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By Thomas S. Bissell, CPA
A previous commentary1 outlined the framework of the "anti-inversion" excise tax under §4985 that may be imposed on individual "insiders" of an expatriating U.S. corporation.2 The §4985 tax operates in tandem with the corporate anti-inversion rules of §7874 and can have similarly draconian effects on the individuals who are covered by it, although the details of the law have not been as widely discussed by commentators as have the details of the related corporate tax rules.
As discussed previously, the excise tax is imposed at the rate of 15% on the "value" of "specified stock compensation" (SSC) that is held by an individual who is classified as an "insider" of the expatriating corporation for SEC purposes. Where the individual is reimbursed for the tax by the corporation of which he/she is an officer or director, the tax gross-up cost to the corporation can be as much as three times the amount of the tax itself, and in addition the reimbursement is not tax deductible by the corporation.
SSC is defined in the law to include a broad array of equity-based compensation arrangements, including but not limited to stock option rights (whether real or "phantom"), stock appreciation rights, and restricted stock rights (again, whether real or "phantom"). An unusual feature of the law is that the tax is imposed using different formulas in the case of a "stock option" plan or "stock appreciation right" (SAR) plan on the one hand (§4985(b)(1)(A)), and in the case of restricted stock rights and other SSC plans on the other (§4985(b)(1)(B)). In the case of stock option and SAR plans, the tax is imposed on the "fair value" of the insider's rights — a rule which may require the application of a complex valuation method such as the "Black Scholes" method.3 In the case of restricted stock rights plans and other SSC plans, a more familiar method is used (referred to in the law as "fair market value"), by computing the amount of income that would have been realized by the insider if on the corporate expatriation date the individual's rights were both fully vested, and exercised by the insider. Regardless of which valuation method is applied on the corporate expatriation date, if at a subsequent date the amount of income that is realized by the individual under the SSC plan turns out to be different than the value that was attributed to those rights on the expatriation date, the amount of the excise tax cannot be changed retroactively. At the same time, if and when income is subsequently realized by the individual under the plan, U.S. income tax is imposed on the income in accordance with the normal rules that apply to income realized under such a plan, in general without regard to how much excise tax had already been paid with respect to the particular SSC rights.
Although most "insiders" who are subject to the §4985 tax are U.S. citizens and resident aliens, who in most cases are subject to U.S. individual income tax in full on the income that is eventually realized by them from the particular SSC plan,4 anecdotal evidence indicates that a substantial number of nonresident alien individuals (NRAs) may also be classified as "insiders" who are subject to the excise tax. These individuals may include NRAs working abroad as officers of a foreign branch or foreign subsidiary, and/or NRAs who are independent directors of the U.S. parent or of a subsidiary.5 To the extent that services are performed outside the United States by the NRA insider, no U.S. income tax is imposed on the income that is eventually realized by the NRA under the particular SSC plan — in contrast with the U.S. income tax that is generally imposed on U.S. citizens and resident aliens. Nor will U.S. social security tax (FICA or SECA) be imposed on the NRA to that extent — again, in contrast with the rules applicable to U.S. citizens and resident aliens.6
Although the eventual income that is realized by an NRA insider may be partially or entirely exempt from U.S. income tax under general tax principles, §4985 contains no exceptions for NRA insiders. In fact, the instructions to Form 1040NR clearly state that the §4985 tax (if applicable) must be reported on line 61 ("other taxes") in the same manner as the tax is reported on Form 1040 by U.S. citizens and resident aliens. It should be noted, however, that there may certainly be situations in which an NRA insider's eventual income from an SSC plan is mostly, or entirely, subject to U.S. income tax. Such a situation could occur in the case of an individual who has previously worked for several years in the United States as a resident alien (for example, between the grant date and the vesting date of the SSC) and only recently became an NRA, or where an NRA is currently working temporarily in the United States on a nonimmigrant visa and either spends significant time outside the United States (for purposes of the "substantial presence" test under §7701(b)(3)) or, more likely, is classified as a resident alien under §7701(b) but as an NRA under the "tie-breaker" provisions of a U.S. income tax treaty. In any event, §4985 imposes no limitations on the imposition of the excise tax on the entire value of an NRA insider's SSC as of the corporate expatriation date. Nor does there appear to be any other provision of the Code that might impose any such limitations on the full application of §4985 to NRAs. The 2004 committee reports are silent on the question, and the IRS has published no guidance on this or any other issues relating to the tax.
If the expatriating U.S. corporation fully reimburses an NRA insider for the tax (as typically happens), the reimbursement itself is also subject to the §4985 tax and would usually be "grossed up" by the corporation. Because the gross-up payment itself would likely be treated substantially as foreign-source income (assuming that most or all of the NRA's services were rendered abroad), there may be little, if any, additional U.S. individual income tax to the NRA on the reimbursement. However, in many cases the reimbursement itself may be subject to foreign income tax and/or social security tax in the foreign country where the NRA is resident and/or is working. Because foreign income tax and social security tax costs are higher in most other OECD countries than in the United States, the actual reimbursement cost to the U.S. corporation could be higher than for a U.S. citizen or resident alien insider.
