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It's a familiar theme - what gets introduced a few times into Congress as a bill will eventually make it into law. This is especially true when it affects foreign persons who don't vote or the relatively few U.S. individuals who wouldn't want to be heard on the issue in any event.

On June 17, 2008, President Bush signed into law the Heroes Earnings Assistance and Relief Tax Act of 2008 (the “HEART Act”). The HEART Act contains a new expatriation tax regime that applies to individuals who expatriate from the United States on or after June 17, 2008. As explained by the Senate Finance Committee, the new expatriation rules are intended to tighten the prior rules so that certain high net worth individuals cannot renounce their U.S. citizenship or terminate their long-term U.S. residency in order to avoid U.S. taxes. It is expected that the new expatriation rules will raise $411 million over the next 10 years.

Under the prior expatriation law, an individual continued to be taxed by the United States as a U.S. citizen or long-term resident until the individual gave notice of an expatriating act or termination of U.S. residency. In that case, a special tax regime applied to persons who expatriated from the United States if the application of the special tax regime would result in greater tax liability than would otherwise be imposed under the rules governing nonresident alien individuals. Specifically, U.S. citizens who relinquished their U.S. citizenship and foreign nationals who terminated their long-term U.S. residency remained subject to U.S. tax on U.S.-source income for the 10 taxable years following expatriation unless such individuals met certain exceptions. Under this regime, U.S.-source income was defined more broadly than for other purposes of the Code. An individual present in the United States for more than 30 days in a calendar year after expatriation would continue to be treated as a U.S. citizen or resident for such taxable year and taxed on his or her worldwide income.

The new expatriation provisions impose a mark-to-market exit tax on individuals who are “covered expatriates.” A covered expatriate is subject to U.S. income tax on the net unrealized gain in his or her property as if the property had been sold for its fair market value on the day before the expatriation or termination of U.S. residency. Any net gain in excess of $600,000 (as adjusted for inflation after 2008) on the deemed sale is recognized. Adjustments are to be made for gain or loss realized after the deemed sale, without regard to the $600,000 exemption, although it is not clear how this will exactly operate.

A taxpayer may elect to defer payment of the mark-to-market tax until the taxpayer actually disposes of the property. Interest accrues on the unpaid tax and the taxpayer must post adequate security. In the case of a resident alien, property held by an individual on the date the individual first became a resident of the United States is treated as having a basis on such date of not less than its fair market value (unless the individual elects otherwise).

In general, a covered expatriate is defined with reference to prior law. A covered expatriate is an expatriate (defined below): (1) whose average annual net income tax for the five taxable years preceding expatriation exceeds $139,000 (as adjusted in 2008 for inflation); (2) whose net worth is $2 million or more on the date of expatriation; or (3) who fails to certify under penalty of perjury that he or she has complied with all U.S. federal tax obligations for the five preceding taxable years or fails to submit such evidence of compliance as the IRS may require. Certain dual citizens and persons who relinquish U.S. citizenship before reaching 18 1/2 years of age are not treated as covered expatriates. Similar rules are not provided, however, in the case of long-term residents.

An expatriate is a U.S. citizen who relinquishes his or her citizenship, or any long-term resident of the United States (i.e., an individual who is a lawful permanent resident of the United States (i.e., one who has been lawfully accorded the privilege of permanently residing in the United States as an immigrant and whose status has not been revoked) in at least eight of the 15 taxable years ending with the taxable year in which the individual terminates U.S. residency) who ceases to be a lawful permanent resident of the United States. Under these rules, an individual ceases to be a lawful permanent resident of the United States for all tax purposes if the individual revokes or abandons his or her green card or if the individual: (1) commences to be treated as a resident of a foreign country under a tax treaty between the United States and that foreign country; (2) does not waive the benefits of the treaty applicable to residents of the foreign country; and (3) notifies the IRS of the commencement of such treatment.

The mark-to-market tax does not apply to interests in certain deferred compensation items, i.e., interests in qualified pension, profit sharing, bonus plans, etc. In the case of certain “eligible” deferred compensation items, the payor must deduct and withhold 30% of a taxable payment (i.e., a payment that would be includible in income if the recipient were a U.S. citizen or resident) made to a covered expatriate. This withholding requirement applies in lieu of any other withholding requirements under current law, but items that are subject to the withholding requirement are nevertheless subject to tax under §871. In the case of deferred compensation items that are not “eligible,” an amount equal to the present value of the item is generally treated as having been received by the covered expatriate on the day before expatriation. In addition, in the case of certain specified tax deferred accounts (i.e., IRAs, tuition plans, HSAs, etc.), the individual is treated as having received on the day before the expatriation date a distribution of his entire interest in that account.

