Omissions And Technical Issues Under The HEART Act
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 are believed to again be working on a substantial notice that is intended to fill in many of the gaps left by the statute. However, to date, the only guidance that has issued regarding the new law is found in the substantially revised Form 8854 that was published at the end of May 2009 and the new Form W-8CE that appeared at the end of April 2009.48
Form 8854 is now divided into separate parts for persons who expatriated under prior law and those who expatriate after June 16, 2008 and are subject to the HEART Act provisions. The form only addresses taxation under section 877A. It does not provide any guidance concerning the succession tax provisions of section 2801.49 The form and its instructions contain several surprises. The first, likely unintentional, is found in the provisions defining who is a "covered expatriate" under the HEART Act provisions. The form's description of the exception for minors expatriating prior to age 18½ implies that it is available to departing long-term residents as well as to minor citizens. However, the statutory provision, at section 877A(g)(1)(ii), clearly appears to limit this exception to young citizens.50
Perhaps the most surprising feature of the revised Form 8854 is the manner in which answering questions as to whether a taxpayer has any eligible deferred compensation or an interest in a nongrantor trust implies that the taxpayer has made an irrevocable waiver of his right to claim any otherwise applicable tax treaty benefits under a treaty between the taxpayer's country of residence and the United States.51 That is tantamount to a coerced waiver of possible treaty benefits merely for truthfully answering a factual question as to possible ownership of certain property interests. In the case of a nongrantor trust interest, in particular, it may well be a wholly contingent or discretionary interest. It would have been preferable for the IRS to request a truthful answer and then allow a taxpayer to make an informed decision as to whether he wishes to waive treaty benefits or suffer the possibly uncertain consequences of not doing so.
Another surprise in the revised Form 8854 is a provision that permits an expatriating taxpayer who is a beneficiary of a nongrantor trust to elect to be treated as having received the value of his interest in the trust on the day prior to the expatriation date. The instructions state that, unless this election is made, an expatriate will not be entitled to claim a reduction of the otherwise applicable 30% withholding tax under any otherwise applicable tax treaty with the United States. In order to make the election, a taxpayer must first obtain a letter ruling from the IRS as to the value of the trust interest, if ascertainable, following the procedures set forth in Rev. Proc. 2009-4.52 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.
Regarding the mark-to-market tax, the form's instructions confirm that the standard for determining whether a taxpayer owns an interest in property is whether that interest would be included in the taxpayer's gross estate for federal estate tax purposes. The instructions add that an interest in the right to use property will be treated as an interest in such property.53
Another notable provision of the revised Form 8854 that pertains to the mark-to-market tax is the determination of the indexed $600,000 gain exclusion. The instructions, at some length, explain how this exclusion amount is to be allocated across all properties in proportion to the amount of taxable gain arising from the notional sale of each property bears to the total gain arising on the deemed sale transaction. The underlying reason for such an allocation is to ensure that taxpayers do not seek to minimize their mark-to-market tax by allocating the exclusion first to the gain on assets taxed at the taxpayer's highest ordinary tax rate.
The instructions to Form 8854 also confirm that an expatriating taxpayer can only elect to defer his tax on gain recognized from the deemed mark-to-market sale and not his regular income tax liability. 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. The form does not add anything to the statute's explanation of the meaning of "adequate security" that must be provided in order to defer the payment of tax, but does provide the address of the IRS office that will be responsible for making appropriate arrangements regarding security. However, importantly, the Form 8854 instructions do set forth, in some detail, the procedure for making the deferred tax election and confirm that a covered expatriate must file an annual Form 8854 for all years until the deferred tax and all interest due are paid.
Regarding section 877A's tax on deferred compensation, the instructions to Form 8854 state that, for purposes of the provision, the term "deferred compensation" includes any amount of compensation payable under any plan, contract or other arrangement as to which: (i) the taxpayer had a legally binding right at the date of expatriation; (ii) the compensation was not actually or constructively received on or before the expatriation date; and (iii) the compensation is payable after the expatriation date. Importantly, the instructions confirm that deferred compensation for purposes of section 877A includes all such amounts whether or not substantially vested (or, presumably, non-forfeitable). Because "ineligible deferred compensation" must be present valued and is taxed as if received the day before expatriation, where there is substantial doubt as to whether deferred compensation will ultimately be received, an expatriate generally will want to ensure that it is treated as "eligible deferred compensation," so that tax will be collected only if and when deferred compensation is actually received. If there is a U.S. payer of the compensation, an expatriate need only provide a Form W-8CE to the payer on which he indicates that all deferred compensation will be eligible deferred compensation. So indicating notifies the payer that the expatriate is irrevocably waiving any otherwise applicable tax treaty benefit and that tax should be withheld and paid to the IRS at the applicable rate. The instructions to both Form 8854 and Form W-8CE indicate that separate guidance will be issued setting forth the procedure for a non-U.S. payer of deferred compensation to be treated as a U.S. payer so that tax may also be collected by means of withholding.
