Thinking of Leaving the US? Know the Expatriation Tax Rules
It’s no secret that many Americans living in Canada are unhappy with their U.S. tax compliance costs and information reporting burdens. For those that are voting with their feet and renouncing their U.S. citizenship(i) or terminating their long-term U.S. residency(ii) (“expatriating”), careful planning should be undertaken prior to expatriating to avoid costly surprises.
A few of the unexpected consequences of expatriating can include an exit tax, accelerated taxation of deferred compensation (e.g. stock options) and an inheritance tax applicable to future gifts or bequests to U.S. persons.
The unexpected U.S. tax consequences only apply to a “covered expatriate.” You will be a covered expatriate if:
- your average annual net income tax for the 5 years preceding the year of expatriation is greater than US$162,000 (for 2017);
- your net worth on the date of expatriation is US$2 million or more; or
- you have not met all your US tax compliance requirements for the 5 years preceding the year of expatriation, and you do not file Form 8854, Initial and Annual Expatriation Statement.
Given the tax cost of being a covered expatriate, a determination should be done prior to expatriating to determine whether the expatriate rules apply. If the rules apply, tax planning opportunities may be available to mitigate their effect.
If you are a covered expatriate solely because of your failure to file past tax returns or information forms, a catch-up filing should be done with the IRS prior to expatriating. As significant penalties may be imposed for the failure to file certain returns and forms, please consult a US tax professional prior to making any submission to the IRS.
If you are a covered expatriate because you meet the tax liability or net worth thresholds discussed above, or if you have prior year compliance failures, you may still be able to avoid covered expatriate status if:
- at birth, you became a U.S. citizen and a citizen of Canada, and, as of your expatriation date, you continued to be a citizen of, and taxed as a resident of, Canada, and you had been a resident of the U.S. for tax purposes for not more than 10 of the 15 years ending with the year of expatriation; or
- you were under age 18 ½ on the date of expatriation, and you had been a resident of the U.S. for tax purposes for not more than 10 years before your date of expatriation.
Also, if you are a lawful permanent resident of the U.S. (i.e. a green card holder), you will not be subject to the covered expatriate rules if you held your green card for less than 8 of the last 15 tax years ending with the year of expatriation.
The U.S. taxes a covered expatriate on a mark-to-market basis. This means that the worldwide assets of a covered expatriate are deemed sold for fair market value on the day before the expatriation date. Capital gains are reduced by capital losses from the deemed sale. Net capital gains in excess of US$699,000 (for 2017) from the deemed sale of assets are included in income in the year of expatriation and an “exit tax” is calculated. For example, if a covered expatriate owned US$3 million of stock with a cost basis of US$1 million, he or she would be deemed to have a capital gain of US$2 million. After excluding US$699,000 of the gain, only US$1,301,000 would be included into income in the year of expatriation.
A covered expatiate can irrevocably elect, on an asset by asset basis, to defer the payment of tax attributable to an asset deemed sold until the due date of the return for the year in which the asset is actually sold. To make the election, the taxpayer must (among other requirements) provide adequate security for the tax debt and agree to pay interest on the deferred tax amount.
The mark-to-market regime does not apply to certain types of property. These include qualified retirement or annuity plans (e.g. 401(k) or 403(b) plans), foreign pensions, deferred compensation (e.g. a deferred bonus or stock options), individual retirement accounts (IRAs) and certain education (529 accounts) and health savings accounts, and interests in non-grantor trusts. Instead, depending on the type of property, and subject to certain exceptions, either a 30% withholding tax will apply on distributions from the plan (with no ability to reduce the amount under a tax treaty), or an amount equal to the present value of the plan (or account) will be treated as received on the day before expatriation and taxable as ordinary income.
The exit tax is imposed on a mark-to-market basis in the year of expatriation. As Canada will also tax the same income again in the year a resident of Canada actually sells an asset, double tax can occur.
While foreign tax credits are generally available to avoid double tax, such relief will not be available if the year in which you pay the exit tax (at expatriation) is not the same year in which you actually sell an asset.
One planning solution to avoid double tax would be for you to sell and repurchase assets prior to your expatriation date. While this would create a similar gain to that incurred on expatriation, there would be a foreign tax credit available to offset any double tax as net gains would be taxed in Canada and the U.S. in the same year.
When a non-U.S. person makes a gift or bequeaths assets to a U.S. person, there is no U.S. gift or estate tax imposed on the recipient. However, based on proposed IRS regulations, if the donor or deceased is a covered expatriate, U.S. gift or estate tax will be imposed on the U.S. citizen or resident recipient. The tax is equal to the value of the gift or bequest multiplied by the highest estate tax rate in effect on the date of receipt. Currently that rate is 40%. This applies regardless of whether the property transferred was acquired by the donor or decedent covered expatriate before or after expatriation.
