This blog post is a bit complex and not for the faint of heart. Readers are forewarned!
Part I of this post examined one form of US citizenship – that is citizenship under the US immigration and nationality rules. The discussion examined how to relinquish citizenship under these rules, whether by renouncing US citizenship or relinquishing it by the performance of certain expatriating acts with the required “intent” to give up the US citizenship. It also looked at the procedures and factors used by the Department of State for such cases and examined which route (relinquishment by renunciation, or by performance of an expatriating act) might be “better”.
Today’s post, Part II, will focus on the other form of US citizenship. That is, the concept of the “US tax citizen”. It will discuss how it came into being, what it means to be a US “tax citizen”, the confusion generated by the current “tax citizenship” laws enacted in 2008, as well as the concern of many who had relinquished US citizenship years before, but now fear a forthcoming frightening journey “back to the future”. The post will also examine the recently published viewpoint espoused by the Tax Section of the American Bar Association concerning the expatriation provisions as applied to certain individuals who had relinquished US citizenship years before the current laws were ever enacted.
Part III, to be posted next week, will look, in part, at the view of another prominent attorney, John Richardson of Toronto, Canada. John is all too familiar with these laws and the difficult issues they create for individuals who had relinquished US citizenship many years before, but now have concerns about their US status. Part III will also set forth the premise that the manner in which legal professionals interpret a particular law will impact how that law is interpreted by other professionals, which in turn will help shape the future evolution of that law. With that as the touchstone, prudence is advised when it comes to interpreting the backward reach of the relevant Internal Revenue Code Sections — Section 877A and 7701(a)(50). Caution is necessary lest the tax professionals, themselves, create a situation where one professional blindly follows the next resulting in a scenario where, without the requisite aforethought and due consideration, the provisions come to be applied retroactively.
Part II: History of “Tax Citizenship”
On June 3, 2004 the US Congress created a second kind of citizenship – the heretofore unknown category of a so-called “tax citizen”. “Tax citizens” do not have the rights bestowed by the first form of US citizenship, discussed in Part I of this blog post (citizenship under the immigration and nationality laws). They do, however, have the obligation to pay income taxes to the United States on worldwide income (and at death, estate taxes based on the fair market value of worldwide assets).
For individuals who relinquished their US citizenship by committing an expatriating act with the intent to give up their US citizenship, the date this act was undertaken will be critical. This date will be determinative whether the US tax laws may continue to treat the individual as a US taxpayer, or “tax citizen”, even though the individual is no longer a citizen for immigration law purposes. This means that even though the individual can no longer enter the US in the same manner as a US citizen (for example, he will need a visa), and can no longer vote, he is still required to pay US taxes. In other words, the individual is a US “tax citizen” but he is not any other type of US “citizen”. To put it another way, he is required to pay US taxes but he will receive no benefits of any type whatsoever from the US government. Perhaps, it is easiest to remember this “second” form of US citizenship as if the individual is simply a “second” class citizen.
Birth of the “Tax Citizen”
In February 2003, the Joint Committee on Taxation published the results of work that it had been undertaking since 1999 reviewing the US tax and immigration rules governing relinquishment of US citizenship and residency. The published work, “Review of the Present Law Tax and Immigration Treatment of Relinquishment of Citizenship and Termination of Long-Term Residency”, (JCS-2-03), was presented in February 2003 (the “2003 JCT Report”). The full report and all of its parts and exhibits can be accessed here.
This Report provided a summary of the then-current US tax and immigration laws as the laws applied to expatriation. The law as it existed in 2003 with regard to a “relinquishment” is quoted below, and can be found on pages 50-51 here. Note, the quote immediately following deals with the US Immigration principles and not the US tax rules, which are discussed later.
“Generally, the Department of State documents loss of citizenship on a certificate of loss of nationality (“CLN”) when the individual acknowledges to a consular officer that relinquishment of citizenship was taken with the requisite intent. There is no obligation for an individual to obtain a CLN or otherwise notify the Department of State of relinquishing one’s citizenship. When an individual acknowledges that the relinquishment of citizenship was done with the requisite intent, the consular officer abroad submits a CLN to the Department of State in Washington, D.C. for approval. Upon approval, a copy of the CLN is issued to the affected individual. The date upon which the CLN is approved is not the effective date for loss of citizenship. The loss of citizenship is effective on the date the relinquishment of citizenship occurs, if done with the relevant intent.” [emphasis added]
From a US tax perspective, the 2003 JCT Report had this to say about the state of the tax law with respect to expatriations, as the tax law existed in 2003 See, p. 209:
“Under present law, the Immigration and Nationality Act governs the determination of when a US citizen is treated for US Federal tax purposes as having relinquished citizenship. Similarly, an individual’s US residency is considered terminated for US Federal tax purposes when the individual ceases to be a lawful permanent resident under the immigration law (or is treated as a resident of another country under a tax treaty and does not waive benefits of such treaty). In view of this reliance on immigration-law status, it is possible in many instances for a US citizen or resident to convert his or her Federal tax status to that of a nonresident noncitizen without notifying the IRS. Although individuals who relinquish their citizenship or terminate their residency are required to provide tax information statements (e.g., on Form 8854), difficulties have been encountered in enforcing this requirement, and in many cases the IRS does not receive information that it needs to enforce the alternative tax regime. In these cases, an individual may become a non-resident non-citizen of the United States for Federal tax purposes-and enjoy reductions in US taxes from such tax status-despite failing to provide the tax information state necessary for the IRS to monitor and enforce compliance with the alternative tax regime.”
