Investopedia defines an expatriation tax, as a tax on someone who renounces their citizenship. Also called an emigration tax or exit tax, this often takes the form of a capital gains tax wherein the computation of capital gains is applied to your entire estate assets on the date of your departure. Although it may seem unfair to most people, this tax was created to discourage tax evasion by residents for renouncing their citizenship for taxation grounds not a true desire to expatriate.
Few countries at present impose a “departure” or “exit” tax on their residents. Some of these countries are Canada, Germany, Netherlands, South Africa, Spain and the United States. Among the six, only the United States taxes its residents on worldwide income regardless if they are US citizens or not. Hence, this article will focus on the expatriation tax provisions of the United States.
The two most significant sections in the US Internal Revenue Code are the 1996 Section 877 and the 2008 Section 877A. Section 877 was the very first law to authorize taxation of former citizens. It taxes US-sourced income of former citizens for up to ten years from their expatriation. Section 877 applies to US citizens who expatriated between June 3, 2004 and June 17, 2008. Taxes are computed based on their gross US-sourced income and net gains. A US Nonresident Alien Income Tax Return Form (Form 1040NR) is required to be filed yearly.
On June 17, 2008, the new section called 877A through the HEART Act was passed. It created an entirely new expatriation tax provisions. Below is the summary of provisions for when you decide to stop being a US citizen on June 17, 2008 or on any day thereafter:
Are you a “covered expatriate”.
Covered expatriates are those individuals having $2 million net worth or an average net income liability of more than $139,000 for five years following the expatriation complying with all the federal tax obligations during the said five years. Natural born dual citizens and minors are not considered to be covered expatriates.
You will be immediately subject to an exit tax.
Similar to the context of estate tax, and exit tax is the amount you pay assuming you just sold all your properties worldwide for its fair market value on the day prior to your departure from the United States. The amount is called net gain which is derived by subtracting the fair market value and owner’s actual purchase price. If you emigrated to the US with assets and trying to claim them as not part of this process will not be considered, therefore all assets will be included in the calculation.
Deferring the exit tax is allowed for as long as the IRS is assured to collect the exit tax in the future. Showing the IRS bonds or any form of collateral/security is a requirement to qualify for this deferral. These bonds have specific requirements and constant monitoring and the IRS approves the requests upon careful scrutinizing so hire an expert.
When you leave, you will still be taxed on your US-sourced income.
Whether you’re a US citizen or not, any form of income you gain from businesses within the US territory will still be taxed. The current financial threshold on Section 877A is $145,000 annual net income tax for 2010. Individuals below this threshold can still be taxed if they fail to comply with US federal tax laws for five years after they expatriation.
Deferred compensation plans, pension plans, stock options are all applicable to the expatriation tax. An expatriate receiving deferred compensation from a US citizen, will be subject to a 30% withholding tax if he waives his right to a lower withholding tax, otherwise he will be taxed based on the present value of the deferred compensation.
There is a chance to avoid expatriation tax.
Atty. Robert Wood in his article on Forbes explained that it is possible for some expatriates to escape exit tax. He stated that there is an exemption amount of $627,000 in the year 2010 which increases for inflation yearly. If you have less than the exemption amount of income from the deemed amount of sale of your assets, you are exempted from the exit tax. However, if your income exceeds this amount, you must allocate the gain pro rata among all appreciated properties.
However, this exclusion amount must be allocated to each item of property with built-in gain on a proportional basis. This involves a complicated process of multiplying the exclusion amount by the ratio of the built-in gain for each asset over the total built-in gain of all gain assets. The exclusion amount allocated to each gain asset may not exceed the amount of that asset’s built-in gain. Moreover, if the total allowable gain of all gain assets is less than the exclusion amount, the exclusion amount that can be allocated to the gain assets will be limited to that amount of gain. For example, in 2010, if the total allowable gain in an expatriate’s assets was $500,000, then that $500,000 would be the limit instead of $627,000. (Atty. Robert Wood)
As you can see the Exit Tax is a complicated process and you should consider getting the right team to make sure that you limit any impact it may have on your assets.
Other countries are considering this approach to limit the amount of citizens that depart their shores. So before you expatriate make sure you know the rules and that you are not subject to a departure tax, the best approach to this would be to slowly move assets offshore before you want to leave.