United States: HEART Act Applicable To Expatriates And Long-Term Residents

The Heroes Earnings Assistance and Relief Tax Act of 2008 imposes an exit tax that applies to expatriates and long-term residents.

On June 17, 2008, U.S. President George Bush signed the Heroes Earnings Assistance and Relief Tax Act of 2008 (HEART Act), which provides tax benefits and incentives for military personnel.  The Act also imposes a "mark-to-market" exit tax applicable to certain U.S. citizens and long-term green card holders who expatriate or relinquish their green cards.  The exit tax applies to individuals who are "covered expatriates" who expatriate or relinquish their green cards on or after June 17, 2008.  The Act also imposes a tax on U.S. citizens or residents who receive certain gifts or bequests from covered expatriates.  In addition, the Act provides that a direct or indirect distribution to a covered expatriate from a non-grantor trust will be subject to a 30 percent withholding tax.  Non-citizens who reside in the United States should consider how the Act will affect them if they intend to permanently depart the United States at a future date.  For ease of reference, long-term residents who relinquish their green cards are referred to herein as "expatriates."

Existing Alternative Tax Regime

Individuals who expatriated before June 17, 2008, remain subject to the "alternative tax regime" (ATR).  Under the ATR, an individual whose income or net worth exceeded certain thresholds and who renounced his or her U.S. citizenship generally is subject to an ATR that differs from the tax regime normally applicable to nonresident aliens.  For a 10-year period following expatriation, an individual subject to the ATR is subject to income tax at the rates applicable to U.S. citizens, albeit only on U.S. source income, e.g., gains on a sale or exchange of stock issued by a domestic corporation. 

Most important, the amount of time that an expatriate may be present in the United States in any year during such 10-year period is limited to 30 days per year.  If the expatriate is present in the United States for more than 30 days in any single year during the 10-year period, he or she will be treated as a U.S. citizen for that taxable year and therefore will be taxed on his or her worldwide income.   In addition, if an expatriate dies during a year in which he or she has been present in the United States for more than 30 days, that individual is subject to U.S. estate tax on his or her worldwide estate.  Similarly, if an expatriate makes a gift of any asset during such a year, he or she is subject to U.S. gift tax on that transfer.  Even if an expatriate is not present in the United States for more than 30 days in any year during the 10-year period, additional rules apply to determine whether property transferred by the expatriate during that period is subject to U.S. transfer taxes.  Once the 10-year period has passed, the ATR ceases to apply and the expatriate becomes subject to the federal tax rules normally applicable to nonresident aliens.  Thus, the ATR was beneficial for an expatriate who could wait 10 years before liquidating U.S. holdings with a large built-in gain.  On the other hand, the 30-day rule is burdensome and was often an unacceptable condition for those considering expatriation.

Definition Of Covered Expatriate

Under the Act, a covered expatriate is a person who renounces U.S. citizenship or who relinquishes permanent resident status after holding it in 8 of the last 15 years and who (i) has an average annual net income tax liability for the five preceding years of more than $139,000 (2008 amount adjusted for inflation), (ii) has a net worth of $2,000,000 or more, or (iii) failed to certify compliance with U.S. tax obligations for the prior five years.

Not all individuals whose income or net worth exceeds the above threshold amounts are covered expatriates.  There are exceptions for dual nationals (from birth) and persons under 18½ years of age, but only if they have not lived in the United States for more than 10 of the last 15 years (dual nationals), or for more than 10 years (for those under 18½), as defined under the "substantial presence" test.

A welcome aspect of the Act is that ATR's 30-day rule does not apply to covered expatriates who may spend significant time in the United States without becoming taxable as a U.S. person unless they became U.S. resident under the substantial presence test.

Imposition Of Exit Tax

Covered expatriates must recognize and pay tax on unrealized gain in excess of $600,000.  This amount is adjusted for inflation.  All worldwide property of a covered expatriate is deemed to be sold for its fair market value on the day before expatriation.  Under some income tax treaties, the deemed recognition may not be a creditable tax.  The taxpayer actually may have to sell his or her U.S. assets to take advantage of a treaty credit.  The exit tax is more punitive than the ATR, since the deemed recognition cannot be avoided.  However, some potential expatriates may prefer the simplicity of the exit tax.

The covered expatriate may elect to defer tax, if adequate security is provided.  If this election is made, it must be accompanied by an irrevocable waiver of any treaty rights that would preclude assessment or collection of any tax.  This election, which must be irrevocable, may apply to some, but not all property subject to the deemed recognition.  Interest is charged for the period the tax is deferred at the rate normally applicable to individual underpayments. 