Note that Form W-8CE is also used to provide notice of a covered expatriate's status to payers of "ineligible deferred compensation" and amounts paid to the expatriate from "specified tax deferred accounts" and "nongrantor trusts." The instructions indicate that a covered expatriate should provide the form within 30 days of expatriation to each payer of amounts covered by the form. No copy of the form is provided to the IRS. The instructions provide guidance to the payer as to each of the types of income that might be paid. In the case of ineligible deferred compensation and specified tax deferred accounts, the payer is instructed to advise the expatriate of the present value of the individual's accrued benefit (in the case of ineligible deferred compensation) or the value of the individual's entire interest in the account (in the case of specified tax deferred accounts) within 60 days of receipt of the form and is advised, in both cases, that the expatriate is to be treated as receiving an amount equal to this account balance on the day before the expatriation date. In the case of a nongrantor trust, if the expatriate has indicated that he wishes to be treated as receiving the value of his beneficial interest on the day before expatriation, the payer is advised to provide the expatriate with the information necessary to calculate this value, again within 60 days of receipt of the form. The instructions list the type of information that is necessary,54 and provide that the payer should withhold 30% from each taxable distribution from the trust until it receives a copy of the IRS valuation letter ruling55 and certification from the expatriate that he has paid any tax due on the value of the trust that he is treated as receiving. If the payer fails to provide the necessary documents and information to the expatriate, the instructions state that the election is not valid, and the payer is required to withhold 30% from any taxable distribution from the trust.
As yet, there is no guidance under the new expatriation rules on a number of important issues, including: (i) whether, and on what terms, the deferred tax election can apply to property disposed of in nonrecognition transactions; (ii) whether the fair market value basis adjustment for property held by an individual when he first became a U.S. resident applies to all such property still held at the date of expatriation, or whether the individual can elect out of the adjustment as to specified property; and (iii) how are the new rules to be coordinated with U.S. tax treaties. In the case of the new tax mark-to-market tax, which is imposed on gains considered to arise on the day before expatriation, the assumption presumably is that the income generally should be residence (i.e., U.S.) based and should not result in any double taxation. That likely isn't always the case, and the deferred compensation and distributions from nongrantor trusts that are paid subsequent to expatriation are likely not to be U.S. source income and, like the eventual gains arising on an actual sale of an expatriate's property, generally will also be taxed by the expatriate's country of residence at receipt or realization.56 Clearly, there will have to be guidance on foreign tax credit issues that are bound to arise. Note that, in the case of the succession tax, the statute provides that credit is given for foreign gift and estate/inheritance taxes.
Two additional points should be made about the need for additional guidance under the new expatriation tax rules. First, although the fundamental precept of the mark-to-market tax is that a covered expatriate is taxed on his wealth at the date of expatriation, there appears to be no income cap on taxable amounts received from nongrantor trusts. The new election to be treated as receiving the value of an individual's interest in such a trust, if ascertainable, is certainly at attempt to resolve or ameliorate this issue, but in many cases it may not be possible to fairly ascertain the value of a beneficiary's contingent, discretionary interest in such a trust with sufficient precision for either the expatriate or the IRS to be comfortable. Nor is there a wealth cap on taxable amounts received from a covered expatriate that are subject to the succession tax. If it is even administrable, this tax might be imposed on individuals and wealth that are generations removed from the covered expatriate's expatriation date.
