Global Watch - United States "Exit Tax" legislation awaiting signature into law 

In the week of 19 May 2008, the Senate and the House of Representatives passed the Heroes Earnings Assistance and Relief Tax Act of 2008 (HEART), which is expected to be signed into law by President Bush shortly.  HEART extends or modifies several tax benefits for active-duty and former military service members, ranging from housing assistance to favorable treatment of some types of service compensation.  As a revenue offset for these provisions, an "exit tax" is included which applies to certain US citizens and long-term permanent residents (i.e., green card holders) who expatriate.
         
Several similar versions of exit tax legislation have been proposed over the last few years.  The version included in HEART is largely similar to H.R. 3997, which the House and Senate passed back and forth several times in December 2007 without settling on a final version, and H.R. 3056, the "Tax Collection Responsibility Act of 2007", which was discussed in our Global Watch of 25 July 2007.
       
Perhaps the most significant change is that the exit tax in HEART - new Internal Revenue Code (IRC) S.877A, replaces the tax implications currently imposed on those who expatriate under S.877.  Section 877A is effective for expatriations on or after the date the provisions are signed into law.
      
Individuals subject to the exit tax
       
The exit tax provisions of S.877A apply to certain US citizens who relinquish their citizenship and long-term residents who terminate their permanent residence status (known as "expatriation").  An individual is a long-term resident if he/she was a lawful permanent resident in at least eight out of the fifteen taxable years ending with the year in which the residency termination occurs.  The mark-to-market tax would apply to any US citizen who relinquishes citizenship and any long-term resident who terminates US residency if the individual:

1. Has an average annual net income tax liability for the five preceding years ending before the date of expatriation that exceeds $139,000 (2008 amount, adjusted annually for inflation);
2. Has a net worth of $2 million or more on the date of expatriation; or
3. Fails to certify under penalties of perjury that he or she has complied with all US federal tax obligations for the preceding five years or fails to submit such evidence of compliance as the Secretary may require.

Certain exceptions apply to individuals born with dual citizenship and those who relinquish US citizenship prior to age 181/2(provided certain requirements are met).
             
Date of expatriation
     
Similar to current S.877, S.877A sets forth rules for establishing the date of expatriation. In the most common cases, this will be the date the individual swears or affirms their oath of renunciation in front of a consular officer and witnesses or files Form I-407 terminating permanent residence status.  Long-term residents would also be treated as expatriating when utilizing residency 'tie-breaker' provisions of income tax treaties to be treated as US non-resident aliens despite their permanent residency status.
        
Note that the rule in the current law, which provides that an individual continues to be taxed as a US citizen or long-term resident for US federal tax purposes until Form 8854 is filed, has been repealed.
          
Mark-to-market tax imposed
      
Section 877A subjects expatriating individuals to tax on the net unrealized gain on their world wide property as if such property were sold for fair market value on the day before the expatriation date.  Gain from the deemed sale is taken into account at that time without regard to other tax code provisions; any loss from the deemed sale would generally be taken into account to the extent otherwise provided in the code.  The value of property held when an individual first became a US resident will be taken into account for purposes of determining the gain, unless the individual makes an irrevocable election for basis to be calculated under general US tax principles.
       
Deemed sale of property upon expatriation
     
The deemed sale rule generally applies to all property interests held by the individual on the date of expatriation.  Special rules apply in the case of certain deferred compensation items, specified tax deferred accounts, and interests in non-grantor trusts.
       
Any net gain on the deemed sale is recognized to the extent it exceeds $600,000 ($1.2 million in the case of married individuals filing a joint return, both of whom relinquish citizenship or terminate residency).  The $600,000 amount is increased by a cost of living adjustment factor for calendar years after 2008.
       
Treatment of deferred compensation items
     
Section 877A(d) provides that certain deferred compensation items are not subject to mark-to-market treatment upon expatriation.  In general, stock option rights, restricted stock units, multi-year long term performance awards, pension rights (qualified or non-qualified) may be regarded as deferred compensation items for these purposes and not subject to mark-to-market treatment.  Where this treatment applies, the individual who expatriated remains subject to US federal taxation when the compensation is realized or otherwise taxable under general US tax principles as long as: 

1. The payor is a US person, or elects to be treated as a US person for purposes of withholding and meets requirements as provided by the Secretary;
2. The individual expatriate notifies the payor of the deferred compensation amount of his status as a covered expatriate; and
3. The individual expatriate irrevocably waives any right to claim any reduction in withholding on such item under a treaty with the US.

In this situation, the payor must withhold and deposit US federal tax from any taxable payment of an eligible deferred compensation item at a rate equal to 30%.  Any deferred compensation amount attributable to a period of US residency realized after the effective date of Expatriation will remain subject to US federal tax withholding 'as if' the individual had remained a US citizen or resident.  However, the deferred compensation amount realized will be subject to US federal taxation in accordance with IRC S.871 when it is otherwise includible in income under US laws.
           
In cases where the withholding tax does not apply (for example, IRAs, S.529 arrangements or any other deferred compensation that does not meet the criteria for eligible deferred compensation as described above), the present value of the expatriate's accrued benefit is treated as having been received by the expatriate on the date before expatriation as a distribution under the plan (though no early distribution tax applies at such time, any acceleration of plan distributions must be reviewed for IRC S.409A penalty purposes).  For these purposes, any property or right to receive property in connection with the performance of services (to the extent not previously taken into account under or in accordance with S.83) is treated as transferable and not subject to a substantial risk of forfeiture on the day before the expatriation.
     
For purposes of these provisions, deferred compensation attributable to services performed outside the US while the expatriate was not a citizen or resident of the US is not taken into account.
            
Deferral of tax
     
Expatriates subject to S.877A are permitted to make an irrevocable election to defer payment of the mark-to-market tax on a property-by-property basis, which includes an interest charge during the deferral period.  Tax may be deferred only until the due date for the return of the taxable year in which the property is disposed of.  The individual would generally be required to provide a bond to the Secretary in order to make this election, and is required to waive any treaty rights that would preclude the assessment or collection of the tax.
       
Information reporting
     
Information reporting requirements under S.6039G apply to those who expatriate under S.877A.  These requirements have historically been satisfied by filing Form 8854.
             
Gifts and bequests from expatriates
       
HEART creates S.2801, which imposes a tax on the recipient of certain gifts or bequests from expatriates.  The tax is imposed at the highest rate of tax specified in S.2001(c) or S.2502(a), as applicable and as in effect on the date of receipt.
    
The tax does not apply to:

1. Any property shown as a taxable gift on a timely filed gift tax return for the expatriate,
2. Any property included in the gross estate of the expatriate for estate tax purposes and shown on a timely filed estate tax return, and
3. Any property with respect to which a deduction would be allowed under S.2055, 2056, 2522, or 2523 (related to transfers for charitable purposes and to spouses).

Additionally, the tax applies to a recipient only to the extent that the total value of covered gifts and bequests received by him/her during the calendar year exceeds the amount in effect under S.2503(b) for such calendar year ($12,000 for 2008).

"The Bottom Line" The change may be beneficial or harmful to different expatriates, depending on their circumstances.  Expatriates with substantial assets may be subject to significant taxes under the new provisions, even if little or no tax would have occurred as a result of S.877.  Other expatriates with relatively low assets may owe no tax under S.877A and be spared the ten-year tax and filing requirements that would have applied under S.877.         Employers should consider the impact of these changes on their equalization policies, and make adjustments as necessary.