As more citizens express their frustration with taxes and crime and hear the “siren song” of foreign lands and the supposed low cost of living offered, tax practitioners should advise clients of the existence of the “exit tax” and its ramifications, even if they are just contemplating expatriation.
I.R.C. § 877(a)(2)(A)(B)(C). (Defining “covered expatriate” as an individual who has an average annual net income tax greater than $124,000, a net worth of $2,000,000 or more, or have failed to certify compliance of meeting requirements of the title.) This mark to market tax provision of the HEART Act has been codified as Internal Revenue Section 877A.
The “exit tax” was not an overnight phenomenon. Its passage in 2008 was preceded by sections in three distinct acts targeting expatriates, the first having been enacted in the Foreign Investors Act of 1966 (FITA), which subjected expatriates to U.S. income tax on income associated with a U.S. source, including an income derived from an U.S. trade or business, for a period of 10 years after termination of citizenship. Foreign Investors Act of 1966 (FITA), 89 Pub. L.No. 809. (Expatriation provisions of FITA were codified as I.R.C. § 877 on November 13, 1966.) However, the expatriation provision applied only to those individuals terminating citizenship for the principal purpose of tax avoidance. (I.R.C. Section 877(a) under FITA stated: “for one of its principal purposes, the avoidance of taxes.”)
Perhaps due to the subjectivity of the term “purpose,” coupled with the fact that U.S. source income could be converted easily to non-U.S. source income, the FITA provision was not aggressively enforced. Scant attention was given to those citizens expatriating. However, Congress and the public received a wake-up call in 1994 with a media blitz describing the good life of those expatriating, particularly the very wealthy. As a consequence of the publicity, FITA was superseded by a provision in HIPAA. In the 1996 HIPAA legislation, the category of expatriates was expanded to include U.S. resident aliens, who previously had been free to terminate their U.S. residency and return to their country of origin without tax consequences. Simply stated, unless “excepted,” a resident alien, if having held status as a green card holder or “long term resident alien” for eight of the 15 years before departure, became subject to the “alternative method” of taxation of expatriates created by FITA. The HIPAA provision also partially curtailed the benefits of bilateral tax treaties, which previously allowed expatriates to escape double taxation.
The next revision of the “expatriation tax” came with The Jobs Act of 2004. The provision within the Act closed many loopholes and tightened up reporting requirements for expatriates, and thus the “alternative tax,” “shadowing” the expatriate for a 10-year period after expatriation. This revision remained intact as the deterrent to expatriation and tax avoidance until the swift and quiet passage in May 2008 of Article III, Revision of Tax Rules on Expatriation, contained within the HEART Act. Examination of discussion of the Act, prior to passage, reveals that the only discussion of the revision of expatriation taxation contained in the bill was in the Senate Chamber, by Senator Baucus, who stated that:
Another offset in the bill is a provision that makes certain that individuals who relinquish their American citizenship or long-term residency pay their fair share of Federal taxes. This provision ensures that these folks pay the same tax for appreciation of assets, such as stocks or bonds, as they would pay if they sold them as U.S. citizens or residents. (154 CONG. REC. H4187)
In order to understand the challenges posed by the “Exit Tax” as a consequence of its inclusion in the HEART Act, those most affected—tax practitioners, expatriating citizens and long-term residents leaving the country—need to examine its substance and interpretation.
The HEART Act, Section 301: Substance and Interpretation
I. Who is subject to the rules?
2. What exactly is the “exit tax,” and how is it determined?