As U.S. gift or estate tax can also be imposed on the donor (e.g. where a covered expatriate gifts, or dies owning, U.S. real property), the tax can actually be assessed twice. The donee can avoid being taxed if the covered expatriate timely files a U.S. gift tax return, or the estate timely files a U.S. estate tax return, and pays any tax due.
There are certain exemptions to these rules, including:
- gifts or bequests to a U.S. citizen spouse;
- the portion of a gift to a non-U.S. spouse that does not exceed US$149,000 (for 2017); and
- the portion of a gift to a non-spouse that does not exceed US$14,000 (for 2017).
If you have paid into the U.S. Social Security system and are eligible for Social Security payments prior to expatriating, your entitlement to Social Security benefits remains.
In the case of Medicare benefits, eligibility also remains after you expatriate. However, in practice, the benefits may never be used as Medicare payments are generally only available for Medicare services rendered in the U.S.
When you expatriate, you no longer have an automatic right to live or temporarily visit the U.S. While the U.S. cannot treat you differently than any other Canadian citizen, a 1996 amendment to the Immigration and Nationality Act gives the U.S. Attorney General the discretion to deny you entry into the U.S. if you renounced U.S. citizenship with the primary purpose of avoiding U.S. tax. This exclusion is limited to former U.S. citizens and does not include former green card holders.
While it may be possible for the U.S. to bar your entry, the probability of such an event is low especially if tax avoidance is not your primary motive and your facts and circumstances support strong and enduring connections to Canada.
The potentially negative U.S. tax consequences of being a covered expatriate are significant enough that you would be remiss if you didn’t plan ahead to avoid covered expatriate status.
One planning consideration would be for you to gift assets to your non-U.S. spouse prior to your expatriation date in order to lower your net worth to an amount that would be below the US$2 million threshold. This may be especially appealing when gifting a Canadian principal residence as there would be no Canadian income tax on the gift and the life-time unified U.S. gift and estate tax exemption of US$5.49 million (for 2007) is likely large enough to shelter the gift from U.S. gift tax.
While a U.S. citizen is always subject to U.S. gift tax regardless of where he or she lives, a green card holder is only subject to U.S. gift tax if domiciled in the U.S. If a green card holder physically moves from the U.S. to Canada with the intention to permanently reside in Canada, the taxpayer may no longer be domiciled in the U.S. and therefore not subject to U.S. gift tax. In this case, the taxpayer could gift as many assets as necessary to bring his or her net worth below the US$2 million threshold. As long as the assets were not U.S. situs assets for U.S. gift tax purposes (e.g. U.S. real property), U.S. gift tax would not apply.
U.S. citizen married couples can take advantage of their ability to gift an unlimited amount of assets between themselves on a tax free basis to try and have each person’s net worth come in below the threshold for the net worth test.
Prior to gifting assets, the Canadian income tax consequences of the gift should be reviewed to ensure there are no surprises.
If you are intending to renounce your U.S. citizenship or terminate your long-term U.S. residency, careful pre-expatriation planning should take place in order to mitigate any negative tax consequences. This is especially true for taxpayers who have sufficient net worth to be treated as covered expatriates.
Post-expatriation planning should also take place even if you are not a covered expatriate as your estate planning documents (e.g. wills) may need to be revised to reflect your new non-resident alien status.
- the date the individual renounces his or her U.S. nationality before a diplomatic or consular officer of the United States, provided the renunciation is subsequently approved by the issuance to the individual of a certificate of loss of nationality by the U.S. Department of State;
- the date the individual furnishes to the U.S. Department of State a signed statement of voluntary relinquishment of U.S. 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 U.S.C. 1481(a)(1)-(4)), provided the voluntary relinquishment is subsequently approved by the issuance to the individual of a certificate of loss of nationality by the U.S. Department of State;
- the date the U.S. Department of State issues to the individual a certificate of loss of nationality; or
- the date a U.S. court cancels a naturalized citizen’s certificate of naturalization.
- the individual’s status of having been lawfully accorded the privilege of residing permanently in the United States as an immigrant in accordance with immigration laws has been revoked or has been administratively or judicially determined to have been abandoned, or
- the individual:
- commences to be treated as a resident of a foreign country under the provisions of a tax treaty between the United States and the foreign country,
- does not waive the benefits of the treaty applicable to residents of the foreign country, and
- notifies the IRS of such treatment on Forms 8833 and 8854.