Is This the First Nail in the Coffin of Citizenship-Based Taxation?

by Mark Nestmann, Nestmann

US citizens who expatriate – those who give up their citizenship and passport – don’t get a lot of respect.

Take Facebook co-founder Eduardo Saverin, for instance. When the Brazilian-born Saverin gave up US citizenship in 2011, it led to a political witch-hunt.

Sen. Charles Schumer (D-NY) responded with a proposal he called the “Ex-PATRIOT Act.” The law would permanently bar wealthy expatriates like Saverin from ever returning to the US, even for a visit. “Eduardo Saverin wants to de-friend the United States of America just to avoid paying taxes,” Schumer declared. “We aren’t going to let him get away with it.”

Oh, yeah? When Eduardo expatriated, he had to pay an “exit tax” on the increase in value of his Facebook stock. Virtually every dollar of gain was subject to the exit tax. I estimate he paid an exit tax of more than $350 million just on the value of these shares.

Does that sound like tax avoidance to you? If that really was Eduardo’s intent, he didn’t do a very good job of it. It’s true the future appreciation of his Facebook shares wouldn’t be subject to US tax, assuming he didn’t have to sell them to pay the tax. But those gains could be subject to tax in another country, and it’s even possible that Eduardo could be forced to pay tax twice on the same gains, since the US exit tax isn’t coordinated with the tax laws in other countries.

But the fact is, for every rich and photogenic expatriate like Eduardo Saverin, there are dozens of Americans who don’t fit his profile.

Carol, a Canadian citizen who emigrated to Canada with her husband in 1969, is a great example. After arriving in Canada, she obtained Canadian citizenship, and later became the mother of a developmentally disabled son, Roy. Since Roy was born to US-citizen parents, he automatically became a US citizen. Now Roy benefits from something called a Registered Disability Savings Plan (RDSP). Carol and her husband regularly contribute to this plan, and the Canadian government matches their contributions up to C$3,500 annually.

When Carol acquired Canadian citizenship, she thought that she had automatically given up her US citizenship. And she had no idea her disabled son would automatically be a US citizen even though he was born in Canada. It’s easy to make that mistake, because the US State Department calls the acquisition of a second nationality an “expatriating act.” (It is, but only if you confirm your intention to expatriate at a US consulate.)

Carol and her husband have now lived in Canada for 46 years, and their son has spent his entire life there. Of course, the entire time, they’ve paid Canadian taxes, which are considerably higher than taxes in the US.

Yet, under the US tax rules, she’s treated as if she never left the US. That’s because unlike any other major country, the US imposes taxes on its citizens, no matter where they live. And get this: The IRS considers the matching grants to Roy’s RDSP as taxable income. Roy’s parents are even supposed to file a form declaring the RDSP as a “foreign trust.” The penalty for not filing the form is $10,000 or 35% of the value of the assets conveyed to the “foreign trust,” whichever is greater. And that penalty applies for every year the RDSP has existed.

Obama Proposes Relief for Some Expatriates

Now the Obama administration has proposed a modest reform of the grossly unfair system of citizenship-based taxation in its 2016 budget presentation. Certain individuals who were dual citizens at birth would be permitted to expatriate under a considerably easier process than currently applies.

Under the current expatriation law, wealthy “covered expatriates” (defined here) are subject to an “exit tax” and other unpleasant tax consequences. Currently, the only ways to avoid the impact of this tax if you’re a covered expatriate is if you:

  • Were at birth a citizen of the US and a citizen of another country and continue to be a citizen of and taxed as a resident of that country and have been considered tax-resident in the US for no more than 10 years during the 15-year period ending with the year in which you expatriate; or

  • Give up US citizenship before you turn 18½ and were resident in the US not more than 10 years before your expatriation.

If you’re not a covered expatriate, or if you meet these tests, you won’t have to pay the exit tax when you give up US citizenship. But you’ll still need to sign a certification that you were compliant with all US tax and reporting obligations for the five years preceding your expatriation. That poses big problems for people like Carol, her husband, and her disabled son Roy, who must still pay tax and interest on the “income” the Canadian government paid into their RDSP.

Obama’s 2016 budget proposes to eliminate this certification requirement for some people who were dual citizens at birth. It’s a step in the right direction, although of the 7 million US citizens living abroad, most won’t qualify for relief under this proposal. But many – perhaps as many as several hundred thousand – will benefit.

Does Obama Really Feel US Expatriates’ Pain?

I’d like to think that Obama and his team heard the outcry from the millions of Americans living overseas, who, uniquely among citizens of major countries, must endure citizenship-based taxation. Due to laws like FATCA (the Foreign Account Tax Compliance Act) they also find it increasingly difficult to hold bank accounts, obtain mortgages, acquire insurance coverage, and carry on the other aspects of ordinary life they once took for granted. It’s simply easier for the foreign financial institutions subject to FATCA to fire their US clients than to deal with the IRS.

But I don’t think Obama gives a rat’s ass about Americans living abroad. He’s much more concerned about making FATCA a success, so he can fulfill his campaign promise of “shutting down” what he calls “offshore tax havens.” And FATCA – the centerpiece of this plan – faces real threats, as I wrote about in this essay.

Now there’s another threat. In Canada, two US-Canadian dual citizens at birth have filed a lawsuit against the Canadian government. The lawsuit demands that the Canadian courts declare it illegal for the Canadian government to discriminate against US-Canadian dual citizens. The FATCA intergovernmental agreement between the US and Canada does discriminate – it forces Canadian financial institutions to release more information to the IRS than they are permitted to disclose to the Canadian tax authorities.

If this litigation succeeds, it could prove disastrous for FATCA – not just in Canada, but globally. But if Obama’s proposal becomes law, it would weaken the plaintiffs’ arguments – perhaps sufficiently to have their claims thrown out of court.

But it’s highly unlikely that the Obama budget proposal will become law. Congressional blowhards like Chuck Schumer will surely oppose it, and Republican lawmakers hardly want to make it look as if they’re friendly to the likes of Eduardo Saverin. In theory, Obama could issue an executive order authorizing the Treasury Department to make the change, but I really doubt he’d use up what little political capital he has left to do it.

That doesn’t change the fact, though, that Obama made the proposal to begin with. While his motives may be purely political, this is the first time since the income tax was adopted in 1913 that a president has proposed modifying the current regime of citizenship-based taxation. While this effort is unlikely to succeed, it won’t be the last. And in retrospect, it may eventually be seen as the first nail in the coffin of citizenship-based taxation.

Mark Nestmann

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