United States: The State Of Expatriation 2011 - Part 1

Introduction and Background

Section 301 of the Heroes Earnings Assistance and Relief Tax Act of 2008 ("HEART" or the "Act")¹ dramatically alters the playing field for individuals who relinquish their U.S. citizenship or terminate their long-term U.S. residence (i.e., U.S. persons who "expatriate"). It does this by adding new sections 877A and 2801 to the Code,² which, respectively, impose "mark-to-market" and "succession tax" regimes on such individuals.

Prior to HEART's enactment, expatriates generally were subject to a 10-year "alternative tax" regime on U.S.-source income, as defined, that was first introduced by the Foreign Investors Tax Act of 1966 ("FITA").³ These rules were contained principally in sections 877, 2107 and 2501 of the Code.

In the intervening four decades, the alternative tax regime was modified twice, first by the Health Insurance Portability and Accountability Act of 1996⁴ ("HIPAA") and then by the American Jobs Creation Act of 2004⁵ ("AJCA"). Both of these Acts generally strengthened the income and transfer tax rules applicable to expatriates under the alternative tax regime.

However, despite these enhancements, the U.S. rules applicable to tax expatriation remained the subject of a continuing Congressional debate that began in 1995, when the Clinton administration proposed a somewhat radical "exit tax" regime as part of its fiscal 1996 Budget. The debate, which included claims calling the exit tax proposal a violation of international human rights, eventually focused on whether the tax opportunities and perceived abuses arising from expatriation can best be deterred or controlled through the alternative tax regime or whether an exit tax or mark-to-market regime would be more effective.⁶ The enactment of the HEART Act's changes, which are generally effective from June 17, 2008, when President Bush signed the legislation into law, appears to indicate that, at least for the foreseeable future, the tax consequences of expatriation by U.S. persons will be governed by the mark-to-market and succession tax regimes.

Prior Law

FITA: Original Provision

Section 877, as originally added to the Code by FITA, generally imposed tax, calculated at the higher of the rates applicable to nonresident aliens who were not former U.S. citizens or at the rates applicable to U.S. citizens, on the U.S. source income of former U.S. citizens who expatriated for a principal purpose of tax avoidance for 10 years following expatriation. Thus, it was necessary to make two calculations of tax to determine which led to a higher tax charge and, hence, the method became known as the "alternative tax" regime. Congress's reason for introducing the provision was because FITA generally eliminated progressive taxation of the U.S. income of nonresident aliens not effectively connected to a trade or business and did not wish to encourage individuals to surrender their citizenship and move abroad.⁷

U.S. source income, for this purpose, generally had its usual meaning under the Code but was defined to include gains from the sale or exchange of property (other than stock or debt obligations) located in the U.S. as well as gains from the sale or exchange of stock or debt obligations issued by domestic corporations or other U.S. persons. In addition, gains from the sale or exchange of property having a basis determined by reference to such property, in whole or part, was also treated as U.S. source income for the 10-year period in order to catch gains from non-U.S. property acquired in nonrecognition transactions.

Under section 2107, also added by FITA, if an expatriate subject to the alternative tax regime of section 877 died within the 10 years following expatriation, then his U.S. estate included, in addition to U.S. situs property generally subject to estate tax in the case of a nonresident alien decedent, shares held at the date of death comprising a 10 percent or greater direct or indirect interest⁸ in a foreign corporation considered owned more than 50 percent by the decedent, directly, indirectly or constructively,⁹ in proportion to the foreign corporation's underlying U.S. situated property. In addition, under section 2501(a)(3), as amended by FITA, the normal gift tax exclusion for intangible property of a nonresident alien did not apply in the case of transfers made within 10 years of expatriation by an expatriate subject to section 877's alternative tax regime. Thus, such an individual was subject to gift tax on transfers of U.S. situs intangible property during the 10-year post-expatriation period.

For purposes of both the income and transfer tax provisions, if the IRS was able to show that it was reasonable to believe that a former U.S. citizen expatriated with a principal purpose of tax avoidance, the burden of proof on the issue was thrown back on the expatriate or, in the case of section 2107, his executor or personal representative.

Prior to the renewed interest in tax expatriation that commenced with the Clinton administration's exit tax proposal in February 1995, there were only two significant reported cases involving section 877 and its related expatriation provisions. In Kronenberg v. Commissioner,¹⁰ the IRS prevailed in its claim that the taxpayer had a principal tax avoidance motive where he expatriated two days before receiving a large corporate liquidating distribution. However, in Furstenberg v. Commissioner,¹¹ the taxpayer was able to demonstrate to the satisfaction of the Tax Court that tax avoidance was not the taxpayer's principal motivation where she had "lifelong ties to Europe" and had married a foreign aristocrat, notwithstanding that she also sought tax advice prior to expatriation. The importance of the decision lies in the fact that the Tax Court held that, to fall within the ambit of section 877 and its related provisions, a taxpayer's tax avoidance motive was required to be not just an important purpose of the expatriation but, indeed, "first in importance." It is likely that the IRS failed to bring many cases under section 877 because of the difficulties of proving a taxpayer's principal motivation within the meaning of the Furstenberg decision.

HIPAA: 1996 Modifications

The debate launched by the Clinton administration's 1995 exit tax proposal ultimately resulted in substantial changes to the tax expatriation rules but not in the enactment of an exit tax. Shortly after legislation incorporating the administration's proposal appeared, House Ways and Means Committee Chairman Bill Archer proposed legislation that generally retained, but significantly strengthened, the existing 10-year alternative tax regime. In part because Archer's proposal was "scored" by the staff of the Joint Committee on Taxation ("JCT") to raise almost four times the revenue that the exit tax proposal was scored to raise and also likely, in part, because the exit tax's proposal to tax income and gains not yet realized was considered to be a somewhat radical departure from existing U.S. tax policy, Archer's proposal carried the day and was enacted as part of HIPAA in 1996.¹²

HIPAA, which was generally applicable to expatriations occurring on or after February 6, 1995, made a number of significant changes to the alternative tax regime of section 877. First and foremost, the category of "covered expatriates" was enlarged to include "long-term resident aliens," defined as "lawful permanent residents" (i.e., green card holders) resident for tax purposes in eight of the prior 15 taxable years.¹³ Expatriation was considered to have occurred at the date prescribed for citizens under nationality law (i.e., as of the date of an expatriating act)¹⁴ and for long-term residents under the tax residence rules.¹⁵

