Expatriating Long-Term Residents Need Clarification

Before the Health Insurance Portability and Accountability Act of 1996 (HIPAA), Sec. 877 would have applied only to U.S. citizens who had renounced or otherwise lost their citizenship (expatriated), if one of their principal purposes for doing so was to avoid paying tax. An expatriating taxpayer subject to Sec. 877 is taxed under Sec. 1 (regular tax) or Sec. 55 (alternative minimum tax), rather than under Sec. 871, for 10 years following his departure. Special sourcing rules apply under Sec. 877(d)(1). A nonresident alien is in most instances not liable for tax on portfolio interest under Sec. 871(h) or can sell stock issued by a U.S. company free of U.S. tax under the general sourcing rules of Sec. 865(a)(2) (if there were no Sec. 871(a)(2) issue). However, an expatriating U.S. citizen (by definition, now a nonresident alien) subject to Sec. 877 has to report those income items and pay tax for 10 years after the expatriation date. Net-worth and tax-liability tests cause Sec. 877 to apply only to the "wealthy." Sec. 877(c) provides a ruling process under which a taxpayer can seek to establish that tax avoidance was not a principal purpose for the expatriation. Although Sec. 877 does not operate perfectly in this respect, it adheres to the general principle that wealth should be taxed where created.

The HIPAA extended the reach of Sec. 877 to include long-term residents who relinquish their "green cards" or otherwise cease to be taxed as residents. A long-term resident for this purpose is defined as a lawful permanent U.S. resident for eight out of the last 15 years, ending with the tax year in which the expatriation occurs. The changes to Sec. 877 may have been necessary to establish equal treatment between departing citizens and long-term residents. However, Congress left many issues to be resolved by regulations (which have yet to be published), and in some situations, it may have tipped the scales more heavily against departing long-term residents.

One such situation can arise when a departing taxpayer owns a controlled foreign corporation (CFC). As expected, Sec. 877 attempts to treat wealth accumulated in foreign corporations no differently from other holdings. Thus, Sec. 877(d)(1)(C) provides that any income or gain derived from CFC stock within 10 years of the date of the shareholder's expatriation is subject to Sec. 877's special tax rules.

Example: A, who is not a citizen, is the sole owner of a corporation that he formed in 1980 to hold financial investments. The country of incorporation imposed no income tax on the corporation's income. Between 1980 and 1990, while A was a nonresident, the corporation accumulated $100,000 in earnings and profits (E&P). In 1990, A became a lawful U.S. resident and, by definition, his company became a CFC. From 1990 until 2002, the company earned another $100,000, all of which A received as dividends, paying the associated U.S. income tax. A surrendered his green card in 2002, but was unable to establish that tax avoidance was not a principal purpose for doing so.

Under Sec. 877(d)(1)(C)(ii), expatriating CFC shareholders are taxed to the extent that the income or gain derived from a CFC does not exceed the E&P attributable to such stock, earned or accumulated before the loss of citizenship and during periods that they met the Sec. 877(d)(1)(C)(i) ownership requirements. These ownership requirements refer to ownership within the meaning of Sec. 958(a), which states that "stock owned" includes "stock owned directly." In the example, A "owned directly" the corporation's stock since 1980. Hence, a literal reading of this statute appears to result in all the E&P of A's corporation being subject to the Sec. 877 10-year rule. The fact that he distributed all of the corporation's E&P during the time he was a resident apparently does not satisfy his U.S. tax liability. Stated differently, a nonresident who becomes a lawful permanent resident of the U.S. may be exposed to more U.S. taxation than expected.

A can argue that the reference to Sec. 958 must be taken in the context of subpart F. Sec. 958 establishes ownership rules for purposes of subpart F (Secs. 951964), which deals with the taxation of "United States shareholders" of foreign corporations. For subpart F to apply, a shareholder must be a "United States person," as defined in Secs. 957(c) and 7701(a)(30). Before he became a resident, A did not meet the definition of a U.S. person. Based on that, he can argue that he did not meet Sec. 958(a)'s ownership requirements during that period and, therefore, the corporation's E&P earned or accumulated during that same period are excluded under Sec. 877(d)(1)(C)(ii).

He can bolster this argument by noting Sec. 877(e)(3)(B), which allows a long-term resident to use the fair market value of assets on the date he established residency as a basis for Sec. 877 purposes (unless the resident irrevocably elects otherwise). This basis step-up for existing assets suggests that Sec. 877 applies only to wealth accretions occurring during U.S. residency. Consequently, A can argue that this statute's intention was never to extend to his corporation's E&P earned or accumulated before he became a lawful permanent U.S. resident.

Regulations, when issued, should clarify that expatriating long-term residents can exclude their CFC's E&P earned or accumulated before they established U.S. residency in the same way they can step up the bases of their assets for purposes of determining their Sec. 877 tax obligations.

From David A. DiMuzio, J.D., LL.M., Grand Rapids, MI