Tax compliant #americansbroad with a principal residence or mutual funds should renounce before becoming a covered #expats

For those who do not want to read this post. Here is the bottom line:

If you are a tax compliant U.S. citizen abroad, with a net worth of less than two million U.S. dollars, with investments (including mutual funds, pensions, and a principal residence in your country of residence), you should renounce your U.S. citizenship at the earliest possible moment. To the extent that your investments are in non-U.S. mutual funds, other kinds of PFICs or your principal residence, the U.S will confiscate large amounts of the proceeds of sale. (And you thought you were solving your problems be being tax compliant.)

Many Canadians are using their principal residence as their retirement plan. Their plan is to sell, downsize and live of the balance of the proceeds. This is NOT possible if you are a tax compliant U.S. citizen! You must NOT be a U.S. citizen at the time the investments are sold.

If you want to preserve your investments  you must relinquish your U.S. citizenship to protect your access to your investments!

For those who want to understand why, read on …

Tax compliance and the U.S. citizen abroad

It has become clear for U.S. citizens abroad that the only thing worse than NOT being tax compliant is  BEING tax compliant.

The cost of U.S. tax compliance is that your U.S. citizenship will disable you from effective financial and retirement planning. The reason is that the U.S. considers most non-U.S. investment vehicles to be PFICs. The sale of your principal residence will be subject to a capital gains tax. Furthermore, the additional “Obamacare taxes” imposed on investment income will make the situation worse.) The above tweet references a very good article explaining why, for U.S. citizens abroad, retirement planning is hazardous to your financial health.

The main point is this:

If you you own a principal residence or a non-U.S. mutual fund  and you sell it (you will want to do this at some point) all the gains (and possibly more will be confiscated). Since some of you may think I am sounding “alarmist” I will quote from the above article by tax lawyer Virginia La Torre Jecker (yes, somebody else thinks so too):

Don’t Mind Losing Your Investment ? PFIC Means Very Harsh Tax Consequences

The harsh bite of the PFIC tax rules will make itself known in either of two events: 1) when the fund makes a distribution (called an “excess distribution”)  to the investor or, 2) when the investor disposes of his PFIC shares (a “disposition” of PFIC shares can occur by redeeming them, selling them, gifting them away, or even by giving up one’s US resident status or citizenship).  When taxation occurs, the amounts will be taxed at the highest ordinary income tax rate for the investor without regard to other income or expenses (currently the highest individual rate is 39.6% plus, don’t forget the 3.8% Medicaid Surcharge). Long-term capital gains treatment does NOT apply.

To add insult to injury, the amounts on which the PFIC tax is to be calculated are “thrown back” evenly over each of the tax years that the investor held his shares. Tax is then assessed for each prior year at the highest possible tax rate that was in effect at such time. Then, interest is compounded on the deferred tax deemed due for each year. These high rates can very easily eat up the investment by removing the benefit of any tax deferral. If an investor has held his PFIC shares for many years, he can basically say goodbye to that investment.  By way of example, assume Taxpayer redeems his PFIC shares at a gain of $10,000 in 2013. Assume he held the shares commencing 2009.  In this case, $2,000 of gain will be deemed to have been earned in each of the five years 2009 through 2013.  Tax will be assessed at the highest possible tax rate for each year and compounded interest will apply on the taxes due.  Various tax elections can possibly be made to avoid this harsh treatment. Making an election, however, is not always a simple matter since certain requirements must be satisfied.   Many times, the requirements cannot be met and the taxpayer is left in the lurch.

What does this mean practically?

It means that you may have to renounce your U.S. citizenship in order to save your financial future. This is why the issue of being a “covered expat” is becoming more and more important. If you are NOT a covered expat, you will get your “Get of Jail Free Card” for free. You are NOT subject to the mark to mark exit tax rules. If you are a “covered expat” there will be a deemed sale of your mutual funds (and all the horror that this sale implies). You cannot afford to be  U.S. citizen when you sell your investments.

U.S. citizens abroad who:

1. are tax compliant

2. have investments they do not want confiscated by the U.S. government

3. have a net worth of less than two million

4. are not paying more than about 150,000 per year in taxes should:

Renounce your U.S. citizenship now!

It’s necessary to preserve your financial future. If you continue your habit of “tax compliance” (playing by the rules) and you reach the two million mark which is inevitable, you will be locked in a fiscal prison the rest of your life!

