AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

Technical Comments on Expatriation Tax Proposals

Developed by:

Trust, Estate, & Gift Tax Technical Resource Panel (TRP)

Expatriation Tax Task Force Members

Evelyn M. Capassakis, Chair of the Task Force, and

Chair of the Trust, Estate, and Gift Tax TRP

Henry P. Alden II

Robert B. Coplan

John H. Gardner

Thomas P. Jaffa

Stephen M. Lopez-Bowlan

Michael A. Spudowski

Neil A.J. Sullivan

Eileen R. Sherr, AICPA Technical Manager

Approved by:

TRUST, ESTATE & GIFT TAX TECHNICAL RESOURCE PANEL

INTERNATIONAL TAX TECHNICAL RESOURCE PANEL

TAX LEGISLATION AND POLICY COMMITTEE

and the

TAX EXECUTIVE COMMITTEE

Submitted to the Congress and Treasury Department

March 21, 2002

1

AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

Technical Comments on Expatriation Tax Proposals

March 21, 2002

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Executive Summary

Taxation of U.S. citizens who give up their citizenship or long-term U.S. residents who give up their residency (collectively known as expatriates) does not work well under current law. Previous administrations have proposed alternative methods of taxing these expatriates, as has Congress. Other commentators have pointed out the flaws of the current system. Accordingly, we do not focus on that system. Rather, the proposals for change are the subject of our analysis here.

Although there have been numerous proposals over the years, as a base for this analysis this paper uses the most recent legislative proposals. These were embodied in H.R. 3099 introduced in 1999 in the 106th Congress (“the Proposal”). The paper also comments on the suggested changes to the immigration law with respect to tax avoidance expatriates.

The AICPA does not take a position on the appropriateness of the Proposal. Instead, the AICPA is concerned that if such an approach were to be adopted, it should be in the simplest form possible. Simplification enhances the viability of a tax system, consistent with AICPA Tax Policy Concept Statement 2 – Guiding Principles for Tax Simplification.

Our suggestions are generally aimed at eliminating conflicts and inconsistencies between existing laws and the Proposal. We also address areas in which we think the approach can be made simpler or fairer with respect to similarly situated taxpayers.

There are two main components to the Proposal: an exit tax and an inheritance tax. With respect to the exit tax, this paper addresses:

(i)Exclusions of gain;

(ii)Basis adjustment at the beginning of U.S. residency;

(iii)Acceptable security arrangements and valuation of the tax liability in deferral scenarios;

(iv)Valuation issues, including those related to assets that are not vested or subject to restrictions and foreign pension plans;

(v)Exclusion for assets that remain subject to U.S. taxation after expatriation, such as compensation items and trusts;

(vi)The definition of a long-term resident;

(vii)The need for a credit for foreign taxes; and

(viii)Effective date rules.

With respect to the inheritance tax, this paper addresses:

(i)The disparate treatment of gifts and bequests from expatriates compared to those from U.S. persons;

(ii)The class of expatriates to whom the tax applies;

(iii)Annual exclusions;

(iv)Transfers in trust;

(v)The application of the tax to long-term residents; and

(vi)Effective date rules.

With respect to immigration provisions impacting expatriates, this paper addresses coordination of such provisions with existing and proposed tax provisions.

Background

The Proposal was introduced in 1999 in the 106th Congress containing changes to existing tax rules "to prevent the continued use of renouncing U.S. citizenship (or terminating long-term residency) as a device for avoiding U.S. taxes." Although never enacted, similar rules were proposed in 1995 (H.R. 1812) and included in former President Clinton's fiscal year 1996 and 2001 budget proposals.

The goal of the Proposal was to close perceived loopholes in the expatriation tax law enacted in 1996 by imposing a new tax (the “Exit Tax”) at the time that an individual relinquishes U.S. citizenship or residence. In addition, a tax would be imposed on gifts and bequests from expatriates to U.S. persons (the “Inheritance Tax”). Although not clear from the legislative language of the Proposal, presumably these rules would replace current income, estate, and gift tax rules applicable to expatriates (see sections 877, 2107, and 2501(a)(3) of the Internal Revenue Code[1]).

Current Law

Section 877 and related provisions impose special income, estate, and gift tax rules on former U.S. citizens and, as of 1996, former long-term residents. The rules apply for the ten years following expatriation, if one of the principal purposes of expatriation was the avoidance of U.S. taxes. During that 10-year period, individuals deemed to be tax-motivated expatriates calculate their income tax liability as the higher of: (i) the tax generally applicable to nonresident aliens under section 871, or (ii) the tax derived pursuant to section 877(b) which applies the normal graduated tax rates (or, if greater, the alternative minimum tax rates and computation rules) applicable to U.S. citizens or residents to U.S. source income that is calculated under a broader definition than that which is generally applicable to nonresident aliens.

