citizenship taxation
Another Common Misunderstanding of U.S. Tax Laws (Myth No. #8)
Myth #8: As a U.S. citizen (USC) there is no need to pay tax on income or gains from assets outside the U.S., as long as the proceeds are not repatriated to a U.S. bank or financial institution.
As a follow-on to the post of Nov. 19, 2015, See WSJ = World/Expats – For an Excellent Overview of U.S. Taxation for U.S. Citizen Individuals in Plain English, I just heard this one this past week from a cross border businessman. It has a perfect logic to it the same as the idea that a controlled foreign corporation that moves cash to its own U.S. bank account (as opposed to a financial account outside the U.S.), is subject to U.S. income taxation at that moment.
Laypeople often focus on – “where is the money” not “who has *’recognized’ the income” irregardless of where the money or property is physically located.
This international business operator is thoughtful and has been doing cross border business for some 20+ years with a principle part of his business outside the U.S.; although he is a dual national citizen and hence necessarily a U.S. income tax resident.
It’s a fairly common misunderstanding that I have seen multiple times in my career.
The federal tax law does not look to where the property or income is physically located or earned; unlike some countries which have a territorial based taxation system for individuals, e.g., Costa Rica, Hong Kong, Malaysia, Panama, Singapore and Paraguay, among many others which are smaller economies.
Plus, the federal tax law is not changed by the laws of the country where the income was earned.
Instead, the tax law looks to who “recognized”* the income, irrespective of where the property or cash from that income is located.
A common sense example brings home the concept. Assume you live in Georgia (the one next to Florida not Russia) and sell real estate in Texas and leave the proceeds from the sale in a Texas bank. Texas may not impose individual income taxation on the sale of the Texas real estate (where the property was physically located), but still the state of Georgia looks to who earned the income. In this case, the income was earned by a resident of Georgia, so Georgia imposes taxation on the income from the sale, even though the cash proceeds from the sale are left in a Texas bank.
By analogy, this is how the U.S. federal government imposes taxation; with one important break in the analogy. The U.S. federal government treats USCs as income tax residents, irrespective as to where they reside; whereas George only taxes those who are physically resident in their state on a worldwide basis.
For instance, a U.S. citizen residing in Singapore, who sells real estate in a country outside both the U.S. and even Singapore, e.g., Malaysia where the tax rate on the real estate capital gains is 0%, will have earned that income in Malaysia (the where). Even if the U.S. citizen keeps his funds in a Malaysian bank or even moves the funds to a Singapore bank the country of residence (still the where), he or she will be subject to U.S. income taxation, since the USC status (the who) creates tax residency irregardless of the physical residency. See, Supreme Court’s Decision in Cook vs. Tait and Notification Requirement of Section 7701(a)(50) posted June 27, 2014 and The U.S. Civil War is the Origin of U.S. Citizenship Based Taxation on Worldwide Income for Persons Living Outside the U.S. ***Does it still make sense? posted April 1, 2014.
It does not matter that the funds are not moved to a U.S. bank account, just like it did not matter for the Georgian resident that she kept her proceeds from the Texas real estate sale’s transaction in a Texas bank.
- * The term “recognized” is a technical U.S. federal tax term that determines at that moment in time a U.S. taxpayer has income for federal tax purposes; and hence, generally the requirement to report the income on their tax return.
WSJ Asks the Question: Is the IRS Undercounting Americans Renouncing U.S. Citizenship?
Is the IRS Undercounting Americans Renouncing U.S. Citizenship?, posted Sept. 16, 2015.
The names of U.S. citizens who have renounced is published quarterly pursuant to IRC Section 6039G. See, prior related posts: 1,426 Individuals Give Up Passport: Record Number of U.S. Citizens Renouncing: Quarter 3 for 2015, October 30, 2015.
No one knows for certain if the IRS (including the IRS per some of my conversations) is getting complete data from the Department of State regarding each name and individual.
The graph I have prepared shows the number of names reported quarterly as I track all reported names quarterly that related to clients and non-clients. The latest cumulative amounts for 2015 (which does not include the 4th quarter) shows 3,221 thus far in the year. If there is close to 1,400 as was the case for the last quarter, the total will be a record – by a bunch; i.e., close to 5,000 renunciations for the year.
