Solving the tax problems caused by U.S. Citizenship
A paper for the 2015 Canadian Tax Foundation BC Tax Conference
Sandhya Chari and Max Reed1
SKL Tax, Vancouver
1
[email protected]
1. INTRODUCTION 3 2. IDENTIFYING THE PROBLEM: WHO IS SUBJECT TO U.S. TAX 5 A. WHO ARE U.S. PERSONS? B. U.S. CITIZENS AS U.S. PERSONS I. ACQUISITION OF U.S. CITIZENSHIP BY BIRTH IN THE U.S. II. ACQUISITION OF U.S. CITIZENSHIP BY BIRTH ABROAD TO U.S. CITIZEN PARENTS 5 6 6 6 3. OVERVIEW OF THE TAX COMPLEXITIES FACED BY U.S. CITIZENS IN CANADA 8 A. I. II. B. I. PROCEDURAL – ANNUAL FILING REQUIREMENTS DISCLOSURE FORMS FOREIGN BANK AND FINANCIAL ACCOUNT REPORTS SUBSTANTIVE PROBLEMS – TAX PLANNING OPPORTUNITIES ARE LIMITED CANADIAN ESTATE-­‐FREEZE 8 9 9 10 10 4. FATCA EXACERBATES THE SITUATION FACING U.S. CITIZENS IN CANADA 10 5. SOLUTION # 1 – DO NOTHING, RELY ON THE FIREWALL 11 6. SOLUTION # 2 – CATCH UP AND CONTINUE TO COMPLY 13 7. SOLUTION #3 – RENOUNCING U.S. CITIZENSHIP 14 A. 15 16 16 17 18 18 19 19 B. C. I. II. III. IV. D. GENERAL REQUIREMENTS OF RENOUNCING U.S. CITIZENSHIP THE IMMIGRATION PROCESS FOR RENOUNCING POTENTIAL TAX OBLIGATIONS ARISING FROM RENOUNCING “COVERED EXPATRIATE” STATUS EXCEPTIONS TO THE CE STATUS MITIGATING THE EXIT TAX COVERED GIFTS AND BEQUESTS POTENTIAL IMMIGRATION CONSEQUENCES OF RENOUNCING 8. SOLUTION #4 – RELINQUISH U.S. CITIZENSHIP 20 A. HOW U.S. CITIZENSHIP IS LOST FOR IMMIGRATION PURPOSES I. THE CLEAVING OF CITIZENSHIP FOR IMMIGRATION AND TAX PURPOSES II. IS THERE A NEED TO “PROVE” RELINQUISHMENT? 21 21 23 9. CONCLUSION – SOLVING THE PROBLEM OF U.S. CITIZENSHIP 24 S. CHARI & M. REED, Page 2 1.
Introduction
The U.S. is one of only two countries in the world that tax their citizens on the basis of
their citizenship regardless of their residency.2 Therefore, citizens living outside the United
States face being taxed both by their country of residence as well as the U.S. From a tax
perspective, U.S. citizenship is a burden. There is no upside to being taxed by two countries.
Most financial activities conducted by a U.S. citizen in Canada―being naturally conducted
where he/she lives―are “foreign” for U.S. tax purposes. This means that the international
sections of the Internal Revenue Code (the “Code”) apply. In other words, U.S. citizens in
Canada are subject to the same tax rules as a high net-worth American resident who has interests
in the Cayman Islands, despite doing nothing out of the ordinary for a Canadian resident. The tax
problems caused by U.S. citizenship are both procedural and substantive: the annual compliance
requirements are complex; the fines for failing to comply are expensive; and the substantive tax
rules frustrate even the most vanilla Canadian tax-planning.
Citizenship-based taxation, as the U.S. style of tax is referred to, has been around for
nearly 150 years.3 Started after the U.S. civil war, it was declared constitutional by the Supreme
Court of the United States in Cook v. Tait.4 For much of that time, American citizens abroad,
even those who are high net-worth, could comfortably ignore their U.S. tax obligations. Then
came the Foreign Account Tax Compliance Act (FATCA), enacted in response to the UBS (a
Swiss global financial services company) controversy. UBS had been helping U.S. residents
shelter income from U.S. taxation. In response, Congress enacted FATCA to compel all foreign
financial institutions to report information on bank accounts held by U.S. Persons abroad.
Foreign financial institutions that do not comply with FATCA face a 30% withholding penalty
on all of their U.S.-source income. There is significant incentive for them to give the IRS the
information it requests. There is no evidence that FATCA was designed to target U.S. citizens
residing outside the United States. Rather, they are collateral damage in the United States’ effort
to safeguard against erosion of its tax base by rooting out global tax evasion.
2
The other being Eritrea which, interestingly, the U.S. voted to sanction at the UN Security Council in part as a
result of their taxation system.
3
http://renouncecitizenship.ca/citizenship-taxation-and-expatriation-background-and-history/tax-on-expatriationbackground-and-history/.
4
Cook v. Tait, 265 U.S. 47 (1924).
S. CHARI & M. REED, Page 3 The new reality is that FATCA makes the tax obligations of Americans abroad much
more difficult to ignore. This paper aims to present solutions to the tax problems caused by U.S.
citizenship. We present four solutions:
A. Do nothing, simply rely on the firewall. U.S. citizens in Canada benefit from a strong
firewall. The Canada-U.S. Tax Treaty prohibits the Canada Revenue Agency (“CRA”)
from collecting U.S. tax as long as the taxpayer was a Canadian citizen at the time the tax
debt arose. That means the IRS has to act alone. It can easily collect taxes against assets
in the U.S. The Supreme Court of Canada, on the other hand, has said that that it will not
enforce a foreign judgment for taxes owed by a Canadian citizen. This is to say that the
IRS may not be able to collect from Canadian assets. Relying solely on this firewall is a
high-risk proposition.
B. Catch up and continue complying. The IRS has created the Streamlined Procedure to help
U.S. citizens abroad get caught up in the event that they have not been in full compliance
with their U.S. tax obligations. While the U.S. annual tax compliance requirements are
complex, they can normally be navigated with a good tax professional. Continued
compliance is a 100%-effective vaccine against any problems at the U.S. border or with
the IRS. Of course, the rules are limiting and compliance can often be expensive from a
professional services point of view.
