Overview (March 2008) - International Law Office

Introduction
Gift Tax
Estate Tax
Reporting Foreign Gifts and Bequests
Generation-Skipping Transfer Tax
Temporary Repeal of Estate and Generation-Skipping Transfer Tax
Income Tax
Income Tax Residency and Transfer Tax Domicile
Anti-avoidance Rules
Reporting Foreign Bank Accounts
US Citizens and Green Card Holders Living Abroad
Expatriation


Introduction

Advisers to international families should note that as of January 1 2008, adjustments have been made to the credits, exemptions, exclusions, rates and filing thresholds used to calculate US gift tax, estate tax, generation-skipping transfer tax and income tax. Some adjustments are driven by inflation or cost of living, while others are scheduled by statute. The one-year repeal of the US estate and generation-skipping transfer taxes is still scheduled for 2010 and lawmakers continue to debate, but have not yet enacted, legislation that would either permanently repeal the estate and generation-skipping transfer taxes or reform the taxes by increasing the exemption amount and lowering the maximum rate. Lawmakers also continue to propose, but, again, have not enacted, an exit tax on wealthy taxpayers who relinquish their US citizenship or long-term residency.

US citizens and non-citizens resident in the United States are subject to US gift and estate tax (sometimes referred to together as a transfer tax) on their worldwide assets, and to US income tax on their worldwide income. Individuals who are not US residents or citizens ('non-resident aliens') are, generally speaking, subject to the US transfer and income tax systems only on US situs property and US source income.

Gift Tax

US citizens and US residents
Transfers of property - whether real property, tangibles or intangibles, and wherever located - by US citizens and US residents are subject to US gift tax. There is a small annual exclusion for gifts up to $12,000 per donee (for tax year 2008, indexed annually for inflation but unchanged from 2007). Direct payments of medical and educational expenses are exempt from gift tax, even if not required by a legal obligation of support, as in the case of an adult child. The US donor may increase the annual exclusion amount to $24,000 (for tax year 2008) by filing a gift tax return and electing to split the gift with his or her spouse. A gift tax credit shelters $1 million worth of lifetime gifts from tax, but then reduces the credit available to use against the estate tax at death. A charitable deduction is available for gifts to qualifying domestic or foreign charities. A marital deduction is available for gifts to a US citizen spouse.

Non-resident aliens
Transfers of intangibles by non-resident aliens are not subject to US gift tax, even if the intangibles are US property (eg, stock in a US company). As a result, only real property and tangible personal property located in the United States are subject to the US gift tax when transferred by a non-resident alien. Advisers to international families will want to seek competent US tax advice on the possible conversion of property from taxable property (eg, tangible US situs property) to tax-free property (eg, intangible stock) prior to making the gift.

The resulting tax can be substantial if the US gift tax system applies to a non-resident alien, due to the following limitations on credits, exclusions and deductions, as compared to gifts by a US citizen or resident:

• There is no credit against gift tax available to a non-resident alien (unlike the estate tax, where a credit shelters assets worth $60,000 from tax in the estate of a non-resident alien);
• A non-resident alien is entitled to the gift tax annual exclusion that allows tax-free gifts of $12,000 per year per donee (for tax year 2008, indexed annually for inflation), but the non-resident alien cannot double this amount using the election to split gifts with the donor's spouse, even with a US citizen spouse;
• The non-resident alien's charitable gifts of US property qualify for a gift tax deduction only if made to a domestic US charity; and
• The US gift tax marital deduction is also likely to be limited for non-resident aliens as a practical matter. Non-resident aliens are entitled to tax-free transfers under the US gift tax marital deduction, just as a US citizen, but no such deduction applies if the recipient spouse is not a US citizen, regardless of the transferor's status. A donor can make tax-free gifts to a non-citizen spouse of up to $128,000 per year (for tax year 2008, indexed for inflation and up from $125,000 in 2007). Gifts free of trust will usually qualify for this $128,000 exclusion. However, careful planning is needed for gifts in trust, since the spouse's interest must be both a deductible interest under marital deduction concepts and a gift of a present interest under the annual exclusion rules.

Return filing
The gift tax return (Form 709)(1) is an annual return filed not earlier than January 1 of the year following that in which reportable gifts were made and not later than April 15. It is possible to extend the time to file the return, but this does not extend the time to pay any gift tax due.

