Reed Redux – The Income Tax Aspects

By Thomas S. Bissell, CPA  

Celebration, FL

Having changed the long-standing anti-expatriation rules of the Code into an "exit tax" in 2008, Congress might now start restoring some of the pre-2008 rules to create, in addition to the §877A exit tax, higher U.S. taxes on an expatriate's ongoing U.S.-source income. Such is part of a broader proposal by Senator Jack Reed (D-R.I.) to strengthen the so-called "Reed amendment," enacted in 1996 so as to prohibit certain "tax expatriates" from visiting the United States after giving up their citizenship, but which has never been enforced by the Department of Justice.1 The new "Reed proposal" (being considered as part of broader immigration law reform) would increase ongoing U.S. income taxes on certain high-net-worth expatriates, while at the same time trying to close the loopholes in the U.S. immigration law that have prevented the 1996 "Reed amendment" from being enforced.

Although the Reed proposal was deleted from the immigration bill that was passed by the Senate on June 27, 2013, the tax portions of the proposal are likely to be reintroduced, especially since they would raise revenue from a population that has virtually no representation (and almost no sympathy) in Congress.2

From 1966 to 2008, U.S. citizens who gave up their citizenship for U.S. tax avoidance reasons were subject to a special tax regime that potentially imposed higher U.S. income tax, estate tax, and gift tax during the 10-year period following their expatriation. In 2008, however, Congress replaced these rules with a tax under §877A on the unrealized appreciation in the worldwide assets of individuals having a net worth of $2,000,000 or more who gave up their U.S. citizenship on or after June 17, 2008 (referred to as "covered expatriates").3 Following his expatriation, however, the former U.S. citizen would be subject to U.S. income, estate, and gift taxes in the same manner as all other nonresident aliens/noncitizens, subject only to deferred tax on certain assets for which §877A permitted the "exit tax" to be postponed until the built-in appreciation was actually realized.4

The Reed proposal, which is co-sponsored by Sen. Charles Schumer (D-N.Y.), would amend §871(a)(2) so as to broaden the scope of the capital gains tax rule that has applied for many years to nonresident aliens generally. That rule imposes a 30% capital gains tax on the net gains "derived from sources within the United States" from capital assets realized by nonresident aliens who are physically present in the United States for 183 days or more. Because it is unusual for a nonresident alien who is present in the United States for 183 days or more in the year to avoid being classified as a resident alien - who is thereby taxed on his worldwide capital gains under §1(h) - the rules of §871(a)(2) generally apply only to nonresident aliens who hold special kinds of nonimmigrant visas (such as F-visa students, and A- or G-visa employees of foreign governments or international organizations), and also to so-called "treaty tie-breaker" aliens. Be that as it may, the Reed proposal would extend §871(a)(2) to cover so-called "specified expatriates," even if they spend no time during the year within the United States. In contrast with the traditional 10-year rule of old §877, the new tax under §871(a)(2) would be imposed until the "specified expatriate" died.

A "specified expatriate" is defined in proposed §871(a)(2)(C) as anyone who has been classified as a "covered expatriate" under §§877A(g)(1) and 877(a)(2) either within the 10 years preceding the enactment of the Reed proposal, or on or after the date of enactment. In most cases, these rules would cover individuals with a net worth of $2,000,000 or more on the date they gave up their U.S. citizenship. Significantly, however, the Reed proposal (if it is enacted before June 17, 2018) would cover individuals who gave up their citizenship prior to the June 17, 2008 effective date of the "exit tax" rules in §877A, and who are thus subject to the prior 10-year rule of §877 itself.5 The Reed proposal would nevertheless authorize the IRS to certify that an individual should not be classified as a "specified expatriate" if his loss of citizenship "did not result in a substantial reduction in taxes."

The Reed proposal includes an additional exception for post-June 16, 2008 expatriates who are subject to the §877A "exit tax." In order to avoid potential double taxation, the bases of the assets of those expatriates would be stepped up to their value on the day before the expatriation date. Query whether this rule also steps up the bases of assets that are exempt from the §877A exit tax as a result of the special $600,000 capital gains exemption of §877A(a)(3)(A) (inflation-adjusted to $668,000 for 2013), thus providing a modest "windfall" to that extent.