C. Renounce U.S. citizenship. The decision to renounce U.S. citizenship is a major one. It
has advantages and disadvantages. Put very simply, the advantages include elimination of
the annual tax compliance requirements, mitigation of the potential penalty exposure, and
removal of many tax-planning roadblocks. The downsides include loss of the ability to
move to the U.S. without restriction, loss of the right to vote in U.S. elections, a potential
exit tax and other tax implications, and possible risks at the U.S./Canada border.
D. Relinquish U.S. Citizenship. Relinquishment refers to a loss of citizenship that may have
happened many years ago and the attendant loss of tax consequences. Under U.S.
immigration law, an individual may have lost his/her U.S. citizenship by virtue of having
been a Canadian citizen or having sworn an oath to a foreign monarch (among other
possible situations). Logically, if an individual lost their U.S. citizenship for immigration
S. CHARI & M. REED, Page 4 purposes many years ago, the date on which they lost their citizenship should also be the
end of their U.S. tax obligations. In many cases, this would be prior to the enactment of
the U.S. exit tax and their net worth may have been lower at the time of citizenship loss
than it is now. Thus, a relinquishment may avoid many of the problematic aspects of the
U.S. exit tax. However, because of a statutory absurdity, the relinquishment option may
have some risks to it.
2.
Identifying the problem: who is subject to U.S. Tax
a.
Who are U.S. Persons?
Under the Internal Revenue Code (the “Code”),5 all “U.S. Persons” are subject to U.S.
tax jurisdiction. The definition of “U.S. Person” has five sub-categories. First, partnerships that
are created or organized in the United States or under the law of a U.S. state are “U.S. Persons.”6
Second, corporations that are created or organized in the United States or under the law of a U.S.
state are U.S. Persons.7 Third, trusts are U.S. Persons if a U.S. court is able to exercise
supervision over the trust and one or more U.S. Persons have the authority to control “all
substantial decisions of the trust.”8
Fourth, “residents” of the U.S. are “U.S. Persons.”9 There are two types of residents: Greencard
holders and factual residents. Greencard holders, whether or not they are located in the United
States, are U.S. residents for tax purposes.10 Note that those who hold a U.S. Greencard remain
subject to the U.S. tax authority until they surrender their Greencard to the U.S. authorities and
notify the IRS.11 The other type of U.S. tax resident is a factual resident. All those who meet the
"substantial presence test" are considered U.S. tax residents.12 The substantial presence test
requires someone to spend at least 31 days in the United States in the current tax year and have a
total day-count of 183 tax days in the previous three years including the current year. The
5
Internal Revenue Code [“IRC”].
IRC §7701(a)(2), 7701(a)(4).
7
IRC §7701(a)(3), 7701(a)(4).
8
IRC §7701(a)(30(E).
9
IRC §7701(a)(30).
10
IRC §7701(b)(1)(A)(i).
11
IRC §7701(b)(6).
12
IRC §7701(b)(3).
6
S. CHARI & M. REED, Page 5 calculation to arrive at 183 days is less straightforward than one might think. Days in the current
calendar year are counted day-for-day towards the 183 number. Days in the year immediately
previous to the current tax year are valued at 1/3rd of their number. Finally, days spent in the
United States two years prior to the current tax year are valued at 1/6th of their total.13
Fundamentally, it is not a simple question of 183 days or not and does require some calculation.
There is an exception to the substantial presence test. An individual who spends fewer
than 183 days total in the United States, has a tax home (similar to tax residency) in a foreign
country and also has a closer connection to that country is not a tax resident of the United
States.14 A person who meets the substantial presence test may also try, relying on the CanadaU.S. Tax Treaty, to establish that he or she is not a tax resident of the United States.
b.
U.S. citizens as U.S. Persons
Finally, all U.S. citizens, irrespective of where they live, are U.S. Persons and thus subject to
U.S. tax filing requirements.15 The determination of who is a U.S. citizen is not always
straightforward. U.S. citizenship can be acquired through naturalization or by birthright. Those
who have acquired U.S. citizenship by naturalization have done so intentionally. This is not
necessarily the case for citizenship acquired through birthright. Consider the two ways U.S.
citizenship is acquired as a birthright: first, by having been born on U.S. soil (jus soli), or second,
by descent (jus sanguinis).
i.
Acquisition of U.S. citizenship by birth in the U.S.
The Fourteenth Amendment to the Constitution, adopted in 1868, cemented the automatic
conferral of U.S. citizenship to all those born in the United States.16
ii.
Acquisition of U.S. citizenship by birth abroad to U.S. citizen parents
Put very generally, under current law the requirements to obtain U.S. citizenship through
birth abroad are:
1. At least one parent must have been a U.S. citizen when the child was born; and
13
IRC §7701(b)(3)(A).
IRC §7701(b)(3)(B).
15
IRC §7701(a)(30).
16
U.S. Const. amend. XIV, § 1, clause 1.
14
S. CHARI & M. REED, Page 6 2. The U.S. citizen parent must have resided or been physically present in the U.S.
to satisfy the requirements of the law in effect at the time the child was born.
Many Canadians may be U.S. citizens by reason of their birth in Canada to parents who
were U.S. citizens. 17
It remains an open question whether a child born abroad to a U.S. citizen parent acquires
citizenship automatically. However, there is a very strong argument that the conferral of
citizenship is not automatic, but rather that the child or his/her parents must make a deliberate
application.
The Immigration and Nationality Act’s provisions on “children born and residing outside
the United States; conditions for acquiring certificate of citizenship,” falls under the heading of
“nationality through naturalization”―not “nationality at birth.” It reads:
b) Attainment of citizenship status; receipt of certificate
Upon approval of the application (which may be filed from abroad) and, except as
provided in the last sentence of section 1448 (a) of this title, upon taking and subscribing
before an officer of the Service within the United States to the oath of allegiance
required by this chapter of an applicant for naturalization, the child shall become a
citizen of the United States and shall be furnished by the Attorney General with a
certificate of citizenship.” [Emphasis added.] 18
Put simply, in order to become a citizen, a child must take the oath of allegiance. A CRS report
for Congress―one of the encyclopedic, public domain research reports written to clearly define
issues in a legislative context― confirms this interpretation. 19 A foreign-born child of US citizen
parents must not only submit an Application for Certificate of Citizenship (Form N-600) for
irrefutable proof of citizenship, but must also take the Oath of Allegiance. Only after these steps
will the USCIS issue proof of citizenship in the form of a Certificate of Citizenship.
