G. Impact of the Proposals on Existing Tax Treaties and Future Treaty Negotiations 1. Impact on current treaty obligations Although the proposals theoretically impose a departure tax immediately prior to the time when a U.S. citizen relinquishes citizenship, the tax is, in various situations, imposed substantially later than the relinquishment.257 Under present law, the U.S. tax laws follow the relevant provisions of the ÎNA in determining when citizenship terminated.258 An individual's citizenship terminates on the date he or she takes the oath of formal renunciation, or on the date he or she commits an expatriating act (e.g., acquires citizenship of another country) with the intent of relinquishing U.S. citizenship, even though the action is not reported to the State department until a later date.259 In the latter case, an issue arises as to whether the departure tax may be imposed on an individual who is no longer a U.S. citizen under the INA. For example, assume the following facts: Ms. A acquired citizenship of Country X on January 1, Under the proposals, Ms. A would be subject to the departure tax even though she had not been a U.S. citizen under applicable U.S. tax law for over five years. Furthermore, she would also be reinstated as a U.S. citizen for tax purposes from January 1, 1990, through February 6, 1995.260 An issue that arises is whether the United States may properly impose the departure tax on Ms. A under the saving clause provision of the treaty between Country X and the United States. Bilateral U.S. income tax treaties do not define the term "citizen." Unless otherwise provided, the parties generally look to the tax laws of the country that taxes the particular income for the definition of undefined terms.261 However, if any of 257 See discussion under Part IV.B. with respect to the issues raised by the proposals to tax a former citizen as a citizen. 258 See Rev. Rul. 92-109, 1992-2 C.B. 3 and Treas. Reg. section 1.1-1(c). 259 See 8 U.S.C. 1481 and 8 U.S.C. 1488. 260 For tax purposes, Ms. A's U.S. citizenship does not terminate until either February 6, 1995 (under the Senate bill and the modified bills) or June 1, 1995 (under the Administration proposal). 261 See Article 3(2) of the 1981 Proposed U.S. Model Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion (the "1981 U.S. Model Treaty"). The provision also states that the competent authorities of the treaty countries may also agree to a common meaning for any undefined term upon request by taxpayers under the "Mutual Agreement Procedure" of the treaty. the proposals are enacted, there will be a conflict under U.S. internal laws (i.e., the Immigration and Nationality Act and the Internal Revenue Code) as to when an individual ceases to be a U.S. citizen. As a result, a taxpayer in Ms. A's situation may take the position that the departure tax does not apply because it was imposed after she ceased to be a U.S. citizen. It is uncertain whether such a position will prevail. Even if it is determined that the tax definition of the term "citizen" controls, another issue is whether the tax definition of the term "citizen" that existed at the time the treaties were signed controls (i.e., a static interpretation) or that when the treaties are being applied controls (i.e., an ambulatory interpretation). The 1981 U.S. Model Treaty does not address the issue of whether an undefined provision or phrase in a treaty should be interpreted in a static or in an ambulatory manner. However, the United States has adopted the ambulatory approach in a case interpreting the meaning of certain terms in the U.S.-U.K. treaty. In Rev. Rul. 80243, 1980-2 CB 413, the IRS denied a U.K. corporation certain deductions in computing its U.S. taxable income (taxable under sec. 882) despite the fact the provision that disallowed such deduction was not in the Code at the time the U.S.-U.K. treaty was signed.262 The commentaries to the 1992 OECD Model Tax Convention on Income and Capital (the "1992 OECD Model Convention") suggest that the law in force when the Convention is being applied should determine the meaning of undefined terms "only if the context does not require an alternative interpretation." 263 The commentaries imply that the intent of the treaty countries upon the signing of the treaties and any conflict regarding the meaning of the terms under the laws of the countries be part of the consideration in determining whether an alternative interpretation is warranted. The objective, according to the commentaries, is to strike a balance between the need to ensure permanency of commitments undertaken by States when signing a convention (since a State should not be allowed to empty a convention of some of its substance by amending afterwards in its domestic law the scope of terms not defined in the Convention) and . . . the need to be able to apply the Convention in a convenient and practical way over time (the need to refer to outdated notions should be avoided)." 264 66 It is unclear whether the static or the ambulatory approach is more theoretically sound.265 Two countries that are signatories to a bilateral treaty may apply different approaches to the same situation, resulting in a dispute. Such a conflict may be resolved by mutual agreement between the competent authorities of the treaty countries. 266 If Ms. A is successful in avoiding being categorized as a citizen for purposes of the departure tax, she theoretically may still be subject to the tax as a former citizen. As illustrated in Appendix 262 See also PLR 7844008, July 26, 1978, on which the revenue ruling was based. 263 See paragraph 12 of the commentaries to Article 3(2) of the 1992 OECD Model Convention. 264 See paragraph 13 of the commentaries to Article 3(2) of the 1992 OECD Model Convention. 265 See J. Ross Macdonald, Annotated Topical Guide To U.S. Income Tax Treaties, Vol. 2, Section 12 "Undefined Terms," p. 1355. 266 See the Treasury Department, "Technical Explanation of the Treaty on the Convention between the United States of America and the Kingdom of Spain for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect with Respect to Taxes on Income Signed at Madrid on February 22, 1990," on Article 3(2). 