Estate Tax

US citizens and US residents
The worldwide estate of a US citizen or US resident is subject to US estate tax. An estate tax credit shelters up to $2 million from tax (for tax year 2008, unchanged from 2007), to the extent not used to offset gift tax on lifetime transfers. A charitable deduction is available for bequests to qualifying domestic or foreign charities. A marital deduction is available for bequests to a US citizen spouse. The maximum estate tax rate for decedents dying in 2008 is 45%, unchanged from 2007.

Non-resident aliens
For non-resident aliens, a significantly broader list of property is subject to US estate tax, as compared to gift tax. In general, the property is subject to the US estate tax if it has a US situs. US real estate and tangible property physically located in the United States, and securities or obligations issued by US persons or entities, are US situs property and subject to tax unless specifically excluded by the Internal Revenue Code.

Most importantly, however, US property includes stock in a US company, but not stock in a non-US company. Thus, the non-resident alien may be able to avoid the estate tax by investing in US property through an offshore holding company or mutual fund. The US estate tax rules generally do not look through these offshore companies except in special circumstances. With careful planning, investments in US property by a non-resident alien can be made through offshore companies, usually owned in turn by an offshore trust. The offshore company must have the characteristics of a corporation and the form must be respected by the shareholder. In addition, the company should acquire the US property, rather than having the shareholder (ie, the non-resident alien or the non-resident alien's trust) acquire the property and transfer it to the company.

The use of offshore companies and trusts requires careful planning. Otherwise, a non-resident alien decedent who funded the trust with US property and retained the right to amend the trust or receive trust income may be subject to US estate tax on the value of the trust assets. The fact that the US property is later converted to non-US property prior to the settlor's death (by contribution to the non-US corporation) does not change the result under the literal language of the Internal Revenue Code.

If the US estate tax applies, the non-resident alien's transfers at death are more severely taxed than those of a US citizen or resident. The threshold level for tax-free transfers is very low and deductions are limited as follows:

• The non-resident alien's estate tax credit shelters only the first $60,000 from tax at the lowest tax brackets, rather than the first $2 million to which estates of US citizens and residents are entitled for tax year 2008;
• The deduction for debts and expenses of the estate of a non-resident alien is very limited. Only a proportion of recourse debts and the expenses of a non-resident alien's estate are deductible, based on the value of the US property and the value of the decedent's entire worldwide estate. The estate of a non-resident alien must disclose the decedent's worldwide assets to the Internal Revenue Service (IRS) in order to take the full deduction in calculating US estate tax on the decedent's US situs property;
• The estate tax charitable deduction is also limited. The non-resident alien's charitable bequests qualify for an estate tax deduction only if made to a domestic US charity; and
• Transfers to or for a surviving spouse can be sheltered completely from US estate tax by the marital deduction, just as for a US citizen - except that if the surviving spouse is not a US citizen, property must pass to a qualified domestic trust in order to qualify for the deduction, even if the spouse is resident in the United States.

The scope of the estate tax is reduced significantly for non-resident aliens who qualify as residents of treaty countries that have a modern treaty with the United States (eg, the United Kingdom, France and Germany). These modern treaties still allow the United States to tax its citizens wherever resident. However, residents of treaty countries who are not citizens of the United States benefit from the treaty because estate and gift taxation on their transfers is limited, in general, to transfers of US real estate and to amounts associated with a 'permanent establishment' located in the United States - a term of art akin to a fixed place of business of the decedent (eg, proprietorship or interest in a business partnership).

Thus, these persons can transfer US equities free of the US estate tax. They may also be entitled to a pro rata share of the estate tax credit available to US persons, based on the ratio of US property to all property. However, treaty protection does not mean that the assets of a non-resident alien will actually pass free of tax, since the estate is likely to be subject to estate or inheritance tax by the home country.

Persons who remain in the United States for an extended period are unlikely to obtain any such treaty relief, even if there is a treaty between the United States and their home country. As a practical matter, these individuals are unlikely to qualify under the treaty as residents of their original home country and, instead, would likely be considered as residents of the United States.

Return filing
The estate tax return (Form 706 or Form 706NA) is due nine months after the date of death. It is possible to extend the time to file the return, including an automatic six-month extension, but this does not extend the time to pay any estate tax due. The return has been revised as of October 2006. In addition to reporting trusts created by the decedent and trusts under which the decedent possessed any power, beneficial interest or trusteeship, the executor must also disclose the decedent's transfer to a trust of any interest in a partnership, limited liability company or closely held corporation. Executors must file the estate tax return at the Cincinnati Service Centre, regardless of whether the decedent was a US citizen residing in the United States, a resident alien or a non-resident US citizen.