Caveat: Those who were born dual citizens and meet other requirements may “Get out of jail free” in any event.

Epilogue – Added one day later …

An interesting discussion which touched on the issue of non-U.S. mutual funds has been taking place at the Isaac Brock Society. See this thread.

Note this comment in particular. Note specifically the words I have bolded. Do NOT see these investments until you are no longer a U.S. person!

@Neill

Ignore this if you plan to reside in the US permanently. Also, I have no idea whether this option would still be available to you if you have already filed returns using the MTM method for PFICs.

Have you examined reporting your PFICs under the excess distribution method? Under this method, you pay tax only on the dividends distributed by the underlying PFICs. Most of the dividends will be treated as ordinary dividends in the year the dividend was received. Dividend distributions in excess of 125% of the three year average are deemed excess distributions and the excess portion as apportioned over the holding period and taxed at the highest marginal rate in the period plus interest. However, it avoids having to pay “capital gains” tax on a MTM basis which is where you can get whacked by dollar depreciation or underlying fund appreciation or both. If the underlying funds you held paid a fairly stable rate of dividends from year to year then most of the dividends will be treated as ordinary dividends.

Additionally, I’ve had two different sets of tax preparers tell me that only dividends from Income class shares need to be reported as dividends since Accumulation class shares don’t distribute dividends.

If you bought and held your PFICs, if you have PFICs that are Accumulation class shares, and if you don’t plan to permanently reside in the US, and if it is possible to amend the returns submitted, it may be worth investigating. This method, however, produces absolutely brutal consequences if you sell the holding while you are US tax resident.

(In context the words “while you are a US tax resident” actually mean “while you are a US person”.)

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9 thoughts on “Tax compliant #americansbroad with a principal residence or mutual funds should renounce before becoming a covered #expats

  1. Virginia La Torre Jeker, J.D.

    Even if one is not a “covered expat”, and gives up US citizenship (or otherwise becomes a nonresident alien) the PFIC tax consequences will apply to those PFIC investments. This is so because the simple act of expatriation (giving up US citizenship or one’s green card, for example, regardless of the tests for classification as a “covered expatriate” of net worth or income tax liability) is treated by the IRS as a “disposition” of the PFIC. Please see Prop. Treas. Reg. Sec 1291-3(b)(2) “Change of US Residence or Citizenship”.

    Reply
    1. Kerrie

      Are you able to explain why a ‘proposed’ regulation is treated as already being adopted please?
      With reference to Prop Reg. Sec 1291-3(b)(2) @Change of US Residence or Citizenship@

      Reply
  2. renounceuscitizenship Post author

    Virginia:

    Thanks very much for this. Could provide a direct link to the section of the proposed regulation that you are talking about.

    Leaving aside the “proposed regulations” (which are at the present time “proposed”), could you provide guidance on where in the Internal Revenue Code itself, there is a section which confirms that the act of relinquishing citizenship, giving up a Greed Card or becoming a “non- resident” mandates the deemed disposition of a PFIC.

    There is an incredibly complicated area with very little guidance.

    For those interested, here is where the regulations governing taxation in the year of a change of citizenship or residence begin:

    http://www.law.cornell.edu/cfr/text/26/1.871-13

    Reply
  3. Virginia La Torre Jeker, J.D.

    Hi – Sorry I have not replied to this earlier. I must have missed it. This area of the law is very, VERY messy and there is no absolute clear answer. Proposed Regulations are not law, but do represent the view of the IRS. You will note the proposed regulations state that the effective date will be April 11, 1992. Sorry I could not find a link to the Prop Regs. My view is that you can expect the IRS to treat ‘expatriation’ as a disposition of the PFIC shares (regardless if T is a “covered expatriate” under IRC Section 877 / 877A – if T is a covered expat, that would be a separate tax problem – under the Exit Tax rules. So T can be hit twice!!). Will the IRS win if you took them to court and fought that position? No clear answer there… but given the current trend of dramatically increased expatriations and the perceived need to stop them dead in their tracks by heaping more and more sanctions on those who wish to expatriate, my bet is on IRS having success. You will find this thread on Tax Almanac of great interest. http://www.taxalmanac.org/index.php/Discussion:PFIC_gift_to_NRA_spouse

    Reply
    1. Virginia La Torre Jeker, J.D.