In order to avoid problems of proof raised by the Furstenberg decision, HIPAA also introduced the notion of "presumptive tax avoidance purpose" based on certain economic factors pertaining to a taxpayer. Thus, tax avoidance motive was presumed if an individual's net average U.S. income tax liability in the five years preceding expatriation was $100,000 or more ("income tax liability test") or if his net worth at expatriation exceeded $500,000 ("net worth test").¹⁶ Exceptions were available for certain categories of individuals if they obtained a ruling from the IRS that tax avoidance was not a principal purpose of their expatriation.¹⁷ In cases in which the Service was unable to make a definitive determination, it was authorized to issue a limited ruling that lifted the statutory presumption, but left the taxpayer subject to subsequent examination, if the taxpayer's ruling request was considered to be complete and made in good faith.¹⁸

HIPAA also significantly enlarged the categories of income considered to be U.S. source income. Thus, for example, income and gains derived from former controlled foreign corporations ("CFC's") considered controlled by an expatriate within two years prior to expatriation were considered to be from U.S. sources if realized within the 10-year postexpatriation period.¹⁹ Further, certain gains arising from otherwise non-taxable exchanges and "other similar occurrences" that resulted in a change of future income source from U.S. to non- U.S. were required to be recognized as U.S. source income.²⁰ In addition, if during the 10-year period following expatriation a taxpayer contributed property giving rise to U.S. source income to a foreign corporation that, had the taxpayer remained a U.S. person, would have been a CFC, then the foreign corporation was disregarded and the expatriate was considered to receive the underlying U.S. source income directly.²¹

HIPAA also introduced limited information reporting for individuals who expatriate in order to assist the IRS to administer the provisions. An expatriating U.S. citizen was required to provide an information statement, including a statement of net worth, to the DOS when disclosing an expatriating act; the DOS routinely forwarded these information returns to the IRS. A departing long-term resident was required to provide the same information statement directly to the IRS with his tax return for the year of expatriation.²² Further, an expatriate was required to file a U.S. tax return, including a worldwide income statement, for any of the 10 years following expatriation in which he had U.S. source income subject to tax.²³ In addition, HIPAA required that the DOS furnish copies of the Certificate of Loss of Nationality ("CLN") of expatriating citizens to the IRS and that names of such persons be published quarterly in the Federal Register. The immigration authorities were also required to furnish the names of all persons whose green cards were revoked or considered to have been administratively abandoned.²⁴

Finally, the legislative history to the 1996 HIPAA expatriation changes indicates that the rules were intended to override inconsistent provisions of pre-existing income and estate and gift tax treaties for 10 years following enactment, or until August 21, 2006.²⁵ Since enactment of the 1996 changes, Treasury generally has added language excluding former U.S. citizens and long-term residents from treaty benefit to the "saving clause" of new or re-negotiated treaties and protocols.²⁶

AJCA: 2004 Modifications

The 2004 AJCA generally adopted recommendations made by the staff of the JCT in a 2003 report²⁷ ("2003 JCT Report") that was spawned by the expatriation debate.²⁸ After a thorough – and lengthy²⁹ – review of the effectiveness of the 1996 HIPAA changes, the JCT staff concluded that there had been little, if any, enforcement of the expatriation rules by the responsible agencies, principally the IRS. The staff also noted certain defects inherent in the 1996 HIPAA regime. However, rather than suggest a fundamental change to the expatriation rules (e.g., the mark-to-market regime), the JCT Report made a number of specific recommendations within the framework of the existing regime that were generally intended to make the rules easier to administer and enforce.

Thus, the AJCA generally left the 10-year alternative tax regime on U.S. source income in place but made a number of important changes. In the first place, the AJCA removed the requirement that an individual have a principal tax avoidance purpose and eliminated the ruling procedure. The income tax liability test threshold was changed only slightly to "greater than" $124,000 (indexed annually beginning in 2005),³⁰ but the net worth test standard was increased substantially to $2,000,000 (not indexed).³¹ In addition, the AJCA added a third test, providing that an expatriate certify that he has fully complied with all U.S. tax requirements for the five years preceding expatriation.³² Exceptions to the provision were limited to certain dual nationals at birth having no "substantial contacts"³³ with the U.S. and minors expatriating before age 18½ who were born in the U.S. to non-citizen parents and who have not been in the U.S. more than 30 days in any of the 10 years preceding expatriation.

The AJCA also amended the expatriation gift tax rules to add a provision that parallels the expatriation estate tax rule of section 2107 and imposes tax on gifts of shares of a foreign corporation considered to be controlled by the expatriate to the extent of such foreign corporation's underlying U.S. property during the 10-year post-expatriation period.³⁴

In addition, the AJCA added a provision for determining when an individual is considered to have expatriated for tax purposes. New section 7701(n) provided that an individual will continue to be treated as a U.S. citizen or long-term resident until he both gives notice of his expatriation to the DOS or DHS, respectively, and furnishes an information statement required by amended section 6039G.³⁵ To give effect to this provision, the instructions to revised Form 8854 set out in some detail the specific acts by which U.S. citizenship and long-term residence may be terminated. The instructions then state very clearly that, notwithstanding the occurrence of these acts, the obligation to file U.S. tax returns and report worldwide income does not terminate until the later to occur of giving notice of these acts to the appropriate agency or filing Form 8854, which expressly has no filing due date for this purpose.³⁶

Further, the AJCA strengthened the information reporting rules by requiring that an expatriate file an annual information statement for each of the 10 post-expatriation years regardless of whether the expatriate had any U.S. source taxable income for such year.³⁷ The annual return requirement is also satisfied by filing revised Form 8854, which requires that a current balance sheet and worldwide income statement be prepared for each year.³⁸

Finally, the AJCA added a new short-term residence rule to the expatriation tax provisions.³⁹ Under it, an individual otherwise subject to the tax expatriation rules will be subject to income and transfer taxes on his worldwide income and property as a U.S. citizen or resident during any of the 10 post-expatriation years in which he is physically present in the U.S. for more than 30 days. This was the most controversial provision of the expatriation changes made by the AJCA and reflects a Congressional view that, if individuals wish to leave the U.S. taxing jurisdiction, they should "really leave" and should not be allowed to benefit from the generous provisions of section 7701(b) that generally permit an alien an average of 121 U.S. days per year without becoming a tax resident. A limited exception of up to 30 additional days of U.S. presence is permitted for certain expatriates performing services in the U.S. for an unrelated employer.⁴⁰

Omissions and Technical Issues under Prior Law

Although the HEART Act repeals the alternative tax regime prospectively,⁴¹ and thereby effectively moots many of the issues under prior law, because the prior rules continue to apply to individuals who expatriated under them and are still in their 10-year post-expatriation period, it remains necessary to understand prior law.

