Example (4): High-basis assets, high consumption Assume the individual has capital assets valued at $10 million with a basis of $10 million. Assume that the individual consumes all of after-tax income and also consumes $500,000 of principal annually. Assume the invested principal pays a 10-percent dividend annually. In addition, assume that the individual dies after 20 years. If the individual retains U.S. citizenship, the individual's lifetime tax liability will be as described in example (3) above, less the $140,000 paid annually in taxes on realized capital gains in example (3), as the individual has no accrued gains. If the individual were to relinquish U.S. citizenship, lifetime tax liability would be as described in example (3), less the $140,000 paid annually in taxes on realized capital gains, both in the case in which tax avoidance was a principal purpose and the case in which the avoidance was not a principal purpose. Under the Administration proposal, the individual would pay no tax at the time of expatriation, as there was no accrued gain. If the individual's new country of residence imposes no taxes, the individual is better off by the entire amount of U.S. taxes forgone. If the individual's new country of residence imposes taxes comparable to the United States, the individual's lifetime tax liability is the same as if he had remained a U.S. citizen. General discussion The examples above highlight the factors that affect the individual's lifetime tax liability under retention of citizenship and relinquishment of citizenship, under present law and under the Administration proposal. Holding all else equal, it is always more advantageous to emigrate to a zero-tax country than to a country with taxes comparable (or higher) to those in the United States. Relinquishment of citizenship and emigration to a country with taxes comparable to those in the United States can subject the individual to a substantially higher lifetime tax liability under either present law or the Administration proposal. If treaties reduce or eliminate potential double taxation under present law, in the absence of relief from double taxation, the Administration proposal could produce greater lifetime tax burdens than present law. Submerged within the simple examples above are subtle tradeoffs of various different tax rates that different countries may impose. For example, some countries do not tax capital gains while others do. Some countries have higher top marginal tax rates on income than does the United States, but lower top marginal estate or inheritance tax rates. The examples simplify the U.S. income tax and estate tax rate structures and ignore State and local income taxes which may add significantly to lifetime income tax burdens. The examples highlight that comparison of the Administration proposal to present law and retention of citizenship involves a comparison of paying taxes on capital gains in the present in lieu of potential taxes on capital gains, ordinary income, and estate taxes in the future. Such comparisons of lifetime tax liability are likely to vary from country to country. Tax treaties also will affect crosscountry comparisons. The United States has treaties with many countries that might be considered to have comparable tax systems. These treaties may reduce the potential for double taxation. 106 The simple examples also ignore withholding rules applicable to U.S.-source income received by non-U.S. persons. While the rates of withholding tax vary under prevailing tax treaties, the existence of withholding implies that with respect to U.S.-source income some tax would be imposed on the income of an individual who expatriates to what might otherwise be a zero-tax country in the examples above. The lifetime tax liability varies substantially between present law and the Administration proposal depending upon whether the would-be expatriate owns "high-basis” assets or "low-basis" assets, that is, depending upon whether or not the wealth consists of substantial accrued gains. Under the Administration proposal, the would-be expatriate generally is never worse by expatriating if he or she has high-basis assets. This is because, unlike present law, the Administration proposal does not impose a tax on income received after expatriation. The lifetime tax liability also shows substantial variance to the consumption pattern of the expatriate. Part of the tax burden that arises from retention of U.S. citizenship is the estate tax liability. If an individual consumes from wealth he or she incurs no current tax liability, as the United States does not have a general consumption tax, and he or she reduces the value of his future estate and thereby diminishes his or her future tax liability. 107 Conversely, low consumption may cause the individual's principal balance to rise and cause an increase in potential future estate tax liability. Such further capital accumulation also may increase current earnings that may be taxable as income. Related to the importance of the individual's consumption pattern is any propensity he or she might have to make charitable donations or bequests from accumulated wealth. While conceptually charitable donations and bequests can be thought of as similar to consumption, in that each diminishes the potential future estate, there is a difference in the case of low-basis assets. As noted above, to consume from low-basis assets generally the taxpayer must recognize gain and pay tax on the gain recognized prior to consuming. 108 A charitable donation of appreciated assets may not require the recognition of income. Other variables important to the comparison of lifetime tax liabilities not directly highlighted by the examples are: the earnings performance of the individual's assets; the individual's expected lifetime; and the appropriate discount rate to apply to future tax liabilities. The Administration proposal would tax accrued gain at the time of expatriation. Present law taxes income for 10 years after expatriation. Clearly, the earnings performance of the individual's assets are important in the comparison. Where the assets 106 See Parts V.F. and V.G. for a discussion of issues of double taxation and tax treaties. 107 This discussion ignores State-level general sales taxes The examples above also ignored the possibility that an expatriate might pay consumption taxes in the new country of residence as many countries of the world have value-added taxes. 