      Addendum – if you read the Legislative History to the PFIC rules, Committee Reports on PL 100-647 (Technical and Misc Revenue Act of 1988), there is a section titled anti-avoidance rules making clear the law should “deny the benefit of any nonrecogition treatment to any transfers of PFIC stock, including transfers at death or by gift.” They go on to use the example of a US person gifting appreciated PFIC stock to a foreign person…. saying that tax avoidance on the appreciation in the stock could occur “unless the gift is treated as a taxable sale at the time of the gift”. This does away w. the points in the Tax Almanac discussion and to me makes it clear you wont escape tax on PFIC appreciation by expatriating regardless if the regs are “proposed” There is enough in the Legislative history making clear Congressional intent. Sorry I have no links to the legis history.

      Reply
  4. Virginia La Torre Jeker, J.D.

    I believe this is the IRC Section dealing w. PFIC that acts as the “catch all” category.
    Sec 1291(f)
    http://www.fourmilab.ch/uscode/26usc/www/t26-A-1-P-VI-A-1291.html

    f) Recognition of gain
    To the extent provided in regulations, in the case of any transfer of stock in a passive foreign investment company where (but for this subsection) there is not full recognition of gain, the excess (if any) of – (1) the fair market value of such stock, over (2) its adjusted basis, shall be treated as gain from the sale or exchange of such stock and shall be recognized notwithstanding any provision of law. Proper adjustment shall be made to the basis of any such stock for gain recognized under the preceding sentence.

    The argument in your favor wi expatriation is that (unless T is a ‘covered expat’), T is not making any “transfer” of stock when he expatriates. At death, one is arguably deemed to transfer assets through the estate; and when making a gift there is clearly a “transfer” to the donee. Upon expatriation – the “transfer” is deemed to take place only by virtue of the Prop Regs inclusion in the definition of a “disposition” — other than that, there is no “transfer”. The Regs though, certainly effectuate the legislative intent to capture he appreciation that would otherwise escape tax.

    Reply
  5. renounceuscitizenship Post author

    Virginia:

    I would like to thank you very much for your detailed comments – you are not kidding when you say that this is a “messy area”.

    This comment is to tie some of your comments/ideas into one and then invite further comment from you.

    The basic questions are:

    1. Does the act of expatriation result in a “transfer” of PFICs?

    2. The effect of S. 877A

    3. The effect of S. 1291 (f)

    4. Regs made pursuant to the PFIC rules – can the IRS make regs in relation to things that are not “transfers”?

    5. The fact that this is an unpublished reg

    6. The fact that this unpublished reg was written well before the June 2008 877A rules.

    7. What should people do?

    Context:

    To set the contexts:

    1. Legal Context: We are discussing whether when a U.S. person expatriates it is treated as a “disposition of a PFIC” which would trigger all the “confiscatory horror” associated with that. This concern is triggered by your earlier July 21 comment where you note:

    “regardless of the tests for classification as a “covered expatriate” of net worth or income tax liability) is treated by the IRS as a “disposition” of the PFIC. Please see Prop. Treas. Reg. Sec 1291-3(b)(2) “Change of US Residence or Citizenship”.”

    https://renounceuscitizenship.wordpress.com/2013/07/11/tax-compliant-americansbroad-with-mutual-funds-should-renounce-before-becoming-a-covered-expats/#comment-5495

    It is interesting that the proposed regs are NOT available online and seem to be known by only by the small number of specialists in the International Tax Community. In other words, this is information that is very very difficult to find.

    2. Practical Context: If expatriation did trigger a deemed “disposition” of a PFIC, this could result in the confiscation (to use your words ” bye bye investment”) of a large portion of the net worth of many Americans abroad. The question is:

    Is it really the case that if a “non-covered expatriate renounces U.S. citizenship that they will be forced to pay a ransom – likely a huge percentage of their assets – in return for their freedom? Furthermore, the justification for the ransom is a “proposed reg” that is NOT online and accessible only to a very small number of practitioners?

    If this were so, then for many Americans Abroad there would be little practical difference between being “covered” or not covered. This is obviously NOT what was intended by the June 2008 877A rules. The attempted application of this would bring IRS abuse to a new and unprecedented level (not that this would stop them).