The issue most likely to come up under prior law concerns whether and when tax expatriation has occurred, especially in the case of long-term residents seeking to tie-break their residence to a foreign country for tax purposes while holding on to their green cards for immigration purposes. This is due to the dual notice requirements established by former section 7701(n) in order to complete tax expatriation and the uncertain relationship between that section, section 877(e)(1) and the effective date of a residence tie-breaker claim under a tax treaty – is the claim effective when actually filed, or does it relate back to the end of the taxable year preceding the year for which the claim is made?

Another possible issue that could arise under prior law concerns whether and when the tax treaty override of the HIPAA changes ceased to apply. The legislative history to the AJCA makes no reference to the issue of treaty override. Presumably, since section 877, the fundamental taxing provision of the alternative tax regime, was neither materially amended nor re-enacted by the AJCA, the 1996 treaty override provision remained intact only until August 21, 2006, the date that was 10 years after the HIPAA changes were enacted.

HEART Act Changes

As previously indicated, the dramatic changes to the expatriation tax regime made by the HEART Act include both a mark-to-market tax regime to replace the former 10-year alternative tax regime on U.S. source income⁴² and a succession tax regime on gifts and bequests received by U.S. persons from a covered expatriate.⁴³ The latter provision, which is perhaps the most dramatic change made by the HEART Act, is scored to raise most of the revenue that the new legislation is expected to bring in.

Section 877A: Mark-to-Market Tax

New section 877A replaces the former 10-year alternative tax regime on U.S. source income of covered expatriates with a mark-to-market tax on gains in excess of $600,000 (indexed for years after 2008; for 2011, $636,000⁴⁴) from a deemed sale of an individual's worldwide assets on the day prior to the individual's expatriation date. As under prior law, the term "covered expatriate" includes individuals who renounce or relinquish U.S. nationality or terminate their status as long-term lawful permanent residents (i.e., green card holders for at least 8 of the 15 taxable years preceding expatriation) and whose average net income tax liability for the 5 years preceding expatriation exceeds $124,000 indexed for inflation (for persons expatriating in 2011, $147,000⁴⁵) or whose net worth at the date of expatriation equals or exceeds $2 million (not indexed). Certain dual nationals at birth who have not met § 7701(b)'s "substantial presence" residence test for more than 10 of the 15 taxable years ending with the year of expatriation and individuals losing U.S. citizenship before age 18½ who have not met the substantial presence test for more than 10 years are excepted.

Under the provision, a covered expatriate can irrevocably elect, on an asset by asset basis, to defer the payment of the mark-to-market tax attributable to an asset until the due date of the return for the year in which such property is sold or exchanged. (Guidance will be provided for dispositions in non-recognition transactions.) In order to make the election, a taxpayer must provide "adequate security" (including a bond conditioned on the payment of tax and interest and meeting the conditions set forth in § 6325 or other security acceptable to the IRS) and irrevocably waive the benefit of any U.S. tax treaty that would preclude assessment of the tax. The election will terminate as to any property not sold or exchanged when a taxpayer dies or when the IRS determines that security is no longer adequate. Interest accrues on the deferred tax at the normal underpayment rate.

Certain property, including deferred compensation items, "specified tax deferred accounts" (i.e., an individual retirement account and certain education and health savings accounts), and interests in nongrantor trusts are excepted from application of the mark-to-market tax.

"Deferred compensation items" include any interest in a qualified plan or other arrangement described in § 219(g)(5), interests in foreign pension, retirement or similar plans or arrangements, any item of deferred compensation, and interests in property to be received in connection with the performance of services to the extent not previously taken into account in accordance with § 83. Deferred compensation attributable to services performed outside the U.S. while a covered expatriate was not a U.S. citizen or resident is not included.

Tax on the payment of an "eligible deferred compensation item" is deferred until a covered expatriate receives a taxable payment (i.e., a payment that would be taxable if the individual were a U.S. person), at which time tax is collected by means of a 30 percent withholding tax under rules similar to those of subchapter B of Chapter 3 (i.e., section 1441 and following). However, no withholding tax is due under section 1441 or chapter 24 (i.e., wage withholding under section 3401 and following). Notwithstanding this, the tax is considered payable under section 871. An item is considered to be eligible deferred compensation if either the payor is a U.S. person or a foreign person who elects to be treated as a U.S. person for this purpose (and meets requirements to be established by the IRS), provided that the covered expatriate notifies the payor of his status and makes an irrevocable waiver of any right to claim benefit under a U.S. income tax treaty.

In the case of deferred compensation items that are not eligible deferred compensation, an amount equal to the present value of an individual's account is treated as received and taxable on the day before expatriation. No early distribution tax is assessed, and appropriate adjustments will be made to subsequent distributions to reflect the prior taxation.

A covered expatriate's interest in a "specified tax deferred account" is treated as distributed on the day before expatriation. Again, no early distribution tax is assessed, and appropriate adjustments will be made to subsequent distributions to reflect such treatment.

The new law provides that a trustee shall withhold tax at 30 percent from the taxable portion of a direct or indirect distribution from a nongrantor trust to a covered expatriate. Again, the "taxable portion" is that part of a distribution that would be taxable if the expatriate remained a U.S. person. If a trust distributes appreciated property, gain is recognized to the trust as if it had sold the property to the expatriate. The provision does not distinguish between domestic and foreign trusts or U.S. or foreign trustees. Thus, it imposes a withholding tax on all taxable distributions from trusts. Withholding tax rules similar to those applicable to payments of eligible deferred compensation items are applied.