Anecdotally, I have seen renunciations surge in our practice, largely as U.S. citizens residing around the world (typically in the “Accidental American” category) learn about the long arm of the U.S. tax law by way of their local financial institutions and reporting and documents requested as part of FATCA. See, Why Most U.S. Citizens Residing Overseas Haven’t a Clue about the Labyrinth of U.S. Taxation and Bank and Financial Reporting of Worldwide Income and Assets, posted Nov. 2, 2015.
None of this answers the question of whether there is under-reporting of the names? Indeed, the question will likely not be answered without more information provided by the U.S. Department of State and the U.S. Treasury (i.e., the IRS officers responsible for issuing the names and report in the Federal Register).
The government is also likely to reject issuing information on these details to individuals and their advisers as part of a Freedom of Information Act (“FOIA”) request. I have had similar requests rejected by the government under the so called “Exemption 7(E)” of FOIA. See,
IT AIN’T FAIR: First (1) taxing me as a U.S. citizen and then (2) taxing me on my relinquishment or renunciation of U.S. citizenship or LPR abandoment and further (3) taxing my children on their inheritance from me!@!@!
This sums up the argument of many critics of U.S. citizenship based taxation of worldwide income.
Many may agree with this conclusion from an equity or sense of fairness argument. See proposal below at the end of this post.
However, the argument of fairness has little place in interpretations of Title 26, the U.S. federal tax law. For example, the U.S. Tax Courts are not courts of equity. See, The United States Tax Court – An Historical Analysis, Dubroff and Hellwig, footnote 668.
Also, virtually no courts of the U.S. find U.S. tax laws to be unconstitutional. It is a very rare occurrence that the U.S. Supreme Court even takes up a tax case to determine its constitutionality. The “Obamacare” with broad application throughout society was a case heard by the Supreme Court which upheld a law signed by President Obama on March 23, 2010, more correctly called the Patient Protection and Affordable Care Act. That law increased Medicare taxes and imposed a penalty surcharge on individuals who do not maintain certain health coverage.
In contrast, U.S. citizens and lawful permanent residents (LPRs) residing overseas are a relatively small population of the U.S. taxpayer population. Accordingly, it was only until late the U.S. government even began focusing on this population to collect taxes from them. See, Is the new government focus on U.S. citizens living outside the U.S. misguided or a glimpse at the new future?, posted March 6, 2014.
Finally, see various proposals to modify the law: e.g., U.S. Citizenship Based Taxation – Proposals for Reform – “Tax Simplification: The Need for Consistent Tax Treatment of All Individuals (Citizens, Lawful Permanent Residents and Non-Citizens Regardless of Immigration Status) Residing Overseas, Including the Repeal of U.S. Citizenship Based Taxation,” by Patrick W. Martin and Professor Reuven Avi-Yonah, September 2013.
Executive Summary
This paper proposes to eliminate the U.S. citizenship based taxation and create a consistent exit tax system. The complex web of the current U.S. tax law has made it nearly impossible for all but the most sophisticated U.S. citizens and lawful permanent residents (“LPRs”) residing overseas to file complete and accurate tax returns. The proposal should bring consistency, tax simplicity for taxpayers residing outside the U.S., and do so in part by eliminating the U.S. citizenship based tax system, which is unique in the world, dates to the civil war and is inappropriate for the global world we live in.
- Summary of Current Status of the Law
To date, there is no serious and comprehensive proposal to modify the U.S. federal tax law imposing U.S. taxation of the worldwide income of USCs and LPRs residing outside the U.S.
There are also no serious proposals to repeal the current U.S. “expatriation tax” on (1) mark to market income and gains (When does “Covered Expatriate” Status -NOT- matter?) and (2) the 40% tax on covered gifts and inheritances (see, Proposed Regulations for “Covered Gifts” and “Covered Bequests” Issued by Treasury Last Week (Be Careful What You Ask For!)
Part II: C’est la vie Ms. Lucienne D’Hotelle! Tax Timing Problems for Former U.S. Citizens is Nothing New – the IRS and the Courts Have Decided Similar Issues in the Past (Pre IRC Section 877A(g)(4))
This is Part II, a follow-on discussion of older U.S. case law and IRS rulings that address how and when individuals are subject to U.S. taxation before and after they assert they are no longer U.S. citizens.