Qualified domestic trusts
Property passing from a US spouse to a qualified domestic trust for the benefit of a non-citizen spouse is entitled to an estate tax marital deduction on the death of the US spouse. A qualified domestic trust ensures that trust principal will eventually be subject to tax, either upon the distribution of principal from the trust during the surviving spouse's lifetime or at the surviving spouse's death, as if it had been included in the estate of the US spouse. A qualified domestic trust can be established by the US spouse, the surviving non-citizen spouse or the executor of the deceased US spouse's estate. Only property which passes from the deceased US spouse to a qualified domestic trust, or which passes to the surviving non-citizen spouse and is then irrevocably transferred or assigned to the qualified domestic trust in a timely manner, qualifies for the estate tax marital deduction.

A trust is a qualified domestic trust only if:

• the trust instrument provides that at least one trustee is a US citizen or a US corporation;
• the trust instrument provides that no distribution of corpus may be made unless the US trustee has the right to withhold from the distribution the amount of estate tax;
• the trust meets any other requirements the secretary of the treasury may impose to ensure the collection of estate tax; and
• the executor of the deceased US spouse's estate elects to have the qualified domestic trust provisions apply to the trust.

Reporting Foreign Gifts and Bequests

US citizens and residents who receive a gift or bequest from a non-US person are required to report the date of the gift or bequest, a description of the property and its fair market value to the IRS. If more than $13,561 is received in 2008 (up from $13,258 in 2007) from foreign corporations or partnerships and treated as gifts, the US recipient has a reporting obligation. For gifts from foreign individuals and estates, the reporting threshold remains at $100,000. However, a US recipient's receipt of a distribution from a revocable trust that is considered to be owned by a foreign person is treated as a gift to the US recipient and, if the trust is a foreign trust, the US recipient has a reporting obligation regardless of the amount received.

The return to report receipt of foreign gifts (Form 3520) is generally due on the same date as the individual's income tax return or the estate's estate tax return (for further details please see "Reporting Deadlines Draw Near").

Generation-Skipping Transfer Tax

US citizens and US residents
When a US citizen or resident makes a transfer to a person two or more generations below that of the transferor (a 'skip person'), whether such transfer is made during life or at death, a generation-skipping transfer tax is imposed in addition to any gift or estate tax that may be due. An exemption of $2 million (for tax year 2008, unchanged from 2007) is available to shelter gifts or bequests from generation-skipping transfer tax. The tax is calculated at a flat rate of 45% for transfers made in 2008 (unchanged from 2007).

Non-resident aliens
The reach of the generation-skipping transfer tax for transfers made by non-resident aliens matches the reach of the estate and gift tax on the underlying transfer. Thus, a transfer by a non-resident alien of non-US property is not subject to the generation-skipping transfer tax, since it is not subject to estate or gift tax; but the tax applies when a non-resident alien transfers US property (other than intangibles transferred by gift).

Most importantly, the time for testing whether the tax applies is the same time as under the estate or gift tax, even though the 'skip' transfer would often occur later. Specifically, the character of the property and the non-resident alien status of the transferor are tested only at the time of the initial transfer as determined for estate tax purposes (at death) or for gift tax purposes (when the gift is complete). Thus, the generation-skipping transfer tax generally does not apply to transfers by non-resident aliens of property situated outside of the United States as of the time of the initial transfer.

The non-resident alien transferor is entitled to the same $2 million (for tax year 2008) exemption from generation-skipping transfer tax as is a US citizen or resident. However, given the limited reach of the tax to transfers by non-resident aliens, this exemption is much less valuable than it is in domestic estate planning. For non-resident aliens, when the generation-skipping transfer tax exemption is needed, its application is fairly straightforward, but some special rules apply. When the transfer by the non-resident alien is fully subject to the tax, the same principles apply as for US transferors, so the non-resident alien will generally decide when to allocate his or her exemption. When the transfer by the non-resident alien is not subject to the generation-skipping transfer tax at all, then the exemption is not and cannot be allocated. The limited scope of the tax as applied to non-resident aliens can be summarized as follows:

• Non-resident aliens need not consider the generation-skipping transfer tax implications of their transfers unless the transfer otherwise requires the filing of a US gift or estate tax return. For instance, a non-resident alien grandfather who has made a gift of non-US property or intangibles worth $1 million to a US grandchild need not file a US gift tax return and need not allocate any generation-skipping transfer tax exemption because the tax simply does not apply;
• A bequest of non-US property avoids the estate tax and therefore the generation-skipping transfer tax, so the exemption is not needed; and
• If the transfer is mixed, so that it is only partially subject to the generation-skipping transfer tax, then a special rule for non-resident aliens applies to calculate the inclusion ratio of the transfer so that the tax can be imposed. The effect of this rule, as in the domestic context, is to encourage the creation of a separate trust in the amount of the allocated exemption, easing administration and minimizing taxes.