The mark-to-market tax applies to assets held by a portion of a trust for which the covered expatriate is treated as the owner under the grantor trust provisions of the Code. In contrast, a 30% withholding tax applies to direct or indirect distributions from the portion of any non-grantor trust of which a covered expatriate is a beneficiary. In this case, the trustee must deduct and withhold from the distribution an amount equal to 30% of the distribution that would be includible in the gross income of the covered expatriate if such person continued to be subject to tax as a U.S. citizen or resident. This portion of the distribution is subject to tax under §871. Further, if the fair market value of the property distributed exceeds its basis in the hands of the trust, gain must be recognized by the trust as if the property were sold to the covered expatriate at fair market value.

The new rules subject U.S. citizens and residents who receive certain gifts or bequests from a covered expatriate to a transfer tax of 45%. This new transfer tax represents a significant departure from the general rules under which donees and heirs do not normally pay tax on the receipt of gifts or bequests. The transfer tax applies to property directly or indirectly acquired by gift from an individual who, at the time of the transfer, is a covered expatriate, or to any property directly or indirectly acquired by reason of the death of an individual who was a covered expatriate immediately before death. However, the first $12,000 (as adjusted for inflation) of gifts received by the U.S. citizen or resident from a covered expatriate in any taxable year is exempt from the transfer tax. Additionally, the tax is reduced by any foreign gift or estate taxes paid in connection with the property. In addition, any U.S. situs property that is subject to U.S. estate or gift tax if given or bequeathed by a nonresident alien of the United States, and for which an estate or gift tax return is filed, is not subject to the above taxes.

Covered expatriates must provide an information statement to the IRS for any year in which the covered expatriate has any obligations under the new rules. Information to be supplied includes the person's social security number, mailing address of the foreign residence, details on the person's income, assets, liabilities, and the number of days present in the United States. The IRS will impose a penalty of $10,000 for failure to comply with these reporting requirements in a timely manner, unless the covered expatriate can show that such failure is due to reasonable cause and not willful neglect.

While there are a number of U.S. citizens who expatriate annually, there are far more resident aliens who are lawful permanent residents, i.e., who hold a green card, and who may be surprised to find out that, unless they have consistently utilized a treaty provision to tie-break in favor of a home country so that they will not have accumulated the eight-taxable-year period for becoming a long-term resident, they will be subject to the exit tax upon abandoning their green cards in the future or upon commencing to be treated as a foreign tax resident under a tie-breaker provision. While the test for determining long-term residency hasn't changed under new §877A, the §877 rules were more easily capable of being defeated than new §877A. Proper planning is in order, especially since the taxable years of receipt and abandonment of the green card are counted as full years, regardless of when the green card was actually received or abandoned. Thus, a person who receives a green card on December 30, 2001, and who abandons it on January 2, 2008, has become a long-term resident as defined, even though the green card was held for only six years plus a few days.

Whether and to what extent new §877A conflicts with and/or takes priority over a treaty is another issue yet to be resolved and a topic for another day. The interplay between §877 (and its various amendments) and the saving clause of most U.S. tax treaties points up how treaty-specific the analysis must be. Arguably, the exit tax (which is imposed by statute on the day before the expatriation date) would not seem to implicate the saving clause. Nonetheless, §877A does deal with deferred compensation items and non-grantor trust distributions beyond the expatriation date, so it remains to be seen how this will play out. Precious little legislative guidance is provided.

The mark-to-market exit tax regime is a harsh one but one which is more likely to be enforced than §877 (which continues to apply to those who have expatriated prior to June 17, 2008). The approach is not novel and is applied in a few other countries, e.g., Canada. The provisions for deferral and adjustments with respect to subsequent actual dispositions (although not yet clear) are helpful, and the mechanics for enforcement via withholding on deferred compensation and non-grantor trust distributions are welcomed provisions which provide guidance and certainty to payors of such income.

This commentary also will appear in the October 2008, issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Klasing and Francis, 918 T.M., Section 911 and Other International Tax Rules Relating to U.S. Citizens and Residents, and in Tax Practice Series, see ¶7130, U.S. Persons--Foreign Activities.