Under IRC Sec. 877(a), a U.S. citizen (or long-term resident) who elects to become a non-resident alien (by losing their U.S. citizenship or relinquishing their green card) is taxable (under U.S. income tax rules) for 10 years after renunciation of their citizenship, unless the loss of citizenship (or residency status) did not have as one of its principal purposes the avoidance of either federal income taxes or federal transfer taxes.
An expatriate is taxable under special U.S. taxation rules under which they are not deemed to be a “U.S. person” but are deemed to be a non-resident alien subject to a special income tax regime.
These special U.S. income tax rules require the following treatment:
1. The net income tax provisions (or the alternative minimum tax) apply so investment income, and income connected with U.S. trade or business income is subject to graduated income tax rates (IRC Sec. 877(b)(1)).
2. Deductions are allowed to the extent they are connected with the income required to be included in gross income (IRC Sec. 877(b)(2)).
3. Gains on the sale or exchange of property (other than individual stock or debt obligations) located in the U.S. are treated as income from sources within the U.S. subject to graduated tax rates (limited to the capital gains tax rate limitation (IRC Sec. 877(c)(1), Property exchanged tax-free for this type of property is to be similarly treated.
4. Gains on the sale or exchange of U.S. debt obligations or U.S. stock (domestic corporations) are treated as income from sources within the U.S. and are subject to graduated income tax rates (subject to capital gains tax rate limitation), (IRC Sec. 877(c)(2)).
A special gain recognition rule applies to prevent an expatriate from avoiding these rules by making a tax-free exchange of U.S. property for foreign property and thereafter selling the foreign-based property immune from U.S. tax (IRC Sec. 877(c)). This assumes the exchange is not for foreign real property, in which event like-kind treatment is not available (IRC Sec. 1031(h)). Consequently, such a like-kind exchange continues the U.S. income taint for purposes of the expatriate income tax provision (although subsequent enforcement of the U.S. income tax liability may be compromised if the expatriate’s assets have been removed from the U.S.).
The burden of proof that loss of citizenship did not have avoidance of U.S. tax (i.e. U.S. income, estate, gift and generation-skipping transfer (GST) taxes) is on the taxpayer if the IRS establishes that it is reasonable to believe that an individual’s loss of citizenship would, but for this provision, result in a substantial reduction for the taxable year in the taxes on his probable income for that year (IRC Sec. 877(e).
Income Tax Treaties
Many U.S. bilateral income tax treaties include Article 1(3) of the U.S. Model Income Tax Treaty which provides that a Contracting State (to the treaty), may tax transfers and deemed transfers of its domiciliaries, and by reason of citizenship may tax transfers and deemed transfers of its citizens for a period of 10 years following loss of citizenship.