Return filing
Schedules to the estate and gift tax returns (Forms 706 and 709) are used to report generation-skipping transfers.

Temporary Repeal of Estate and Generation-Skipping Transfer Tax

Under the Tax Relief Reconciliation Act 2001, amounts sheltered from estate tax are increasing and maximum tax rates are decreasing until 2010, when the estate tax and generation-skipping transfer tax are scheduled for repeal (for further details please see "Transfer Tax Rates and Credits"). The act does not repeal the gift tax. Instead, the maximum marginal gift tax rate is to be reduced for 2010 to the top income tax rate, currently 35%. The act includes transitional rules for qualified domestic trusts.

Under the sunset provision of the act, all of the act's provisions are repealed as of January 1 2011. Thus, on January 1 2011 the estate, gift and generation-skipping transfer tax provisions are scheduled to revert to those in effect prior to the act (ie, a credit that will shelter $1 million from transfer and generation-skipping transfer tax and a maximum tax rate of 55% (plus a 5% estate tax surcharge on certain large estates)). The exemption from generation-skipping transfer tax would be indexed for inflation.

Income Tax

US citizens and US residents
A US citizen and any non-citizen resident in the United States for income tax purposes will be subject to US income tax on his or her worldwide income. The top income tax rate for 2008 remains at 35% on income over $357,701 (up from $349,700 in 2007). The tax rate for qualifying dividends and long-term capital gains remains at 15% in 2008. Qualified dividend income includes dividends from domestic corporations and from foreign corporations incorporated in a US possession or eligible for the benefits of a US income tax treaty.

The US income tax system includes an alternative minimum tax structure that now affects more US citizens than ever before. The alternative minimum tax requires taxpayers to recalculate their income tax under alternate rules that include income otherwise exempt from tax and to disallow certain exemptions, deductions and other preference items.

Non-resident aliens
A non-resident alien is generally subject to US income tax only on US source income. However, special exemptions for certain types of US source income earned by non-resident aliens have been enacted to promote investment in the United States, to facilitate enforcement or to avoid enacting rules that cannot be enforced. The following two exemptions are the most important.

Portfolio interest exemption
Interest on US bank accounts and on certain portfolio debt instruments is exempt from US income tax when earned by a non-resident alien. In general, portfolio interest is interest on a debt obligation issued by a US taxpayer to a holder whose status as a non-resident alien has been substantiated in a certain specified manner provided by the tax rules. The effect is that the interest is not subject either to regular US income tax or to withholding tax.

Capital gains exemption and Foreign Investment in Real Property Tax Act
The second important exemption is that capital gains are generally exempt from US income tax. However, capital gains on real estate or stock in US real estate holding companies are taxed at a graduated rate, as a result of the Foreign Investment in Real Property Tax Act. This act simply treats a non-resident alien's gains from US real estate as 'effectively connected' with a US trade or business, which means the gains are subject to the same tax regime as domestic taxpayers. This tax is backed up by a special withholding tax regime.

Effectively connected income
'Effectively connected income' is income that is treated as attributable to the conduct of a trade or business in the United States. Broadly speaking, the concept is designed to distinguish between business income and investment income. Thus, effectively connected income is taxable at graduated rates on a net basis that allows related deductions to be used in determining the amount subject to tax, as with the income of a US citizen or resident. This result is considered by the tax law to be appropriate for income derived from assets that are used in an active US-based business or when such a business was a material factor in the production of the income - which essentially defines what is meant by 'effectively connected income'.

Effectively connected income is generally subject to the same graduated tax rates as apply to all the income of US citizens and residents - 25%, 28%, 33% and 35% - in effect from January 1 2003 until 2010. There is a 15% tax rate on most long-term capital gains. Qualified dividends earned since January 1 2003 are subject to a 15% tax rate, at least through 2008. Qualified dividend income includes dividends from domestic corporations and from foreign corporations incorporated in a US possession or eligible for the benefits of a US income tax treaty, provided the treaty includes an exchange of information provision. Dividends from foreign corporations will also qualify for the 15% rate if the corporation's dividend-paying stock is readily tradable on an established US securities market. The qualified dividend rate is not available for dividends paid by a foreign personal holding company, a foreign investment company or a passive foreign investment company. Payments in lieu of dividends (eg, substitute dividends paid on stock loaned from margin accounts) also do not qualify for the 15% rate.