"Expatriation date" is defined to mean the date that a citizen relinquishes U.S. nationality or a long-term resident alien ceases to be a lawful permanent resident (i.e., green card holder). Section 7701(n), added to the Code by the AJCA, which provided that a covered expatriate is treated as a U.S. person for tax purposes until the later of the date he gives notice to the IRS on Form 8854 or to whichever of the DOS or the DHS is relevant, is repealed.

A citizen is considered to have relinquished U.S. citizenship at the earliest of the dates: (i) he renounces his nationality before a U.S. diplomatic or consular officer; (ii) he provides a statement of voluntary relinquishment to the DOS; (iii) the DOS issues the individual a Certificate of Loss of Nationality ("CLN"); or (iv) a U.S. court cancels a naturalized citizen's certificate of naturalization.

Section 7701(b)(6), which generally defines who is a "lawful permanent resident," is amended to provide that an individual ceases to be a lawful permanent resident if he: (i) commences to be treated as a resident of a foreign country under the provisions of an applicable tax treaty with the U.S.; (ii) does not waive tax benefits available under the treaty; and (iii) notifies the IRS of the commencement of such treatment (e.g., by claiming treaty benefits on a Form 8833 filed with his U.S. income tax return).⁴⁶

Finally, for purposes of the mark-to-market tax, all nonrecognition deferrals and extensions of time for the payment of tax are considered terminated as of the day before expatriation. In addition, solely for purposes of calculating the mark-to-market tax, the basis of property held when an individual first became a U.S. resident for tax purposes and still held when he expatriates will be stepped up (but not down) to its fair market value on such date. Such an individual can irrevocably elect not to have this basis rule apply.

Section 2801: Succession Tax

New section 2801 imposes a tax, at the highest applicable gift or estate tax rates, on the receipt by a U.S. person of a "covered gift or bequest," which is defined as a direct or indirect gift or bequest from a "covered expatriate" within the meaning of section 877A. Thus, the new succession (or inheritance) tax only applies to gifts and bequests from individuals who expatriate on or after June 17, 2008, the effective date of the new mark-to-market regime. The tax is assessed on, and intended to be paid by, the recipient of a covered gift or bequest. The succession tax will be reduced by any foreign gift or estate tax paid.

The new succession tax does not apply to gifts covered by the annual exclusion of section 2503(b), currently $13,000 per donee per annum.⁴⁷ Nor does it apply to gifts or bequests entitled to a marital or charitable deduction. Thus, for example, gifts or bequests to a U.S. citizen spouse will be exempt from the tax, while gifts to an alien spouse will be limited to the amount allowed by sections 2503(b) and 2523(i), currently $134,000 per annum,⁴⁸ and bequests to an alien spouse will benefit from a marital deduction only if left to a qualified domestic trust, per sections 2056(d) and 2056A. The succession tax also will not apply to a taxable gift shown on a timely filed gift tax return or to property included in the estate of a covered expatriate that is shown on a timely filed estate tax return.

Section 2801 creates a special rule for covered gifts and bequests made to trusts. In the case of such a transfer to a domestic trust, the succession tax will be assessed on and paid by the trust. In the case of a covered gift or bequest made to a foreign trust, the succession tax will apply to the receipt by a U.S. person of a distribution, whether of income or capital, attributable to a transfer from a covered expatriate. A foreign trust is entitled to elect to be treated as a domestic trust solely for purposes of section 2801. Finally, in calculating his income tax liability on the receipt of a taxable distribution from a foreign trust attributable to a covered gift or bequest, a U.S. recipient will be entitled to deduct, under section 164, the amount of tax imposed under section 2801 that is attributable to gross income of the recipient but not to the capital portion of the distribution.

Guidance under the HEART Act: Notice 2009-85

There are many issues that need to be addressed in public guidance under the expatriation tax provisions of the HEART Act. After a hiatus of some months, Treasury and the IRS issued Notice 2009-85 (the "2009 Notice" or "Notice"),⁴⁹ which provides guidance for individuals subject to section 877A. The 2009 Notice does not provide any new guidance regarding section 877. Nor does the Notice provide any guidance under section 2801, other than to confirm that satisfaction of the reporting and tax obligations for individuals receiving covered gifts or bequests is deferred until further guidance is provided. Additional guidance regarding section 877A can also be found in the substantially revised Form 8854 that was published most recently in January 2010 and Form W-8CE that was revised most recently in November 2009.⁵⁰

Mark-to-Market Tax

Regarding the operative provisions of the HEART Act's central "mark-to-market" tax, the 2009 Notice generally confirms the statute's principles in a straightforward manner, clarifying and explaining those provisions most requiring it. In discussing the definition of "covered expatriate," the Notice confirms that certification of 5-year tax compliance (the "certification test") must be made on Form 8854 and filed on or before the due date of the taxpayer's tax return for the year of expatriation. The Notice also confirms that all U.S. citizens who relinquish citizenship and all long-term residents who cease to be lawful permanent residents within the meaning of amended section 7701(b)(6) will be treated as covered expatriates if they fail to certify 5-year tax compliance, notwithstanding that they fail to meet the income tax liability or net worth tests at the date of expatriation.

The Notice parrots the statute's language regarding the exceptions to covered expatriate status for certain dual nationals at birth and individuals under age 18½ at the date of expatriation, but no effort is given to explain how the substantial presence test of section 7701(b)(3) should be applied to an expatriating citizen to determine if he was a U.S. resident in more than 10 of the 15 years preceding the year of expatriation. For example, does such an individual have the benefit of the "closer connection" exception to residence?⁵¹

Importantly, the 2009 Notice confirms that the date of cessation of lawful permanent residence by a long-term resident, who "tie-breaks" his residence to a foreign country under the provisions of an applicable U.S. income tax treaty, occurs when the individual's foreign residence "commences" for treaty purposes and not at the date that notice of such commencement is provided to the IRS. That notice appears on Forms 8833 and 8854, filed with the individual's tax return for the year of expatriation (which frequently occurs as many as 18 months after the foreign residence "commencement" date).⁵²

The 2009 Notice also confirms that the determination of whether an individual meets the income tax liability or net worth tests for "covered expatriate" status, as set forth in section 877A(g)(1)(A) (by reference to section 877(a)(2)), is done pursuant to the principles of Notice 97-19, the initial guidance issued under the 1996 HIPAA changes to the expatriation tax provisions.⁵³ Thus, for purposes of section 877A, an expatriating individual's net U.S. income tax liability is still determined under section 38 (with joint return filers each responsible for the total net income tax liability shown on a return), and, for purposes of determining his net worth at expatriation, an individual is considered to own property that would be taxable on a gratuitous transfer under the gift tax provisions of Chapter 12 of Subtitle B of the Code (disregarding available exemptions, etc.).

