| ||The Tax Regime for Individual Expatriates: Whom to Impress? |
*Partner, Milbank, Tweed, Hadley & McCloy, LLP, New York, New York; University of Cape Town, South Africa, B.A., 1990; M.A., 1991; Harvard Law School, J.D., 1994. The author is grateful for the research and assistance of his colleagues Drew Batkin, Alan Schwartz, and Benjamin Yu.
The American Jobs Creation Act of 2004 (the “2004 Act”) includes provisions to amend the tax regime for individual expatriates. This salvo is the latest in a politically charged exchange about the taxation of expatriates that ignited in the mid-1990s. Proposals to replace the current expatriate tax regime with an “exit tax” and treat expatriation as a realization event have been reintroduced a number of times in the Senate and were included in the 2004 Senate Bill that was rejected in Conference.
While the term “expatriation” is often used interchangeably to mean both the act of relinquishing legal status as a U.S. national and the act of abandoning United States domicile, it is important to distinguish between the two concepts. For most countries, which tax based on residence rather than nationality, it is not a change in legal nationality status, but rather the act of emigrating that alters an individual’s tax status as a person generally subject to the country’s taxing jurisdiction. The U.S. international tax regime for individuals turns on nationality status rather than domicile, as discussed below. Under the U.S. system, it is the loss of legal U.S. nationality that causes an alteration of general U.S. taxing jurisdiction. Of course, emigration is a necessary condition of expatriation, but it is not a sufficient condition, and, frequently, the two acts do not occur contemporaneously.
Legislative attention was drawn to expatriation by the wide publicity accorded a few egregious tax-motivated expatriations. The expatriates involved were citizens and life-long U.S. residents who had enjoyed the privileges of U.S. nationality and residence, including the opportunity to accumulate vast wealth. They then expatriated to sunny tax-havens, presumably to avoid U.S. taxes, while maintaining significant continuing contacts with the United States. Faced with facts like these, a legislator’s reaction to fulminate then legislate is understandable. Nevertheless, while this may be the situation at which the current expatriate tax regime is primarily aimed, it does not describe the situation of many, perhaps most, potential expatriates.
While few have much sympathy for the tax motivated expatriates described above, the current expatriate tax regime captures many other individuals whose situation is more sympathetic. Increasing international mobility has led, particularly in the case of wealthy families, to significant diversity of citizenship and nationality among family members. It is common for a wealthy family to include members who, by reason of birth in the United States, marriage, or otherwise, are U.S. citizens or green-card holders and stand to inherit a significant portion of the family’s wealth. In its origins, the family’s wealth may have had little or no relation to the United States. The actual contacts of U.S. citizen family members with the United States may range widely, from the individual who has chosen to make the United States his or her home, to the individual who takes advantage of his or her status to study or to reside temporarily in the United States, to the individual who maintains little or no actual contact with the United States but retains U.S. citizenship or a green card primarily to ensure access to a stable safe haven in the event of political instability at home. Yet all are fully taxed by the United States on their worldwide income on the basis of their nationality status. The appropriate tax regime for individuals who expatriate in these circumstances may be far less intuitive.
The United States was among the first countries to recognize expatriation as an important right. At common law, sovereign allegiance was immutable. The common law doctrine of “perpetual allegiance” denied a subject the right to sever his allegiance to the place of his birth. The rule was widely recognized, initially even in the United States. However, American attitudes to the doctrine soured when the British vigorously asserted the doctrine to justify impressing captured British-born, U.S.-naturalized sailors into service in the British navy. American outrage led ultimately to the War of 1812.
While U.S. citizens today enjoy a statutory right to expatriate, these former citizens navigate treacherous international tax waters. Which expatriates are the United States able to capture in the extra-territorial exercise of its taxing power? Which captured expatriates should it impress? Should the expatriate tax regime satisfy domestic tax policy norms, conflicting international tax norms, or serve merely to impress upon the electorate that their elected representatives share their distaste for wealthy taxpayers who seek to escape their fair tax burden?
Part I of this Article compares the U.S. tax regime for citizens and permanent legal residents to that for nonresident aliens and explains the income tax and wealth transfer tax advantages of expatriation. Part II summarizes the current law regime applicable to expatriates, primarily under section 877 of the Code prior to the changes made by the 2004 Act. Part III summarizes the changes adopted in the 2004 Act and the competing Senate proposal to adopt an exit tax imposed on a mark-to-market basis. Part IV summarizes constitutional law, international law, and tax policy concerns that should inform the design of the expatriate tax regime and evaluates how successfully these are addressed by prior law, the law as amended by the 2004 Act, and the competing proposal. Finally, Part V tentatively suggests an alternative and more rational regime. Under this regime, to avoid a full departure tax (based on estate tax principles) on property owned at the time of expatriation, the expatriate would be required to transfer the property to a custodian who agrees to act in that capacity. The custodian would generally be required to withhold taxes imposed on income from the custodial property. This income would continue to be taxed as income of a citizen up to the point at which the aggregate tax imposed is equal to a tentative tax amount computed based on mark-to-market principles at the time of expatriation. A substitute wealth transfer tax would apply to assets transferred to the custodian, based on estate tax principles but at a rate discounted to reflect the actuarial likelihood of death for someone of the expatriate’s age.