Thanks in part to FATCA and onerous tax reporting requirements, in the first quarter of 2016, there were 1,158 U.S. citizenship renunciations — up nearly 9.5% from the last quarter of 2015.
Renouncing is a personal decision, but there are a number of pros and cons.
- Form-free living. You are rid of the complex annual U.S. filings.
- Freedom from U.S. tax rules. There is no upside to being taxed by two countries.
- Protection from future legal changes. S. obligations on citizens residing outside the country may become more onerous. Renouncing now insures against this risk.
Further, once clients renounce citizenship, they can expect:
- No border problems. With proper advice, most people can travel to the U.S. without issue after renouncing.
- No taxes. With proper advice, most people won’t have to pay taxes as a result of renouncing.
- Loss of the benefits of U.S. citizenship. After renouncing, you can’t easily move to the U.S., vote in U.S. elections, hold a U.S. passport or benefit from U.S. consular services.
- Expense. The U.S. government charges a fee of US$2,350 to renounce.
Of these, the tax and immigration aspects warrant further discussion.
Renouncing without tax consequences
To renounce U.S. citizenship without adverse tax consequences, a taxpayer cannot be a “covered expatriate.” That’s a person who meets one or more of the following criteria:
- a net worth exceeding US$2 million on the date of expatriation;
- average annual U.S. income tax liability for the five years preceding the year of expatriation exceeding US$161,000; and
- had not filed correct U.S. tax returns for the five years prior to expatriation.
However, two classes of people can renounce without worry about their net worth or average annual U.S. income tax liability:
- those who were born dual citizens of Canada and the U.S.;
- those who are under age 18 and a half.
Both exceptions require the person to have not lived in the U.S. for more than 10 of the past 15 years. Additionally, both exceptions still require that U.S. tax returns were correctly filed for the past five years. In short, to get out of the U.S. tax system without tax issues, your clients need to be up to date on their U.S. taxes.
The consequences of being a covered expatriate are dire. They include an exit tax and a 40% tax on any gifts and bequests the covered expatriate gives to U.S. citizens.
These taxes can be expensive. Take the example of John Doe: his assets are a house worth CA$1.5 million that has gone up in value by $500,000; an RRSP worth CA$800,000; and a stock portfolio worth CA$800,000 that has increased in value by CA$500,000. He is a covered expatriate because at a 0.75 exchange rate, his net worth is more than US$2 million, and he will be subject to U.S. tax on a hypothetical sale of his assets when he renounces.
While the first US$690,000 of gain would be tax free, the exit tax would capture the increase in value of the house, the stock portfolio, and would tax the RRSP as if it had been withdrawn all at once. All of this is taxed at normal U.S. tax rates, but may not be taxed in Canada. This may lead to double taxation, as the tax will be paid in Canada later on when the assets are actually sold without a credit for the U.S. taxes already paid.
Avoiding covered expatriate status is thus key to renouncing without tax issues. Ensure there are no errors in the tax returns for the prior five years. Those who are behind on tax filings may be able to use the streamlined procedure to get caught up. Few U.S. citizens in Canada will have an average U.S. tax liability of more than US$160,000, because of the U.S. credit for tax paid to Canada. The asset threshold is a different matter. With house prices at record levels in many places, more Canadian-resident U.S. citizens are above the US$2-million threshold. These taxpayers will have to plan so as not to be subject to covered expatriate rules. This may include making gifts to a spouse. Such gifts should not be taxed in Canada, but may reduce the U.S. citizen’s lifetime estate and gift-tax exemption. As long as your client has exemption room available, this isn’t a concern because after renouncing, the client won’t have estate tax exposure on non-U.S. assets any longer.
Now, consider the example of John Doe outlined above, but with the added twist that John’s spouse, Jane, is not a U.S. citizen. If, prior to expatriating, John gifts the house to Jane, he will no longer be subject to covered expatriate status. As with complex tax matters, John should get some advice before he renounces, as there are traps, such as the application of a potential anti-avoidance rule and family law considerations, to avoid when making these gifts.
Renouncing without immigration consequences
The Reed Amendment allows the U.S. government to deny entry to someone who has renounced U.S. citizenship for tax reasons, but, for four reasons, the risk of the amendment applying is low.
- The Reed Amendment applies to those renunciants who are avoiding taxation, rather than those annoyed by the filing obligations of dual citizenship.
- The Reed Amendment lacks regulations to guide its application so there are no details on how it should be applied.
- The IRS doesn’t have the ability to share a taxpayer’s information so that the Attorney General can make a determination that someone has renounced for tax purposes.
- Even if the taxpayer lets the IRS share the information, additional barriers exist. A report released on November 30, 2015 about enforcing the Reed Amendment notes that those in charge of making the determination do not have the necessary expertise to analyze complex U.S. tax information.
The difficulty of applying the Reed Amendment is evidenced by the few times it has been applied. There have only been two documented instances of the Reed Amendment being applied to deny someone entry between 2002 and 2015, even though thousands of people have renounced.
There is still some risk at the border. A foreign passport may identify a U.S. birthplace, which is a telltale sign of U.S. citizenship. Since U.S. law requires that citizens enter the country with a U.S. passport, it may prompt border officers to ask about a client’s citizenship status.
Regardless, it should be possible to divorce Uncle Sam with no tax or immigration consequences, but it may take some time and planning to break the pre-nup.