The idea that a child does not automatically acquire U.S. citizenship at birth was recently
addressed by the United States Tax Court in a matter dealing with child dependence and
eligibility for tax deductions/credits. The Court found:
17
8 U.S.C. § 1401, paragraphs (c), (d), (g), and (h).
8 U.S.C. § 1433.
19
U.S. Congressional Research service. Basic Questions on U.S. Citizenship and Naturalization (92-246; March 3,
1992), by Larry M. Eig at section 3.
18
S. CHARI & M. REED, Page 7 “As is apparent from the statute, citizenship acquired pursuant to 8 U.S.C.
sec. 1433 is not acquired automatically, but pursuant to application. [...] An
application for citizenship made under 8 U.S.C. sec. 1433 must be approved by
the Attorney General, and the applicant must appear in the United States and,
unless the requirement is waived (e.g. because of the age of the child), take an
oath of allegiance before the certificate of citizenship may be conferred.”20
[Emphasis added.]
The Court continues to state that, while other courts “may have recognized the conferral of a
certificate of citizenship [to be] ministerial rather than discretionary,” the oath is “mandated by
Congress, which, except in cases governed by treaty, has the sole authority to govern the process
by which those born abroad may become naturalized citizens.”21
In short, there is a strong position that those who were not registered as U.S. citizens at
birth are not automatically U.S. citizens. Consequently, they ought not have U.S. tax obligations
unless they have formally applied for U.S. citizenship.
3.
Overview of the tax complexities faced by U.S. citizens in Canada
Consider the two aspects to the tax problems caused by U.S. citizenship: the annual
procedural requirements, and the substantive problems.
a.
Procedural – annual filing requirements
U.S. citizens in Canada are generally subject only to U.S. federal taxation, not state taxes.
This is a result of states taxing based on residency while the federal tax system relies on
citizenship as well as residency. They are of course subject to Canadian taxation (federal plus
provincial) by virtue of their Canadian residency. This amount is generally higher than the U.S.
federal tax rate. They are, however, saved in large part from double taxation and afforded a
credit for the Canadian taxes paid. This generally offsets the U.S. tax such that most U.S. citizens
in Canada will owe minimal U.S. tax, if any.
They must, however, annually submit U.S. tax filings in order to be compliant. This
reporting can be complicated, time-consuming and expensive. While no tax monies may be due,
20
21
Carlebach v. Commissioner, filed July 19, 2012 at p. 9.
See Wong Kim Ark, 169 U.S. at 702-703.
S. CHARI & M. REED, Page 8 there are possible penalties for noncompliance if the appropriate filings are not completed on
time.
i.
Disclosure forms
Disclosure forms―though the following is in no way an exhaustive listing―are required
for transfers to or distributions from a foreign trust,22 foreign corporation23 and foreign
partnership.24 Heavy penalties apply if filings of disclosure forms are not timely or are found to
be incomplete. One example illustrates the severity of these penalties with respect to foreign trust
disclosure on Form 3520. The initial penalty, subject to a minimum of $10,000, is the greater of
35% of the gross value of any property transferred to/distributions from a foreign trust, or 5% of
the gross value of the portion of the trust’s assets treated as owned by a U.S. person. The
penalties may be waived if the taxpayer can demonstrate that the non-compliance is due to
reasonable cause.
ii.
Foreign Bank and Financial Account Reports
Over and above tax filings, U.S. Persons25 are also required to disclose information
(records and reports) on foreign financial agency transactions.26 Where a U.S. person has a
financial interest in, or signature authority over, foreign financial accounts with an aggregate
value exceeding $10,000 at any time during the calendar year, U.S. persons must file a Foreign
Bank and Financial Account Report (“FBAR”) that reports all such accounts.27
For each account not reported on an FBAR form, the initial penalty is $10,000. The fine
will increase to the greater of $100,000 or half the value of the delinquent account, should the
reporting violation be found to be willful.28 The penalty can be avoided if reasonable cause for
the non-compliance can be demonstrated and if missing account information is reported.29
22
IRC §6034A.
IRC §6038.
24
IRC §6038.
25
31 CFR § 1010.350(b). As with the Code, the FBAR regulations defines “U.S. person” broadly.
26
31 U.S.C. § 5314. In 1970, Congress passed the “The Currency and Foreign Transactions Reporting Act”,
commonly referred to as the Bank Secrecy Act) and directing that the Treasury secretary to obtain this disclosure.
27
31 CFR § 1010.350, the corresponding regulation to the Bank Secrecy Act.
28
31 U.S.C. § 5321(a)(5)(C).
29
31 U.S.C. § 5321(a)(5)(B)(ii).
23
S. CHARI & M. REED, Page 9 b.
Substantive problems – tax planning opportunities are limited
The Code’s international tax provisions will complicate, and most likely frustrate, even
the most basic Canadian tax planning. Consider the very common example of a Canadian estate
freeze.
i.
Canadian estate-freeze
An estate-freeze is a common estate-planning and business-succession technique in
Canada. It enables the transfer of ownership of a privately held company, while deferring the
taxation of future capital gains to the next generation of owners. An estate freeze involves the
transfer of property that has appreciated in value and there is an inherent risk that capital gains
could be subject to tax. This is why the freeze must be carefully structured to comply with
Canadian taxation rules, to ensure tax consequences are deferred. Put very simply, for the estate
freeze to be a tax-deferred transaction, one Canadian requirement is that the preferred shares
must be redeemable.
For U.S. tax purposes, however, receipt of preferred shares that are retractable or
redeemable in exchange for property contributed to a corporation often means that the
transaction is no longer tax-free and capital gain income is realized as a consequence of the
transfer.30 The result is directly contrary to the goal: what was intended as a tax-free transaction
in Canada unintentionally becomes a taxable transaction in the United States. Additionally, since
the tax will be realized in Canada only in the future, there is a timing mismatch in the trigger of
the tax that creates the possibility of the same amount being taxed twice. The tax due on the
capital gain cannot then be offset between the countries as it may occur in different tax years.
