On 17 June 2008, President Bush signed into law a $1.2 billion military tax relief package that includes an “exit tax” on U.S. citizens and long-term green card holders who expatriate from the United States. The exit tax is part of the Heroes Earnings Assistance and Relief Tax (HEART) Act of 2008. Although the exit tax had been seriously considered by Congress in the past, until now, the measure had never been approved by both houses of Congress, usually because of disputes over the provisions the exit tax was meant to fund.

The exit tax provision requires many U.S. citizens and long-term permanent residents who expatriate on or after 17 June 2008 to recognize and pay tax on unrealized gains in excess of $600,000 on their assets (i.e., they must “mark to market” their assets and pay tax on the excess gains). In addition, the exit tax provision imposes a new tax on gifts and bequests made by those expatriates to U.S. citizens or U.S. residents. This new provision (styled Section 877A) is a replacement of the former expatriation tax rules of Section 877.

Covered Expatriate
“Covered expatriates” will be subject to the new exit tax provision. A covered expatriate is defined as anyone who renounces his or her U.S. citizenship or who relinquishes his or her permanent residence status after having held it for 8 of the last 15 years (“expatriates”) and who (i) has an average annual net income tax liability for the 5 preceding years of more than $139,000 (2008 amount adjusted for inflation), (ii) has a net worth of more than $2,000,000, or (iii) failed to certify compliance with U.S. tax obligations for the prior 5 years. The exceptions provided are for dual nationals (from birth) and for persons younger than 18½ 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 younger than 18½), as defined under the Code’s “substantial presence” test of residency. These are broader, more generous exceptions than those under Section 877, which, among other things, required that a dual citizen never have held a U.S. passport at any time.

Key New Rules

• Exit Tax—Property Subject to Mark to Market. All property of a covered expatriate is deemed to be sold for its fair market value on the day before expatriation. This rule applies even to U.S. real property interests, thus accelerating the recognition of gains that would be taxed in any event. Covered expatriates must recognize gains on the deemed sale and pay U.S. income tax on gains greater than $600,000 (adjusted for inflation). Some assets are not marked to market (e.g., deferred compensation items and interests in nongrantor trusts), but they are otherwise taxed (see below).
• Gifts and Bequests from Expatriates to U.S. Citizens and Residents. U.S. citizens or residents receiving gifts or bequests of more than $12,000 (adjusted for inflation) from a covered expatriate will be taxed at the highest gift or estate tax rate (45 percent in 2008 and scheduled to increase to 55 percent in 2011). This provision has no time limitation; a person who expatriated could make a gift to a U.S. citizen 40 years after expatriation out of newly acquired assets (i.e., postexpatriation assets) and the tax would be imposed on the U.S. citizen or U.S. resident. Furthermore, it appears that the donor need not have been a “covered expatriate” at the time he or she expatriated—only at the time the gift or bequest is made. In the statutory language, the expatriate need only satisfy the “covered expatriate” definition, just given, at the date the gift or bequest is made. So, if an individual becomes modestly wealthy (net worth of $2 million, not adjusted for inflation) after expatriating, any gift he or she makes to a U.S. citizen or U.S. resident will be taxed to the recipient. There is an exception to the imposition of this tax for gifts and bequests to spouses of the expatriate and to U.S. charities.
• Deferred Compensation Items. Depending on the exact nature of the deferred compensation item, it will be either subject to 30 percent withholding tax or immediately includible in the covered expatriate’s income and taxable at U.S. income tax rates.
• Treatment of Specified Tax Deferred Accounts. A covered expatriate’s entire interest in such accounts (e.g., qualified tuition plan, Archer MSA) will be treated as immediately includible in his or her income and taxable at U.S. income tax rates.
• Special Rules for Nongrantor Trusts. The exit tax expressly excludes nongrantor trusts from the property subject to the mark-to-market calculation; however, the trustee of a nongrantor trust must withhold 30 percent when a covered expatriate receives (directly or indirectly) a distribution from a nongrantor trust, regardless of the fact that a lower withholding rate may apply under a treaty. Moreover, nongrantor trusts must recognize gains on distributions of appreciated property to covered expatriates. The new law imposes the withholding requirement on the trustees of both a U.S. resident and foreign resident trusts. As such, under the new rules, a trustee of a foreign nongrantor trust is under an obligation to withhold on distributions to a covered expatriate.
• Tax Effect of Expatriation. Expatriation will be effective for tax purposes even if the expatriate does not file Form 8854, the Expatriation Information Statement. Thus, the imposition of the exit tax cannot be delayed (as can application of the former expatriation tax rules) by failing to file Form 8854.

