The Effect of Residency in International Estate Planning

The Tax Adviser September 2006 The Effect of Residency in International Estate Planning Clients are more likely than ever to have a financial interest subject to the tax laws of another county. This article explores the concepts of residency and domicile, and how they affect the taxation of multinational clients. Paula M. Jones, Esq. Associate McCarter & English LLP Philadelphia, PA For more information about this article, contact Ms. Jones at PJones@McCarter.com. Executive Summary Establishing the residency of a multinational individual is important in estate planning. Individuals with more than one residence may unknowingly subject themselves to each country s taxing jurisdiction. There are many planning opportunities to help clients minimize worldwide taxes imposed at death. At first, the topic of international estate planning may conjure up notions of the very wealthy shifting assets to tropical locations via offshore trusts. But, seemingly average clients are more likely than ever before to have a financial interest outside of the U.S. subject to the tax laws of two or more countries, resulting in the need for professional tax advice. This article addresses the basis on which the U.S. claims jurisdiction for Federal estate tax purposes. It explores the concepts of residency and domicile through a case study of a multinational client. Other case studies will apply Federal estate tax treaty provisions to a client (1) with property in more than one country and (2) trying to decide in which country to claim residency. Copyright 2006 American Institute of Certified Public Accountants

Basis of Taxing Jurisdiction Once a client has an interest outside of the U.S., the first question is, On what basis is the client subject to U.S. estate taxation? There are very different tax consequences if the individual is a U.S. citizen, a U.S. resident or a nonresident citizen owning U.S. property. All U.S. citizens, regardless of domicile, are subject to Federal estate tax at death. They are afforded the full U.S. Federal estate tax exemption, which is $2 million in 2006. This law has been the subject of many political debates in recent years, but at press time has not been changed. This exemption amount is scheduled to increase to $3.5 million in 2009 and is repealed in 2010. It returns to $1 million in 2011 due to a sunset provision in the law. 1 Under Sec. 2031, the gross estate of a citizen or resident includes all property wherever situated to the extent of the decedent s interest therein. This includes all property located inside and outside the U.S. The philosophy behind the IRS s wide reach to citizens and residents is the protection afforded them by the U.S. government wherever they travel. In fact, taxation is payment for the benefits that U.S. citizens can access wherever they are located. 2 Individuals who are neither citizens of the U.S. nor residents (i.e., nonresident aliens (NRAs)) are subject to Federal estate tax on property situated in the U.S. The exemption for those individuals is only $60,000, under Sec. 2107(c)(1). Thus, practitioners who are used to working with only wealthy individuals should not overlook the estate tax issues for NRAs with more than $60,000 of U.S. real property. Expatriation The U.S. even exerts its taxing authority over certain former U.S. citizens who have renounced citizenship and left the country. This authority can last for up to 10 years after citizenship is renounced. The U.S. also claims taxing authority over certain long-term U.S. residents who have renounced residency. Thus, even individuals who leave the U.S. permanently can still be subject to the Federal estate tax if they die within 10 years after their exit. Under Sec. 877, the individuals subject to this are those with (1) an average annual net income of $124,000 (indexed) for the five tax years prior to the loss of citizenship or residency or (2) a net worth of $2 million or greater. This portion of the estate tax law was recently updated, to enable the Service to reach even further. Under Sec. 877(g), an expatriate who returns to the U.S. for more than 30 days during any one of the first 10 years after loss of citizenship or residency is reclassified as a U.S. resident for that tax year for all tax purposes (with some extension of the 30-day limit for individuals in the U.S. for certain employment reasons). In addition, there is now a formal renunciation requirement on citizens and long-term residents wishing to become expatriates, under which they must give notice to either the State Department or the Department of Homeland Security. They must also provide a statement to the IRS contain- The Tax Adviser September 2006 2