Also during that period, tax-motivated expatriates are subject to U.S. estate and gift tax on transfers of U.S. assets. For estate tax purposes, the definition of a U.S. asset of an expatriate decedent is expanded beyond that generally applicable to a nonresident alien to include a proportionate part of the value of stock in certain non-U.S. corporations holding U.S. assets. For gift tax purposes, the definition of a U.S. asset for an expatriate who makes a gift is expanded beyond that generally applicable to a nonresident alien to include stock issued by U.S. corporations and debt obligations of U.S. persons, the U.S. government, and political subdivisions thereof.

Expatriation is presumed to have a principal purpose of tax avoidance if either: (i) the average of the individual’s annual net federal income tax over the five years prior to expatriation exceeds $100,000 (the "Income Tax Test"); or (ii) the individual’s net worth at expatriation is $500,000 or more (the "Net Worth Test"). Each of these test amounts is adjusted for inflation with the dollar thresholds for 2002 being $120,000 and $599,000, respectively. Individuals who fall below these thresholds may nevertheless be subject to the expatriation tax provisions if their expatriation is otherwise proven to be tax-motivated.

In addition to these tax rules, changes in 1996 to the immigration laws included a provision known as the “Reed Amendment” pursuant to which the U.S. Attorney General has discretion to determine that a former U.S. citizen renounced his U.S. citizenship to avoid U.S. taxation and thereby may be ineligible to receive a U.S. visa and may be denied re-entry into the U.S.

The Proposal

Exit Tax

Immediate Recognition of Gain or Loss

The Proposal would have created a mark-to-market Exit Tax on previously unrecognized gains and losses on property held by "Covered Expatriates” (see Definitions below) on the day prior to expatriation. Under the Proposal, the property of a Covered Expatriate would be treated as sold at its fair market value on the day before expatriation, and any gain or loss would be included in the tax year of the deemed sale. This taxation of unrealized gains and losses would be a departure from the general rule that taxes only realized gains, but is consistent with the existing provisions of: (i) section 367 that taxes previously unrecognized gains upon contribution of appreciated property to non-U.S. corporations; and (ii) section 684 that taxes previously unrecognized gains upon contribution of appreciated property to non-U.S. trusts and on the change in status of a U.S. trust to a non-U.S. trust.

Exclusion of Gain and Exempt Property

Under the proposed Exit Tax, Covered Expatriates could exclude up to $600,000 ($1.2 million for a married couple) of the expatriation gain from gross income. The Exit Tax does not apply to certain property, including: (i) U.S. real property interests; (ii) qualified retirement plans; and (iii) up to $500,000 in foreign pension plans. Other property that remains subject to U.S. tax after the expatriation of the owner is not excluded from the Exit Tax, such as items of deferred compensation income and beneficial interests in U.S. trusts.

Election to Defer Tax

The Proposal would permit expatriates to make an irrevocable election to defer payment of the Exit Tax until the return due date for the tax year in which the affected property is actually disposed of or sold. The deferred tax would accrue interest at the rate provided for underpayments of tax from the time such tax was originally due without respect to the election to defer payment of the tax until such time as the tax is actually paid. To make the election, the taxpayer would be required to provide adequate security in an amount equal to the deferred tax and waive any tax treaty rights that would preclude collection or assessment of the tax.

Beneficiaries’ Interests in Trusts

Two sets of complex rules are provided in the proposal for the application of the Exit Tax to beneficiaries’ interests in trusts. One set applies to beneficiaries’ interests in a newly defined type of trust called a “Qualified Trust”. The other set of rules applies to beneficiaries’ interests in all other trusts.

A Qualified Trust is defined as one: (i) that is organized under and governed by the laws of the U.S. or one of its states; and (ii) the trust instrument of which requires that at least one trustee is a U.S. individual or U.S. corporation. A beneficiary’s interest in a Qualified Trust is not subject to the Exit Tax in the manner described above, but is instead subject to an alternative regime that establishes on the day before expatriation a “Deferred Tax Account” within the Qualified Trust and then taxes distributions to the Covered Expatriate from the Qualified Trust at the highest income tax rate applicable to estates and trusts. The initial balance of the Deferred Tax Account is an amount equal to the Exit Tax that would have been imposed on the allocable expatriation gain with respect to the trust interest if such interest was not an interest in a Qualified Trust. The balance in the Deferred Tax Account is increased for interest calculated at the rate for underpayment of tax. The balance in the Deferred Tax Account is reduced by the taxes imposed on a distribution. The tax on distributions is limited to the balance in the Deferred Tax Account immediately prior to a distribution. All distributions to the Covered Expatriate are subject to this tax even though the distributions may be out of currently generated U.S. source income that is also subject to withholding tax under section 1441. Any balance in the Deferred Tax Account is to be paid by the trustees of such trust if: (i) the trust ceases to be a Qualified Trust; (ii) the Covered Expatriate disposes of his interest in the Qualified Trust; or (iii) the Covered Expatriate dies. The proposal provides equity rules in the Tax Code, presumably intended to override state statutes governing the administration of trusts, that allow a trust beneficiary to recover from the Covered Expatriate any taxes borne by such beneficiary as a result of the payment by the trustees of the balance of the Deferred Tax Account.