108 The individual could consume without recognizing gain. The individual could pledge his or her entire wealth as collateral for a loan. The individual could then consume the loan proceeds over his or her lifetime. No income tax liability arises from the receipt of loan proceeds. Upon his or her death, the estate would consist of the original assets and the debt owed on the loan, resulting in no net estate and no estate tax. produce little or no future income, and hence no income tax, by collecting tax on accrued gain in advance of any future realization the Administration proposal may increase the lifetime tax liability of the expatriate. Similarly, if the assets were to decline in value subsequent to expatriation, the lifetime tax liability imposed by the Administration proposal increases relative to potentially lower future income and estate tax liabilities that might arise were the individual to retain U.S. citizenship. Conversely, the greater the earnings, the less the lifetime tax liability the Administration proposal is likely to impose compared to present law which may tax those earnings. Where the estate tax, either in the United States or in a new country of residence, is important to the comparison of lifetime tax liability, the individual's life expectancy and the determination of an appropriate rate of discount are important to the comparisons of lifetime tax liabilities. For a given rate of appreciation of assets, the greater the individual's life expectancy and the greater the discount rate, the lower the present value of the expected future estate tax liability. V. SPECIFIC ISSUES RELATING TO PROPOSALS TO A. Effectiveness and Enforceability of Present Law With Respect to the Tax Treatment of Expatriation 1. Effectiveness of present law Although there are provisions in present law imposing a special tax on individuals who expatriate for tax avoidance reasons (e.g., sec. 877), there is conflicting evidence as to whether these provisions are effective in discouraging individuals from expatriating to avoid their United States tax liabilities. A U.S. citizen who expatriates for tax avoidance reasons is subject to a special tax on U.S. source income for 10 years after expatriation. In addition, if the expatriate dies or transfers property by gift within the 10-year period, special U.S. estate and gift tax provisions apply. Tax practitioners and personnel in U.S. embassies have provided at least some anecdotal evidence that individuals inquiring about the potential tax liability they might incur upon expatriation have expressed concern that they could be subject to U.S. taxation for an additional 10 years. Other practitioners, however, have indicated that these provisions do not act as a deterrent to individuals seeking to expatriate for tax reasons. While there is no way of actually knowing how many individuals are dissuaded from expatriating by the existence of the present-law rules, it is relevant to note (as discussed in Part V.B., below) that the incidence of expatriation generally, and by wealthy persons in particular, is relatively insignifi cant. The Treasury Department views the present-law provisions as not effective and not enforceable. There are several reasons why Treasury may view present law in this manner. First, there are legal methods to avoid taxation under section 877 (and the corresponding estate and gift tax provisions) through proper tax planning, although in certain cases such planning requires an individual to accept certain risks. Even if an expatriate is subject to tax under section 877, the income taxed under section 877 is limited in scope. No tax is imposed on foreign source income, even though such income would be taxed if the individual remained a U.S. citizen or resident. In addition, the section 877 tax applies only for the first 10 years after expatriation. Thus, an individual who is willing to hold appreciated assets for at least 10 years after expatriation would not be subject to the section 877 tax when such assets are sold. Extensive books have been written, and seminars conducted, setting forth details on how to legally and effectively avoid taxation upon expatriation under present law. 109 For example, individuals are advised to own only foreign assets, to convert most or all of their income into foreign source income, and to carefully plan the timing of their transactions to avoid taxation under the existing U.S. expatriation tax rules. Because of the limitations in the scope of present law, an individual may be able to achieve significant tax savings through expatriation, even if the person is found to have 109 See, e.g., Langer, The Tax Exile Report: Citizenship, Second Passports and Escaping Confiscatory Taxes (2d ed., 1993-1994). had a tax avoidance motive, and is thus subject to the special expatriation tax rules. In general, the U.S. tax system is dependent upon voluntary compliance in order to be effective, but there appears to be conflicting evidence as to the extent of voluntary compliance with respect to present-law section 877. The Joint Committee staff discovered some evidence that there may be voluntary compliance with section 877 by certain expatriates in the course of its study. The IRS apparently was unaware of this evidence of possible compliance and believes there is generally no voluntary compliance with section 877.110 There are at least two possible explanations for the IRS's view that there is little voluntary compliance with section 877. First, it could be because the special tax imposed under section 877 applies only to those individuals who expatriate with a principal purpose of avoiding tax, and few individuals will voluntarily admit that they have such a motive. (Instead, it is generally left to the IRS to "catch" these individuals after they have expatriated, which may be difficult given the practical limitations of monitoring and pursuing taxpayers who have physically left the United States.) Second, it may be that individuals expatriating with a tax avoidance motive have structured their affairs so as to legally avoid the application of section 877. Alternatively, the IRS's failure to find evidence of voluntary compliance with section 877 may be substantially attributable to the possibility that there are relatively few individuals with any significant wealth who are expatriating, for tax avoidance purposes or any other purpose. Finally, section 877 is ineffective with respect to individuals who relocate to certain countries with which the United States has a tax treaty, because these treaties may not permit the United States to impose a tax on its former citizens who are now resident in that country. This issue is discussed more fully in Part V.F., below. 2. Enforcement of present law The IRS appears to have devoted little in the way of resources to the enforcement of section 877. No regulations have been issued under section 877 since its enactment in 1966. Regulations could have been issued setting forth factors under which a tax avoidance motive would be presumed to exist (for example, if the taxpayer moved to one of a specified list of tax havens, or engaged in certain types of pre-emigration tax planning). A taxpayer would then have the burden of showing that either these factors did not exist, or that even though these factors did exist, the loss of citizenship did not have as one of its principal purposes the avoidance of taxes. The IRS also has not attempted to exercise any regulatory authority, nor has it sought Congressional expansion of regulatory authority, to preclude the use of sections 367 or 1491 by taxpayers seeking to avoid taxation after expatriation by converting their U.S. income into foreign source income. If the requirements of sections 367 and 1491 were tightened, taxpayers would be less able to transfer their wealth out of the United States without the payment of U.S. tax. 110 See, letter from Commissioner Richardson dated April 26, 1995 (included in Appendix G) indicating as follows: "[The IRS] is not aware of any taxpayers who have voluntarily filed returns indicating that they are subject to section 877." ... |