Termination of Existing Expatriation Tax Regime
The exit tax provision does have a bright side: The former expatriation income tax rules (Section 877) will no longer apply to a covered expatriate if the expatriation occurs on or after 17 June 2008. Under the former expatriation rules of Section 877, an expatriating individual subject to Section 877 who visited the United States for 30 days in any calendar year for the 10 years after expatriation was treated as a U.S. person for tax purposes for that calendar year. Thus, under the new exit tax, a covered expatriate is able to travel to (and potentially reside in) the United States without becoming taxable as a U.S. person unless he or she becomes a U.S. resident under the normal U.S. tax rules. The repeal of Section 877 by the exit tax provision is, in this respect, a marked improvement over previous legislative proposals of the exit tax and may make expatriation have less onerous tax effects in some cases.

Interaction of New and Old Law
If an individual “expatriates” as that term is defined under the exit tax provision prior to 17 June 2008, the individual is not subject to the new law. This appears to be true even if the individual does not file a Form 8854 until after the enactment of the new law. Such a filing is necessary for an individual’s effective expatriation for tax purposes under current law (Section 877) but not under the exit tax provision. This situation has interesting consequences for those who expatriate (as defined in the exit tax provision) prior to 17 June 2008 but who have yet to file Form 8854. Such individuals will continue to be covered by Section 877 as if the exit tax provision had not come into effect and will continue to be taxed as U.S. persons until they file Form 8854.

Conclusion
On the one hand, the exit tax provision’s mark-to-market tax offers a clean break with the U.S. tax system as of the date of expatriation without imposing a 10-year period after expatriation during which special tax rules apply. Instead, a covered expatriate will pay the mark-to-market tax and immediately thereafter be treated for U.S. tax purposes as a nonresident alien. In addition, up to $600,000 of the covered expatriate’s unrealized gains will escape U.S. taxation permanently, unless the gains would otherwise be taxed to a nonresident alien owner under normal U.S. tax rules (e.g., real estate). Moreover, a covered expatriate may visit the United States for more than 30 days a year without becoming a U.S. tax resident, again, unless he or she would become resident under the normal rules. Importantly, under the exit tax provision, the covered expatriate can freely acquire and dispose of U.S. securities or receive U.S. portfolio interest without incurring any special U.S. taxation (a marked improvement over the former rules, which encouraged expatriates to avoid investment in U.S. assets).

On the other hand, the exit tax provision contains a number of “shadow” provisions that can trigger additional U.S. tax liability even though the mark-to-market tax was paid on a covered expatriate’s worldwide gains in excess of $600,000. For example, a covered expatriate is subject to 30 percent tax on any distributions he or she receives from a nongrantor trust, regardless of whether the trust is a foreign or domestic resident trust for U.S. tax purposes. And the new tax imposed on U.S. recipients of gifts or bequests from a covered expatriate applies indefinitely after expatriation and is likely to be a trap for the unwary.

Pursuant to requirements relating to practice before the Internal Revenue Service, any tax advice in this communication (including any attachments) is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties imposed under the United States Internal Revenue Code or (ii) promoting, marketing, or recommending to another person any tax-related matter.
 
This news item is an excerpt from a recent alert from the Baker & McKenzie global private banking team. Details are available on the Private Banking Helpdesk, an online information and training service offered by LawInContext, the interactive knowledge and training venture of Baker & McKenzie.