The second issue that requires further guidance pertains to the definition of the expatriation date for long-term residents. If such an expatriation occurs as a result of the election of a "dual resident taxpayer"57 to be treated, under the provisions of an applicable U.S. tax treaty, as a resident of the foreign treaty partner, does the expatriation occur when the individual "commenced" to be treated as a resident of the foreign country or only when notice of such action (i.e., a nonresident tax return on Form 1040NR with an attached Form 8833 treaty claim) is provided to the IRS, generally 18 or more months after the date that such foreign residence commenced? In the case of a lawful permanent resident making such an election prior to becoming a "long-term resident," the election is clearly effective as of the date foreign residence commences and becomes paramount under the tie-breaker provision of the relevant tax treaty. Prior to the expatriation changes contained in 2004's AJCA, which introduced the dual notice requirement of former section 7701(n),58 the IRS routinely accepted this position in connection with expatriations under the 1996 HIPAA changes. The introduction of former section 7701(n), with its dual notice requirement to the IRS (on Form 8854) and the DHS (which likely wasn't always given) threw this into some doubt, but no clear guidance was ever issued. The repeal of that section and the introduction of the provisions contained in sections 877A(g)(3)(B) and amended 7701(b)(6) presumably return the position to that formerly acknowledged by the IRS, namely, that the expatriation date relates to the date of commencement of foreign residence, but clarification would be helpful.
Finally, as with the 2004 AJCA that preceded it, the HEART Act does not address the so-called "Reed amendment" provision of immigration reform enacted in 1996.59 That provision bars re-entry to the U.S. of former citizens who expatriated for a principal tax avoidance purpose in the opinion of the Attorney General.60 Because of certain statutory defects, it has never been implemented or enforced.61 The 2003 JCT Report recommended changing the provision to bar U.S. re-entry only to former citizens who have not fully complied with their expatriation tax obligations, but this unfortunately was not included with the AJCA's expatriation changes, notwithstanding that its provisions generally followed the 2003 JCT Report recommendations and tax avoidance purpose is no longer relevant to tax expatriation. Several prior mark-to-market proposals, including some under consideration in 2007, included provisions based on the 2003 JCT Report, but these provisions unfortunately were not part of the HEART Act. As the Reed amendment continues to have a chilling effect on U.S. citizens considering expatriation (notwithstanding that, in its present formulation, it likely is unenforcible), it is to be hoped that Congress will address this problem.
Controlling the tax consequences of expatriation has attracted considerable attention, and given rise to much spirited debate in Congress and elsewhere, since the Clinton administration first proposed an exit tax in its fiscal 1996 budget.62 The proposed solution contained in 1996's HIPAA, although no doubt affecting the actions of many wealthy individuals considering the potential tax benefits arising from expatriation, was not, in the opinion of the 2003 JCT Report, ultimately successful in deterring tax-motivated expatriation. Nor, certainly, was it successful in raising the revenues envisioned by the 1996 scoring for the HIPAA provisions. The 2003 JCT Report concludes that this was attributable, in no small part, to the failure of the IRS to fully and properly administer and enforce the 1996 changes, although the report also acknowledges that the alternative tax regime has some inherent weaknesses.
The changes contained in 2004's AJCA were intended to facilitate easier administration and improved enforcement of the amended expatriation tax rules by removing the difficult, frequently uncertain and expensive (for both taxpayers and the Government) ruling program and requiring enhanced information reporting by expatriating taxpayers. In addition, the new short residence rule contained in section 877(g) was introduced to deter expatriation by many U.S. taxpayers. Whether this was sound fiscal or social policy is questionable, especially in the case of former long-term residents, who may have left the U.S. in retirement to return to the countries from which they originally arrived. Many such persons have children and grandchildren who have remained in the U.S., as well as continued U.S. vacation residences and other investments. Limiting their presence so drastically with the threat of renewed worldwide taxation seems short-sighted. However, in the final analysis, the alternative tax regime after the AJCA likely wasn't in place long enough to determine whether it achieved its intended goals.
Exactly what the goals of an expatriation tax should be is perhaps the core of the problem. Congress has several times indicated that tax neutrality is the correct policy – the law should neither serve as an inducement to leave U.S. tax solution nor as a bar to doing so. Unfortunately, the actions of Congress have not always followed this course.
The mark-to-market and succession tax regimes contained in the HEART Act are likely less a further philosophical or emotional onslaught against individuals who choose, for whatever reason, to leave full U.S. tax solution than a short-sighted and misguided effort to close the ever-present "tax gap." The several new taxing provisions, especially those pertaining to eligible deferred compensation, interests in nongrantor trusts, and the succession tax are not even wholly consistent with the implicit objective to tax an individual's wealth as he leaves the U.S. tax system. Further, additional IRS resources likely will be required to efficiently administer and try to enforce the tax. However, even in an increasingly transparent financial world with greater cross-border cooperation amongst national tax administrations, it will be difficult to impose and collect tax on foreign income and assets from individuals who are no longer generally within the U.S. jurisdiction.