In response to these perceived shortcomings of the then-current law, the Joint Committee on Taxation introduced for the first time ever, the concept of the “tax citizen”. This meant that an individual could cease to be a citizen (or resident) for US Immigration law purposes, but could nonetheless remain a citizen (or resident) for US tax purposes unless and until the individual satisfied certain tax law requirements. Thus, the Joint Committee on Taxation recommended that an individual should continue to be treated as a citizen or “long term” resident for US federal tax purposes until such time as the individual: (1) notified the Department of State or the INS, and (2) filed a complete and accurate tax information statement with the IRS on Form 8854. With this report, the JCT created the concept of a new kind of US citizen, – that is the “tax citizen”.
No action was taken with respect to the 2003 JCT Report until enactment of the American Jobs Creation Act of 2004, Pub. L. 108-357 (the “2004 Act”). The 2004 Act wrought numerous significant changes to the expatriation rules. While many changes were adopted, this blog piece will focus first on the 2004 Act’s amendment to the Internal Revenue Code – a new Section 7701(n). This Section created new rules, which for the first time ever, severed the link between an individual’s status as a US citizen (or resident) under the immigration laws from his status as a US “tax citizen” (or resident) for purposes of the tax laws. How was this accomplished?
Introducing Section 7701(n) of the Internal Revenue Code: Welcome to “Tax Citizenship” – June 3, 2004
A new Internal Revenue Code Section 7701(n) provided as follows (I have omitted the statutory language pertaining to US residents):
(n) Special rules for determining when an individual is no longer a United States citizen or long-term resident. For purposes of this chapter- (1) United States citizens. An individual who would (but for this paragraph) cease to be treated as a citizen of the United States shall continue to be treated as a citizen of the United States until such individual- (A) gives notice of an expatriating act (with the requisite intent to relinquish citizenship) to the Secretary of State, and (B) provides a statement [Form 8854] in accordance with section 6039G (if such a statement is otherwise required).
An individual who relinquished his or her US citizenship, for example, by becoming a citizen of another country with the intention to no longer remain a US citizen, would remain a US “tax citizen”, until he or she (1) notified the Secretary of State, and (2) if required, filed Form 8854 with the IRS.
Effective Date: “Tax Citizen”
Code Section 7701(n) had a specific effective date: the law stated that the Section (as well as the other expatriation provisions adopted with the 2004 Act) “shall apply to individuals who expatriate after June 3, 2004.”
An examination of the relevant laws in effect at the time indicates without doubt that individuals who, on or before June 3, 2004, committed an expatriating act with the intent to relinquish their US citizenship were neither US citizens for immigration law purposes nor US citizens for US tax law purposes. This would be the case regardless of whether they had obtained a CLN or whether they had submitted tax notification to the IRS on Form 8854. As stated in a March report by the American Bar Association Section of Taxation (March 2, 2015) (“ABA Tax Section Report”) at page 8:
“Thus, there is no question that individuals who successfully relinquished their citizenship for nationality purposes on or before June 3, 2004 continued to be respected as noncitizens for federal tax purposes after the 2004 Act.”
The concept of the “tax citizen” did NOT exist prior to June 3, 2004. Therefore, those who relinquished US citizenship (under the Immigration and Nationality Act) on or prior to June 3, 2004 could not magically be turned into “tax citizens” on June 4, 2004.
Enter the HEART Act 2008
The expatriation rules were completely revamped in 2008 with “The Heroes Earnings Assistance and Relief Tax Act of 2008” P.L. 110-245 (the “HEART Act”). The so-called Exit Tax contained in new Code Section 877A enacted by the HEART Act replaced what was known as the “alternative tax regime, a punitive tax regime imposed on those considered to have a tax avoidance purpose for expatriating. Under this regime, certain items of income are re-characterized so as to have a US source, and are thus taxable to the nonresident alien individual – for example, gains on sales of US stocks. (The alternative tax regime had been part of the tax law in some form or another for over 40 years since passage of the Foreign Investors Tax Act of 1966).