There may also be gift tax issues with the estate freeze.
4.
FATCA exacerbates the situation facing U.S. citizens in Canada
As noted above, the tax obligations for U.S. citizens residing abroad have existed for a
long-time. The advent of the Foreign Account Tax Compliance Act (“FATCA”) has made these
obligations harder for U.S. citizens to ignore. FATCA was recently implemented in Canada
30
Code § 351(g).
S. CHARI & M. REED, Page 10 through the Canada-USA Intergovernmental Agreement (“IGA”), enacted as part of the 2014
Canadian federal budget.
Any entity that does not comply with FATCA is subject to a 30%-withholding tax on all
U.S.-source payments it receives.31 This gives foreign entities a significant incentive to comply
with FATCA. Most Canadian financial institutions are required to perform due diligence to find
accounts held by U.S. persons at their institutions and report that information to the CRA. The
IGA stipulates that CRA will then pass it on to the IRS. The information required for this due
diligence by an FFI includes a search for any U.S. indicia.32
It is unclear what the IRS will do with the FATCA-triggered information it receives from
thousands of financial institutions all over the world. Theoretically, the IRS could easily crossreference the detailed information it receives through FATCA against the list of people who file
U.S. taxes to send out letters, notifications, and eventually penalties to those who are not filing as
disclosed by the entities. While postage is cheap, flying an IRS agent to Canada to conduct an
examination certainly is not. It is hard to know how an IRS that is chronically hamstrung by a
lack of funding will use this information. What is clear, though, is that the enactment of FATCA
has made it much harder from a legal perspective for U.S. persons in Canada to ignore their U.S.
tax and reporting obligations, because there are tangible penalties and an increased likelihood of
being “found out.” With the advent of FATCA, U.S. citizens need now more than ever to focus
on solutions to the problems. That’s where we turn to next.
5.
Solution # 1 – Do nothing, rely on the firewall
The first possible solution for U.S. citizens in Canada is to hunker down and do nothing.
Thankfully, U.S. citizens in Canada have some legal protections in the form of a sort of legal
firewall that effectively prevents the collection of U.S. tax against assets located in Canada. The
firewall has two equally important components.
31
IRC §1471(a) and §1472(a)(2).
Treas. Reg. §1.1471-4 specifies U.S. indicia to include any sign or indication of a United States place of birth of
an account holder or beneficial owner of an account, a United States address, a United States phone number, a grant
of power of attorney to an individual with a U.S. address, or standing orders to transfer funds to the United States.
32
S. CHARI & M. REED, Page 11 First, the Canada Revenue Agency will not help the IRS collect a U.S. tax debt as long as
the taxpayer was a Canadian citizen at the time the tax debt arose. The Canada-U.S. Tax Treaty
(“the Treaty”) sets out the conditions under which the Canada Revenue Agency (“CRA”) may
assist the IRS in collecting tax from a Canadian citizen. The Treaty being part of Canadian
domestic law, the CRA is bound by it.33 Article XXVIA(1) of the Treaty defines a “revenue
claim” as one in which one state assists the other state to collect taxes, interest and civil
penalties. Article XXVIA(8) states that neither state shall provide assistance to the other in
collecting back taxes owed if the taxpayer can demonstrate that, during the period when the tax
became due, the taxpayer was a citizen of the state whose assistance is requested. Discussing this
article of the Treaty, the Federal Court of Canada wrote in Chua v. M.N.R., “[t]he effect of this
paragraph is to exempt Canadian citizens from the IRS using Revenue Canada to pursue
collection in Canada of U.S. debts, provided they were Canadian citizens in the taxable period
concerned.”34 Thus, the CRA is prohibited under the Treaty (which is also Canadian domestic
law) from assisting the IRS in collecting alleged U.S. tax debt from a citizen of Canada. It is
important to note that the CRA can in fact assist the IRS in collecting the tax owed if the
taxpayer was not a Canadian citizen at the time that the tax debt arose. As such, this firewall only
works for those who were dual citizens (or Canadian citizen/U.S. resident) at the time of tax
owing.
Second, Canadian courts will not enforce U.S. judgments for tax owed against assets in
Canada. In short, an individual may owe tax to the U.S. as a legal matter, but the U.S. will be
unable to collect. Where the CRA is both unwilling and unable (i.e. when the taxpayer is also a
Canadian citizen) to help the IRS collect alleged tax debt, the IRS will have to act unilaterally.
The IRS might be able to procure a judgment from a U.S. court reflecting such alleged tax
liability. As a matter of Canadian law, however, it will not be able to enforce this judgment
against that person's assets in Canada. In United States v. Harden the Supreme Court of Canada
held that a judgment from a U.S. court regarding the collection of U.S. tax owed is not
enforceable in Canada.35 Harden remains the law of Canada. In 2014 the Ontario Court of
33
Canada–United States Tax Convention Act, 1984 S.C. 1984, c. 20.
Chua v. M.N.R., [2001] 1 FCR 608, 2000 CanLII 16087 (FC) at para 18.
35
[1963] 41 D.L.R. 2d 721.
34
S. CHARI & M. REED, Page 12 Appeal held in Prince v. ACE Aviation Holdings Inc. that Harden was still applicable in
Canada.36
Where the person concerned has no assets in the United States or anywhere outside of
Canada, the IRS is stuck between a rock and a hard place. As a practical matter, the IRS can only
collect the alleged liability against assets owned in Canada. As a matter of Canadian law, this is
impossible.
A couple of caveats are in order. Laws can and do change. Simply relying on the firewall
might not provide totally risk-free protection for a U.S. citizen resident north of the 49th. Further,
intentional refusal to pay a U.S. tax debt is a criminal offense in the United States. It is possible,
although perhaps unlikely, that the U.S. government would eventually pursue criminal charges
thereby rendering travel to the U.S. tricky for a delinquent taxpayer. In certain situations, the
more prudent approach for U.S. Person might be to catch up on his U.S. taxes using the
Streamlined Procedure (discussed below) before the IRS finds him through FATCA, even if only
as a prelude to ultimately renouncing U.S. citizenship.