'Passive investment income' (ie, income that is not attributed to a US trade or business activity) is either exempt entirely from US tax under the special exceptions for capital gains and portfolio interest or otherwise taxed at flat rates (at 30% withholding on what is called 'fixed or determinable annual income').

Real estate assets often warrant a special election by the non-resident alien owner, because they may or may not be considered a trade or business for this purpose. Rent may thus be taxed as fixed or determinable income taxed at a flat 30% rate rather than as effectively connected income. Net taxation on effectively connected income will often result in lower tax, due to the benefit of deductions, as compared to the 30% withholding regime. This special election is the so-called 'net basis' election.

Withholding tax
Withholding tax refers to a 30% flat rate of tax collected at the source by the US payer of dividends, interest, rents, royalties and the like. The withholding tax is collected on a gross basis, without deductions, but generally reduced substantially by any applicable income tax treaty between the United States and the non-resident alien's home country. The US payer of this income is required to withhold the tax from each payment to the foreign taxpayer and then submit the withheld amount to the IRS. Since many other tax systems around the world have a similar concept, the issue of the rate is often addressed in treaties on a mutual basis. The regime for real property transactions subject to tax under the Foreign Investment in Real Property Tax Act is similar, but it applies different and varying withholding rates and rules depending on the type of payment.

Return filing
Income tax returns (Forms 1040 and 1040-NR) are generally due on April 15 for individuals. It is possible to extend the time to file the return, including an automatic six-month extension, but this does not extend the time to pay any income tax due.

Income Tax Residency and Transfer Tax Domicile

Resident for income tax purposes
It is possible to become resident in the United States for income tax purposes without any deliberate decision to acquire that status. The following two tests are used to determine residence for US income tax purposes.

Green card test
A lawful permanent resident of the United States for immigration purposes (ie, a green card holder) is conclusively resident for income tax purposes.

Substantial presence test
US income tax residency will be acquired by an individual who regularly conducts business or otherwise maintains a physical presence in the United States, and who does not engage in very deliberate planning to avoid exceeding the limit on days spent in the United States, even if that person's permanent home is outside of the United States. The substantial presence test consists of two separate and alternative tests: the 183-day test and the three-year formula test.

Under the 183-day test, a person who is physically present in the United States for at least one-half of the year (ie, 183 days or more) in a given calendar year, and who does not qualify for any special treatment as a student, teacher, diplomat or similar, will be conclusively considered a US income tax resident, unless a treaty tie-breaker provision applies. Relief may be available to qualified residents of treaty countries. If a modern US tax treaty applies, the income tax residency of an individual who is considered resident by the domestic law of both countries can be resolved under a treaty tie-breaker rule that generally looks to the following factors in descending order:

• where the individual has a permanent home;
• the centre of vital interests;
• habitual abode; and
• citizenship.

A person who is a US income tax resident under the Internal Revenue Code but not under the treaty tie-breaker rule can claim non-resident status for all purposes of computing his or her US income tax liability, not just for treaty purposes.

It will still be difficult for the non-resident alien to avoid residency, even with fewer days of presence, once the limit under the three-year formula test is exceeded. The formula limit is exceeded if: (i) the time spent in the United States is at least 31 days in the current calendar year; and (ii) the total days over the current year and the two prior calendar years exceed 183 days (after multiplying days in the immediately prior year by one-third and days in the next prior year by one-sixth). If the formula limit is exceeded, the client will avoid US income tax residency only if he or she can qualify for a treaty tie-breaker or for the closer connection/tax home exception, which applies if the taxpayer maintained closer ties to another country for the year in question, and files the required statement substantiating that claim.

Domiciled for transfer tax purposes
In the gift and estate tax context, 'residence' means domicile, and a person acquires a US domicile when physically present in the United States with the intention to reside there permanently. In general, this means that the immigrant must have also become a lawful permanent resident for immigration purposes, but that is not necessarily the case.

