Expatriation – U.S. Income Tax Filing and Reporting

Under IRC Sec. 6039G, Tax Act 2008, the ensuing IRS Notice 2009-85 (IRS Notice 2009-85) expands the U.S. tax filing and reporting that is due from covered expatriates in years following the year of expatriation.

Prior to the 2008 Tax Act, (“HEART Act”), a covered expatriate was required to file annual information returns on Form 8854 for the 10-year post-expatriation period that he remained subject to tax under the alternative tax regime, whether or not he had any income tax liability.  For every year that a covered expatriate had U.S. source income on which tax due was not fully withheld at the source, a covered expatriate was required to file a Form 1040 NR.

IRS Notice 2009-85, (as authorized by the 2008 Tax Act) imposes annual filing requirements (Form 8854) to certify either that no distributions have been received or to report distributions that have been received by a “covered expatriate” having either:

I.   Deferred Compensation; or

II.  Non-Grantor Trust Interests

Eligible Deferred Compensation Items (i.e. A U.S. payor of qualified retirement plan interests, IRC Sec.219(g)(5) arrangements, interests in a foreign pension, any item of deferred compensation, property interests to be received in connection with the performance of services to the extent not previously taken into account in accordance with the IRC Sec. 83.  Deferred compensation attributable to services performed outside the U.S. while a covered expatriate was not a U.S. citizen or resident is not included.

Tax on the payment of an “eligible deferred compensation item” is deferred until a covered expatriate receives a taxable payment (i.e. a payment that would be taxable if the individual were a U.S. person), at which time tax is collected by means of a 30% withholding tax (however, no withholding tax is due under IRC Sec. 1441, or wage withholding under IRC 3401).  The 30% withholding tax is considered payable under IRC Sec. 871.

An item is considered to be eligible deferred compensation if either:

1. The payor is a U.S. person, or
2. The payor is a foreign person who elects to be treated as a U.S. person for this purpose, provided that the covered expatriate notifies the payor of his status and makes an irrevocable waiver of any right to claim benefit under a U.S. income tax treaty.

In contrast, deferred compensation items that are not eligible deferred compensation or a covered expatriate’s interest in a “specified tax deferred account” (i.e. an individual retirement account and certain education and health savings accounts) is treated as received and taxable on the day before expatriation (and subject to a 30% withholding tax on the “deemed distribution”).  No early distribution tax is assessed, and appropriate adjustments will be made to subsequent distributions to reflect the prior taxation.

IRS Notice 2009-85 Notice confirms that the present value of a covered expatriate’s accrued benefit will be treated as received by the taxpayer on the day before expatriation and must be included on the taxpayer’s tax return for the portion of the year preceding the expatriation date.  IRS Notice 2009-85 discusses appropriate adjustments that may be made to subsequent distributions from an ineligible deferred compensation plan to ensure that amounts included in future distributions will not be taxed a second time.

The IRS Notice 2009-85 confirms that the rules pertaining to deferred compensation items do not apply to any deferred compensation attributable to services performed outside the U.S. while a covered expatriate was not a U.S. citizen or resident, whether before or after expatriation.

The IRS Notice 2009-85 Notice permits a taxpayer to use any reasonable method consistent with existing guidance pertaining to the sourcing and taxation of deferred compensation (Treas. Reg. Sec. 1.86-1-4(b)(2), Rev. Rul. 79-388, 1979-2, C.B. 270, Rev. Proc. 2004-37, 2004-1C.B. 1099.

Interests in Non-Grantor Trusts.  The “taxable portion” of distributions for a covered expatriate, who was a beneficiary but not also an owner of a trust on the day before the expatriation date, are subject to a 30% withholding tax.

IRS Notice 2009-85 clarifies that a trust beneficiary is a person permitted to receive a direct or indirect distribution under a trust’s terms or local law, having power to apply trust income or corpus for his own account, or a person to whom income or corpus would be paid if current trust interests were terminated.

IRS Notice 2009-85 does not address beneficial interests in non-grantor trusts that may arise after the date of expatriation, pursuant to a discretionary trust power to add or exclude beneficiaries.

IRS Notice 2009-85 provides that if a trust was a non-grantor trust prior to expiration becomes a grantor trust as to a covered expatriate, following expatriation, the conversion of status will be treated as a taxable distribution to the covered expatriate to the extent of his interest in the trust as owner.

Annual Tax Filings

The IRS Notice 2009-85 states that a covered expatriate having eligible deferred compensation items or interests in non-grantor trusts must annually file Form 8854 to certify either that no distributions have been received or to report distributions that have been received.  Unlike under prior law, there apparently is no time limit on this obligation.