For purposes of computing a covered expatriate's tax liability under the mark-to-market provisions, the 2009 Notice states that an individual is considered to own any property that would be considered to be within his estate under the provisions of Chapter 11 of Subtitle B of the Code (with certain adjustments), were he to die on the day before his expatriation date. Property considered owned through a grantor trust is included, but property considered owned through a non-grantor trust, pursuant to the principles set out in Notice 97-19 (which are applied for determining whether an individual meets the net worth threshold for covered expatriate status), is disregarded. This is because beneficial interests in non-grantor trusts, as well as deferred compensation items and specified tax deferred accounts, are expressly excepted from operation of the mark-to-market tax and subject to expatriation taxation under other provisions. Finally, the Notice provides that the valuation of property considered owned for purposes of the mark-to-market regime generally is to be made under estate tax principles. Thus, where appropriate, formal valuations are required.

In discussing section 877A's exclusion amount (currently $627,000), the 2009 Notice states that the amount must be allocated pro rata across all assets having built-in gain and without regard to a taxpayer's election to defer tax with respect to certain assets. Thus, the exclusion cannot be allocated to the highest taxed income first. Further, the Notice states that, if the total built-in gain on all taxable assets is less than the exclusion amount, then the exclusion amount that can be allocated across the property will be limited to the amount of built-in gain.⁵⁴ It is also clear from the Notice that built-in gain cannot always be reduced by built-in losses. The use of losses is generally limited by other applicable Code provisions (not including the wash sale rule of section 1091).

With respect to basis issues involved in the mark-to-market regime, the 2009 Notice makes it clear that the basis of an asset will be adjusted for purposes of determining gain or loss on a subsequent disposition by the amount actually taken into account in determining gain or loss without regard to the exclusion amount attributable to the asset. As regards the in-bound basis step-up afforded to alien individuals at the time they become resident aliens (which is solely for purposes of the mark-to-market provisions), the Notice confirms that the basis in property is only stepped up (and not also down) and indicates that an individual can irrevocably elect not to have the automatic basis step-up to fair market value apply on an asset-by-asset basis. The 2009 Notice also indicates that Treasury and the IRS intend to exercise their regulatory authority to deny this basis step-up to U.S. real property interests and property used in a U.S. trade or business owned by a nonresident alien prior to becoming a U.S. resident.

With respect to a covered expatriate's right to defer the payment of the mark-to-market tax, the Notice establishes a 30-day cure period in the event that an individual's proffered security for payment of the mark-to-market tax becomes inadequate. The Notice discusses the conditions of, and procedures for entering into, a deferral election agreement and, importantly, attaches a template of a tax deferral agreement as an appendix. The Notice also explains at some length the calculation of the deferred tax considered attributable to each asset for which the election is made. Note, in particular, that the deferral election only applies to the tax arising as a result of section 877A and not to an individual's regular U.S. tax liability for the year of expatriation.⁵⁵

Finally, the 2009 Notice discusses the interaction of section 877A with other Code provisions providing for the deferral of gain. In general, an expatriation under section 877A terminates any other prior tax deferrals, and all such deferral terminations must be accounted for before determining the consequences of expatriation under section 877A. In particular, the Notice discusses the expatriation tax consequences arising in respect of a terminated section 367(a) gain recognition agreement, section 684 and section 897.

Tax on Deferred Compensation

As for the three exceptions to the general mark-to-market rule, the 2009 Notice first confirms the breadth of what constitutes an "item of deferred compensation." In particular, the Notice confirms that property received in connection with the performance of services is included whether or not such property is substantially vested, but only to the extent not previously taken into account in accordance with section 83. The Notice reiterates the statutory conditions for application of the deferred 30% withholding tax on the taxable portion of postexpatriation distributions of "eligible deferred compensation" but unfortunately only promises future guidance regarding the elective procedure for a non-U.S. person to be treated as a U.S. person so that otherwise "ineligible deferred compensation" may also benefit from the deferred 30% withholding tax regime. Absent such an election, the Notice confirms that the present value of a covered expatriate's accrued benefit will be treated as received by the taxpayer on the day before expatriation and must be included on the taxpayer's tax return for the portion of the year preceding the expatriation date.⁵⁶ The Notice discusses at some length the appropriate adjustments that may be made to subsequent distributions from an ineligible deferred compensation plan to ensure that amounts included in future distributions will not be subject to income tax a second time.

The 2009 Notice confirms that the rules pertaining to deferred compensation items do not apply to any deferred compensation attributable to services performed outside the United States while a covered expatriate was not a U.S. citizen or resident, whether before or after expatriation. Until further guidance is issued, the Notice permits a taxpayer to use any reasonable method consistent with existing guidance pertaining to the sourcing and taxation of deferred compensation⁵⁷ to determine amounts that may be excluded.

Specified Tax Deferred Accounts

Regarding "specified tax deferred accounts," the 2009 Notice does little more than confirm the scope of the term (i.e., what statutory schemes are covered) and the manner of taxation for such items. The Notice also reiterates the provisions contained in the instructions to Form W-8CE.⁵⁸

Interests in Nongrantor Trusts

In the case of "interests in nongrantor trusts," the 2009 Notice generally confirms the rules set forth in the statute, namely that the "taxable portion" of distributions to a covered expatriate who was a beneficiary of a trust on the day before the expatriation date are subject to a 30% withholding tax. The Notice seeks to clarify who is a trust beneficiary in broad terms (i.e., a person permitted to receive a direct or indirect distribution under a trust's terms or local law having power to apply trust income or corpus for his own account, or a person to whom income or corpus would be paid if current interests were terminated) but does not address the obvious questions concerning beneficial interests in nongrantor trusts that may arise after the date of expatriation (e.g., pursuant to a discretionary trust power to add or exclude beneficiaries). The Notice does add that, if a trust that was a nongrantor trust prior to expatriation becomes a grantor trust as to a covered expatriate following expatriation, the conversion of status will be treated as a taxable distribution to the covered expatriate to the extent of his interest in the trust as "owner."