6.
Solution # 2 – Catch up and continue to comply
There is nothing preventing a U.S. citizen from simply getting caught up and complying
with his/her tax obligations. Compliance is a 100% effective vaccine against future U.S. tax
problems (as well as associated immigration issues). To help U.S. citizens abroad get caught up
on overdue tax returns, the IRS has a number of voluntary disclosure programs. They are:
1. The Offshore Voluntary Disclosure Program (OVDP) for U.S. taxpayers whose
non-compliance has been willful;
2. The Streamlined Foreign Offshore Procedures (“Streamlined Procedure”) for U.S.
taxpayers whose non-compliance has not been willful; as well as
3. Procedures for reporting delinquent information returns such as the FBAR.
The most current overhaul of the voluntary disclosure programs is from mid 2014.
36
Prince v. ACE Aviation Holdings Inc., 2014 ONCA 285 at para 54.
S. CHARI & M. REED, Page 13 A full discussion of the pros and cons of each option is beyond the scope of this paper.
However, the Streamlined Procedure should be reviewed briefly. The Streamlined Procedure is
available to U.S. persons residing in and outside of the United States. To qualify for the program,
a taxpayer must submit the three most recent years of income tax and information returns and
submitting six years of FBARs, along with remittance of payment for any tax and interest owed.
To be eligible for the Streamlined Procedure, the taxpayer must certify that the failure to
file tax returns and foreign financial disclosures as well as to pay taxes in respect of these is not
due to willful conduct. Taxpayers under examination, whether civilly or criminally, by the IRS
are ineligible. U.S. Persons outside the United States must not have a U.S. domicile and must be
physically outside the U.S. for at least 330 full days in any one or more of the most recent three
years for which the U.S. tax return due date has passed.37
An upside of the Streamlined Procedure is that the successful taxpayer will not be subject
to “failure-to-file and failure-to-pay penalties, accuracy-related penalties, information return
penalties, or FBAR penalties,” unless subsequent to an audit and examination the original
noncompliance is found to be fraudulent or the FBAR violation is found to be willful.38
Secondly, the taxpayer can obtain retroactive relief for failure to timely elect income deferral on
certain retirement and savings plans (such as RRSPs) where deferral is permitted under the
applicable treaty, so long as the request accompanies the filing submissions.
Subsequent to catching up and becoming compliant under the Streamlined Procedure, the
taxpayer is expected to regularly file and remain compliant with tax filing and information
reporting obligations. While the ongoing duty is burdensome, the U.S. citizen is able to enjoy
U.S. citizenship without worry.
7.
Solution #3 – Renouncing U.S. citizenship
A permanent solution to the tax problems caused by U.S. citizenship is to simply give up
that citizenship altogether. A deeply personal decision, renunciation is easier said than done as it
37
38
http://www.irs.gov/Individuals/International-Taxpayers/U-S-Taxpayers-Residing-Outside-the-United-States.
Supra, fn 49.
S. CHARI & M. REED, Page 14 a complicated process that requires careful consideration of all the consequences, both
advantages and disadvantages. Put generally, the advantages are as follows:
● Form free living. The compliance burdens are eliminated.
● Tax planning options restored. The tax planning limitations imposed by the Internal
Revenue Code are removed.
● Ideological satisfaction. Some taxpayers gain significant ideological satisfaction from
renouncing their U.S. citizenship, especially in cases where the individual has never
actually resided in the U.S.
Against these benefits the taxpayer must weigh the potential drawbacks:
● No longer a U.S. citizen. The loss of U.S. citizenship means that an individual can no
longer realize the benefits of U.S. citizenship. These are, among many others, voting in
U.S. elections, permanently moving to the U.S. without issue, accessing U.S. consular
services abroad, and having a U.S. passport. Further, a person who has renounced can
never become a U.S. citizen again.
● Potential tax obligations. If a U.S. citizen is a “covered expatriate” upon renunciation, he
or she may be subject to a punitive tax regime including an exit tax. These consequences
are discussed further below.
● Potential border hazards. A 1996 law, known as the Reed Amendment, gives the U.S.
government the power to bar those determined to have renounced for tax purposes from
entry to the United States. Of course, if a taxpayer is renouncing for reasons other than
tax purposes, such as the ideological reasons mentioned above, this should not be an
issue. Additionally, while this law has been on the books since 1996, there are no
documented invocations of the law nor are there any regulations on how exactly to
enforce it.
Prior to analyzing these drawbacks in more detail, it is worthwhile to review the procedure for
renouncing U.S. citizenship.
a.
General requirements of renouncing U.S. citizenship
The renunciation process has two facets: immigration law and tax law. Put generally,
immigration law controls who is a U.S. citizen. Tax consequences generally flow from that.
S. CHARI & M. REED, Page 15 Thus, it makes sense to first address the immigration process necessary to renounce U.S.
citizenship.
b.
The immigration process to renounce
The most common way to renounce U.S. citizenship is to make a formal renunciation of
nationality before a diplomatic or consular officer of the U.S. in a foreign state.39 An irrevocable
action, it cannot be carried out within the United States.
An individual who seeks to renounce their U.S. nationality must submit, among other
things, the following:
1. Form DS-4079, Questionnaire: Information for Determining Possible Loss of U.S.
Citizenship;
2. A “Statement of Understanding Concerning the Consequences and Ramifications
of Relinquishment or Renunciation of U. S. Citizenship”; and
3. A copy of the individual's U.S. and foreign-country passports.
It is upon these documents that the Department of State will base its decision regarding the
renunciation.
If all the forms and required documents are prepared properly, the loss of nationality can
be processed in one interview. However, two appointments are generally needed. In addition,
there is a current administrative fee of $2,350 USD for processing of the renunciation. The
immigration process is not the end of the journey, however. A soon to be former U.S. citizen
must still settle up with the IRS.
c.
Potential tax obligations arising from renouncing
U.S. law specifically addressed the tax treatment of former U.S. citizens in 1966,40 by
targeting cases where the principal purpose of expatriation was the avoidance of U.S. taxes.
