The Committee recognizes that citizens and residents of the United States have a right not only physically to leave the United States to live elsewhere, but also to relinquish their citizenship or terminate their residency. The Committee does not believe that the Internal Revenue Code should be used to stop U.S. citizens and residents from relinquishing citizenship or terminating residency; however, the Committee also does not believe that the Code should provide a tax incentive for doing so. In other words, to the extent possible, an individual’s decision to relinquish citizenship or terminate residency should be tax-neutral.

The Committee recognizes that the American Jobs Creation Act of 2004 altered prior law regarding expatriation in a number of respects, including the replacement of the subjective “principal purpose of tax avoidance test” with objective rules.

Notwithstanding these changes, the Committee remains concerned that the present-law expatriation tax rules (as modified in 2004) are difficult to administer and could be made more effective. In addition, the Committee is concerned that the alternative method of taxation under Section 877 can be avoided by postponing the realization of U.S.-source income for 10 years.

Consequently, the Committee believes that the present-law expatriation tax rules should be replaced with a new tax regime applicable to former citizens and residents. Because U.S. citizens and residents who retain their citizenship or residency generally are subject to income tax on accrued appreciation when they dispose of their assets, as well as estate tax on the full value of assets that are held until death, the Committee believes it fair to tax individuals on the appreciation in their assets when they relinquish their citizenship or terminate their residency. The Committee believes that an exception from such tax should be provided for individuals with a relatively modest amount of [income and net worth, or] appreciated assets. The Committee also believes that, where U.S. estate or gift taxes are avoided with respect to a transfer of property to a U.S. person by reason of the expatriation of the donor, it is appropriate for the recipient to be subject to [an income tax based on the value of the property] a transfer tax similar to the avoided transfer taxes.^[1]

The Committee also believes that the present-law immigration rules applicable to former citizens are ineffective. The Committee believes that the rules should be modified to eliminate the requirement of proof of a tax avoidance purpose, and to coordinate the application of those rules with the tax rules provided under the new regime.

Instead of paying the exit tax at the time of expatriation, the Senate bill allows an expatriate to make an irrevocable election to be taxed as a U.S. citizen with respect to all property that otherwise would be covered by the exit tax. An electing individual would continue to pay U.S. income taxes at the rates applicable to U.S. citizens following expatriation on any income generated by the property and on any gain realized on the disposition of the property. Also, the property would continue to be subject to U.S. Federal gift, estate, and generation-skipping transfer taxes. The election to continue to be taxed as a U.S. citizen would not be available unless the individual were to (i) provide security to ensure payment of the tax under this election in such form and manner, and in such amount, as the Secretary of the Treasury (the "Secretary") requires, (ii) waive future rights under treaties that would otherwise protect such individual from paying the U.S. tax, and (iii) comply with such other requirements as the Secretary may prescribe. The amount of the exit tax that would have been owed but for this election (including any interest, penalties and certain other items) would be a lien in favor of the United States on all U.S.-situated property owned by the individual until (i) the tax liability was satisfied, (ii) the tax liability became unenforceable by reason of lapse of time, or (iii) the Secretary was satisfied that no further tax liability could arise. The House bill does not include this election.

Both the Senate and House bills allow a covered expatriate to elect to defer payment of the exit tax with respect to particular property on an asset by asset basis. The election would be irrevocable. However, an individual who elected to defer payment of the tax would be charged interest for the period the tax was deferred. Under the Senate bill, the interest rate would be two percentage points higher than the rate normally applicable to individual underpayments. Under the House bill, the interest rate would be the usual rate on underpayments. Under the election, the deferred tax attributable to a particular asset would be due on the due date of the return for the taxable year in which the asset was disposed of (or, if the asset is disposed of in a transaction in which gain was not recognized in whole or in part, at such other time as the Secretary might prescribe). In order to elect deferral of the exit tax, an individual would be required to provide security. Under the Senate bill, a bond in the amount of the deferred tax would be required except if an individual established to the satisfaction of the Secretary that another security arrangement was adequate. Under the House bill, the security could be a bond meeting the requirements of Code Section 6324 or another form of security for payment (including letters of credit) that met requirements prescribed by the IRS. The individual also would be required to waive rights under treaties that would otherwise protect such individual from paying the applicable U.S. Federal tax. Under the Senate bill (but not the House bill) the deferred tax amount (including any interest, penalties and certain other items) would be a lien in favor of the United States on all U.S.-situated property owned by the covered expatriate until (i) the tax liability was satisfied, (ii) the tax liability became unenforceable by reason of lapse of time, or (iii) the Secretary was satisfied that no further tax liability could arise.