There is no statutory provision in section 877A that would permit a foreign trustee of a foreign trust to elect to be treated as a U.S. person for purposes of withholding the 30% tax on taxable distributions to a covered expatriate, as there is in the case of a foreign payor of deferred compensation (for which there is, as yet, no guidance). Further, Treasury and the IRS apparently have determined that they do not have sufficient regulatory authority to create such a parallel mechanism, which might actually aid in the collection of this tax, which otherwise appears to be largely unenforceable. (Such a provision may also afford foreign fiduciaries with U.S. operations a measure of relief against being caught up in a future U.S. tax enforcement action.) However, the Notice does confirm the existence of an elective procedure whereby a covered expatriate can apply to obtain a letter ruling from the IRS as to the value, if ascertainable, of his interest in a nongrantor trust as of the day before his expatriation date.⁵⁹ If a valuation ruling is forthcoming, the covered expatriate will be considered to have received the value of his trust interest immediately prior to expatriation, and tax will be due with his tax return for the period ending on his expatriation date. As a consequence, no subsequent trust distribution will be subject to the 30% withholding tax under section 877A(f),⁶⁰ and the covered expatriate will be entitled to claim treaty benefits vis-à-vis any distribution from the trust under an applicable income tax treaty.⁶¹

Footnotes

1 Pub. L. No. 110-245 (2008).

2 Except as otherwise indicated, all section references are to provisions of the U.S. Internal Revenue Code of 1986 (the "Code"), as amended, and to the Treasury regulations issued thereunder.

3 Pub. L. No. 89-809 (1966).

4 Pub. L. No. 104-191 (1996).

5 Pub. L. No. 108-357 (2004).

6 The "mark-to-market" approach generally has been sponsored by the Senate. Prior to the HEART Act and its immediate 2007 antecedent, the "Defenders of Freedom Tax Relief Act of 2007," H.R. 3997, 110th Cong., 1st Sess.(Senate Amendment, Dec. 12, 2007), the most recent mark-to-market proposal was contained in the Tax Relief Act of 2005, S. 2020, 109th Cong., 1st Sess. (2005). The provision went to conference in early 2006, but failed to be included in the Tax Increase Prevention and Reconciliation Act of 2005 ("TIPRA"), Pub. L. 109-222 (2006). The language of the Senate's 2005 bill was substantially identical to that of the Jumpstart Our Business Strength (JOBS) Act, S. 1637, 108th Cong., 2nd Sess. (2004), which vied in a prior conference with the House proposal contained in H.R. 4520, 108th Cong., 2nd Sess. (2004), that was incorporated into the AJCA virtually unchanged.

7 See, e.g., S. Rep. No. 89-1707 (89th Cong., 2nd Sess., 1966).

8 Within the meaning of § 958(a).

9 Within the meaning of §§ 958(a) and (b).

10 64 T.C. 428 (1975).

11 83 T.C. 755 (1984).

12 In this regard, it is worth noting -- and somewhat ironic -- that § 2801, the HEART Act's succession tax provision (and likely the provision scored to raise most of the $411 million estimated to be raised under the new expatriation changes over the next 10 years), was a direct result of the scoring of the original exit tax proposal. The succession tax provision -- which is likely the most controversial part of the HEART Act changes -- was added to the Clinton administration's exit tax proposal in 1996 by the Senate Finance Committee in order to compete with the Archer proposal that was ultimately enacted as part of HIPAA.

13 HIPAA § 501(f)(1), adding new § 877(e).

14 This was subject to an exception for citizens expatriating after February 5, 1994, who had not furnished a statement confirming their loss of citizenship to the Department of State ("DOS") prior to February 6, 1995, the general effective date of the HIPAA expatriation changes. HIPAA, § 511(g). Such individuals remained subject to § 877 for 10 years following the furnishing of such statement.

15 Section 877(e) refers to § 7701(b)(6) for purposes of determining when an individual ceases to be a lawful permanent resident. That section provides that an individual granted lawful permanent resident status will remain a tax resident until such status has been revoked or administratively or judicially determined to have been abandoned. The regulations, at Reg. § 301.7701(b)-1(b), state that abandonment will be considered to occur as of the date an individual provides written notice of such action to the Immigration and Naturalization Service ("INS") or a consular officer, or the INS (or a consular officer) issues an order of revocation or abandonment. [The role of the INS has now been taken over by the U.S. Citizen and Immigration Services ("USCIS"), an agency of the Department of Homeland Security ("DHS").] Note that, in the latter case, it is the date of issuance that marks cessation of residence and not the prior effective date of such an order.

16 HIPAA § 511(a), amending § 877(a)(2). Both figures were indexed for post-1996 years. For expatriations occurring in 2004, the year that the AJCA modified the expatriation rules, the figures were $124,000 and $622,000, respectively.

17 HIPAA § 511(b)(1), adding § 877(c)(2). That provision set out the categories of expatriating citizens who could apply for a ruling. In Notice 97-19, 1997-1 C.B. 394 (the initial expatriation guidance that, inter alia, laid out the requirements of the ruling procedure), the IRS established substantially parallel classes of long-term residents that could apply for a ruling. These categories were modified somewhat in Notice 98-34, 1998-2 C.B. 29.

18 The IRS established the "complete good faith" ruling in Notice 98-34, note 17, supra. The 2003 JCT Report, note 27, infra, questioned whether this limited ruling position was supported by HIPAA's legislative history, and the IRS temporarily ceased issuing such rulings in 2003. When AJCA was enacted in October 2004 and it became clear that the expatriation ruling program would henceforth be eliminated, the IRS re-commenced issuing "complete good faith" rulings in order to finish work on its backlog of suspended rulings.