ing the information specified in Sec. 6039G. 3 Expatriates must then file an annual statement with the Service for the first 10 years after losing citizenship or residency, even when no tax is due. Revised Form 8854, Initial and Annual Expatriation Information Statement, serves as both the initial statement and the annual statements required under Sec. 6039G. Failure to file will result in a $10,000 penalty, under Sec. 6039G(c). Residency Issues Individuals with more than one residence may fit the legal definition of residency for more than one country, unknowingly subjecting them to each country s taxing jurisdiction. Establishing the residence of a multinational individual is important in planning. ote: This discussion of residency relates to the Federal estate tax, not the income tax. Their definitions of residency differ. 4 The definition of residency for U.S. estate tax purposes is a decedent, who at the time of death, had domicile in the U.S. A person acquires domicile, according to Regs. Sec. 20.0-1(b)(1), by living in a particular location for even a brief period of time, with no definite present intention of later removing therefrom. Practitioners should be aware that there are many other nontax reasons why a client may wish to be affiliated with one country as opposed to another, such as the political climate, laws on residency benefits and personal ties. These factors may change as time goes on; thus, the residency issue should be revisited often. Individuals who have permission to remain in the U.S. only temporarily can still be deemed residents, giving rise to the IRS s taxing jurisdiction. For example, in Rev. Rul. 80-363, 5 the decedent was an employee of an international organization and a citizen of a foreign country. He entered the U.S. by way of a visa for international employees on a temporary work assignment. He was found to have formed the intent to remain in the U.S. shortly after his arrival. At death, his estate was subject to the Federal estate tax, because he met the definition of a U.S. resident, notwithstanding his visa and immigration status. Even an illegal alien residing in the U.S. can be found to be a resident for Federal estate tax purposes. In Rev. Rul. 80-209, 6 an individual entered the U.S. illegally, purchased a home and remained there until his death 15 years later. During his term in the U.S., he was a member of local clubs and active in community affairs. He continued to purchase real property inside and outside of the U.S. and to rent it out. On his death, his estate argued that the decedent was not a citizen or resident of the U.S. and, thus, his property outside of the U.S. should not be subject to Federal estate tax. However, legal capacity to acquire a domicile of choice has been found to exist even when an individual is subject to transfer to another domicile at the direction of others. Thus, the fact that the decedent was subject to deportation did not render him legally incapable of acquiring a domicile even if in the country that can deport him. The decedent, even though an illegal alien, was found to be a U.S. resident; all of his property, wherever situated, was subject to Federal estate tax. Marital Deduction In calculating estate tax, there is an unlimited marital deduction under Sec. 2056; however, this is only allowed for spouses who are U.S. citizens. As a result, even despite the reach of the U.S. The Tax Adviser September 2006 3

estate tax system to property of citizens and residents wherever situated, any amount of assets passing to a surviving citizen spouse are afforded an unlimited marital deduction. For instance, if a decedent leaves a $20 million estate to a surviving spouse who is a U.S. citizen (regardless of where that citizen resides), the estate can take a $20 million marital deduction, leaving a zero Federal estate tax bill. A surviving spouse who is not a U.S. citizen (regardless of where he or she resides), however, is not afforded this marital deduction. The $20-million transfer from the decedent to the noncitizen surviving spouse is subject to Federal estate tax. ( ote: The $2 million Federal estate tax exemption would still apply, leaving the remaining $18 million subject to Federal estate tax. 7 ) This law exists because a noncitizen spouse might relocate outside of the U.S. along with the assets inherited from the deceased spouse. Because the noncitizen spouse is neither a U.S. citizen nor resident, he or she is no longer within the IRS s taxing jurisdiction. The elimination of the marital deduction allows the Service to shift the tax liability to the estate of the first spouse to die, which ensures collection, regardless of the noncitizen surviving spouse s actions. 8 Planning Opportunities There are many planning opportunities to help clients minimize worldwide taxes imposed at their death. It is important to determine whether a client could be taxed as a resident by more than one country. The worldwide estate and death tax consequences should be calculated for each possible residence. This will enable the client to make a more informed decision on establishing residency. After this decision, the client should state his or her intention to remain in a particular place. For instance, the evidence used to determine whether an individual intended to reside in the U.S. is a culmination of many factors, which might include residence location, whether or not the individual owns or rents a home, the size and value of any home owned, personal ties to the location (e.g., club memberships), personal possessions and even a burial site. Other factors used to determine residence include the residence listed on legal documents, passports, visa applications, voter registration and income tax returns. 9 An important part of a client s estate planning can be updating or changing voter registration records, establishing community ties or joining community organizations, changing references to a residence in legal documents, or re-registering an automobile. Case Study o. 1 Residency A, an Australian citizen, spends about half of the year in Australia and half of the year in the U.S., and has property in both countries. She has a $50,000 bank account in an Australian bank; personal real estate in Sydney worth $400,000; commercial real estate in Sydney worth $500,000; and an investment account, holding the stock of Australian companies, worth about $450,000. These Australian assets total $1.4 million. Her U.S. assets include $10,000 in a bank account; personal real estate worth $475,000; a vacation home worth $750,000; an investment property worth $250,000; and retirement plans invested in U.S. companies, worth $700,000. These U.S. assets total $2.185 million; thus, her total worldwide estate is $3.585 million. All values are in U.S. dollars; see the exhibit below. The Tax Adviser September 2006 4