The proposed security arrangements would be costly and, under some circumstances, would unduly burden an individual's right to expatriate. If an individual did not have sufficient transferable assets to satisfy the security requirement, he or she could not satisfy the tax obligations imposed by the exit tax either by paying the tax or by providing security to defer the payment of tax. For example, the exit tax might be attributable in large part to a beneficial interest in a trust, an accrued benefit in a retirement plan, nonvested deferred compensation arrangement, or an interest in a closely held business that was subject to transfer restrictions, none of which could be sold or assigned as security for a loan or a bond. The security arrangements would impose an undue hardship on such an individual, who neither had nor had access to liquidity.

We recommend that the security requirement not apply to the extent the covered expatriate lacked the financial resources to provide it. Instead, the final bill should include a limitation on the amount of security required based upon the covered expatriate's assignable assets. Such a limitation would minimize the burden on an individual's right to expatriate in situations in which the covered expatriate owned little property in his or her own name but was treated as owning property under the provisions of the bill.

The Senate bill specifically lists only one type of security arrangement (a bond) and fails to address what standard the IRS might use to determine whether an alternate security arrangement would be "adequate." Historically, under Code Section 6166, bonding requirements have been onerous, considering the expense and length of time for which bonds are required. We recommend that the final bill specifically identify other acceptable security arrangements, including: (i) an irrevocable letter of credit from (1) a U.S. financial institution, (2) the U.S. branch of a foreign bank, or (3) a foreign bank and confirmed by a bank described in Code Section 581; (ii) a withholding arrangement with a U.S. brokerage firm; or (iii) a taxpayer-established U.S. trust with security provisions similar to those available for qualified domestic trusts under Code Section 2056A and Regs. Section 20.2056A-2(d). The proposed alternate security arrangements should be coordinated with the lien imposed on the U.S. property owned by the covered expatriate. We also recommend that clarification be provided in the case of the election to continue to be taxed as a U.S. citizen, with respect to whether the amount of security would have to be increased if the value of the property that would trigger the tax increased after expatriation.

The Senate and House bills would require payment of the exit tax based on values at the time of expatriation, whether or not the expatriate ever realized gain on the actual disposition of the property held at the time of expatriation. The bills fail to take into consideration the possible decline in the value of the property following expatriation, which could be particularly severe in the case of stock options. Moreover, the interest that would be charged under the deferral election under the Senate bill is extremely high and when added to the tax could exceed the value of the property when sold. Although we agree with the concept of deferring payment of the exit tax until the disposition of the underlying assets, we recommend that the bill limit the amount of the exit tax payable under the deferral provision to the lesser of (i) the unrealized gain at the time of expatriation plus interest, and (ii) the amount realized at the time the individual disposes of the property reduced by foreign taxes paid as a result of such disposition. The amount in clause (i) should be reduced by gain subject to the deferred tax in prior dispositions.

For example, suppose that the aggregate deferred gain on four assets was $2 million, $500,000 each. Suppose that two years after expatriating, the covered expatriate sold one of the assets and realized a gain of $600,000. Under our proposal, all of that gain would be realized and taxed in the year of the actual sale, rather than only the $500,000 of gain attributable to that asset on the date of expatriation (as under the Senate and House bills.) However, only $1.4 million of accrued gain would remain to be recovered upon further dispositions of assets by the covered expatriate. This rule would accelerate the collection of tax because the amount due on the sale of a particular asset would not be limited to the portion of gain attributable to such property on the date of expatriation. However, this rule also would insure that a tax payment obligation would not be created in an amount that exceeded a person’s ability to pay.