19 HIPAA § 511(b)(1), adding new § 877(d)(1)(C). Such income was treated as U.S. source to the extent of the former CFC's earnings and profits attributable to an expatriate's stock accumulated while the expatriate met the control test.

20 Id., adding new § 877(d)(2).

21 Id., adding new § 877(d)(4).

22 HIPAA § 512(a), adding new § 6039G. This statement was provided on Form 8854, "Expatriation Information Statement."

23 This requirement was added by Notice 97-19, note 17, supra. The Notice states that a failure to include a worldwide income statement will cause a return not to be considered a true and accurate return. The consequence of that, if a taxpayer's return is later examined, is a loss of entitlement to deductions and credits. See generally Reg. § 1.874-1.

24 HIPAA § 512(a), adding new § 6039G(d).

25 H. Rep. 145, 104th Cong., 1st Sess. 30 (1995); H. Rep. 496, 104th Cong., 2nd Sess. 155 (1996). However, several treaties negotiated and signed before, but ratified after, HIPAA's date of enactment do not preserve the right of the U.S. to tax former long-term residents otherwise subject to § 877. See, e.g., the income tax treaties with Austria (1996), Ireland (1997), Luxembourg (1996) and Switzerland (1996). Thus, the intended treaty override has not been effective to bar the use of these treaties by former long-term residents emigrating to these countries.

26 See, e.g., the post-August 21, 1996 treaties with Thailand and Venezuela, the new treaties with the United Kingdom, Japan and Belgium, and the new protocols with Australia and Mexico, each of which reserves the right of the U.S. to tax former long-term residents subject to § 877. See also the December 2000 protocol to the estate and gift tax treaty with Germany, in which the "saving clause" was amended to preserve the right of the U.S. to tax the gifts and estates of former long-term residents for 10 years following expatriation. Note that Germany, which also has a 10-year expatriation provision under domestic law, receives a reciprocal treaty benefit.

27 Joint Committee on Taxation, Review of the Present-Law Tax and Immigration Treatment of Relinquishment of Citizenship and Termination of Long-Term Residency (JCS-2-03), February 2003.

28 The JCT Report was undertaken in response to a 1999 request by then Ways and Means Committee Chairman Bill Archer (R-TX) to evaluate the 1996 expatriation changes, which Archer had sponsored. Archer was responding to renewed calls by House Democrats (including, notably, the current Ways and Means Committee Chairman, Charles Rangel (D-NY)) to replace the HIPAA changes with a mark-to-market regime based largely on the original 1995 exit tax proposal of the Clinton Administration.

29 The JCT Report was originally due in May 2000, and much work had been undertaken to meet the original due date, including a detailed report prepared by the Government Accounting Office ("GAO") in May 2000. Why the JCT Report was not issued then is unclear. However, when the Congressional Democrats again clamored for its release during 2002, considerable additional work had to be done to bring the information previously compiled up to date.

30 The income tax liability test threshold for individuals expatriating in 2008 was $139,000. Rev. Proc. 2007- 66, 2007-45 I.R.B. 970 (Oct. 18, 2007), Sec. 3.29.

31 AJCA § 804(a)(1), amending § 877(a)(2).

32 AJCA § 804(a)(1), adding new § 877(a)(2)(C). The AJCAis silent as to when this certification must be made, but the requirement is now satisfied by completion and filing of Form 8854. The form's instructions indicate that an expatriating individual will be subject to tax under § 877 if he has not complied with his tax obligations, regardless of whether he meets the income tax liability or net worth thresholds. In Notice 2005-36, 2005 I.R.B. 1007 (Apr. 22, 2005), the IRS granted relief from the potentially prejudicial effect of the retroactive statutory change requiring certification of tax compliance for five years preceding expatriation by allowing individuals who expatriated after June 3, 2004, to treat the date they provided notice of expatriation to the DOS or DHS, respectively, as their expatriation date, provided that such persons filed a revised Form 8854 by June 15, 2005.

33 Under new § 877(c)(2)(B), added by AJCA § 804(a)(1), an individual will be considered to have "substantial contacts" with the U.S. if he ever held a U.S. passport, was a U.S. tax resident within the meaning of § 7701(b), or spent more than 30 days in the U.S. in any of the 10 years preceding expatriation. This exception is available only to individuals who were dual citizens at birth and remain a citizen of the other country.

34 AJCA § 804(d)(2), adding new § 2501(a)(5). As with § 2107, pertaining to the imposition of U.S. estate tax on shares of a closely-held foreign corporation owning U.S. property, new § 2501(a)(3)(B), added by AJCA § 804(d)(1), affords a tax credit for foreign gift taxes imposed on a transfer.

35 AJCA § 804(b), adding new § 7701(n). Section 6039G formerly required only that an expatriating citizen provide an initial information statement on the occurrence of the earliest of several events confirming the expatriating act. See former § 6039G(a), (c). The events were: (i) formal renunciation of nationality before a diplomatic or consular officer; (ii) furnishing a statement of voluntary relinquishment confirming a prior event of expatriation; (iii) issuance of a certificate of loss of nationality ("CLN"); or (iv) a U.S. court's cancellation of a naturalized citizen's certificate of nationality. A former long-term resident was not required to submit the initial information statement until filing his tax return for the year of expatriation. See former § 6039G(f). The potential prejudice of this retroactive change to individuals expatriating after June 3, 2004, and before the issuance of guidance (especially to former long-term residents), was also relieved by the issuance of Notice 2005-36. See note 27, supra. Note that the interplay between § 7701(n) and the requirement that an individual certify compliance with all tax obligations for the five years preceding expatriation, as set forth in Form 8854, raises a potentially interesting issue of tax compliance standards. What level of compliance is sufficient to permit an individual (possibly a longterm non-filer making a voluntary disclosure) conclusively to expatriate for tax purposes? Presumably, the normal compliance standards as set forth in, e.g., Beard v. Comm'r, 82 T.C. 766 (1984), aff'd, 793 F.2d 139 (6th Cir. 1986) will apply. A higher standard would make the statutory scheme unworkable.