Domicile, unlike income tax residency, is based on facts and circumstances in all cases. Most importantly, domicile is presumed to continue in the foreign jurisdiction until it is established in the United States. The location of business or employment activities does not necessarily determine domicile. Since domicile is less clearly related to current income-producing activities than the US income tax concept of residency, it may be easier to maintain a foreign domicile in a country to which the client currently has no prohibitively expensive tax-producing affiliation. A treaty may also provide relief from the application of the US transfer tax regime. Modern treaties (eg, those with the United Kingdom, France and Germany) provide a tie-breaker rule much like the income tax treaties, but also provide special protection (of varying degrees) for citizens of one country who were not present in the other country for a substantial period of time before the gift or death.

Anti-avoidance Rules

US shareholders of foreign corporations
Several special US tax provisions address ownership in non-US corporations by US persons. Since the United States generally does not tax non-US corporations on foreign source income, these special tax rules are designed to prevent US persons from using non-US corporations to avoid tax by accumulating income offshore. The rules require that certain types of passive income of controlled foreign corporations and passive foreign investment companies be taxed to their US shareholders currently, whether or not distributions are made to them. The effect of these rules can be particularly disruptive if, for instance, a non-US trust in a tax-haven jurisdiction owns one or more such passive investment corporations and the trust has one or more US beneficiaries governed by these rules. Similarly, a non-resident alien shareholder's plan to immigrate to the United States triggers a need for US tax planning.

Temporary loss of residency
The US tax laws contain a special anti-avoidance rule that applies to certain non-US citizens who temporarily abandon their status as a US income tax resident alien. This provision applies to any alien individual who: (i) is resident in the United States for a period of at least three consecutive years; and (ii) thereafter ceases to be resident, but subsequently becomes a resident again before the close of the third calendar year after the close of the initial residency period.

This anti-avoidance rule can have a serious effect. An alien individual who falls within this provision will generally be subject to tax in the same manner as a resident alien on all US source income or gains derived during the intervening period of non-residence - including for this purpose all of the special source rules applicable to expatriated citizens and long-term residents. Thus, US income tax will apply to interest income on portfolio debt and any gains from the sale or exchange of: (i) property situated in the United States; and (ii) securities of US issuers. In computing gain, the IRS has allowed a special step-up provision to apply, so the original pre-residency appreciation can avoid tax. Additionally, gains on US property cannot be avoided by exchanging the property tax free for non-US property, and certain income in controlled foreign corporations will be attributed to the alien.

The principal purpose of this anti-avoidance provision is to prevent resident aliens from avoiding tax on non-recurring US source capital gains by temporarily abandoning resident status. Apart from this rule, US domiciliaries or income tax residents who are not US citizens or long-term residents can immediately shift from worldwide taxation to the limited taxation applicable to non-resident aliens. This rule is of particular importance for persons who have not invested in US real estate and who can leave the United States for a longer period of time and thus avoid the rule.

Reporting Foreign Bank Accounts

The Bank Secrecy Act requires US citizens and residents who own a foreign bank account, brokerage account, mutual fund, unit trust or other financial account to file Form TD F 90-22.1, "Report of Foreign Bank and Financial Authority" (FBAR). This can include individual and trustee owners of single-member limited liability companies with foreign bank accounts. FBAR reporting is required if the aggregate value of such financial accounts exceeds $10,000 at any time during the prior calendar year, even if the accounts do not generate taxable income. Although there are many legitimate reasons to hold foreign financial accounts, the IRS stresses that account holders who do not comply with the reporting requirements may be subject to civil penalties, criminal penalties or both. The FBAR must be filed on or before June 30 and requests for a filing extension will not be granted. As it is not an income tax return, the FBAR is filed on its own and not with income tax returns (for further details please see "Reporting Deadlines Draw Near").

US Citizens and Green Card Holders Living Abroad

US citizens and green card holders are taxed on their worldwide income, regardless of where they live and work. A credit for foreign taxes paid may offset a portion of the US income tax or, alternatively, the taxpayer living abroad may be entitled to a foreign-earned income exclusion, which is adjusted annually for inflation. The amount eligible for exclusion in 2008 is $87,600 (up from $85,700 in 2007), but income over this amount is now taxed at the marginal tax rates applicable as if the exclusion did not exist, instead of applying the lower tax rates.

An individual who elects to use the foreign income exclusion may also exclude a portion of housing costs. The base excludable housing cost is 16% of the foreign earned income exclusion (eg, 16% of $87,600 - $14,016). Housing costs less than this base amount are not excludable. There is a cap on the excludable housing costs of 30% of the foreign earned income exclusion (eg, 30% of $87,600 - $26,280). The difference between these two amounts is generally the maximum excludable housing costs (ie, $12,264, - $26,280 less $14,016 - is excludable in 2008). The IRS can adjust the 30% cap on excludable housing costs on the basis of geographic differences in housing costs relative to costs in the United States. For example, in 2007 the cap in Hong Kong was set at $114,300 and London at $77,800. The IRS has not yet published caps for 2008.