Alternatively, the election to continue to be subject to U.S. tax could be allowed on an asset by asset basis, so that the U.S. tax would be based on the amount actually realized whether it was greater or less than the unrealized gain at the time of expatriation. This proposal likewise would avoid the problem of having a tax calculated on a hypothetical gain which may bear no relationship to the actual gain, if any. It could also potentially subject those covered expatriates who deferred payment of the exit tax to a greater amount of tax than would have been imposed without the deferral election.

For example, assume that the unrealized gain on four assets was $500,000 each on the date of expatriation and an election was made to treat three of those assets — representing unrealized gain of $1.5 million - as subject to U.S. tax after expatriation. If one asset becomes worthless but the other two assets were sold at a gain of $1,000,000 apiece, the gain subject to U.S. tax would be $2 million, an amount $500,000 more than the aggregate gain on expatriation. However, if the gain ultimately realized on the sale of the three assets was less than $1.5 million, only the amount of gain realized would be subject to the deferred exit tax.

The deferred exit tax should not apply to any asset which is included in the covered expatriate's estate for U.S. federal estate tax purposes at death, assuming that under then applicable U.S. law the asset is entitled to a basis step-up under Code Section 1014. To impose the deferred tax in these circumstances would be contrary to the stated goal of tax neutrality. If the exit tax has been paid prior to death of a covered expatriate (e.g. because payment of the exit tax was not deferred) and the same asset later is subject to U.S. Federal estate tax, an adjustment for the exit tax paid on that asset should be allowed against the U.S. Federal estate tax attributable to that asset.

Similarly, if an asset on which payment of the exit tax has been deferred later is subject to the U.S. Federal gift tax, an adjustment should be made to the exit tax to reflect the adjustment to basis allowed under Code Section 1015. If the exit tax has been paid before the gift is made, an adjustment for the exit tax should be allowed against U.S. Federal gift tax attributable to that asset.

The Senate and House bills provide that the payment of the exit tax may be deferred until the due date of the return for the taxable year in which the covered expatriate disposes of such property, or, in the case of property disposed of in a transaction in which gain is not recognized in whole or in part, "until such other date as the Secretary may prescribe." In order to eliminate uncertainty regarding the due date for payment of deferred tax, we suggest that the Secretary's authority to prescribe alternate dates for payment of the exit tax be removed from the bill and that the date for all payments be the due date of the return for the taxable year in which the individual either transfers the property in a taxable or nontaxable transaction, including a gift.

Recommendations

Limit security requirements where the covered expatriate lacks the resources to secure the deferred tax;

Allow alternative security arrangements;

Limit interest accruals on deferred tax to the deficiency rate;

Limit the deferred tax due on the disposition of an asset on which tax has been deferred to the net amount realized on disposition;

Allow an election to subject an asset to continuing U.S. tax jurisdiction on an asset-by-asset basis;

Provide an adjustment for the exit tax where an asset is subject to the U.S. Federal gift or estate tax following expatriation; and

Clarify the due date for payment of any deferred tax.

Under current law, a person who is a grantor of a trust may be subject to tax upon expatriation under some circumstances. For example, if the trust is foreign and the grantor ceased to be treated as the owner of the trust upon expatriation, Code Section 684 may impose gain as if the assets in the trust were sold. Gains are deemed realized, but losses are not deemed realized and do not offset gains. If a U.S. trust became a foreign nongrantor trust as a result of a person’s expatriation, gain may be realized under Code Section 684. Except as provided in Code Section 684, however, expatriation would not change the taxation of trust income, and income distributed to a covered expatriate would be taxed to the same extent as if received directly and not through the trust.

The rules for trusts are significantly different in the Senate and House bills.

The Senate bill

The Senate bill exposes a covered expatriate to a exit tax on account of his or her status as a beneficiary of a trust if it is determined that he or she “holds” an interest in a trust on the day before his or her expatriation date. Despite the significance of the holding requirement, the proposal contains no clear method by which to determine whether or not a covered expatriate actually holds an interest in a trust. Proposed Code Section 877A(f)(3)(A) provides that a covered expatriate’s “interest in a trust shall be based upon all relevant facts and circumstances, including the terms of the trust instrument and any letter of wishes or similar document, historical patterns of trust distributions, and the existence of any functions performed by a trust protector or any similar advisor.” At best, these factors are nothing more than indications as to what the covered expatriate might expect to receive from a trust rather than any actual property interest in the trust. Except when an individual’s trust interest can be actuarially valued, as is the case with an interest such as the right to receive trust income for a term, it is impossible to predict how these factors can be used to measure an individual’s interest in a trust. We are, therefore, very concerned that the proposed Code Section 877A will give rise to substantial inequities.