I might point out that I am of the belief that we humans always like to hear the news we want to hear; and/or interpret it in the way we find most beneficial to us. Who doesn’t like good news versus bad news? Whether we (laypeople and tax lawyers alike) interpret Section 877A(g)(4) in any particular way; it is of no real consequence when it is the IRS that will enforce the law and ultimately the Department of Justice, Tax Division who will handle any such case interpreting this provision before a U.S. District Court or the Court of Federal Claims. For those who have not litigated before these Courts and seen how aggressive are the government lawyers in advocating for the government, the following discussion will hopefully be illustrative.
See, Part I: Tax Timing Problems for Former U.S. Citizens is Nothing New – the IRS and the Courts Have Decided Similar Issues in the Past (Pre IRC Section 877A(g)(4)), dated October 16, 2015.
The question is what is the correct date of “relinquishment of citizenship” as defined in the statute; IRC Section 877A(g)(4)? Many argue the law cannot be applied retroactively?
However, the specific case discussed here, did just that; applied the law retroactively to determine U.S. citizenship status of an individual and corresponding tax obligations. This was also in a time of a much simpler tax code with (i) no international information reporting requirements (e.g., IRS Forms 8938, 8858, 5471, 8865, 3520, 3520-A, 926, 8621, etc.), (ii) no Title 31 “FBAR” reporting requirements and (iii) no constant drumbeat by the IRS of international taxpayers and enforcement. See, recent announcement by IRS on Oct. 16, 2015 (one day after tax returns were required to be filed by many) Offshore Compliance Programs Generate $8 Billion; IRS Urges People to Take Advantage of Voluntary Disclosure Programs. However, for cautionary posts on the IRS OVDP and the deceptive numbers published (e.g., “$8 Billion”), see How is the offshore voluntary disclosure program really working? Not well for USCs and LPRs living overseas posted May 10, 2014 and The 2013 GAO Report of the IRS Offshore Voluntary Disclosure Program, International Tax Journal, CCH Wolters Kluwer, January-February 2014. PDF version here.
Of course, the answer to this question helps determine if and when will the individual be subject to the federal tax laws of the U.S. on their worldwide income and global assets. In the case of Ms. Lucienne D’Hotelle (an interesting 1977 appellate opinion from the firs circuit) she had spent little time in the U.S. and had sent a letter in her native language French to the U.S. Department of State, which stated “I have never considered myself to be a citizen of the United States.” This is not unlike many individuals around the world today; at least as of late – in the era of FATCA, who assert they are not a U.S. citizen because they “relinquish[ed] it by the performance of certain expatriating acts with the required “intent” to give up the US citizenship” and did not notify the U.S. federal government.
The Court nevertheless found Ms. Lucienne D’Hotelle retroactively subject to U.S. income taxation on her non-U.S. source income (up until she received a certificate of loss of nationality from the Department of State); for specific years even when the immigration law provisions of the day said she was no longer a U.S. citizen during that same retroactive period.
There have been many contemporary commentators who argue an individual does not need to (i) have, (ii) do, or (iii) receive any of the following, and yet still should be able to successfully argue they have shed themselves of U.S. citizenship and hence the obligations of U.S. taxation and reporting on their worldwide income and global assets –
(i) receive a U.S. federal government issued document (e.g., a certificate of loss of nationality “CLN” per 877A(g)(4)(C)),
(ii) receive a cancelation of a naturalized citizen’s certificate of naturalization by a U.S. court (per 877A(g)(4)(D)),
(iii) provide a signed statement of voluntary relinquishment from the individual to the U.S. Department of State (per 877A(g)(4)(B)), or
(iv) provide proof of an in person renunciation before a diplomatic or consular officer of the U.S. (per paragraph (5) of section 349(a) of the Immigration and Nationality Act (8 U.S.C. 1481(a)(5)), in accordance with 877A(g)(4)(C)).
Some older tax cases that interpreted similar concepts are worthy of consideration. They will certainly be in any brief of the attorneys for the U.S. Department of Justice, Tax Division and/or Chief Counsel lawyers for the IRS in any case where the individual challenges that none of the above items are required in their particular case to avoid U.S. taxation and reporting requirements.
The D’Hotelle case is illustrative of the efforts taken by the Department of Justice, Tax Division in collecting U.S. income tax on a naturalized citizen. You will notice they did not take a sympathetic approach to her case. Ms. Lucienne D’Hotelle was born in France in 1909 and died in 1968 in France, yet the U.S. government continued to pursue collection of U.S. income taxation on her foreign source income from the Dominican Republic, France and apparently Puerto Rico even after her death during a period of time when she used a U.S. passport. Lucienne D’Hotelle de Benitez Rexach, 558 F.2d 37 (1st Cir.1977). She, not unlike many individuals today, claimed she was not a U.S. citizen – or at least stated “I have never considered myself to be a citizen of the United States.”