36 Note that, as originally enacted, § 7701(n) also unintentionally appeared to affect the residency termination of aliens who are not long-term residents within the ambit of § 877. This is because it required that all aliens terminating U.S. residence status provide notice of termination to the DHS. Although such notice is frequently provided by departing green card holders on DHS Form I-407, no comparable form is required to be filed by substantial presence aliens who terminate residence. This error was clarified by a technical correction contained in the Gulf opportunity Zone Act of 2005 ("GOZA"), Pub. L. 109-135, § 403(v)(2).

37 AJCA § 804(e), amending § 6039G(a).

38 Annual information reporting is done on Form 8854, Part III. If an expatriate has taxable U.S. source income and is required to file Form 1040NR for the year, Form 8854 should be attached to it, and a second copy of the form filed with the IRS at Bensalem, PA. If an expatriate is not required to file a tax return for the year, Form 8854 must be filed only with the IRS at Bensalem, PA.

39 AJCA § 804(c), adding new § 877(g).

40 The classes of individuals potentially entitled to this exception include only expatriates becoming a citizen or resident fully subject to tax of a country where they, their spouse or either of their parents were born or expatriates who have not spent more than 30 days in the U.S. in any of the 10 years preceding expatriation. For this purpose, days of presence due to a medical condition arising while an individual is in the U.S. or while an individual is an "exempt individual" are disregarded. The exclusion of days as an "exempt individual" was another technical "clarification" of the AJCA rules by GOZA. See GOZA § 403(v)(1).

41 HEART Act § 301(d).

42 HEART Act § 301(a), adding new § 877A..

43 HEART Act § 301(b), adding new § 2801.

44 Rev. Proc. 2010-40, 2010-46 I.R.B. 663 at § 3.18. For individuals expatriating in 2010, the comparable gain exclusion figure was $627,000. Rev. Proc. 2009-50, 2009-45 I.R.B. 617 at § 3.27.

45 Rev. Proc. 2010-40, note 44, supra, at § 3.17. For individuals expatriating in 2010, the comparable income tax liability figure was $145,000. Rev. Proc. 2009-45, note 44, supra, at § 3.26.

46 These provisions, added as "conforming amendments" by HEART Act § 301(c)(2), may eliminate the confusion caused under prior law by the interaction of §§ 877(e)(1) and 7701(n). The former section defined the act of tie-breaking residence to a foreign country under an applicable tax treaty as an expatriating act, but the latter section provided that a long-term resident had not expatriated until he notified both the IRS and the DHS, which generally wasn't done by someone who wanted to compute his U.S. tax as a nonresident alien but, at the same time, wished to retain his lawful permanent resident status for immigration purposes. There likely will still be issues pertaining to the effective date of a treaty tie-breaker claim that must be addressed by guidance provided by Treasury and the IRS.

47 Rev. Proc. 2009-50, note 44, supra, at § 3.30(1).

48 Id. at § 3.30(2).

49 Notice 2009-85, 2009-45 I.R.B. 598 (Oct. 15, 2009).

50 The revised Form 8854 ("Expatriation Information Statement") and Form W-8CE ("Notice of Expatriation and Waiver of Treaty Benefits") can be found under the forms and publications heading on the IRS's website at www.irs.gov.

51 The Code, at § 877A(g)(1)(B)(ii), refers to the § 7701(b)(1)(A)(ii) definition, so the full provisions of the substantial presence test presumably apply, other than, e.g., the "exempt individual" categories that could never have applied to a former U.S. citizen.

52 See Notice 2009-85, note 44, supra, at § 4, Ex. 8. This is consistent with IRS practice under the HIPAA provisions, before the AJCA amendments introduced § 7701(n) and its "dual notice" requirement for expatriation to occur. The Service's acknowledgment of this practice is important, since it also permits taxpayers, in appropriate cases, to cease lawful permanent resident status before reaching the "8 out of 15" year threshold for long-term resident status.

53 See note 17, supra, and accompanying text.

54 Interestingly, the Notice indicates that each individual is eligible for only one lifetime exclusion amount, as may be adjusted for inflation. Prior expatriation regimes have never addressed the consequences of serial or multiple expatriations.

55 The instructions to Form 8854 indicate that, in order to determine the maximum tax that can be deferred, a taxpayer is required to prepare two hypothetical tax returns, one reflecting all income, including the section 877A gain and loss, and the other including all income without the section 877A gain and loss.

56 The taxation of ineligible deferred compensation is a particular hardship for, e.g., long-term resident employees of the World Bank and other international organizations who may wish to return to their countries of origin following retirement. Absent the ability for the former employer to elect to be treated as a U.S. person in order to operate the withholding tax regime, such retirees are subject to tax on the present value of their accrued benefit under a retirement plan but may not be entitled to take a distribution for purposes of paying the tax.

57 E.g., Treas. Reg. § 1.861-4(b)(2), Rev. Rul. 79-388, 1979-2 C.B. 270, and Rev. Proc. 2004-37, 2004-1 C.B. 1099.

58 See generally discussion at pages 18-19, infra.

59 This procedure was foreshadowed in a revision of Form 8854 that appeared prior to issuance of Notice 2009-85. In making a ruling request, a taxpayer is required to follow the procedures set out in Rev. Proc. 2009-4, 2009-1, C.B. 118.

60 Although a distribution may, of course, be subject to U.S. tax under other Code provisions, if carrying out U.S. source income or income effectively connected with a U.S. trade or business.

61 It is difficult to predict whether expatriating U.S. taxpayers will consider the possible availability of such an elective procedure to be useful. The obvious advantage to making this election is to limit the taxation of distributions from nongrantor trusts to the value of the interest existing at the date of expatriation, if this can be determined. Otherwise, under section 877A, there could be a liability to pay the withholding tax forever, in which case it may be imposed on wealth that did not exist while the taxpayer was a U.S. person. This election might offer some advantages to expatriates having beneficial interests in domestic nongrantor trusts. Whether an expatriate would wish to make this election vis-à-vis a beneficial interest in a foreign nongrantor trust, against which the IRS may have no practical ability to collect the withholding tax, is doubtful.

This article is designed to give general information on the developments covered, not to serve as legal advice related to specific situations or as a legal opinion. Counsel should be consulted for legal advice.