A not unusual, simple example will illustrate our concern. Suppose that P created a discretionary trust 10 years ago for the benefit of all of his or her descendants. C, a covered expatriate, is one of three living children of P, but has never received any distributions from the trust. At the time of C’s expatriation, P had three living grandchildren as well as three living children. In fact, no distributions have ever been made from the trust. P’s letter of wishes to the trustee indicated that P viewed the trust as a financial safety net for her children and that she would prefer that the trustee accumulate income and maintain principal unless a child or more remote descendant was in need of funds for educational or medical expenses or other support related needs. What facts should determine whether C holds an interest in the trust? Should he or she be able to show that he or she holds no interest because it is unlikely that he or she would ever receive a distribution. Or, would he or she be treated as holding a 1/6th interest because there are six beneficiaries. If the latter approach is followed, C risks paying a substantial tax on values he or she is likely never to receive.

Once it is determined that a covered expatriate holds an interest in a trust, proposed Code Section 877A(f) creates two different regimes for the tax treatment of these interests - one for interests in Qualified Trusts, defined as trusts that are United States Persons within the meaning of Code 7701(a)(30)(E), and one for interests in all other trusts, referred to in this section as “Foreign Trusts.”

Treatment of Covered Expatriates Holding Interests in Foreign Trusts

If a covered expatriate holds an interest in a Foreign Trust, he or she will not be treated as having sold the interest. Instead, his or her interest is to be treated as a separate share in the trust, the share is to be treated as a separate trust consisting of the trust assets allocable to the share, and the separate trust is to be treated as having sold all of its assets on the day before the expatriation of the covered expatriate and as having distributed all its assets to the covered expatriate. The covered expatriate then pays the tax he or she would have paid if his or her deemed separate trust had actually distributed the sale proceeds to him or her and is treated as having recontributed the assets he or she received back to the trust.

We assume that the object of the proposal is to require the covered expatriate to include in his or her gross income any gain deemed to have been recognized on the deemed sale as well as any previously undistributed income earned in the year of expatriation prior to the expatriation event and the trust’s undistributed income from prior years. This result interacts uneasily with the various existing methods for taxing trusts and their beneficiaries and creates a number of anomalies and unanswered questions, including:

1.     What happens to the trust’s undistributed net income when the separate trust is constituted? If the covered expatriate is deemed to have an interest consisting of a 20% vertical slice of all of the trust’s assets, does his or her trust have 20% of the trust’s undistributed net income? Will the deemed distribution be treated as a distribution of some portion of that undistributed income potentially exposing the covered expatriate to heavy interest penalties?^[9]

2.     When a covered expatriate’s interest in a trust consists only of the right to receive income, either absolutely or in the discretion of a trustee, how should his or her interest in the trust be established? Suppose, for example, that the covered expatriate had a right to receive all of the income from the trust for life and that the actuarial value of his or her right to income was equal to 20% of the value of the trust? Should his or her share consist of a vertical slice of all of the trust’s assets? Suppose the trust consisted of $50 million worth of shares of U.S. stock with a basis of $10 million. Should he or she be treated as having capital gain income of 20% of $40 million despite the fact that, if he or she had not expatriated, he or she would never have paid any tax on the capital gains generated by the trust? Going forward, he or she will continue to be taxed by the United States on the dividends he or she receives from the trust. Should there be a mechanism that would permit him or her to offset future U. S. Federal taxes on dividend income by the tax he or she paid on expatriation?

3.     Will the assets deemed to have been recontributed to the trust by the covered expatriate have a new basis equal to fair market value on the deemed sale upon expatriation?

4.     Will the covered expatriate who receives future distributions from the trust be treated as having received them from the portion he or she recontributed so that the tax advantage, if any, of the new basis will inure to his or her benefit?