Rules Applicable To Deferred Compensation Items

Depending on the type of "deferred compensation item," it will be either immediately includible in the covered expatriate's income and taxable at U.S. income tax rates, or subject to 30 percent withholding tax when it is later paid out.  A covered expatriate's entire interest in "specified tax deferred accounts" (e.g., an IRA, qualified tuition plan, health savings account, Archer MSA or Coverdell education savings account) will be treated as immediately includible in his or her income and taxable at U.S. income tax rates.

Generally, deferred compensation items under the Act include qualified pension, profit sharing and stock bonus plans, e.g., 401(k) plans.  If the covered expatriate notifies the payor of such an item that he or she is a covered expatriate and irrevocably waives certain treaty rights to claim a reduction in withholding on such an item, the deferred compensation item is deemed an "eligible deferred compensation item."  Eligible deferred compensation items are subject to 30 percent withholding tax, which is preferable to the Act's treatment of deferred compensation items that are not deemed "eligible."  Generally, with respect to non-eligible deferred compensation items, an amount equal to the present value of the covered expatriate's accrued benefit is deemed to have been received by him or her on the day before expatriation as a distribution under the plan.  The Act provides that no early distribution tax will apply and "appropriate adjustments shall be made to subsequent distributions from the plan to reflect such treatment."

Gifts And Bequests From Covered Expatriates

The Act imposes a new tax on "covered gifts and bequests" (in excess of the $12,000 annual exclusion, adjusted for inflation) by covered expatriates to U.S. citizens or residents, with certain exceptions.  Tax will be imposed on the recipient of the covered gift or bequest at the highest gift or estate tax rate then in effect, e.g., 45 percent.  This tax will be reduced by the amount of any gift or estate tax paid to a foreign country with respect to the gift or bequest.  A transfer that normally would attract a generation-skipping transfer (GST) tax in addition to a gift or estate tax (i.e., a transfer from grandparent to grandchild) will be subject only to the gift or estate tax.  The Act does not differentiate, for example, between gifts subject only to gift tax and gifts also subject to GST tax. 

The tax is imposed on a covered gift or bequest from a person who is a covered expatriate at the time of the transfer, regardless of whether that person fell within that definition at the time of expatriation.  Thus, an individual who attains wealth subsequent to expatriation and who qualifies as a "covered expatriate" at the time of his or her gift or bequest to a U.S. person will be subject to this regime.

This tax is not imposed on gifts and bequests to a spouse or charity.  Moreover, not all gifts are "covered gifts or bequests."  The term does not include:  (i) property reported on a timely filed gift tax return that is a taxable gift by the covered expatriate, or (ii) property included in the gross estate of the covered expatriate and reported on his or her timely filed estate tax return.

Receipt of a covered gift or bequest by a domestic trust is treated no differently than if an individual had received it, but the trustee must pay the tax from the trust.  Receipt of a covered gift or bequest by a foreign trust is treated differently.  Namely, the tax is paid not by the trust, but by the U.S. beneficiary when he or she receives a distribution attributable to such gift or bequest.  In other words, the tax is not due until a distribution is made to a U.S. beneficiary.  A foreign trust may elect to be treated as a domestic trust for these purposes.

Distributions From Non-Grantor Trusts

The Act distinguishes between grantor trusts and non-grantor trusts.  Property in a grantor trust of which the covered expatriate is the grantor is subject to the exit tax, as is the case under existing law.  The deemed recognition concept does not apply to beneficial interests in non-grantor trusts.  Instead, with respect to any direct or indirect distribution to a covered expatriate from a non-grantor trust, the trustee must deduct and withhold an amount equal to 30 percent of such part of the distribution as would have been includible in the gross income of the covered expatriate if he were subject to U.S. income tax.  There is no time limit upon this tax, and a covered expatriate will remain taxable on distributions he or she receives from a non-grantor trust years after the expatriation event.  In addition, a non-grantor trust must recognize gain on distributions of appreciated property to a covered expatriate.  These provisions apply to a non-grantor trust only if the covered expatriate was a beneficiary of the trust on the day before the expatriation date.  The rules applicable to non-grantor trusts apply to both domestic and foreign non-grantor trusts, raising the issue of how compliance can possibly be enforced with respect to foreign trustees.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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