Whether this is the final expatriation tax solution remains to be seen. The expatriation provisions found in the HEART Act are not sound tax policy, but they are scored to raise not insignificant revenue.63
48. 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.
49. The IRS is developing a new form, Form 708 ("U.S. Return of Tax for Gifts and Bequests Received From Expatriates"), for the purpose of making a return under the provisions of § 2801. The form is referred to in the latest version of Form 3520, Part IV, issued at the end of November 2008. The instructions to Form 3520, item 57, state that, if the new Form 708 is not available when a return under § 2801 is due, a taxpayer should attach a plain paper statement to his return showing the computation of the tax.
50. If this was a conscious decision of Treasury and the IRS, it is to be applauded, as there seems to be no good policy reason to distinguish between minor citizens and long-term residents in this regard. However, it is questionable whether the drafters of the form had the authority to broaden the exception to the definition of covered expatriate in this manner.
51. See Form 8854, Part B, Sec. 1, items 7a and 7d.
52. 2009-1 I.R.B. 118. This revenue procedure generally outlines the requirements for obtaining rulings pertaining to employee benefit plans from the IRS's Exempt Organization division.
53. This is at some variance with the accepted notion that a loan of tangible property from a trust, including the rent-free use of a residence owned by a trust, does not constitute a taxable distribution to a trust beneficiary.
54. The information includes (but is not limited to): (i) a copy of the trust deed; (ii) a list of the assets (and their values) held on the day before the expatriation date; (iii) information regarding other potential trust beneficiaries; (iv) birth dates for all measuring lives for the trust's perpetuity period; (v) policies followed by the trustees when making discretionary distributions that might constitute an "ascertainable standard;" and (vi) any other relevant information.
55. See discussion at pages 14-15, supra.
56. That an expatriate may have made a coerced waiver of treaty benefits in order to try to comply with U.S. reporting obligations so that, inter alia, his expatriation might be considered complete under §§ 877(a)(2)(C) and 877A(g)(1)(A), shouldn't be found to preclude him from claiming treaty benefits under otherwise applicable residence-based tax treaties.
57. As defined by Treas. Reg. § 301.7701(b)-7(a)(1).
58. See discussion at pages 8-10 and 12, supra.
59. The Reed amendment was contained in the Illegal Immigration Reform and Immigrant Responsibility Act of 1996 (Pub. L. No. 104-208), enacted September 30, 1996.
60. Responsibility for administering and enforcing the provisions of the Reed amendment was formerly within the province of INS, an agency within the Department of Justice ("DOJ"). Because the role of the INS has now been transferred to USCIS, an agency of DHS , overall responsibility presumably has shifted from the Attorney General to the Director of DHS.
61. There are several apparent statutory defects with the Reed amendment. First, it is unclear from the language of the statute whether it encompasses all acts of expatriation or only those expatriations accomplished by formal oath of renunciation. Second, it is unclear what the applicable tax avoidance standard is or should be; this is especially troublesome since tax avoidance has ceased to be relevant to enforcement of the expatriation tax provisions. Since the objective of the provision is to bar certain former citizens from re-entering the U.S. and, therefore, effectively to penalize them, it is questionable whether due process would permit the necessary tax avoidance to be presumed based upon certain economic factors, as was the case under HIPAA's § 877 changes. More likely, USCIS, which now administers the provision, would be required to make a factual determination on a case-by-case basis. However, its ability to do this would be severely limited, since, under § 6103, the IRS is precluded from disclosing specific taxpayer information even to other federal agencies, except in limited circumstances that would not extend to enforcement of the Reed amendment. Notwithstanding these problems, it is known that USCIS (and, before it, INS) was working to develop regulations to implement the Reed amendment, and the project was on the DHS's regulatory agenda as recently as 2006. See 71 Fed. Reg. 22643 (Apr. 24, 2006). The current status of the regulation project is unknown, but the inability of the IRS to provide tax information pertaining to specific taxpayers may require tax legislation to amend § 6103, if the project is to move forward. Several of the former mark-to-market proposals would have done that.
62. Indeed, the actions of the U.S. even spurred the enactment of limited expatriation tax provisions in a number of other countries, including France, Germany and the Netherlands.
63. See note 12, supra.
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.