Expatriation

Current 10-year expatriation provisions
A person who expatriates after June 3 2004 continues to be subject to income tax as a US citizen or resident until that individual: (i) gives notice to the secretary of state or the secretary of homeland security that he or she has intentionally undertaken an expatriating act or terminated US residency; and (ii) files an information statement with the IRS (Form 8854).

A common expatriating act is the making of a formal renunciation of nationality before a US diplomatic or consular officer in a foreign country. Although there is no specific prohibition on dual nationality under current US law, certain acts relevant to the acquisition of foreign nationality may, when undertaken voluntarily and with the intent to give up US nationality, be considered an expatriating act, such as formally declaring allegiance to another country or serving in a foreign army.

A long-term resident who relinquishes his or her US green card or commences to be treated as a resident of a foreign country under the provisions of a tax treaty between the United States and the foreign country, and who does not waive treaty benefits applicable to residents of the foreign country, will be treated for tax purposes as if he or she were a former citizen of the United States. A 'long-term resident' is an individual who has been a lawful permanent resident of the United States in at least eight taxable years during the period of 15 taxable years ending with the year in which the individual relinquishes his or her US green card or commences to be treated as a resident of a foreign country.

An individual who has complied with the notice and filing requirements will thereafter be subject to either the US income tax imposed on non-resident aliens or the 10-year alternative income tax imposed on expatriates who meet specified income tax or worth criteria. The alternative income tax modifies the tax rules generally applied to non-resident aliens by:

• subjecting the expatriate's US source income to US-citizen income tax rates rather than the 30% flat rate of withholding tax imposed on non-resident aliens;
• not applying the exemption from US capital gains tax available to non-resident aliens for gains on the sale of US situs property (other than real estate) or US issued securities;
• taxing exchanges of certain US source income property for foreign-source income property; and
• treating an expatriate as receiving income or gain directly from property contributed to a controlled foreign corporation.

Objective income tax and net worth tests
For persons expatriating after June 3 2004, the alternative income tax applies to any expatriate:

• whose average annual net income tax for the period of five taxable years ending before the date of the loss of US citizenship is greater than $139,000 in 2008, up from $136,000 in 2007 (increased by a cost-of-living adjustment for calendar years after 2006);
• whose net worth is $2 million (not indexed for inflation) or more as of the date of the loss of US citizenship; or
• who fails to certify under penalty of perjury that he or she has met the requirements of the Internal Revenue Code for the five preceding taxable years or fails to submit evidence of compliance as required by the IRS.

The expatriate must pay the alternative tax (after reducing it for the payment of foreign taxes) if it is greater than the ordinary tax imposed on non-resident aliens.

Exceptions
Although exceptions are very limited, the average income tax and net worth tests will not be applied to certain dual citizens or to certain individuals who expatriate while still minors. An individual will be considered a dual citizen and not subject to the alternative 10-year tax if he or she was born a citizen of the United States and another country, continues to be a citizen of the other country and has had no substantial contacts with the United States. 'No substantial contacts' means that the individual was never a resident of the United States, has never held a US passport and was not present in the United States for more than 30 days during any calendar year which is one of the 10 calendar years preceding loss of US citizenship.

An expatriate is also not subject to the alternative 10-year tax, regardless of income or net worth, if:

• he or she became at birth a citizen of the United States;
• neither parent was a citizen of the United States at the time of the individual's birth;
• his or her loss of US citizenship occurs before he or she attains age 18-and-a-half; and
• he or she was not present in the United States for more than 30 days during any calendar year which is one of the 10 calendar years preceding loss of US citizenship.

Annual statement filing
All expatriates subject to the 10-year alternative tax rules must file Form 8854 annually with the IRS. A penalty of $10,000 will be imposed if this expatriation information statement is not timely filed, fails to include the required information or includes incorrect information, unless it can be shown that the failure is due to reasonable cause and not wilful neglect.

Physically present in the United States more than 30 days
An expatriate subject to the 10-year alternative tax rules will be taxed as a US citizen and resident if he or she is physically present in the United States at any time during the day on more than 30 days in a year during the 10-year period following expatriation. The general exceptions for presence (eg, certain medical conditions and exempted individuals) used in defining resident aliens do not apply to expatriates subject to the alternative tax.