The HEART Act for the first time, separated expatriates into two groups: those who were so-called “covered expatriates” and those who were not “covered expatriates”. Covered expatriates are deemed to have expatriated for a tax avoidance motive, and they (and any US person to whom they give a gift or bequest) must suffer certain tax consequences as a result of this motive.
Who is a “Covered Expatriate”?
Under the US expatriation rules, an individual will be treated as a “covered expatriate” if any of the following tests apply:
- The individual’s average annual net income tax for the 5 years ending before the date of expatriation or termination of residency is more than a specified amount that is adjusted for inflation ($147,000 for 2011, $151,000 for 2012, $155,000 for 2013 and $157,000 for 2014 and $160,000 for 2015).
- The individual’s net worth is $2 million or more on the date of expatriation or termination of residency.
- The individual fails to certify on Form 8854 that he or she has complied with all US federal tax obligations for the 5 years preceding the date of expatriation or termination of residency.
If any of these tests are triggered, the individual is a “covered expatriate” subject to the “Exit Tax” or “Mark-to-Market” regime. Under this regime, generally, all property owned by the covered expatriate worldwide is treated as sold for its fair market value on the day before the expatriation date. This ‘phantom’ gain is then taken into account for the tax year of the deemed sale and subject to tax, usually at capital gains rates. In addition, a 3.8% “net investment income tax” will likely also apply to this deemed gain if certain modified adjusted gross income thresholds are met. The Exit Tax must be computed via one’s Form 1040 with the gain or loss being reported on the relevant part of the 1040 for the part of the year that the taxpayer is still considered a US person. You can read more here about the 3.8% surcharge and how it affects nonresident aliens and US persons abroad.
The tax burdens don’t stop there. Special onerous tax rules apply to the covered expatriate’s deferred compensation plans and specified tax deferred accounts. In addition to the Exit Tax, US recipients of any gift or bequest at any time in the future from the “covered expatriate” will be hit with a special tax upon receiving that gift or inheritance under Code Section 2801. In essence, this is an alternative way for the US to recoup US Gift or Estate taxes that it would otherwise have received (upon the making of lifetime gifts, or upon death) had the individual not given up his US citizenship or long-term residency. More information about the current expatriation tax regime can be found on my tax blog posting here.
Bye Bye, Section 7701(n) and Hello Sections 7701(a)(50) and 877A(g)(4)
Significantly, the HEART Act repealed Internal Revenue Code Section 7701(n), discussed earlier, and replaced it with Internal Revenue Code Sections 7701(a)(50) and 877A, to be discussed. Code Section 877A was effective for “any individual” whose “expatriation date (as so defined) is on or after” [June 17, 2008].
In relevant part (I have omitted the statutory language pertaining to residents).
Code Section 877A(g)(3) defines the term “expatriation date” as “(A) the date an individual relinquishes United States citizenship…”
Section 877A(g)(4) provides:
Relinquishment of citizenship
A citizen shall be treated as relinquishing his United States citizenship on the earliest of-
(A) the date the individual renounces his United States nationality before a diplomatic or consular officer of the United States pursuant to paragraph (5) of section 349(a) of the Immigration and Nationality Act (8 USC. 1481 (a)(5)),
(B) the date the individual furnishes to the United States Department of State a signed statement of voluntary relinquishment of United States nationality confirming the performance of an act of expatriation specified in paragraph (1), (2), (3), or (4) of section 349(a) of the Immigration and Nationality Act (8 USC. 1481 (a)(1)-(4)),
(C) the date the United States Department of State issues to the individual a certificate of loss of nationality, or
(D) the date a court of the United States cancels a naturalized citizen’s certificate of naturalization.
Subparagraph (A) or (B) shall not apply to any individual unless the renunciation or voluntary relinquishment is subsequently approved by the issuance to the individual of a certificate of loss of nationality by the United States Department of State.
Internal Revenue Code Section 7701(a) (50)
Code Section 7701(a)(50) provides:
Termination of United States citizenship
(A) In general
An individual shall not cease to be treated as a United States citizen before the date on which the individual’s citizenship is treated as relinquished under section 877A (g)(4).
(B) Dual citizens
Under regulations prescribed by the Secretary, subparagraph (A) shall not apply to an individual who became at birth a citizen of the United States and a citizen of another country.