Although there is apparently no rule in the Code that would prevent the §4985 tax from being imposed on an NRA whose income as an officer or director is mostly or entirely exempt from U.S. income tax, there may nevertheless be a strong argument against imposing the tax based on U.S. courts' increasing reluctance in recent years to impose U.S. withholding taxes on a "cascading" basis. In the recent case of Validus Reinsurance, Ltd. v. United States,7 the D.C. Circuit held that there is a "presumption against extraterritoriality" of the U.S. withholding tax provisions. In that case, the court held that, although §4371(3) literally imposes a 1% excise tax on premiums paid for the reinsurance of U.S. risks, without regard to the identity of either the payor or the payee, the tax could not be imposed on premiums paid by a foreign reinsurer that was not engaged in a U.S. trade or business (ETBUS) with respect to premiums it paid in "laying off" part of its risk to an unrelated foreign reinsurer (called a "retrocessionaire") that was also not ETBUS. The court held that the tax could not be imposed in such a situation, regardless of what the Code itself says, unless there was legislative history indicating that Congress intended to impose the tax in an entirely foreign-to-foreign situation. The court's holding follows a similar decision in SDI Netherlands B.V. v. Commissioner,8 in which the Tax Court refused to follow the IRS's holding in Rev. Rul. 80-362 to the effect that where royalties were paid from one non-ETBUS foreign corporation (the licensor-sublicensor) to another non-ETBUS foreign corporation (the licensee) with respect to software that had been sublicensed for use by a U.S. sublicensee in the United States, those foreign-to-foreign royalties were subject to 30% U.S. withholding tax under §1442. That decision, however, relied on a somewhat tortuous interpretation of §1442 itself, rather than on a refusal to apply the literal language of §1442 on tax policy grounds in an entirely extraterritorial situation — as was done by the court in the recent Validus case.9 Underlying both decisions, although unstated, was perhaps a residual concern on the part of the courts that to enforce the Code extraterritorially in a foreign-to-foreign situation could possibly be deemed to be unconstitutional, and as a general rule courts try to avoid reaching constitutional issues.
It is not unusual for Congress to enact tax legislation that applies on a worldwide basis, although this situation sometimes occurs because the drafters simply did not take time to carve out the new law's jurisdictional limits. Thus, the U.S. wage withholding tax rules apply in many cases to wages paid to a U.S. citizen working entirely outside the United States for a foreign-owned, foreign employer that has no U.S. contacts whatsoever; the same rules apply even more extensively to resident aliens (usually "green card" holders working abroad).10 Prior to the promulgation of the current regulations under §6041 and §6041A, for many years the Code technically required every payor in the world who was engaged in business to furnish Form 1099 to every self-employed individual in the world to whom it made payments, although the IRS ruled privately in 1980 that it would not enforce the law in the case of most NRA payees.11 In the area of international charities, §6033(j) technically requires almost every foreign charity in the world to file annual statements with the IRS (whether or not the charity has any U.S. contacts) or risk a variety of potential penalties.12 In these and in other situations, the developing doctrine of the "presumption against extraterritoriality" offers a necessary brake against the application of the law in situations where Congress did not clearly state its "intention" concerning extraterritoriality, and where the constitutional validity of the law could be questioned in an extraterritorial setting.
In the case of NRAs and the §4985 excise tax, it is difficult to know exactly what Congress's "intended" with respect to a situation where most or all of an NRA insider's eventual income from an SSC is exempt from U.S. income tax and social security tax. In this case there are two very strong but conflicting policy considerations — Congress' intent in 2004 to make subsequent inversions more costly to both the expatriating U.S. corporation and to many of its "insider" officers and directors, versus the long-standing "bedrock" rule of the Code that NRAs are not subject to U.S. income tax on any compensation for services performed outside the United States, no matter who pays it. However, based on the trend in recent decades among U.S. courts to allow the Code to be applied on an "extraterritorial" basis only if the legislative history clearly mandates such a result, Congress's silence on this issue in enacting §4985 could be a strong incentive for courts to refuse to enforce the law in the appropriate NRA situation.
If instead it is assumed that a court would uphold the law against all NRA insiders (whatever their facts), additional issues arise if an NRA is resident in a country having an income tax treaty with the United States. In that case, there could be strong arguments that the treaty "overrides" §4985, and as a result that the tax cannot be imposed. Those issues will be discussed in a subsequent commentary.
This commentary also appears in the April 2016 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, Davis, 919 T.M., U.S.-to-Foreign Transfers Under Section 367(a), and in Tax Practice Series, see ¶7120, Foreign Persons — Gross Basis Taxation.
2 As indicated in the previous commentary, §4985 requires in part that the expatriating U.S. corporation be reorganized into a "surrogate foreign corporation" (within the meaning of §7874(a)(2)(B)), and under §4985(c) there must be gain recognized by "any shareholder" (i.e., by at least one shareholder).
4 However, in the case of a U.S. citizen or resident alien who is entitled to claim the foreign earned income exclusion under §911, some or all of the eventual income may be excluded. A similar situation could occur in the case of a U.S. citizen or resident alien who is resident in a U.S. possession and claims the exclusion under §931 or §933. With respect to U.S. citizens and resident aliens working abroad, U.S. income tax on their compensation income could be reduced or eliminated by foreign tax credits under §§901 ff.
5 The NRA could also be classified as an insider if he/she owns 10% or more of the corporation — although this situation would arise more commonly in the case of a privately held corporation than in the case of a publicly traded corporation.
9 For an excellent article on the Validus case and on the "cascading royalty" issue under §1442, see Mayer-Brown, , A Matter of Semantics: Validus Reinsurance Invalidates Foreign to Foreign Withholding.
12 See Bissell, 6810 T.M., U.S. International Tax Aspects of Charitable Giving and Charitable Operations, and Bissell, IRS Tax Return Filing Requirements and Ancillary Considerations for Foreign Charities, 42 Tax Mgmt. Int'l J. 83 (Feb. 8, 2013).
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