Some of the particularly interesting facts relevant to Ms. D’Hotelle, a naturalized citizen, which are relevant to the question of U.S. taxation of citizens, were set forth in the appellate court’s decision as follows:
Lucienne D’Hotelle was born in France in 1909. She became Lucienne D’Hotelle de Benitez Rexach upon her marriage to Felix in San Juan, Puerto Rico in 1928. She was naturalized as a United States citizen on December 7, 1942. The couple spent some time in the Dominican Republic, where Felix engaged in harbor construction projects. Lucienne established a residence in her native France on November 10, 1946 and remained a resident until May 20, 1952. During that time s 404(b) of the Nationality Act of 19402 provided that naturalized citizens who returned to their country of birth and resided there for three years lost their American citizenship. On November 10, 1947, after Lucienne had been in France for one year, the American Embassy in Paris issued her a United States passport valid through November 9, 1949. Soon after its expiration Lucienne applied in Puerto Rico for a renewal. By this time she had resided in France for three years.
* * *
On May 20, 1952, the Vice-Consul there signed a Certificate of Loss of Nationality, citing Lucienne’s continuous residence in France as having automatically divested her of citizenship under s 404(b). Her passport . . . was confiscated, cancelled and never returned to her. The State Department approved the certificate on December 23, 1952. Lucienne made no attempt to regain her American citizenship; neither did she affirmatively renounce it.
* * *
Predictably, the United States eventually sought to tax Lucienne for her half of that income. Whether by accident or design, the government’s efforts began in earnest shortly after the Supreme Court invalidated *40 the successor statute4 to s 404(b). In in Schneider v. Rusk, 377 U.S. 163 (1964), the Court held that the distinction drawn by the statute between naturalized and native-born Americans was so discriminatory as to violate due process. In January 1965, about two months after this suit was filed, the State Department notified Lucienne by letter that her expatriation was void under Schneider and that the State Department considered her a citizen. Lucienne replied that she had accepted her denaturalization without protest and had thereafter considered herself not to be an American citizen.
There are other facts that make clear the government was not fond of her husband, the income that he earned and how he managed his and his wife’s assets during and after her death. The Court also discusses at length the fact that she had used a U.S. passport during the years when she alleges she was not a U.S. citizen. The Court goes on to analyze her U.S. citizenship, and the following discussions are illustrative of the ultimate tax consequences.
The government contends that Lucienne was still an American citizen from her third anniversary as a French resident until the day the Certificate of Loss of Nationality was issued in Nice. This case presents a curious situation, since usually it is the individual who claims citizenship and the government which denies it. But pocketbook considerations occasionally reverse the roles. United States v. Matheson, 532 F.2d 809 (2nd Cir.), cert. denied 429 U.S. 823, 97 S.Ct. 75, 50 L.Ed.2d 85 (1976). The government’s position is that under either Schneider v. Rusk, supra, or Afroyim v. Rusk, 387 U.S. 253, 87 S.Ct. 1660, 18 L.Ed.2d 757 (1967), the statute by which Lucienne was denaturalized is unconstitutional and its prior effects should be wiped out. Afroyim held that Congress lacks the power to strip persons of citizenship merely *41 because they have voted in a foreign election. The cornerstone of the decision is the proposition that intent to relinquish citizenship is a prerequisite to expatriation.
411 F.Supp. at 1293. However, the district court went too far in viewing the equities as between Lucienne and the government in strict isolation from broad policy considerations which argue for a generally retrospective application of Afroyim and Schneider to the entire class of persons invalidly expatriated. Cf. Linkletter v. Walker, supra. The rights stemming from American citizenship are so important that, absent special circumstances, they must be recognized even for years past. Unless held to have been citizens without interruption, persons wrongfully expatriated as well as their offspring might be permanently and unreasonably barred from important benefits.6 Application of Afroyim or Schneider is generally appropriate.* * *
During the interval from late 1949 to mid-1952, Lucienne was unaware that she had been automatically denaturalized.