Together Code Sections 7701(a)(50) and Section 877A(g)(4) continued to treat an individual who became a former citizen (or long-term resident) for US immigration law purposes, as a US citizen (or resident) for federal tax purposes (that is, a “tax citizen”) until one of the above-specified “Notice Events” contained in paragraphs (A) through (D) of Code section 877A took place. Working together, Code Sections 7701(a)(50) and 877A(g)(4) continued the prior (2004) law’s creation of two classes of “citizens”. One class, based on citizenship for purposes of the US immigration laws and the other, completely separate, being based on retention of citizenship strictly for US tax law purposes (that is, the “tax citizen”) even if the individual no longer has citizenship for immigration law purposes.
On March 2, 2015, the American Bar Association Section of Taxation issued a report entitled “Comments on the Tax Status of Certain Expatriates” (“ABA Tax Section Report”)*.
The ABA Tax Section Report provides an excellent example of the confusion generated by the tax law changes wrought in 2008 with the HEART Act. This confusion stems from poor drafting of the relinquishment date provisions:
“Example: John Doe is a natural-born US citizen who naturalized in Canada on January 1, 1975, with the intention of no longer being a US citizen. Pursuant to the INA, he ceased to be a citizen on that date. Recently, Mr. Doe spoke with an immigration lawyer who advised him to get a certificate of loss of nationality (‘CLN’). On February 1, 2014, Mr. Doe furnishes to the Department of State a signed statement of voluntary relinquishment of United States nationality regarding his prior act of expatriation. On September 1, 2014, the Department of State issued a CLN to Mr. Doe, confirming that he ceased to be a citizen on January 1, 1975.
As discussed above, section 877A(g)(3) defines the expatriation date as the date an individual relinquishes his citizenship. For this purpose, section 877A(g)(4) provides that an individual is considered to have relinquished citizenship on the earliest of (A) the date the individual renounces his US nationality before a diplomatic or consular officer of the United States, (B) the date the individual furnishes to the US Department of State a signed statement of voluntary relinquishment of United States nationality confirming the performance of a specified act of expatriation, (C) the date the US Department of State issues to the individual a CLN, or (D) the date a US court cancels a naturalized citizen’s certificate of naturalization. Section 7701(a)(50) similarly provides that an individual shall not cease to be treated as a US citizen prior to the date on which the individual’s citizenship is treated as relinquished under section 877A(g)(4).
Under a literal application of these rules, Mr. Doe arguably is considered to have relinquished citizenship for federal tax purposes on February 1, 2014, because the provision of his signed statement to the US Department of State on such date was the first to occur of the “[N]otice [E]vents” set forth in section 877A(g)(4). And, because section 301(g) of the 2008 Act provides that sections 877A and 7701(a)(50) apply to any individual whose ‘expatriation date’ is on or after the date of enactment, i.e., June 17, 2008, Mr. Doe arguably is retroactively deemed to have remained a citizen for federal tax purposes through January 31, 2014, even though he ceased to be a citizen under the INA in 1975, nearly four decades earlier.”
Expanding upon this analysis, since the first “Notice Event” occurred on February 1, 2014 when Mr. Doe provided the Department of State a signed statement of voluntary relinquishment of his US citizenship regarding his prior act of expatriation, that is arguably the first date on which Mr. Doe is considered to have relinquished his US citizenship within the meaning of Code Sec. 877A(g)(4). It is also the “expatriation date” as defined in Code Sec. 877A(g)(3). Taking the analysis further, it would follow that Mr. Doe must retroactively be considered to have remained a US citizen for the entire 39-year period beginning on January 1, 1975. Mr. Doe would also arguably be retroactively responsible for taxes, interest and penalties for each year during the 1975-2014 period; in addition, he could be subject to the Exit Tax contained in Code Sec. 877A(a).
It is clear that the “effective date” provisions in the HEART Act were not well drafted. Section 301(g) of the [HEART] Act provides (with specified exceptions not here relevant) that “the amendments made by this section [including section 301(a) of the [HEART] Act, which enacted Code Sec. 877A] shall apply to any individual whose expatriation date (as so defined) is on or after the date of the enactment of this Act.” Under a possible literal reading of this provision, Code Sec. 877A might apply to Mr. Doe, because his expatriation date, as defined under Code Section 877A(g)(3) is February 1, 2014, which is on or after June 17, 2008.
Part III of this blog post will appear next week and will examine possible interpretations of Code sections 877A and 7701(a)(50) and the resulting interpretational consequences. The viewpoints of the Section of Taxation of the American Bar Association and other attorneys will be compared and finally, I will offer my own concluding remarks.
* The ABA Tax Section Report contains comments submitted on behalf of the American Bar Association Section of Taxation. These comments have not been approved by the House of Delegates or the Board of Governors of the American Bar Association and should not be construed as representing the position of the American Bar Association
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