5.     Will the covered expatriate’s share of the trust be treated as a separate trust with respect to which he or she is a grantor so that, if consistent with Code Section 672(f), he or she would be treated as the owner of that portion of the trust?

6.     In the case of an interest in a charitable remainder trust, how is the distribution to be allocated among the various categories of accumulated income? Will the covered expatriate receive a charitable deduction for the deemed recontribution of assets back to the trust? Will a charitable remainder annuity trust lose its status as a charitable remainder trust because of the deemed contribution by its expatriating beneficiary? Charitable remainder trusts are not permitted to accept additions and are not permitted to make distributions in excess of the amounts originally provided for in the trust instrument.

7.     In the case of an interest in a pooled income fund within the meaning of Code Section 642(c) and in the case of a charitable lead trust, will the covered expatriate receive a charitable deduction for the deemed recontribution of assets back to the trust?

8.     When one of the assets in the trust is a United States Real Property interest (as defined in Code Section 897(c)(1)), should that asset be excluded from the deemed sale with respect to the covered expatriate’s separate trust to give the covered expatriate the same protection he or she would have received under proposed Code Section 877A(d)(1)(A) if he or she had owned such property directly?

Treatment of Covered Expatriates Holding Interests in Qualified Trusts

If a covered expatriate holds an interest in a Qualified Trust, he or she will not immediately be subject to the exit tax regime imposed by proposed Code Section 877A(a).

Instead, a system that permits deferral of tax, but in many cases will result in double taxation of the same unrealized amounts, is imposed.

The amount of exit tax that would have been imposed on the covered expatriate’s allocable expatriation gain is to be calculated and used to establish a “deferred tax account.” This account, with various adjustments, will be used to calculate the amount of future tax to be paid by the covered expatriate. The calculation of this amount starts with the determination of the interest that the covered expatriate holds in the trust, a calculation that is subject to the same uncertainties discussed above, with the addition of one other factor. Proposed Code Section 877A(f)(2)(D) introduces the concept of “vested and unvested” interests in the trust. A covered expatriate’s allocable expatriation gain is to be determined only with respect to his or her vested and unvested interests. An “unvested interest” is to be determined by “assuming the maximum exercise of discretion in favor of the beneficiary and the occurrence of all contingencies in favor of the beneficiary.” This concept limits the amount of exit tax that will be imposed on a later distribution to an expatriate. For example, an addition to the trust made after expatriation or appreciation accruing after expatriation are shielded from tax.

After expatriation, when the covered expatriate receives a distribution from the trust, he or she will be subject to the taxes on such distribution that a nonresident alien would ordinarily pay on distributions from a trust that is a United States person, (i.e., a 30% tax on dividends received from United States corporations), and will be subject to an additional tax equal to the lesser of (i) the amount of the distribution multiplied by the highest tax rate imposed by Code Section 1(e) for the taxable year which includes the day before the expatriation date and (ii) the amount in the deferred tax account. The additional tax is to be withheld by the trustees.

As discussed above, the deferred tax account is calculated as of the expatriation date. Thereafter it is increased by interest determined at a rate 2% in excess of the rate of interest on underpayments of tax under Code Section 6621, producing a current interest accrual of 10%, compounded daily. It is decreased by the taxes imposed on the covered expatriate under proposed Code Section 877A§, and, if the covered expatriate’s interest is unvested, to the extent provided in regulations, by the amount of tax imposed by proposed Code Section 877A§ on distributions with respect to unvested interests not held by the covered expatriate. Thus, distributions with respect to a covered expatriate’s unvested interest that are made to any other beneficiary who is not also a covered expatriate would not reduce the covered expatriate’s deferred tax account. An adjustment to the covered expatriate’s deferred tax account should be made in order to avoid overstating his or her share of the trust’s unrealized gain at the time of expatriation.