The intention of the Reed proposal seems clearly to impose U.S. capital gains tax on the sale by a "specified expatriate" of U.S. stocks and bonds and other U.S.-situs investments, as well as the sale of tangible personal property located within the United States, such as art, jewelry, and other collectibles. Under present law, unless the nonresident alien seller is present in the United States for 183 days or more in the year or unless the sale is "effectively connected" with a U.S. trade or business or is from a U.S. real property interest, the gain is almost always exempt from U.S. income tax. It should be noted that the 30% tax rate under §871(a)(2) is higher than the 15% or 20% rate that applies generally to long-term capital gains realized by U.S. citizens and resident aliens under §1(h). It is possible that the Reed proposal would also increase the 15% or 20% rate on long-term capital gain from the sale or exchange of a U.S. real property interest under the FIRPTA (Foreign Investment in Real Property Tax Act) rules of §897 in the case of a "specified expatriate."

With respect to non-FIRPTA gains, however, it must be questioned whether the Reed proposal has been properly drafted.  The proposal does not change the rule in §871(a)(2) that the gain must be "derived from sources within the United States," a term that in turn is defined in §865. If a nonresident alien's "tax home" is in a foreign country (or if he has no "tax home" at all), then gains from the sale of both U.S. and non-U.S. assets (other than U.S. real estate, and U.S.-related business assets) are classified as foreign-source income.6 In contrast, the 10-year rule of §877 (which does not apply to post-June 16, 2008 expatriates) includes a special sourcing rule in §877(d)(1)(A) and (B) that treats as U.S.-source any gain from the sale of tangible property located within the United States and any gain from the sale of U.S.-issued stocks and bonds - thus overriding §865, but only for expatriates who are subject to the 10-year rule of §877 itself. Because the Reed proposal does not include an amendment that would apply this special sourcing rule to "specified expatriates," presumably the general foreign-source rule of §865 would apply to them under proposed §871(a)(2).

The Reed proposal would require the withholding provisions of §1441 to be amended so as to require 30% withholding on the U.S.-source gains of a "specified expatriate" (whether on a "gross" or a "net" basis is unclear).  Because the population of "specified expatriates" is likely to be miniscule in comparison with the number of nonresident alien investors who furnish Form W-8 to U.S. brokerage firms and directly to the issuers of U.S. securities, one must question whether the expense of substantially revising Form W-8 and the §1441 withholding procedures will be worth it to either the IRS or to the withholding agents involved. Technically, the new withholding rules would also apply even to casual purchases of U.S.-situs tangible personal property from a "specified expatriate" - provided, of course, that the source rules of §877(d)(1)(A) and (B) are eventually incorporated into the proposed rules.

Even if the apparent "sourcing" defect in the Reed proposal is eventually corrected and effective withholding procedures are implemented by the IRS, it must be questioned whether many "specified expatriates" will actually arrange their investments in a manner that will subject them to the new rules.  Because most nonresident aliens (both expatriates and non-expatriates) are potentially subject to U.S. estate tax at their death on U.S.-situs equities and U.S.-situs real property and tangible personal property, it is common for nonresident aliens to hold those investments through a foreign corporation so as to avoid the U.S. estate tax upon their death.8 The §877 rules themselves include a limited look-through rule in §877(d)(4) to the extent that a pre-June 17, 2008 expatriate controls a foreign corporation that realizes certain kinds of income from U.S.-situs assets, but the Reed proposal would not apply those rules to "specified expatriates" in applying the proposed §871(a)(2) rule.

If a "specified expatriate" does not hold U.S.-situs assets through a foreign holding corporation, he might still be exempt from the proposed §871(a)(2) tax if he is resident in a country having an income tax treaty with the United States. Most income tax treaties contain a broad exemption for U.S.-source capital gains other than gains from U.S.-situs real property and "effectively connected" business gains; thus, under almost all income tax treaties, gains from most U.S.-situs investment assets and U.S.-situs tangible personal property are treaty-exempt.9 It is true that most treaties also contain a special rule that permits the United States to tax its former citizens as if the treaty were not in effect, but only for a period of 10 years.10 Therefore, although proposed §871(a)(2) would apply to a "specified expatriate" for the rest of his life, once 10 years had elapsed after his expatriation, he could well be treaty-protected from the new rule. However, if the Reed proposal is enacted, it must be asked whether Congress intended to override the 10-year limit in all existing treaties or intended that the limit continue.

