The past several years have been a wild ride for many U.S. taxpayers (and tax practitioners), in particular for those residing outside of the country. While there are a surprising number of U.S. persons still grappling with becoming compliant, in general, the progression to considering expatriation has been somewhat predictable, as follows:
- Get compliant – Countless American citizens and green card-holders residing in Canada have been scrambling to become compliant with what, even in seemingly straightforward situations, can be an extremely complicated U.S. foreign reporting regime. The U.S. tax treatment of Canadian mutual funds, Canadian-registered education savings plans and Canadian tax-free savings accounts (to name a few) can result in significant complexity and, sometimes, a U.S. tax cost.
- Revisit tax and estate planning – Once compliant, the real fun begins. Even "plain vanilla" Canadian tax and estate planning structures (e.g. professional corporations, family trusts, alter-ego trusts, etc.) can have significant adverse U.S. tax implications and, at the very least, substantial tax compliance requirements. Every corporation or trust added to a corporate structure compounds the level of complexity and the associated reporting requirements.
- Consider expatriation – For certain U.S. taxpayers residing in Canada, mostly those without significant historical, philosophical, personal or economic ties to the United States, the possibility of shedding all of the above-noted complexity by expatriating can sound very attractive.
It comes as no surprise that the number of Americans renouncing citizenship increased by 20 per cent in 2015 to about 4,300 persons. This number may be deceptively low since, in many cities, it can take months to get an appointment at the U.S. consulate. This is in spite of the fact that the U.S. has increased the fee for processing renunciations by 422% to $2,350.
Not so fast! The basics of the U.S. expatriation rules (IRC 877A)
While expatriation (i.e. giving up your U.S. citizenship or green card) seems like an easy "fix" to the compounding complexity of cross-border tax and estate planning and compliance, there can be real, immediate and significant tax implications to renouncing citizenship or relinquishing your green card. All U.S. taxpayers considering expatriation should carefully consider the U.S. expatriation rules (IRC 877A) since they are easy to be subject to and can have dire U.S. tax implications.
Who do the rules apply to?
The U.S. expatriation rules apply to a "covered expatriate;" someone who expatriates and meets any of three objective tests:
- Net Worth Test – The taxpayer has a net worth at the time of expatriation in excess of US$2 million.
- Tax Liability Test – The taxpayer has an average annual U.S. income tax liability in excess of US$161,000.
- Compliance Test – The taxpayer fails to certify on form 8854 that he or she has complied with all U.S. federal tax obligations for the five years preceding the year of expatriation.
Exemptions from the Net Worth Test and Tax Liability Test may apply for certain individuals, namely those born with dual citizenship and individuals who expatriate prior to turning 18.5 years of age. Both exceptions require the individual to have resided outside of the U.S. for a certain period of time prior to expatriation.
For the wealthy, US$2 million is a very low threshold. This combined with the severe implications (below) make these rules a significant deterrent. For the unwary, even with modest means, these rules can have significant and adverse consequences.
What are the implications?
In terms of implications, covered expatriates are subject to a set of rules similar, at least in part, to Canadian departure tax rules; however, they are much more severe and punitive. The basic implications are as follows:
- Exit tax – The taxpayer will be subject to immediate taxation of all unrealized gains and income (however, the first US$693,000 of gain is exempt). Special rules apply to deferred compensation, certain "specified" tax-deferred accounts and interests in foreign non-grantor trusts.
- Transfer tax – Any future transfers by the taxpayer to U.S. persons (while living or as a consequence of death) are subject to transfer tax at a rate equal to the maximum U.S. estate/gift tax rate of 40 per cent. Note that this tax is levied on the recipient of the gift or bequest.
What can I do?
There are some basic planning techniques we can use to avoid the application of the U.S. expatriation rules:
Confirm your U.S. status
It seems obvious; however, we have had many situations where clients thought they were U.S. taxpayers but, upon further consultation with immigration counsel, were determined not to be. U.S. immigration attorneys are well versed in the rules and should be able to confirm with relative certainty whether you are a U.S. citizen or green card-holder.
Timing your expatriation
Asset values and foreign currency rates can fluctuate wildly, and the net worth threshold is denominated in U.S. dollars. Since the greenback is relatively strong against the Canadian dollar, now may be a good time to consider expatriation.
If you are a green card-holder, it may also be possible to time your expatriation to avoid long-term resident status, which is an additional prerequisite to covered expatriate status for green card-holders. Long-term residents are green card-holders who are taxed as U.S. residents in at least eight of the 15 years preceding expatriation.
Give it away
While U.S. citizens and domiciliaries are subject to U.S. gift tax on worldwide assets, the lifetime estate/gift tax exemption is relatively generous at US$5.45 million. Also, one can gift up to US$148,000 to a non-citizen spouse without using up any unified credit. It may be possible to gift some or all of your assets to bring your net worth below the US$2 million threshold. Naturally, you would need to analyze both Canadian and U.S. tax (and non-tax) implications before considering such a strategy.
If you are a green card-holder residing in Canada, you may not be subject to U.S. estate and gift tax rules on your worldwide assets. This is because only U.S. citizens and domiciliaries are subject to U.S. estate and gift tax on their worldwide assets. To that end, one may be able to gift assets in excess of the exemption amount without incurring gift tax.
Finally, even if you cannot bring your net worth below the US$2 million threshold, you may be able to lessen the impact of the mark-to-market rules by gifting appreciated assets to another person, such as your spouse.
Align Canadian taxation
While not an ideal scenario, if covered expatriate status is inevitable and U.S. tax is going to be triggered by the expatriation rules, you should, at the very least, align Canadian tax to avoid the potential of double taxation in the future. This could be done by triggering actual realizations prior to expatriation or by utilizing preferential provisions in the tax treaty that would have a similar effect.
Above all else...Get help!
Cross-border tax planning can be very complex and rife with risk and uncertainty. To that end, any U.S. taxpayers considering expatriation should seek the help of advisors who are well versed in this specialized area of taxation.
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.