If the covered expatriate disposes of his or her interest in the trust, if the trust ceases to be a Qualified Trust, or if the covered expatriate dies while there is a positive balance in his or her deferred tax account, a tax is to be imposed on the trust equal to the lesser of (i) the amount in the deferred tax account or (ii) the amount of tax the covered expatriate would have paid with respect to the interest he or she held in the trust if she had expatriated on the date of the disposition, cessation, or death. If the covered expatriate only owned a lifetime interest in a trust, presumably his or her interest at death is zero and no exit tax would be owed. However, this point should be clarified. Curiously, proposed Code Section 877A(f)(2)(F) appears to give other trust beneficiaries the right to recover this tax from the covered expatriate or from his or her estate. It is unclear how or in what jurisdiction this right of recovery could be pursued successfully.

An illustration will show how far this approach strays from the goal of tax neutrality that proposed Code Section 877A§ is intended to achieve for covered expatriates. Suppose that C, a covered expatriate, is determined to hold a 50% interest in a trust that consists of $50 million worth of shares of U.S. stock with a basis of $10 million all of which had been held for more than one year, and that expatriation occurred in a year in which the tax on long term capital gains was 15%. C’s initial deferred tax account will consist of $3 million. ($50 million minus $10 million multiplied by 50% and again multiplied by 15%.) For the next 5 years after expatriation, C receives no distributions from the trust. In the meantime, the trust sells all of its stock and pays total U.S. taxes of $6 million, and reinvests the proceeds in new securities with respect to which there is now $8 million of unrealized appreciation. By the end of 5 years, C’s deferred tax account will have grown to approximately $4.9 million (assuming a continuing interest rate of 10%). In year 6, the covered expatriate receives a distribution of $1 million worth of dividend income generated by the trust’s investment in stocks of U.S. corporations. The trustee withholds tax of $300,000, calculated at the 30% rate applicable to nonresident aliens as it is required to do under Code Section 1441. In addition, the trustee will be required to withhold an additional $350,000 (35% of $1 million) under proposed Code Section 877A§. C will be subject to total taxes of $650,000 on C’s $1 million distribution, notwithstanding that the trust has already paid the taxes on C’s portion of the unrealized capital gains that existed at the time of C’s expatriation. And C’s deferred tax account continues to hold about $4.55 million ($4.9 million - $350,000), exposing C to future taxes up to this amount (plus accumulated interest thereon).

It is not clear from the Senate bill whether additional tax would be due upon C’s death. If C’s beneficial interest terminates at death, no further tax should be due because C would not have benefited from the assets remaining in the trust. C’s beneficial interest at that point is zero. However, if this is not the intended rule and additional tax is due upon C’s death, in the above example, the trust will pay a tax equal to the lesser of the amount in C’s deferred tax account or the amount of tax C would have owed with respect to C’s beneficial interest in the trust had C expatriated on the date of C’s death, assuming that the trust were not then a qualified trust. Total taxes imposed on C and the trust as to C’s interest, would then amount to at least almost $4 million and possibly more than $8 million:

•      $300,000 withheld tax on dividends actually paid to C

•      $350,000 withheld tax imposed by Code Section 877A on distributions to C

•      $3,000,0000 tax paid by the trust on C’s 50% share of assets sold by the trust

•      Either $600,000 tax paid by the trust on C’s 50% share of unrealized gains at the time of C’s death (or the $4,550,000 balance of C’s deferred tax account, depending upon how the law is applied in this context).

If C had not expatriated, total taxes imposed on C and the trust as to C’s interest would have been only $3,150,000, consisting of $3,000,000 of capital gain tax paid by the trust and $150,000 on $1,000,000 of dividends received and distributed to C.

The Senate bill should be modified to produce a more reasonable result. The deferred tax account should be reduced by taxes actually paid by the trust attributable to the covered expatriate’s share of unrealized gain at the time of expatriation. In the above example, the tax attributable to C’s share of unrealized gain at the time of C’s expatriation was $3 million. If the trust realizes the gain five years later and pays U.S. tax on that gain, there is no justification for taxing the same gain to C when distributions are made. If the gain has been taxed to C under Code Section 877A before the trust realizes the gain, the trust should be allowed a credit for the tax withheld from C. As discussed below, a much simpler rule is possible without loss of revenue.