Most commentators believed in 2008 that, after the enactment of the new §877A exit tax and the repeal of the special 10-year taxing regime of §877 (as well as the related U.S. estate and gift tax rules) for post-June 16, 2008 expatriates, an expatriate who satisfied the exit tax rules would thereafter be treated under the Code in the same manner as a non-expatriate nonresident alien. The new Reed proposal suggests that Congress may in fact begin to re-enact the special §877 taxing rules, and without the 10-year limitation that historically was part of those rules.

This commentary also will appear in the August 2013 issue of the  Tax Management International Journal.  For more information, in the Tax Management Portfolios, see Bissell, 907 T.M., U.S. Income Taxation of Nonresident Alien Individuals, and Klasing and Francis, 918 T.M., Section 911 and Other International Tax Rules Relating to U.S. Citizens and Residents,  and in Tax Practice Series, see ¶7150, U.S. Persons - Worldwide Taxation.

Copyright©2013 by The Bureau of National Affairs, Inc.

  1 See "Reed Offers Amendment to Prevent Ex-Citizen Tax Dodgers From Reentering the U.S.," The text of the "Reed proposal" can be found at at page S4429 (amendment SA1252).

  2 The immigration portions of the Reed proposal were re-introduced without the taxing portions, as part of a bill dealing with the Department of Homeland Security. See amendment SA 1609 as inserted into Senate bill 744, at at page 5075.

  3 See Alden and Bissell, "The Increased Cost of Expatriation: Is This the Final Chapter?" 38 Tax Mgmt. Int'l J. 429 (7/10/09). An individual is also classified as a "covered expatriate" if his average annual net U.S. income tax for the five years prior to expatriation was $155,000 or more (as adjusted for inflation as of 2013), or if he fails to certify that he has satisfied his U.S. tax obligations for the prior five years. In practice, however, most individuals who are "covered expatriates" are so classified under the $2,000,000 net worth test.

  4 Although U.S. estate and gift tax would be imposed on the expatriate in the same manner as on nonresident noncitizens who are not expatriates, a special transfer tax could be imposed under §2801 on U.S. persons who receive gifts or bequests from a "covered expatriate."

  5 The revised immigration portions of the Reed proposal that have been attached to Senate Bill 744 do not have a 10-year lookback rule, but only apply to individuals who lost their U.S. citizenship on or after June 17, 2008, and who are thus subject only to §877A. Thus, if and when the taxing portions of the Reed proposal are reintroduced, they could have an "effective date" that stretches back only to June 17, 2008.

  6  See Bissell, 907 T.M., U.S. Income Taxation of Nonresident Alien Individuals, at VI, C, 2.

  7 For example, an individual (whether a U.S. citizen, a resident alien, or a nonresident alien) who purchases an item of tangible personal property located within the United States - such as furniture at a "garage sale" - could technically be required to withhold 30% from the gross purchase price if the seller happens to be a "specified expatriate." If he did not do so, then, under general withholding tax rules, the purchaser would be secondarily liable for the withholding tax if he failed to obtain reliable documentation that the seller was not a "specified expatriate."

  8 See Bissell, 903 T.M., Tax Planning for Portfolio Investment into the United States by Foreign Individuals, at III. Under six U.S. estate tax treaties (those with Austria, Denmark, France, Germany, the Netherlands, and the United Kingdom), U.S.-situs property other than U.S. real estate and U.S. business assets is exempt from U.S. estate tax even if owned directly by the deceased resident of the treaty country, and limited relief is also available from U.S. estate tax under the U.S.-Canada Income Tax Treaty. See 903 T.M. at II, E, 4.

  9 See Article 13(6) of the U.S. Treasury's 2006 Model Income Tax Treaty.

  10 See Article 1(4) of the U.S. Treasury's 2006 Model Income Tax Treaty.