There are four ways to calculate and compare to determine in which country (the U.S. or Australia) A should claim residency for Federal estate tax purposes. In these examples, any estate or inheritance tax imposed at the state level is not addressed. However, when working with actual clients, practitioners should note that, because some states have decoupled from the Federal estate tax system and some have not, 10 this factor may change the total tax consequences of each possible scenario. U.S. Taxes for Australian Resident What would the U.S. tax consequences be if A claimed residency in Australia? Because A is neither a citizen nor a resident of the U.S., she would be taxed by the U.S. as an NRA. NRAs are subject to U.S. estate tax only on property physically located within U.S. borders, which for A is her real estate, totaling $1.475 million. NRAs also have a different exemption amount from U.S. citizens and residents. As discussed above, only the first $60,000 is exempt from U.S. estate tax for NRAs. Thus, about $1.415 million of A s property is subject to U.S. estate tax. Her tax bill from the IRS would total $532,050. The Tax Adviser September 2006 5

Australian Taxes for Australian Resident What would the Australian tax consequences be if A claimed residency in Australia? No estate tax is imposed on the estate of an Australian resident decedent. However, there is an Australian capital gain tax (CGT) based on the value of any property passing to a beneficiary. For Australian tax purposes, the real estate located outside of Australia is valued as of the date A became an Australian tax resident. This value is the Australian basis in the property; CGT is due when the property is sold. 11 All remaining property A owns is subject to the CGT at the time of transfer from A s estate to her beneficiaries regardless of where the beneficiaries are located. In this scenario, it is difficult to calculate the Australian tax consequences for the U.S. real estate. There is no tax due at A s death, and her beneficiaries may inherit the real estate in kind and not sell it, thus deferring the CGT for many years while the property appreciates in value. The Australian CGT is calculated at A s marginal income tax rate. A 50% discount is applied to assets owned for more than one year. Assuming the maximum CGT rate on A s $1.475 million in U.S. real estate, which is capped at 24.25% for assets held for more than one year, she would owe CGT of $357,687. The extent of A s Australian property consists of all property wherever situated, minus the U.S. real estate. Her total taxable estate is $2.11 million. Again, assuming the maximum CGT rate, A would owe $511,675 in Australian CGT: U.S. Taxes for U.S. Resident As a U.S. resident, A is taxed on her worldwide estate, wherever situated. Her total estate of $3.585 million is her gross estate. As a U.S. resident, she is afforded a $2 million U.S. estate tax exemption; thus, about $1.585 million will be subject to Federal estate tax. Assuming a 46% estate tax rate, the U.S. tax bill is about $868,300. Australian Taxes for U.S. Resident If A claims residency in the U.S., Australia will tax only her real estate physically located in Australia. It will tax the capital gain in the real estate on a property s sale. The beneficiary of the real estate receives the same cost basis as the decedent had at death there is no step-up in basis, as in the U.S. When the real estate is sold, Australia will tax the capital gain, regardless of where the owner of the real estate claims residency. Once again, this portion of the equation is difficult to calculate, because the CGT is not triggered at A s death, but on the sale of the property by the The Tax Adviser September 2006 6