    Now, to continue your analysis and to bring some of these ideas (in this comment thread together) and in the hopes that you will comment further …

    Part 1 – 877A Analysis

    Under the S. 877A rules, the deemed sale occurs only if one is a covered expatriate.

    “a) General rules
    For purposes of this subtitle—
    (1) Mark to market
    All property of a covered expatriate shall be treated as sold on the day before the expatriation date for its fair market value

    The definition of “covered expatriate is found is S. 877 (2) (A):

    (2) Individuals subject to this section
    This section shall apply to any individual if—
    (A) the average annual net income tax (as defined in section 38(c)(1)) of such individual for the period of 5 taxable years ending before the date of the loss of United States citizenship is greater than $124,000,
    (B) the net worth of the individual as of such date is $2,000,000 or more, or
    (C) such individual fails to certify under penalty of perjury that he has met the requirements of this title for the 5 preceding taxable years or fails to submit such evidence of such compliance as the Secretary may require.
    In the case of the loss of United States citizenship in any calendar year after 2004, such $124,000 amount shall be increased by an amount equal to such dollar amount multiplied by the cost-of-living adjustment determined under section 1 (f)(3) for such calendar year by substituting “2003” for “1992” in subparagraph (B) thereof. Any increase under the preceding sentence shall be rounded to the nearest multiple of $1,000.”

    Therefore the S. 877A rules would NOT result in the disposition of PFIC shares a “deemed sale”. To put it another way:

    The clear intent of S. 877A which took effect in June 2008 (far later than the proposed PFIC regulations) is to impose “deemed sale” rules on only “covered expatriates”.

    Furthermore, any regs (whether proposed or not) are subject to the provisions of the IRC. (Do we have regs on expatrations?)

    Part 2 – Other sections of the IRC

    So, the question becomes whether there is another section(s) of the IRC what would impose “deemed sale status” on PFICs regardless of the fact of expatriation.

    Possibility 1: Let’s look to S. 1291 of the IRC – “Interest on tax deferral”.

    You reference S. 1291 (f) which reads as follows:

    “(f) Recognition of gain
    To the extent provided in regulations, in the case of any transfer of stock in a passive foreign investment company where (but for this subsection) there is not full recognition of gain, the excess (if any) of—
    (1) the fair market value of such stock, over
    (2) its adjusted basis,
    shall be treated as gain from the sale or exchange of such stock and shall be recognized notwithstanding any provision of law. Proper adjustment shall be made to the basis of any such stock for gain recognized under the preceding sentence”

    I note S. 1291 (f) requires two events:

    First “To the extent provided in regulations”. There are no PFIC regulations. There are only “proposed regulations”.

    Second, S. 1291 (f) reads:
    in the case of a “transfer”.

    Now, your comments addressed this fact. The word is “transfer”. In order for there to be a “transfer”, doesn’t there have to be a “transferee”?

    There is (as far as I know) no section of the IRC that states or implies that on expatriation there is a “transfer” of assets. The words “deemed sale” are used in 877A precisely because there is (as a matter of fact) NO transfer of assets.

    Therefore, it seems to me that S. 1291 (f) would NOT apply here. No “transfer” no application of S. 1291(f)

    Possibility 2 – Legislative History to the PFIC rules, Committee Reports on PL 100-647 (Technical and Misc Revenue Act of 1988) – Your comment:

    Addendum – if you read the Legislative History to the PFIC rules, Committee Reports on PL 100-647 (Technical and Misc Revenue Act of 1988), there is a section titled anti-avoidance rules making clear the law should “deny the benefit of any nonrecogition treatment to any transfers of PFIC stock, including transfers at death or by gift.” They go on to use the example of a US person gifting appreciated PFIC stock to a foreign person…. saying that tax avoidance on the appreciation in the stock could occur “unless the gift is treated as a taxable sale at the time of the gift”. This does away w. the points in the Tax Almanac discussion and to me makes it clear you wont escape tax on PFIC appreciation by expatriating regardless if the regs are “proposed” There is enough in the Legislative history making clear Congressional intent. Sorry I have no links to the legis history.

    https://renounceuscitizenship.wordpress.com/2013/07/11/tax-compliant-americansbroad-with-mutual-funds-should-renounce-before-becoming-a-covered-expats/#comment-6314

    Again, this is triggered by a “transfer” of a PFIC. The question becomes does the fact of expatriation mean that there is a “transfer” of a PFIC?

