considered owned proportionately by the U.S. person for controlled foreign corporation (“CFC”) rules. Some have questioned if the value shocks owned by a nonresident spouse can be imputed to an expatriate individual’s expatriation tax liability. For reasons discussed below, under Internal Revenue Code Section 958(b)(1), stock owned by a non-resident spouse is not considered owned by an expatriating individual for purposes of the expatriation tax.
History of the Expatriation Tax
Historically, an individual who relinquished his or her U.S. citizenship with “a principle purpose of avoiding U.S. taxes” was subject to special U.S. income, gift, and estate tax rules under the Internal Revenue Code. Individuals now expatriating from the United States now are generally treated as having lost such citizenship or terminated such residency with a principal purpose of tax avoidance if either the individual’s average annual U.S. federal income tax liability for the five taxable years ending before the date of the loss or termination is greater than $100,000 or the individual’s net worth as of the date of the loss or termination is $500,000 or more, unless the expatriate can establish that the renunciation did not have a principal purpose of tax avoidance. In practice, the only categories which are likely to be commonly available to a departing American will be either the one that requires the individual to have been present in the United States for no more than 30 days during any year in the ten-year period immediately preceding the date of his or her loss of citizenship of that the individual becomes a citizen of the country in which the individual, the individual’s spouse or one of the individual’s parents was born.
Under both the original and current Internal Revenue Code Section 877 rules, an expatriating individual is subject to tax on U.S. source income or gain for a ten-year period at the graduated rates applicable to U.S. citizens. The tax applies whether or not the assets giving rise to the income or gains were acquired prior to or after the date of departure. Internal Revenue Code Section also previously recharacterized certain foreign source gains as U.S. source gains, thereby causing them to be subject to U.S. federal income tax. Gain from the sale or exchange of stock of a U.S. corporation or debt of a U.S. person continues to be treated as taxable U.S. source income (regardless of whether it otherwise would be taxable to a regular nonresident alien). In addition, if the expatriate exchanged such property for other property that would normally give rise to U.S. source income (in the course of a rollover or reorganization transaction in which the gain was not recognized), any gain realized from a subsequent sale of the foreign property received in exchange would, by exception, be treated as taxable U.S. source income.
The Current Rules Governing Expatriation Tax
The Heroes Earning Assistance and Relief Act of 2008 (“HEART”) created Internal Revenue Code Section 877A. Under the new tax regime created under HEART, a covered expatriate is required to recognize gain on their worldwide assets as part of a deemed sale the day before the expatriation date. Gain up to $737,000 is currently exempted from the expatriation tax. The regime created under HEART applies to “covered expatriates” which generally includes those individuals who 1) relinquish their U.S. citizenship or lose their permanent resident status (but only if they were a permanent resident during 8 out of the last 15 years), and 2) meet one of the following tests: a) they have a net worth of over $2 million when they expatriate; b) they have an average annual income tax burden of more than $171,000 during the five preceding years; or c) they have have failed to certify compliance with US tax obligations over the last five years.
Attribution Rules for Foreign Corporations
A foreign corporation is a CFC if more than 50 percent of the total combined voting power of all classes of stock of such corporation entitled to vote, or of the total value of the stock of such corporation, is owned (within the meaning of Section 958(a)) or is considered as owned (by attribution of ownership under Section 958(b)) by “U.S. shareholders” on any day during the taxable year of such foreign corporation. See IRC Section 957(a). To prevent the avoidance of the stock ownership rules by dividing ownership among related persons. Under Internal Revenue Code Section 958(a), stock owned directly or indirectly by or for a foreign corporation, foreign partnership, foreign trust or beneficiaries. Stock so considered as owned is treated as actually owned for purposes of applying the direct and indirect ownership rules.
Prior to the enactment of the 2017 Tax Cuts and Jobs Act, for purposes of subpart F, a “U.S. shareholder” only included a U.S. person who owns or is considered as owning 10 percent or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation, with the above attribution rules applying. The 2017 Tax Cuts and Jobs Act expanded the definition of U.S. Shareholder to also include U.S. persons who own 10 percent or more of the total value of shares of all classes of stock of the foreign corporation.
Internal Revenue Code Section 958(b) provides for the rules of Internal Revenue Code Section 318(a) to apply for the purpose of treating a U.S. person as a U.S. Shareholder under the ten percent test of Internal Revenue Code Section 951(b), for classifying a foreign corporation as a CFC under Internal Revenue Code Section 957 and for certain related purposes. Thus, for example, under Internal Revenue Code Section 318(a)(2), stock owned directly or indirectly by a foreign trust is treated as considered as owned by its beneficiaries in proportion to the actuarial interests of such beneficiaries. Internal Revenue Code Section 958(b) also provides special rules of application for the constructive ownership rules of Internal Revenue Code Section 318, the most important of which is that in applying the family attribution rules, stock owned by a nonresident alien individual, other than a foreign trust or foreign estate, is not attributed to a U.S. citizen or resident alien.
Since stock owned by a nonresident spouse is not attributable to a U.S. citizen or resident, the value of the nonresident spouse’s stock cannot be imputed into the calculation of an expatriating individual for purposes of calculating the expatriation tax.
Conclusion
The area tax and immigration consequences of expatriation is incredibly complex. If you are considering expatriating, it is important that you consult with a qualified attorney that has experience advising individuals on the tax and immigration ramifications of expatriating from the United States. We have significant experience advising individuals in all phases of the expatriation process.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in tax matters domestically and internationally throughout the United States, Asia, Europe, Australia, Canada, and South America. Anthony Diosdi may be reached at (415) 318-3990 or by email: 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.