* * *
Exploring the Vexing Issues of U.S. Citizenship Based Worldwide Taxation – University of Michigan School of Law (October 8th and 9th, 2015)
Those of us who are international tax practitioners have to deal with the messy details of the tax law. Advising private clients on the law and its consequences and finding opportunities within the law is a large part of the practitioner’s role. Additionally, as private tax practitioners, we find ourselves advocating for client’s best interests vis-à-vis the U.S. federal government, state governments, the Courts and other governmental agencies.
Policy makers and academics have the luxury of dedicating much of their time to exploring what they think should be the law and what changes should be made to current law.
I have the privilege of participating at an upcoming academic conference on TAXATION AND CITIZENSHIP held at the University of Michigan School of Law. The agenda and speakers will explore numerous issues surrounding taxation and citizenship. It is set out below, for those who might find the topics of interest (and most of the participants have published extensively on the topic):
DRAFT 7/31/15
TAXATION AND CITIZENSHIP
Conference Organizers: Reuven Avi-Yonah & Allison Christians
Conference Sponsors:
University of Michigan Center for Comparative and International Law
Procopio, Cory, Hargreaves & Savitch LLP
Michigan Journal of International Law
October 8, 2015
7:30-9:00 Student Panel
Gene Magidenko (University of Michigan) chair
Montano Cabezas (Georgetown)
Christine Kim (NYU)
Gianluca Mazzoni (Brescia)
Miguel Nicolas (University of Paris)
October 9, 2015
University of Michigan Law School
8:30-9:00 Registration
9:00-9:15 Welcome
Monica Hakimi, Associate Dean, University of Michigan School of Law
9:15-10:30 Panel One
Hugh Ault, (Boston College and OECD) Senior Advisor to the OECD’s Centre for Tax Policy and Administration
Reuven Avi-Yonah (Michigan), Irwin I. Cohn Professor of Law, Director, International Tax LLM Program
Constructive Unilateralism
Wei Cui (UBC), Co-Director, Tax LL.M. Program at The Allard School of Law at University of British Columbia
- Source and Residence as Interconnected Concepts
Tessa Davis (University of South Carolina School of Law)
Of Tax Evasion and “Bad” Citizens: The Role of Tax Law in Making a Citizen
Michael Kirsch (University of Notre Dame, the Law School)
- Citizenship-Based Taxation vs Residence-Based Taxation: Distilling the Competing Normative Arguments
- 10:30-10:45 Coffee Break
Philip West (Steptoe), Chairman
Allison Christians (McGill), H. Heward Stikeman Chair in Tax Law
- 10:45-12:20 Panel Two
- Uncle Sam Wants Who?
- Patrick Martin (Procopio), tax team leader
- The Need for Consistent Tax Treatment of All Individuals Residing Overseas
- Defining the National Community
- Linneu Mello (Bichara)
- How the Brazilian IRS keeps an eye on Brazilian residents and what FATCA has to do with it
- Saul Templeton (University of Calgary Law)
- FATCA: Problems and Potential in the Developing World
12:20-1:30 Lunch Break
1:00-1:30 Keynote: Elise Bean, Co-Director of the Levin Center at Wayne Law School, Former Chief of Staff, US Senate Permanent Subcommittee on Investigations
1:30-2:45 Panel Three
Ed Zelinsky, Benjamin N. Cardozo School of Law – Yeshiva University
Ajay Mehrotra (Director of American Bar Foundation)
The Problems of Defining Residence: The U.S. Experience
Jane Frecknall-Hughes (University of Hull)
- Tax and the citizen: the philosophical underpinnings
Christine Harlen (University of Leeds)
- Making America Exceptional: Perfectionist Civic Republicanism and the Taxation of Americans Abroad in the Progressive Era, 1890-1920
Sagit Leviner (Ono Academic College)
- Citizenship Transcended
2:45-3:00 Coffee Break
Allison Christians (McGill), chair
- Henry Ordower (St. Louis University School of Law)
3:00-4:15 Panel Four
- Is the Expatriation Tax Constitutional? Mark to Market and the Macomber Conundrum
Adam Rosenzweig (Washington University Law, St. Louis)
- Once a US Person, Always a US Person
- Daniel Shaviro, Wayne Perry Professor of Taxation, New York University School of Law
- Taxing Potential Community Members’ Foreign Source Income
- Peter Spiro, Temple University, Beasley School of Law
- Citizenship Overreach and FATCA
4:15-5:00 Concluding Panel
Hugh Ault, Reuven Avi-Yonah, Allison Christians, Ajay Mehrotra and Philip West