Beneficial interests held by Covered Expatriates in all other trusts are treated as a separate share of such trust. On the day prior to expatriation, the assets of such fictitious separate share trust are treated as sold at their fair market value, distributed to the Covered Expatriate, and in turn such assets are treated as re-contributed to such fictitious separate share trust. The Exit Tax applies to any income, gain, or loss of the individual arising from the fictitious distribution from the fictitious separate share trust.

A Covered Expatriate’s beneficial interest in a trust is based upon all relevant facts and circumstances including the terms of the trust instrument and any letter of wishes or similar document, historical patterns of trust distributions, and the existence of and functions performed by a trust protector or similar advisor. Non-vested interests in trusts are to be determined by assuming the maximum exercise of discretion in favor of a Covered Expatriate beneficiary and the occurrence of all contingencies in favor of such beneficiary.

Definitions in the Proposal

Covered Expatriate – Means an Expatriate (see definition below) who meets the Income Tax Test or the Net Worth Test (see Current Law above). Exceptions are provided for individuals who: (i) became at birth a citizen of another country, continue to be a citizen of such other country at the expatriation date, are taxed as a resident of such other country, and have not been resident in the U.S. for more than 8 taxable years during the 15-taxable year period ending with the taxable year during which expatriation occurs; or (ii) expatriate before attaining age 18½ and have not been resident in the U.S. for more than 5 taxable years before expatriation.

Expatriate – Means: (i) any U.S. citizen who relinquishes his U.S. citizenship; and (ii) any long-term resident of the U.S. (see definition below) who ceases to be a lawful permanent resident of the U.S. (i.e., a “green card holder”), or commences to be treated as a resident of another country under the provisions of a tax treaty between the U.S. and such other country and who does not waive the benefits of such treaty.

Long-Term Resident – Means any non-citizen of the U.S. who is a lawful permanent resident of the U.S. in at least 8 taxable years during the 15-taxable year period ending with the taxable year during which expatriation occurs.

Effective Date

The Exit Tax was proposed to apply to Expatriates whose expatriation occurred on or after the date of action on the Proposal by the Committee on Ways and Means.

Inheritance Tax on Gifts and Bequests by Expatriates

The Proposal also included a tax, in the nature of an “Inheritance Tax”, be imposed on any U.S. citizen or resident who receives from an Expatriate, gifts or bequests that exceed $10,000 in any calendar year. The tax is imposed at the highest estate tax rate and is reduced by any non-U.S. gift or estate taxes paid with respect to such gift or bequest. Transfers of property otherwise subject to U.S. estate and gift tax would be excluded. Gifts or bequests from an Expatriate that are made in trust are treated as made directly to the beneficiaries of such trust in proportion to their respective interests in such trust as determined under the rules provided in the Exit Tax for determining a beneficiary’s interest in a trust.

The Inheritance Tax was proposed to apply to gifts and bequests received from Expatriates on or after the date of action on the Proposal by the Committee on Ways and Means regardless of when the transferor expatriated. President Clinton's 2001 budget proposal contained similar inheritance tax provisions, but would have applied this tax only to gifts or bequests received from those who expatriated after the effective date.

The Reed Amendment

The Proposal would have also eliminated the ability to expatriate without formal renunciation of citizenship. By eliminating the possibility of expatriation on an informal basis, the Proposal would appear to close the current perceived limitation in the Reed Amendment’s language that only denies re-entry to tax-motivated expatriates who have formally renounced their citizenship.

President Clinton’s 2001 Budget also proposed modifying the Reed Amendment. However, where the Proposal would have denied re-entry regardless of tax motivation, the 2001 Budget proposal would have denied re-entry only to expatriates who did not comply with their expatriation tax obligations.

Commentary on Proposed Changes

The AICPA offers the following comments in the spirit of improving the administration of the tax laws by eliminating conflicts and inconsistencies between the Proposal and existing law. Additionally, our comments attempt to simplify the application of the law where possible.

Exit Tax

Exclusion of Gain

Threshold dollar amount exclusions should be significantly increased to better correlate the application of the Exit Tax with the true abusers of the U.S. tax system. This will have the added benefit of greatly reducing the number of covered individuals and streamline enforcement and administration. Consideration should be given to tying the Exit Tax exclusion amount to a benchmark, such as twice the amount of the unified credit for estate tax purposes under section 2010(c).

Basis Adjustment

We suggest providing for an adjustment to the bases of all assets to fair market value upon commencement of U.S. tax residency. This would bolster the underlying policy of the Exit Tax to tax the economic income accrued during U.S. residency that is not otherwise subject to U.S. taxation at the end of such residency. This is comparable to the approach taken in other countries with an exit tax system. The entry adjustments should include basis adjustments for all forms of deferred compensation, including pension plans and equity compensation plans. At the termination of the U.S. residency period, Expatriates should be entitled to adjust the basis of assets subject to the Exit Tax to the fair market value used in the Exit Tax calculation for property deemed disposed of at the time of expatriation. Alternatively, an individual (e.g., a former Long-Term Resident) who leaves the U.S., pays the Exit Tax, and then subsequently returns, should be allowed to apply for a refund of the original Exit Tax and take a basis in his assets equal to the fair market value on the date his original period of residency began.