Despite a number of revisions, these attempts to restrict expatriation were unsuccessful, due to
difficulties in proving a tax-avoidance motivation. Consequently, the intent requirement was
dropped and solely objective tests were put in place in the new regime in 2008. The new rules
bring three major potentially adverse impacts for persons seeking expatriation:
39
40
8 U.S.C. § 1481(a)(5)
From whence Internal Revenue Code section 877.
S. CHARI & M. REED, Page 16 1. An exit tax;
2. Increased withholding on certain U.S.-based income sources; and
3. An excise tax on future gifts and bequests to U.S. persons.
The general principle is that to renounce, an individual needs to be caught up on their tax
filings and payments prior to foregoing U.S. citizenship. While President Obama’s budget for
2015 proposed some tempering of the taxation and requirements on individuals with dual
citizenship at birth (not all U.S. citizens abroad), it has not yet been adopted at the time of
writing.
i.
“Covered Expatriate” status
The adverse taxation consequences of expatriation apply only to a “covered expatriate”
(“CE”), a person who meets one of the following criteria:
● A net worth exceeding USD $ 2 million on the date of expatriation;41,42
● Average annual U.S. income tax for the five years preceding the year of
expatriation exceeding USD $ 155,000 (indexed to inflation);43
● Failure to certify full compliance with U.S. tax obligations for each of the five
years preceding expatriation, comprising all tax and information returns and
payment of all tax amounts on account of income, employment, estate, gifts,
interest and penalties.44
For CEs, the exit tax is owed is on a mark-to-market disposition of all assets, i.e. the
difference between the cost basis of all assets owned and their current fair market value. The first
USD $ 660,000 are exempt and to be allocated pro rata among all the assets to which the exit tax
applies.
41
IRC §877(a)(2)(B).
The computation of this net worth is complicated. For greater detail, the reader is directed to “Nightingale, Kevyn
and Turchen, David, The American's Tax Experience in Canada. Canadian Tax Journal/Revue Fiscale Canadienne,
Vol. 61, No. 1, 2013” who have done a superb job of setting out the mechanics for calculating the exit tax and the
net worth calculations.
43
IRC §877(a)(2)(A).
44
IRC §877(a)(2)(C).
42
S. CHARI & M. REED, Page 17 ii.
Exceptions to the CE status
There are two exceptions by which an individual will not be treated as a CE, despite
meeting one or more of the criteria noted above.
Firstly, individuals who currently have and have maintained dual citizenship since birth
are exempt from the exit tax regime if they were a resident of the U.S. for no more than 10 years
of the fifteen tax years ending with the tax year during which the renunciation of citizenship
occurred.45 Further, the individual must reside in the country of their second citizenship and pay
taxes to that country.
This is a very powerful exception for many U.S. citizens in Canada who may not know
that they were actually Canadian citizens at birth. The government of Canada has recently
enacted retroactive grants of Canadian citizenship to birth that may expand the number of
Canadians who are considered dual citizens at birth.
Secondly, for individuals who relinquish citizenship prior to attaining the age of 18.5 and
have been residents of the U.S. for not more than 10-taxable years before the date of
relinquishment.46
For individuals falling under an exception, they must still certify on Form 8854, under
penalties of perjury, that they have been U.S. tax compliant for the past five years in order to lose
U.S. citizenship on a “tax free” basis.
Since there is more than one exception to the CE-characterization and possible
approaches to renunciation, an analysis should be performed as to the more advantageous path
for an individual who is seeking to renounce citizenship based on their particular facts.
iii.
Mitigating the Exit Tax
Article XIII(7) of the Treaty can mitigate the exit tax burden. Basically, the election
forces Canada to recognize gain on the same assets on the U.S. deemed disposition. Canada will
impose tax, but it can be offset by foreign tax credits resulting from U.S. tax paid on
45
46
IRC §877A(g)(1)(B)(i)(I).
IRC §877A(g)(1)(B)(i)(II).
S. CHARI & M. REED, Page 18 expatriation. Essentially, the cost basis for Canadian tax purposes will increase for “free,” not
considering the fact that the Canadian tax rates are generally higher than American ones.
iv.
Covered gifts and bequests
In general, a U.S. citizen or resident who is recipient of a gift or bequest from a CE pays
the associated tax,47 at the highest marginal gift and estate tax rate.48
d.
Potential immigration consequences of renouncing
Those who renounce citizenship can actually be barred from entering the United States.
The Reed Amendment, enacted in 1996, sought to impose an entry ban on some of those who
have renounced their U.S. citizenship. It states:
“Any alien who is a former citizen of the United States who officially renounces United
States citizenship and who is determined by the Attorney General to have renounced
United States Citizenship for the purpose of avoiding taxation by the United States is
inadmissible.”49 [Emphasis added]
According to a review by the Joint Committee on Taxation, as of 2003 this provision had
not been applied to any former citizen. There is no more recent evidence available. Anecdotal
evidence suggests that the trend of non-application continues and that few, if any, citizens who
have renounced are denied entry. Importantly, the Reed amendment delegates to the U.S.
Attorney General the power to determine who is inadmissible. In order for the Attorney General
to exercise this power, she has to make a formal “finding.” It is unclear how this would occur as
the U.S. government has yet to issue accompanying regulations to implement the Reed
Amendment. Further, the Attorney General is not authorized to obtain information from the IRS
in order to confirm a former citizen’s motivation for renouncing citizenship.50 Note that this
means that a U.S. CIS agent (a border guard) cannot legally make this determination alone.
That said, there is some practical risk at the border. A Canadian passport will identify a
U.S birthplace – a sure sign of U.S. citizenship. A border agent might then inquire where the
former U.S. citizen’s passport is. Of course, the former citizen would not have a U.S. passport.
The border agent may then query why the former citizen renounced. In this case, the tax irritants
47
IRC §801.
IRC §2001(c).
49
8 U.S.C. § 1182(a)(10)(E).
50
IRC §6103.
48
S. CHARI & M. REED, Page 19 caused by U.S. citizenship should not be mentioned. After all, the U.S. CIS agent has the power
to prevent entry to the U.S. and subsequent legal recourse, even if successful, will be slow and
expensive.