    There is nothing in a statute that suggests this. As you point out death and gifts are transfers. In death and gift the PFIC actually leaves the possession/ownership of the donor or deceased. The point is that in the case of expatriation the person retains the asset. Possession does NOT leave the person expatriating. This is the simple fact of the matter.

    Part 3 – Possible effect of “propsed regs”

    Can the proposed regs be used as a way to properly interpret the statute. This is the nub of the problem. I can’t find Prop. Treas. Reg. Sec 1291-3(b)(2) “Change of US Residence or Citizenship”. But based on your comment above it appears to read that the IRS will treat expatriation as a deemed disposition of a PFIC.

    Again regulations are to be used to interpret the statute. Again, S. 1291 (f) speaks of a transfer. The IRS CAN make regulations (I would think) in relation to a transfer. The IRS CANNOT under s. 1291 make regulations in relation to things that are NOT transfers. This is simply outside their regulation making authority under S. 1291.

    Therefore, even assuming the proposed regs were binding (which they are not) the reg could operate only to make certain “transfers” deemed dispositions. The regs cannot invent transfers where there are none. Put it another way: Because of the requirement of “transfer” in S. 1291 (f), if there is no “transfer”, the IRS can’t make a reg calling it a transfer.

    Transfer: Your example of a gift is a good one because a gift is a transfer. So, the reg, if binding should be read to ensure that all transfers are caught by the PFIC rules – not things that are NOT transfers.

    Part 4 – Whether published or not, what about the timing of the reg and the timing of the law?

    The question I would ask is:

    Whether published or not, can a reg (proposed effective date April 1992) that precedes a law (effective June 2008) overrule that later law?

    I would hope the answer is NO.

    Therefore, even if passed this reg should NOT be binding on the taxpayer. S. 877A clearly reflects a Congressional intent to apply the “deemed sale” provisions to ONLY “covered expatriates”, how can an earlier reg, (that did not contemplate the 877A rules) overrule that law?

    Part 5 – In summary …

    Your comment:

    “The argument in your favor wi expatriation is that (unless T is a ‘covered expat’), T is not making any “transfer” of stock when he expatriates. At death, one is arguably deemed to transfer assets through the estate; and when making a gift there is clearly a “transfer” to the donee. Upon expatriation – the “transfer” is deemed to take place only by virtue of the Prop Regs inclusion in the definition of a “disposition” — other than that, there is no “transfer”. ”

    makes a lot of sense to me.

    That said, as you point out this is very very messy. It seems to me that because this is a messy area that those who are NOT covered should expatriate quickly. Expatriation is clearly not going to get easier.

    Finally your link is interesting – PFIC Gift to NRA Spouse

    http://www.taxalmanac.org/index.php/Discussion:PFIC_gift_to_NRA_spouse

    This discussion take places in he context of a gift which does involve a transfer.

    But, it demonstrates how confused this area is.

    Thanks again!

    Reply
  6. Virginia La Torre Jeker J.D.

    At the end of the day, there are no clear answers on this Q. The PFIC legislation specifically gives IRS the power to make regulations that will implement the law. When Congress does this in a statute, the regulations that are issued are called “legislative” regulations. They are different from so-called “interpretive” regulations and are given far more deference by a court. Interpretive regulations are issued under the IRS’s general authority of IRC Sec. 7805(a) and these are promulgated to clarify the language of the Internal Revenue Code. These regulations are subject to challenge if they do not reflect congressional intent. On the other hand, legislative regulations are specifically authorized by Congress to provide the substantive requirements of a specific Code provision, here the PFIC rules re a “disposition” (You can find authority for issuance of a legislative regulation in the specific Code section which will state words to the effect, “The Secretary shall provide such regulations …”). Generally, when legislative regulations are properly promulgated and non-arbitrary, they will carry the same legal weight & authority as the tax code itself.

    SO — back to your Q — Will the IRS win if you took them to court and fought its position that “expatriation” is a “disposition”? I’m afraid we won’t really know till a case comes to court! Again, given the current trend of dramatically increased expatriations and the perceived need to stop them dead in their tracks by heaping more and more sanctions on those who wish to expatriate, my bet is on IRS having success.

    Now, if you’ll excuse me, I need to get back to my clients — the paying ones, that is 😉

    Reply

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