beneficiaries, which could occur many years in the future. However, if the Australian real estate is sold at A s death and the maximum CGT rate of 24.25% applies, the Australian tax bill is $218,250: The above example shows the basic process for determining where a client should reside. The total tax as an Australian resident is $1,043,725; the total tax as a U.S. resident is $1,086,550. In both cases, some of the same property is taxed by both countries. It is important to determine whether there is a tax treaty that addresses the double taxation issue; most tax treaties do. (For a discussion of the effect of a tax treaty on where to reside, see below.) Change in Immigration Status A change in immigration status may be a viable estate planning technique for a multinational client. For instance, a U.S. resident may decide to naturalize (i.e., change from a U.S. resident to a U.S. citizen) to obtain a marital deduction. To be naturalized, a candidate must be a legal resident of the U.S. for at least the last five consecutive years; be 18 years of age or older, have the ability to speak, read and write English; have a basic knowledge of U.S. government and history; and have good moral character. 12 In contrast, a U.S. citizen living abroad may decide to renounce his or her citizenship to avoid the Service s taxing jurisdiction at death. For example, a U.S. citizen moves to Canada. She lives there for 30 years without maintaining many ties to the U.S., except for the occasional visit to family in Chicago. Canada has no estate tax. If she remains a U.S. citizen, she will be taxed on her worldwide estate at death. If instead, she renounces her U.S. citizenship and dies more than 10 years later (as was discussed), she will not pay any Federal estate tax. Expatriation is a wise estate planning technique for this client. Tax Treaties A quick and easy answer to any estate planning challenges presented by a multinational s situation might be found in an estate tax treaty between the U.S. and the other country or countries in which the individual has an interest. The objectives of tax treaties are to prevent double taxation and to protect all countries from tax evasion. However, there are only 16 estate tax treaties in force 13 : Australia, Austria, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, Netherlands, Norway, Sweden, Switzerland, Union of South Africa and the U.K. Not all aspects of the estate tax law are addressed in each treaty. The Tax Adviser September 2006 7

These tax treaties generally define citizenship, location of assets, domicile and residency. They will determine which property is subject to tax; specify where property is situated, depending on type; and calculate allowable exemptions, deductions and credits. When a decedent takes a position that a U.S. treaty modifies a Code provision and thereby effects a change in any tax incurred by the taxpayer, the taxpayer must disclose this position on Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b). 14 Case Study o. 2 Invoking a Tax Treaty During Estate Administration To illustrate how to invoke an estate tax treaty, consider B, a U.S. citizen and resident who owns a house in Scotland worth about $800,000. It is clear that on B s death, she is a U.S. citizen and resident, subjecting her to the U.S. estate tax on her worldwide estate, including the house in Scotland. However, Scotland will apply capital transfer tax 15 on all of the property located there, which includes the house and the tangible personal property located therein. This results in the house and tangible personal property being taxed twice once by the U.S. and once by the U.K. Fortunately, there is a U.K. U.S. estate tax treaty 16 that addresses double taxation. It states that the decedent s domicile country can tax all of the property, except property physically located elsewhere. Thus, the U.S. can tax all of B s property, except the Scotland house and tangibles. The treaty also states that the country in which the decedent does not reside, but in which the decedent owns physical property, can tax the value of the physical property located within its borders. Thus, the U.K. will tax the house and tangibles, and the U.S. will tax the rest, thereby avoiding double taxation. To invoke the treaty, the executor of B s estate must file Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, listing the Scotland home and tangibles, but noting the includible value as zero. The description of the property should note that Form 8833 is attached to the return, which gives details of the tax treaty sections that apply to the exclusion of the assets from the U.S. s taxing jurisdiction. Case Study o. 3 Invoking a Tax Treaty for Residency In Case Study No. 1, A lived in both the U.S. and Australia. Because there was double taxation regardless of where A claimed residency, it is important to look for a tax treaty between the U.S. and Australia to try to remedy this problem. Fortunately, the U.S. and Australia signed a treaty that prevents the double taxation of the same property by both countries. It also establishes where certain property is deemed located. For instance, if A claims U.S. residency, she would be taxed on her worldwide estate and would also be subject to CGT on her Australian property. The U.S. would not tax assets deemed to be situated in Australia, and Australia would apply the CGT. The treaty establishes the location of assets owned by the decedent, depending on the type of asset. For instance, real estate (referred to as immovable property ) is deemed located in the country in which it is physically located. Government bonds are deemed situated in the country in which the government issuer is located, and stocks are deemed situated in the country in which the The Tax Adviser September 2006 8