Although the current border risk is very low, it may change in the future. The U.S. has
put a renewed focus on international tax collection. Several recent legislative initiatives have
been put forward, but ultimately failed, to strengthen the existing laws and retroactively examine
the intention of all those who have expatriated. A U.S. citizen wishing to expatriate should
exercise caution while renouncing to not leave any evidence that tax irritants were a factor in the
renunciation.
8.
Solution #4 – Relinquish U.S. citizenship
The fourth solution to the tax problems caused by U.S. citizenship is for an individual to
take the position that he or she relinquished his or her U.S. citizenship many years ago without
any formal process. Here is a very common scenario. Janet was born in the United States and
came to Canada in the late 1960s as a result of ideological opposition to the Vietnam War. She
became a Canadian citizen shortly thereafter. Her understanding of U.S. immigration law at the
time was that the act of becoming a Canadian citizen terminated her U.S. citizenship
automatically, because she intended to do so. She’s never had a U.S. passport since or taken any
other advantage of her U.S. citizenship. Years later, Janet is very financially successful.
Solutions 2 and 3 above would be very costly from a tax perspective. Solution 1 would be risky.
But Janet has a good case that her U.S. citizenship, and the attendant U.S. tax obligations,
terminated when she became a Canadian citizen. Janet relinquished her U.S. citizenship and may
be able to get a Certificate of Loss of Nationality from the State Department proving this. The
tax implications of doing so are murky, but this is a viable option. Below, we explore how U.S.
citizenship is lost for immigration purposes and how this might be different for tax purposes.
S. CHARI & M. REED, Page 20 a.
How U.S. citizenship is lost for immigration purposes
The Immigration and Nationality Act (“INA”) sets out various ways by which a U.S.
Person can lose his or her U.S. citizenship. These are known as “expatriating acts”. Under the
current law, they are as follows51:
● Naturalization in a foreign state, after the age of 18;52
● Swearing or affirmation of allegiance to a foreign state, after the age of 18;53
● Entering or serving in the armed forces of a foreign state that is either engaged in
hostilities against the U.S. or serving as an officer;54 or
● Working for and under the government of a foreign state or a political subdivision
thereof, after the age of 18 if nationality of that state has been acquired or when a
declaration of allegiance to that state is made.55
Note that under the current version of the INA requires these acts to be done with the
intent to lose U.S. citizenship.56 There is a rebuttable presumption that the required intent was
not present. The person who desires to lose her U.S. citizenship must prove “based on a
preponderance of the evidence” that she had the requisite intent to lose her U.S. citizenship as
she performed one of the expatriating acts mentioned above.57
Before The American Jobs Creation Act of 2004 (“the Jobs Act”), there was no
requirement of formal notice to the IRS or any other U.S. government agency of the occurrence
of an expatriating acts which, it itself, was sufficient for relinquishing citizenship for both
immigration and tax purposes.
i.
The cleaving of citizenship for immigration and tax purposes
Under the “Jobs Act” the loss of citizenship for tax purposes was, for the first time,
divorced from the loss of citizenship for immigration purposes. A U.S. citizen who had
renounced his/her citizenship could nevertheless continue to have U.S. federal tax obligations.
51
Loss of U.S. nationality can also arise due to an individual committing an act of treason against the United States,
pursuant to 8 U.S.C 1481(a)(7).
52
8 U.S.C. § 1481(a)(1).
53
8 U.S.C. § 1481(a)(2).
54
8 U.S.C. § 1481(a)(4)(A).
55
8 U.S.C. § 1481(a)(4)(B).
56
8 U.S.C. § 1481(b).
57
8 U.S.C. § 1481(b).
S. CHARI & M. REED, Page 21 Drafted to snag individuals who expatriated for tax avoidance purposes and to force compliance
with reporting to the IRS, section 7701(n) of the Jobs Act58 mandated that an individual who
otherwise lost his or her U.S. citizenship would continue to be a citizen for federal tax purposes
until the Secretary of State was formally notified of the expatriating act and the IRS was
provided with an expatriating tax statement (Form 8854, as discussed in the section on the
requirements for renunciation). The Jobs Act was applicable to those “who expatriate after June
3, 2004.”59 In short, if an individual lost her U.S. citizenship prior to 2004, she did not have to
provide notice to the IRS. If it was after 2004, she was obligated to provide the IRS with notice.
Recent legislative developments made things much more complicated. The 2008 Heroes
Earnings Assistance and Relief Act (“HEART Act”) not only maintains a distinction between
expatriation for immigration and tax purposes, but imposes a requirement of a “certification of
loss of nationality” (“CLN”). Code section 877A(g)(4) provides that loss of citizenship for U.S.
federal income tax purposes will occur on the earlier of:
● “The date the individual furnishes to the United States Department of
State a signed statement of voluntary relinquishment of United States
nationality confirming the performance of an act of expatriation [...];60
Or
● “The date the United States Department of State issues to the individual
a certificate of loss of nationality”.61
The plain meaning of these provisions (which is the ordinary way to interpret U.S.
statutes) is that under current law U.S. citizenship for federal tax purposes continues
regardless of any expatriating act performed decades ago until a CLN is obtained. Worse,
the date of expatriation would have occurred after the enactment of the exit tax. Recall the
example of Janet offered above who had lost her U.S. citizenship in the 1960s as a result of
becoming a Canadian citizen. If in 2015 she went to the State department to get a CLN that
recognized her loss of citizenship in 1967, under the plain meaning of 877A(g) she would
58
IRC §7701(n), though now repealed and replaced by IRC §877A.
Section 804(f) of the American Jobs Creation Act of 2004.
60
IRC §877A(g)(4)(B).
61
IRC §877A(g)(4)(C).
59
S. CHARI & M. REED, Page 22 have remained subject to US federal income tax for the intervening years despite the fact
that the Department of State had not recognized her loss of US citizenship. She would also
be caught by the exit tax and be deemed a covered expatriate. This is an absurd outcome,
and courts generally avoid absurd outcomes in interpreting statutes.
ii.
Is there a need to “prove” relinquishment?
