“Expatriation: Sometimes, the cure is worse than the disease (2nd of 2 parts)” by Ken Meissner (October 17, 2011)

Business World (10/17/2011)

(Part 2 of 2)

In last week’s article, we introduced Section 877A of the US Internal Revenue Code (IRC), which imposes an “exit tax” on people who cease being US taxpayers on or after June 17, 2008. We continue the discussion on specific rules that US citizens or long-term residents will have to face should they wish to cease being US taxpayers.

Property not subject to hypothetical sale

Certain property rights are ignored in calculating an expatriate’s hypothetical sale gain. These property rights (each of which is subject to its own special rules) are:

• certain items of deferred compensation;

• certain tax-deferred benefit accounts, such as IRAs; and

• interests in trusts that are not considered “grantor trusts,” under US tax law.

Treatment of items not subject to hypothetical sale

(a) Deferred compensation (things like stock options, restricted or “shadow” stock, sign-up or performance bonuses that vest at a future date, nonqualified retirement plans, and so forth) may or may not be subject to immediate taxation upon expatriation. The basic rule is that the present value of the deferred compensation on the day prior to the expatriation date is taxed and cannot be offset by the $636,000 exclusion mentioned in the previous article, unless the expatriate takes steps to make it “eligible” deferred compensation.

Eligible deferred compensation is subject to 30% withholding when it is paid. For deferred compensation to be “eligible” it must be payable by a US person or by a person or company willing to be treated as a US person, and the expatriate must agree to waive any treaty-based right he or she may have to avoid withholding. This waiver is done by checking a box on Form 8854, which must be filed with the final-year 1040.

• To ensure compliance, an expatriate must file IRS (Internal Revenue Service) form W-8CE with the payer of the deferred compensation.

• If the payer of the deferred compensation is not a US person, it must file an agreement with the IRS to comply with US withholding rules as though it were a US person.

• The IRS has not yet published procedures for a non-US payor of deferred compensation to make such an agreement, nor does it seem likely that many would do so. So most deferred compensation payable by non-US persons will probably be taxed in the expatriation year unless the compensation is derived from services the expatriate rendered before he or she became a US taxpayer.

• The fact that a payor is required to withhold at a 30% rate does not mean the expatriate will ultimately have to pay tax at that rate. But if an expatriate feels he or she is entitled to a lower rate or is not subject to tax, he or she will have to file for a refund of the withheld tax and may be required to establish that a lower rate or an exemption from tax is correct.

(b) Specified tax deferred benefit accounts (IRAs, etc.) are taxed based on the present value of whatever future benefits the account is meant to provide. As with deferred compensation, these accounts can’t be sheltered under the $636,000 exclusion described above. But to avoid double taxation, part of each post-expatriation payment from the account is excluded from tax. The amount of the exclusion is based on rules similar to those that apply to annuities purchased with after-tax dollars. The expatriate must furnish IRS form W-8CE to the custodian of the special account, indicating that they are expatriating, and that the present value of the account is subject to tax.

(c) Benefits provided under non-grantor trusts are excluded from the hypothetical sale computation. A grantor trust is a trust whose existence is essentially ignored for purposes of US income tax law. Generally the person who established the trust and retained certain rights over the trust or someone else who holds certain rights over property held in the trust is treated as the “owner” of a grantor trust, and is liable for tax on any income the trust assets generate.

If an expatriate is considered a “grantor” with respect to a trust, the value of that trust’s assets will be included in the hypothetical sale calculation.

If an expatriate is an actual or potential beneficiary under a trust that is not a grantor trust, no tax is triggered by reason of the expatriation. But if the beneficiary subsequently receives a trust distribution, the trustee is supposed to withhold 30%. Again a requirement that the trustee withhold 30% doesn’t necessarily mean the expatriate is ultimately subject to tax at that rate.

An expatriate/trust beneficiary may elect to pay tax on the value of his or her interest in a non-grantor trust. Again, the expatriate is required to file form W-8CE with the trustee. The trustee must then withhold 30% of any subsequent trust distribution or provide the beneficiary with the information needed to calculate the taxable value of the trust interest if the expatriate is electing immediate taxation.

Two things stand out: (1) It is difficult to imagine that many expatriates would want to make the immediate taxation election; and (2) There is no mechanism to apply these rules and require withholding by a non-US trustee.

Given the strict and complex regulations being implemented, it may be prudent for affected individuals to seek experienced legal and tax counsel to ensure that they are fully compliant with IRC 877A.

(Ken Meissner is a Tax Senior Director of SGV & Co.)

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.