IRS Notice 2009-95 confirms that in accordance with Treas. Reg. Sec. 1.6012-1(b), a covered expatriate having taxable income (i.e., eligible deferred compensation or distributions from non-grantor trusts) for which taxes are not fully withheld at source must file a tax return on Form 1040 NR.  Since foreign fiduciaries may not withhold and remit a 30% tax on distributions from non-grantor trusts, covered expatriates have an affirmative tax filling obligation.  Any covered expatriate who has elected to defer payment of the Mark-to-Market tax must also file an annual Form 8854 through the year that the deferred tax and all interest is paid.

Form W-8CE

IRS Notice 2009-85 confirms that a covered expatriate who has a deferred compensation item, a specified tax deferred account, or a beneficial interest in a non-grantor trust generally must file Form W-8CE with the relevant payor on or before the earlier of:  the day prior to the first distribution, on or after the individual’s expatriation date, or 30 days after the expatriation date.

With respect to a distribution of an eligible deferred compensation item, on an interest in a non-grantor trust, Form W-8CE generally provides notice to the payor that the individual has waived any otherwise applicable treaty benefits.

In the case of a non-grantor trust, if the covered expatriate has indicated on the form that he will request a letter ruling from the IRS as to the value of his beneficial interest on the day before his expatriation date, the trust is “required” to furnish the individual’s information necessary to calculate such value.

The instructions to Form W-8CE indicate that the necessary information includes (but is not limited to):

1. A copy of the trust deed;
2. A list of the assets (and their value) held on the day before the expatriation date;
3. Information regarding other potential trust beneficiaries;
4. Birth dates for all necessary lives for the trust’s perpetuity period;
5. Policies followed by the trustees when making discretionary distributions that might constitute an “ascertainable standard”; and
6. Any other relevant information.

For an ineligible deferred compensation item, Form W-8CE is notice to the payor that the individual is a covered expatriate who is treated as receiving an amount equal to the present value of his accrued benefit on the day before his expatriation date.  It is also notice to the payor that adjustments may have to be made to future distributions to account for the tax required to be paid by the covered expatriate as a result of his expatriation.

For a specified tax deferred account, Form W-8CE is notice to a payor that the individual is a covered expatriate for whom adjustments may be required on future distributions from the account.

Within 60 days of receiving Form W-8CE, the payor is required to provide a statement to the covered expatriate of the account balance on the day before the expatriate date.

The IRS Notice 2009-85 does not address certain tax issues arising under the 2008 “HEART Act”:

1.  Whether, and on what terms, the deferred tax election can apply;

2.  How the 2008 Tax Act rules are to be coordinated;

3.  Regarding the “Mark-to-Market” tax imposed on gains deemed to arise on the day before expatriation, income generally will be residence (i.e. U.S.) based which should not result in “double taxation”.  However, gains arising from the subsequent actual disposition of a covered expatriate’s assets, deferred compensation and non-grantor trust distributions received subsequent to expatriation may not be U.S. source income and may be also taxed by the expatriate’s country of residence at realization or receipt.

An expatriate who makes a coerced waiver of treaty benefits in order to comply with U.S. reporting obligations, so the expatriation is considered complete under IRC Sec. 877(a)(2)(C) and Sec. 877(g)(1)(A) should not be forced to preclude himself from claiming treaty benefits under residence-based tax treaties.

Treaty issues may include (where a covered expatriate resides in a U.S. treaty partner following expatriation), 30% tax withholding on:  (imposed under IRC Sec. 871):

1.  Payments of eligible deferred compensation;

2.  Distributions from non-grantor trusts.

IRC Sec. 906(b)(4), regarding allowance of foreign tax credits to non-resident aliens (which a covered expatriate becomes), provides that a foreign tax credit is not allowed against any tax imposed by IRC Sec. 871(a).

Under IRC Sec. 871(a), tax is imposed on U.S. source income of non-resident aliens.  Income subject to tax under IRC Sec. 877A(d)(1) and (f)(1) will not be from U.S. sources which would be entitled to foreign tax credits.

Under the 2008 Tax Act expatriation rules, the “Mark-to-Market” tax on a covered expatriate is taxed on his wealth on the date of expatriation.  However, there appears to be no income cap on taxable amounts received from non-grantor trusts.  The election to be treated as receiving the value of an individual’s interest in such a trust may not be possible to accurately ascertain the value of a beneficiary’s contingent, discretionary interest in such a trust.

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