So what should Janet do? The risk is that she will be picked up under FATCA and have
her information reported to the IRS. Under FATCA and the IGA, an individual with an
unambiguously American place of birth is presumed to have U.S. citizenship, so any such
individual’s financial account is reportable.62 Moreover, the IGA defines U.S. person as a U.S.
citizen in keeping with the Internal Revenue Code.63 So, a financial institution may make a
default determination of an account holder’s citizenship and report it to the CRA (which will
then inform the IRS) such that a former U.S. citizen gets flagged by the IRS. While this
presumption of citizenship can be rebutted, the two means for rebuttal are presentation of a CLN
or a reasonable explanation for the lack of a CLN.64 This puts Janet between a rock and a hard
place. She can either take a risk and get a CLN or do nothing and subject herself to FATCA
reporting. Being reported to the IRS under FATCA might trigger IRS enforcement. Of course,
Janet could always reply to the IRS that she was not a U.S. citizen. Fighting the IRS would be
expensive and stressful for Janet – even if the IRS could never actually collect any US tax from
her Canadian assets and even if Janet in fact owes nothing to the IRS.
To exempt herself from FATCA reporting, Janet could get a CLN to prove to her
financial institutions that she is no longer a US citizen. But then Janet might walk into the legal
ambiguity discussed above that the exit tax may apply since the CLN would be issued after the
imposition of the exit tax.
The third alternative (providing a reasonable explanation for the lack of a CLN) is
nebulous: no guidance or parameters have yet been issued by the IRS, the CRA, or any
62
Agreement Between the Government of the United States of America and the Government of Canada to Improve
International Tax Compliance through Enhanced Exchange of Information under the Convention Between the
United States of America and Canada with Respect to Taxes on Income and on Capital, Feb. 4, 2014, annex
(I)(II)(B)(1)(b) [“IGA”].
63
Ibid., article (1)(1)(ee).
64
Ibid., annex I (II)(B)(4)(a); CRA, Guidance on Enhanced Financial Account Information Reporting - Part XVIII
of the Income Tax Act (June 20, 2014), 8.27.
S. CHARI & M. REED, Page 23 governmental body as to what constitutes a “reasonable explanation” in this context. Left in
limbo, Canadian financial institutions can do no more than formulate and follow their own policy
on how to interpret an account holder’s necessarily half-baked explanation to determine her
citizenship.
Recently, the taxation section of the American Bar Association has called upon the IRS
to issue guidance on the tax status of those who relinquished citizenship per the INA on or before
3 June 2004, or per the now repealed section 7701(n) provisions after 3 June 2004 but prior to 17
June 2008. Providing a compelling, careful reasoning through the knot of enactments, the request
for guidance argues persuasively that the only logical and sound analysis is for these individuals
to be treated as non-U.S. citizens for taxation purposes irrespective of the 2008 Act.65 That they
are, in fact, non-citizens of the United States as of the date of their expatriating acts for federal
tax purposes, free from of the impositions arising from the 2004 and 2008 legislative changes.
The ABA’s submission illustrates the absurdity facing Janet and provides solid legal arguments
to the contrary. However, until the IRS takes a formal position on the issue, the risk of
relinquishment and confirming it through a CLN, albeit perhaps low, remains.
9.
Conclusion – Solving the problem of U.S. Citizenship
The development of FATCA and its recent implementation through the IGA have stirred
concern that the IRS may likely identify U.S. citizens and those with potential U.S. nationality
and subsequently burden them with onerous, annual U.S. tax and reporting obligations. Although
previously subject to these requirements, non-resident citizens have so far largely passed
unnoticed under the IRS’ radar, usually unknowingly and unintentionally. In addition, being
subject to both U.S. and Canada taxation systems complicates even the most rudimentary of tax
planning.
Four possible solutions to address the new reality of the burdens of U.S. citizenship are:
65
Section of Taxation, American Bar Association, Letter to the Commissioner of the IRS regarding “Request for
Guidance on the Tax Status of Certain Expatriates”. Dated 2 March 2015.
S. CHARI & M. REED, Page 24 1. Do nothing and continue as before, relying on the fact that the IRS has difficulty
collecting in Canada the taxes owed to it. This is the most attractive option in
cases where an individual has no assets based or sourced in the U.S., and where
the individual has no intention of returning to the U.S. This approach is, however,
fraught with the most danger, as the legal landscape could change such that the
IRS pursues criminal charges or the individual encounters greater difficulties
crossing the U.S. border.
2. Catch up and continue to comply is a more prudent approach. The IRS has created
a program requiring only three-years’ and six-years’ worth of tax and reporting
obligations, respectively. While becoming compliant carries a present-day cost,
this is fixed and can be estimated. It shields the individual against border-crossing
troubles, but it does not remove the tax complications posed by US citizenship.
3. Renounced citizenship frees individuals from future tax and reporting obligations
after they have become compliant and enables them to actively engage in
effective tax planning. Individuals renouncing may be subject to an exit tax. With
the loss of citizenship comes loss of the right to vote and loss of automatic entry
into the U.S. In particular, if renouncing is motivated by tax purposes, former
citizens may conceivably be barred entry into the U.S. in the future.
4. Relinquished citizenship may be a possibility for individuals who naturalized
elsewhere or performed an expatriating act prior to 2008. Individuals who
relinquished nationality long ago, when citizenship for taxation and immigration
purposes were still one and the same, ceased having tax and reporting obligations
and effectively sidestepped compliance issues. On the upside, they should be free
to tax plan effectively. However, these individuals may, because of default
presumptions in FATCA and discrepancies in drafting legislations, be wrongly
netted by the IRS and considered as subject to tax and reporting obligations. The
IRS has been called upon to issue guidance on how these individuals will actually
be treated; however, when this pronouncement will be made and what it will be
are as yet unknown.
S. CHARI & M. REED, Page 25 In deciding which solution to implement, individuals have a lot to consider: long-term
financial risk and uncertainty, mobility preferences and needs, and the cost of accounting
and compliance. What is clear is that non-resident U.S. citizens should carefully weigh
their options and seek proper counseling to ensure that the solution chosen is the most
effective and appropriate for the given person’s particular situation.
S. CHARI & M. REED, Page 26