Limited employment exception
However, a day of physical presence (not in excess of 30 days) will be disregarded if an expatriate with certain ties to countries other than the United States is performing services in the United States on that day for an employer and has had minimal prior physical presence in the United States. An expatriate has ties to another country for the purposes of the employment exception if he or she: (i) became a citizen or resident of the country in which the individual was born or, if married, in which the spouse was born, or in which either of the expatriate's parents were born; and (ii) is fully liable for income tax in that other country.

Minimal prior physical presence is met if, for each year in the 10-year period ending on the date of expatriation, the individual was physically present in the United States for 30 days or less. Here the medical condition exception applies, so that the expatriate will not be treated as having been present in the United States on any day that he or she could not leave the country because of a medical condition that arose while he or she was in the United States.

The exception for days of employment does not apply where the expatriate is working for an employer which is related (as defined in the Internal Revenue Code) or fails to meet any requirements the IRS may prescribe to prevent avoidance of these rules.

Estate tax
The expatriate estate tax rules apply to any expatriate who dies during the 10-year period during which he or she is subject to the alternative income tax regime. The estate of such an expatriate will include for US estate tax purposes his or her US situs property (including US real estate and tangible property physically located in the United States, and securities or obligations issued by US persons or entities), and a portion of his or her stock in foreign corporations in which the decedent owned: (i) directly, 10% or more of the combined voting power of all the foreign corporation's voting stock; and (ii) directly or indirectly, more than 50% of the foreign corporation's total voting stock or more than 50% of the total value of all stock.

The portion of foreign stock that can be included is calculated using the ratio that the fair market value of the US situs assets owned by the corporation bears to the corporation's total assets.

Gift tax
The expatriate gift tax rules apply to any expatriate who makes a taxable gift during the 10-year period during which he or she is subject to the alternative income tax regime. In addition to tax on gifts of US situs real estate and tangibles, the expatriate will be liable for gift tax on transfers of US situs intangibles such as stock in US corporations and the US asset value of gifts of stock in certain foreign corporations. The 'US asset value' is an amount bearing the same ratio to the stock's fair market value at the time of the gift as the fair market value of the corporation's US situs assets bears to the total fair market value of all the corporation's assets.

The gift tax rules apply regardless of how the expatriate acquired the stock. However, stock in a foreign corporation owned by such an expatriate is subject to the gift tax rules only if the expatriate: (i) owned, directly or indirectly, 10% or more of the total combined voting power of all classes of stock entitled to vote; and (ii) owned, directly or indirectly, or is considered to have constructively owned, more than 50% of the total combined voting power of all classes of stock entitled to vote, or the total value of the corporation's stock.

There is a credit available to reduce the gift tax by the amount of any gift tax the expatriate pays to any foreign country on the gift.

Proposed exit tax
Periodically legislation is introduced that would impose an exit tax (or mark-to-market tax) on US citizens who renounce citizenship and long-term US residents who relinquish their green cards. To date, such provisions have not been enacted. Most recently, a bill entitled Tax Collection Responsibility Act 2007 (HR 3056) passed the House of Representatives on October 10 2007.(2) The bill has now been sent to the Senate and referred to the Committee on Finance. The bill's primary focus is to stop the private debt collection programme at the IRS, but it also sets forth the following changes to the expatriate tax rules:

• Property of an expatriate is treated as having been sold on the day before the expatriation for its fair market value, with any gain exceeding $600,000 to be included in taxable income. The expatriate may defer payment of the tax until the due date of the tax return if adequate security is provided.
• A 30% withholding tax is required on certain deferred compensation items payable to expatriates.
• A 30% withholding tax is imposed on certain payments from non-grantor trusts to expatriates.
• A tax is imposed on gifts or bequests in excess of $10,000 received by a US citizen or resident from an expatriate.

Advisers to international families should keep a close eye on US tax developments. With the 2010 repeal of the estate and generation-skipping transfer taxes looming and another bill with exit tax provisions under consideration, 2008 may bring changes beyond the standard annual estate, gift and income tax adjustments.

For further information on this topic please contact Jennie Cherry or Rashad Wareh at Kozusko Harris Vetter Wareh LLP by telephone (+1 212 980 0010) or by fax (+1 212 751 0084) or by email (jcherry@kozlaw.com or rwareh@kozlaw.com).

Endnotes

(1) Tax forms are available from www.irs.gov.

(2) Further information and status can be found at www.govtrack.us/congress/bill.xpd?tab=main&bill=h110-3056.

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