Code Section 877A should impose a tax only on principal distributions that reduce the U.S. tax base. As a general rule, capital gains realized by a U.S. trust are going to be taxed in the United States regardless of the citizenship or residency of the beneficiary. Distributions of trust principal do not reduce the U.S. tax base in such cases because capital gains are not included in distributable net income of a U.S. trust and remain taxable to the trust, a U.S. taxpayer, despite the level of distributions. Therefore, no protections are necessary to preserve U.S. taxing jurisdiction because of a beneficiary’s expatriation except in cases where capital gain would be included in distributable net income or distributions of appreciated property are made to a beneficiary. In general, capital gain is not included in distributable net income except where it is required to be distributed and a distribution of appreciated property to a beneficiary carries out income only to the extent of basis, which becomes the basis of the property in the hands of the beneficiary. In the case of a distribution of property to a covered expatriate, this rule would allow avoidance of U.S. tax if the gain realized by the beneficiary upon a later sale of the property would not be U.S. source income. Therefore, distributions of property (other than U.S. real property) to beneficiary who is a covered expatriate should be considered a gain recognition event. These cases are limited and the tax imposed by Code Section 877A should be restricted to cases where a distribution erodes the U.S. tax base.

It is particularly inappropriate to impose tax on a covered expatriate based on his or her share of unrealized gains of a trust where the covered expatriate has only an income interest in a trust. In such a case, the covered expatriate has no right to such gains. More importantly, as explained above, imposition of tax on unrealized gains is not necessary to preserve U.S. taxing jurisdiction in the case of a U.S. trust.

Finally, the bill should be clarified to provide that there is no tax due upon the death of the covered expatriate with respect to his or her beneficial interest in a trust if his or her interest is extinguished at death.

The House bill

The House bill contains special rules for nongrantor trusts. Presumably no special rule is necessary for a grantor trust because the expatriate is treated as owning, and therefore as selling, the portion of the grantor trust that he or she is deemed to own under the grantor trust rules on the date of expatriation.

For both foreign and U.S. nongrantor trusts, the House bill imposes a 30% tax withholding requirement on distributions to covered expatriates. Also, a nongrantor trust is deemed to have sold appreciated assets distributed to a covered expatriate beneficiary. No enforcement mechanism is provided with respect to foreign trusts. As a result, as a practical matter it may be difficult to enforce the withholding regime on a foreign trust that has no U.S. beneficiary.

The most significant feature of the House bill’s treatment of nongrantor trusts is that the amount subject to withholding is not capped by the covered expatriate’s share of the amount of unrealized gain on trust assets on the date of expatriation. In addition, the covered expatriate is not given the benefit of the lower tax rates normally applicable to certain kinds of income such as long term capital gains. Finally, the withholding obligation appears to be applicable to trusts created by the covered expatriate after expatriation. These rules unreasonably extend U.S. Federal taxing jurisdiction beyond the traditional norms of international taxation. Consistent with these norms, the amount subject to U.S. Federal tax and withholding should be capped by the expatriate’s share of unrealized income and gain as of the date of expatriation. This can be accomplished by using the concept of a deferred tax account like the one proposed in the Senate bill, with the adjustments recommended above.

Recommendations

Adopt the withholding rules used in the House bill for nongrantor trusts but cap the amount withheld at the amount in a deferred tax account similar to that in the Senate bill (adjusted as stated below), except that the amount in the deferred tax account should not increase by more than the deficiency rate;

The deferred tax account should be reduced by U.S. taxes paid by the trust that are attributable to a covered expatriate’s share of pre-expatriation gain;

The deferred tax account should be adjusted if distributions with respect to a covered expatriate’s unvested interest in a trust are made to another beneficiary (whether or not the other beneficiary also is a covered expatriate);

Tax should be imposed under new Code Section 877A on principal distributions from U.S. trusts to covered expatriates only where (i) the distribution is made in kind with appreciated assets (other than U.S. real property); (ii) the distribution is included in distributable net income of the trust and therefore reduces the trust’s taxable income; or (iii) the distribution is from a charitable remainder trust;

When applicable, lower rates on long term capital gains or other tax advantaged income should be available to a covered expatriate;

The exit tax should not apply to an expatriate who has only an income interest in a trust;

Do not impose the exit tax at the death of the covered expatriate attributable to his or her beneficial interest in a trust if the interest expires at death; and

Exempt charitable split interest trusts.