90-981 0 - 95 - 5 A, substantially all of the bilateral U.S. treaties that contain saving clauses permitting the United States to tax its former citizens require the loss of citizenship to be tax motivated. Because the proposed departure tax is designed to tax all expatriates who have a certain level of gain regardless of their reasons for relinquishing their citizenship, the Category II saving clause provision (i.e., the one that preserves the right of the United States to tax its former citizens whose loss of citizenship is tax motivated) would not permit the United States to impose the departure tax on someone who did not expatriate for tax avoidance motives. To alter this result, all of the existing U.S. tax treaties that contain Category I and II saving clauses (41 out of the 45 treaties currently in force) would have to be renegotiated to allow the United States to impose a departure tax on its former citizens regardless of the intent to relinquish their citizenship. Only four U.S. income tax treaty currently in force, namely the U.S. treaties with the Czech Republic, Hungary, Russia Federation and the Slovak Republic, do not require tax avoidance to be present in order for the United States to tax its former citizens who are residents of the treaty partner. There is no evidence to suggest that U.S. citizens are expatriating with the objective of becoming residents or citizens of these countries, for tax avoidance or otherwise. 2. Impact on future treaty negotiations As discussed above, if a departure tax is enacted, the United States would need to renegotiate existing treaties to impose the tax on former citizens who have legally relinquished their citizenship on an earlier date under the applicable U.S. law. For the following reasons, our treaty partners may object to the United States' imposition of the departure tax on unrealized income of individuals who became residents of their country: First, they may prefer to preserve for their own residents the benefits under the treaty (i.e., not subject to U.S. taxing jurisdiction). Second, they may resist the continuing expansion of taxation by the United States based on citizenship status. Third, they believe that they will lose revenue if they cede to the United States primary jurisdiction over non-U.S. source income.267 In order to extract such a concession from our treaty partners during the negotiation process, it probably would be necessary for the United States to forego certain other benefits to obtain a balance of benefits under the treaties. Furthermore, to resolve the issue of double taxation by renegotiating existing treaties, the following options could be considered: (1) The United States could preserve its right to have primary taxing jurisdiction over the gain from the deemed sale, and the treaty partner could grant a step-up in the basis to the extent of such gain. This alternative is modelled after Article 13(6) of the U.S.-Germany Treaty (discussed above) and would require a treaty partner to cede to the United States its right to tax 267 See Roberts, "Is Revenue Ruling 79-152, Which Taxes an Expatriate's Gain, Consistent With the Code?," 51 J. Taxation 204 (1979). the gain accrued while the individual is a U.S. citizen or longterm resident. (2) The United States could cede to its treaty partner the primary taxing jurisdiction over the gain from the deemed sale by giving a foreign tax credit for taxes paid by the expatriate to the treaty partner. This alternative is generally modelled after Articles XIII(5), XIII(7) and XXIV(3)(b) of the U.S.-Canada Treaty (discussed above). (3) The United States could preserve its right to have primary taxing jurisdiction over the gain from the deemed sale, and the treaty partner could grant a credit for U.S. taxes incurred despite the fact that the realization event in the foreign country occurs later. This alternative is a modification of the provisions under the U.S.-Canada Treaty (discussed above). This is the converse of the second alternative mentioned above and would require a treaty partner to cede its right to tax gain (and hence, cede a portion of the revenue currently collected by its fisc) of a resident to the extent the gain is taxed by the United States under the proposals. H. Mark to Market Issues; Treatment of Trusts All three versions of the expatriation proposal (i.e., the Administration proposal (included in H.R. 981 and S. 453), the Senate bill (amendment to H.R. 831), and the modified bills, introduced by Senator Moynihan (S. 700) and Representative Gibbons (H.R. 1535)) would require the marking to market of: (1) all interests of an expatriating individual that would have been included in that individual's gross estate were that individual to die immediately before expatriating; (2) any other interest in a trust which the expatriating individual is treated as holding or the assets underlying such trust interests; and (3) other property interests specified in Treasury Regulations necessary to carry out the purposes of the proposal. For purposes of the proposals, a beneficiary's interest in a trust generally would be based on all of the facts and circumstances. If interests in a trust could not be determined on the basis of facts and circumstances, the rules are different under the various proposals. Under the Administration proposal and the Senate bill, the beneficiary with the closest degree of family relationship to the grantor would be presumed to hold such remaining trust interests. In the event that two or more beneficiaries have the same degree of kinship to the grantor, they would be treated as holding the remaining trust interests equally. Under the modified bills, the ownership of a trust interest (not determined under the facts and circumstances test) would first be allocated to a grantor if a grantor is a beneficiary of the trust. Otherwise, the ownership of such a trust interest would be based on the rules of intestate succession. The facts and circumstances test, however, does not apply to a grantor trust (or any portion of a trust treated as a grantor trust). Under the various proposals, only the grantor of a grantor trust would be treated as owning an interest in the trust; thus, beneficiaries (other than the grantor) would not be required to mark to market their interests in such a grantor trust if they were to expatriate. 1. Problems of applying a mark-to-market provision to property interests generally a. In general A number of issues are raised by the proposals to mark to market interests in property. These problems generally can be divided into three categories: (1) ownership identifying the person who would bear the tax if the appreciated property were sold; (2) liquidity-providing the opportunity for the taxpayer to raise funds from the interests with which to pay the tax; and (3) valuation-determining the value of such interests. The problems often are related-something that makes it difficult to determine who owns an interest in property often makes that interest very illiquid which, in turn, makes the value of such interests difficult to determine.268 Many of these problems are especially difficult in the case of interests held through trusts. As discussed above, the various propos 268 Similar liquidity and valuation concerns arise under the estate tax; identifying the owner of property, however, generally is easier in the estate tax context. |