Saying goodbye to Uncle Sam and his taxman can be harder than you think. Many U.S. citizens, dual citizens and long-term permanent residents (certain green-card holders) living in Canada are surprised to discover they're subject to U.S. income, estate and gift tax, as well as Canadian income tax. In addition to creating ongoing U.S. tax compliance obligations, this may result in significant tax down the road. For instance, the top U.S. estate tax is 45% on the fair market value of a U.S. citizen's worldwide estate.
If your client is a U.S. citizen, one strategy for dealing with U.S. tax exposure is to relinquish that citizenship. However, before doing so, it's critical to consider the implications of the U.S. expatriation rules.
New U.S. expatriation rules, passed just last year, apply to any U.S. citizen who relinquishes citizenship after June 16, 2008. Individuals are not subject to these rules if they:
- have a net worth less than $2 million on the date of expatriation;
- have an average net federal income tax liability of less than $145,000 for the five preceding years ending before the date of expatriation; and
- have complied with all U.S. federal tax obligations for the five years before expatriation.
An exception is provided for certain dual citizens. To qualify, an individual must:
- have acquired both citizenships at birth;
- be a resident of Canada at the date of expatriation and continue to be a citizen and taxed as a resident of Canada; and
- have resided in the U.S. for fewer than 10 of the 15 years in the period that ends with the year during which expatriation occurs.
This is good news for your Canadian clients who find themselves U.S. citizens even though they have never spent any significant time in the U.S. For example, this exception should exempt many Canadians who acquired U.S. citizenship because they:
- were born in the U.S. to Canadian-citizen parents but returned to live in Canada when they were young children and have never since lived in the U.S.; or
- were born in Canada to U.S.-citizen parents and have never lived in the U.S.
To take advantage of this exception, dual citizen clients must still be able to certify that they have met all U.S. federal tax requirements for the five years prior to expatriation. If this is not the case, the dual citizen must take steps to bring past filings up to date. This may require some kind of negotiated settlement with the IRS if the client has significant unpaid U.S. tax or is facing penalties for failure to provide certain information returns.
Let's say your client, Jim, is not exempt from the new rules. He will be subject to special income and gift tax provisions, which are commonly referred to as the "exit tax".
All of Jim's capital property is deemed to have been sold for fair market value on the day before the expatriation date. Any net gain on the deemed sale is included in income during the year of expatriation but only if the gain exceeds $626,000.
Jim can elect to defer the exit tax. If so, security will have to be posted with the IRS, and interest will be charged.
Certain pension and trust assets are handled differently. Instead of a deemed disposition at the time of expatriation, either the future value of the interest is immediately included in the income or a 30% withholding tax and/or a capital gains tax is levied at the time payments are actually received by Jim. These rules may apply to:
- Canadian and foreign pension plans;
- qualified tuition, education and health savings accounts; and
- certain trust interests.
The $626,000 exemption applies only to gains derived from capital property and does not reduce income inclusions resulting from treatment of special property.
If Jim gives a gift to a U.S. person, the recipient (not Jim, as the donor) will be subject to U.S. gift tax based on the value of the gift and the highest U.S. estate tax rate then in effect (for 2009, this rate is 45%). This gift tax applies to gifts made during Jim's lifetime as well as to gifts made under his will. As a result, if Jim's family members are U.S. persons, expatriation may not be a viable option because it will effectively subject Jim's estate to U.S. tax.
Although relinquishing U.S. citizenship may be an alternative to dealing with certain U.S. tax obligations, your clients must do a thorough analysis of their worldwide assets before taking any steps to renounce citizenship.
Also be aware that your clients may be subject to these expatriation rules if they terminate their green-card status and they held the green card for at least eight of the 15 years ending with the year of termination. This article contains excerpts from an article that originally appeared in the winter 2009 issue of PricewaterhouseCoopers' Wealth and Tax Matters.
Christopher Gandhu is a senior associate in the tax services practice of PricewaterhouseCoopers LLP.