company issuing the stock is organized. Bank accounts are deemed situated at the bank or branch in which the account is located. Does the application of this treaty make A s tax situation better than the initial calculations in Case Study No. 1? What would the tax consequences be if A claimed residency in Australia? She would be taxed by the U.S. on all property deemed to be in the U.S., according to the treaty; see the exhibit. Because A is neither a citizen nor resident of the U.S., she would be taxed by the U.S. as an NRA, which offers only a $60,000 exemption amount; thus, $2.125 million is subject to Federal estate tax. A s bill from the IRS would be $854,750. The Australian CGT would apply to the rest of her assets, because they are deemed to be located in Australia. Australian assets total $1.4 million dollars; the maximum CGT would be $339,500. The client s total tax bill to both countries is almost $1.2 million, if she is an Australian resident. If A claimed residency in the U.S., her U.S. assets (under the tax treaty) are the same as described above, yet she would have a $2 million U.S. estate tax exemption and an unlimited marital deduction. With $2.185 million subject to U.S. estate tax, A s Federal tax bill would be $86,950. Her $1.4 million in Australian assets would be subject to the maximum Australian CGT, for a tax bill of $339,500. Her total tax bill to both countries is $426,450 if she is a U.S. resident: Concepts like the exemption amount and the unlimited marital deduction in the Federal estate tax system can minimize the effect of the U.S. rate, which is usually higher than most countries analogous taxes. As demonstrated above, it is important to calculate each scenario to know the true effect of each country s taxation system. Clearly, A should claim U.S. residency and invoke the U.S. Australia tax treaty for U.S. estate tax purposes. The Tax Adviser September 2006 9

Conclusion The multinational individual presents a number of planning issues. The factors that give rise to the taxing jurisdiction of the U.S. should be determined, as well as the individual s residency, immigration status and asset location. Special issues, such as the use of tax treaties, should also be considered, to arrive at a comprehensive estate plan that is both tax-efficient and meets client goals. Notes 1 See Sec. 2010(c); for a discussion, see Sawyers and Satchit, Significant Recent Developments in Estate Planning, p. 540, this issue. 2 See Richard L. Doernberg, International Taxation in a utshell (West Group, 5th ed., 2001), 5. 3 See Sec. 7701. 4 See Joint Committee on Taxation, Review of the Present-Law Tax and Immigration Treatment of Relinquishment of Citizenship and Termination of Long-Term Residency, JCS-2-03 (February 2003). 5 Rev. Rul. 80-363, 1980-2 CB 376. 6 Rev. Rul. 80-209, 1980-2 CB 248. 7 See Sec. 2001(c). 8 See H Rep t No. 100-795, 100th Cong., 2d Sess. (1988), p. 592. 9 See Est. of Edouard Paquette, TC Memo 1983-571. 10 See Godfrey, The Phaseout of the Federal State Death Tax Credit, Part I, 35 The Tax Adviser 96 (February 2004) and Part II, 35 The Tax Adviser 148 (March 2004). 11 See Income Tax Rates Act 1986, Schedule 11. 12 See U.S. Citizenship and Immigration Services, I am a Permanent Resident How Do I Apply for U.S. Citizenship? at www.uscis.gov/graphics/services/factsheet/howdoi/b3.pdf. 13 See Osborne and Schurig, Asset Protection: Domestic and International Law and Tactics (Clark Boardman Callaghan, 2006), Vol. 2, 24:20. 14 See Regs. Sec. 301.6114-1(d). 15 See Finance Act, 1986, Section 100. 16 See Convention Between the Government of the United States of America and the Government of the United Kingdom of Great Britain and Northern Ireland for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Estates of Deceased Persons and on Gifts (signed 10/19/78), Article 9. The Tax Adviser September 2006 10