United States: Taxation Caused By Or After A Change In Residence ~ Part 2

E. Treaty Solutions

Article 13 of the OECD Model Treaty provides that gains from the alienation of any property, other than immovable property, movable property relating to a permanent establishment, or fixed base and ships or aircraft operated in international traffic, will be taxable only in the contracting state of which the alienator is a resident.

1. Gains derived by a resident of a Contracting State from the alienation of immovable property referred to in article 6 and situated in the other Contracting State may be taxed in that other State.

2. Gains from the alienation of movable property forming part of the business property of a permanent establishment which an enterprise of a Contracting State has in the other Contracting State, or of movable property pertaining to a fixed base available to a resident of a Contracting State in the other Contracting State for the purpose of performing independent personal services, including such gains from the alienation of such a permanent establishment (alone or with the whole enterprise) or of such fixed base, may be taxed in that other State.

3. Gains from the alienation of ships or aircraft operated in international traffic, boats engaged in inland waterways transport or movable property pertaining to the operation of such ships, aircraft or boats, shall be taxable only in the Contracting State in which the place of effective management of the enterprise is situated.

4. Gains from the alienation of any property other than that referred to in paragraphs 1, 2 and 3, shall be taxable only in the Contracting State of which the alienator is a resident.

Thus, gains from the alienation of two types of property are taxable by the source country: (i) immovable property; and (ii) property forming part of a permanent establishment or pertaining to a fixed base. The gains from the alienation of all other property, including shares of stock in a corporation, are only taxable in the seller's country of residence. Article 13 is dependent on current residence; former residence is irrelevant.⁶⁴

Moreover, both an exemption method and a credit method for elimination of double taxation grant relief where, in accordance with the provisions of the convention, the gain may be taxed in the other contracting state.

In order to avoid double taxation of the gain on these properties where the internal law of the states is inconsistent with the provisions of article 13, articles 23A (exemption method) and 23B (credit method) provide two alternatives:

Article 23A:

1. Where a resident of a Contracting State derives income or owns capital which, in accordance with the provisions of this Convention, may be taxed in the other Contracting State, the first-mentioned State shall, subject to the provisions of paragraphs 2 and 3, exempt such income or capital from tax.

Article 23B:

1. Where a resident of a Contracting State derives income or owns capital which, in accordance with the provisions of this Convention, may be taxed in the other Contracting State, the first-mentioned State shall allow:

a) as a deduction from the tax on the income of that resident, an amount equal to the income tax paid in that other State;

b) as a deduction from the tax on the capital of that resident, an amount equal to the capital tax paid in that other State.

Since the gain is realized before emigration, an exit tax would not normally result in a credit in the country of new residence.

The mutual agreement procedure does not appear to be applicable. Article 25 provides that "where a person considers that the actions of one or both of the contracting states will result for him in taxation not in accordance with the provisions of this convention, he may. . . . " Since the action of the former country of residence is not dealt with in the convention, it does not appear that the mutual agreement procedure will be available.

With most countries covered in this article having an exit or trailing tax, the OECD should formulate a policy to remedy the potential for double taxation. The current remedies are not identical, and are discussed below.

1. Australian Solution

In its modern treaties, Australia preserves the operation of its domestic rules on capital gains. Hence, in cases where it levies a trailing tax through an election of the taxpayer, the tax is in accordance with the treaty and the other country would normally be required to give double tax relief for gain accrued after emigration from Australia. No special rules are included to deal with problems caused by the exit tax. The outcome is similar to the Netherlands.

2. Canadian Solution

Most of Canada's tax treaties were negotiated prior to the announced changes in the deemed disposition rules and at a time when Canada did not impose the exit tax on taxable Canadian property. Under those treaties, Canada postponed, for various periods ranging between 5 and 10 years, the right of the ex-Canadian resident of the other contracting state to benefit from the capital gains article of the tax treaty, thereby entitling Canada to impose the capital gains tax as a sort of trailing tax on the former resident in respect of gains on dispositions of taxable Canadian property for a period of years. Unless such treaties are amended, and unless new treaties being negotiated extend the benefits of the capital gains article to former Canadian residents⁶⁵ who are resident in the other contracting state without the delay period, then departing Canadian residents will suffer the worst of both worlds, an exit tax plus a trailing tax, with the trailing tax extending for 5 to 10 years after emigration.

Where Canada has retained the right to tax capital gains for 5 to 10 years under its treaties, the country of new residence is usually obligated to grant a tax credit for the Canadian tax on the gain accruing after departure or exempt the gain from tax.⁶⁶ Where the collection of the exit tax has been postponed by the deposit of security or where the period during which Canada has retained the right to tax the capital gain has expired, article 13 arguably allocates the right to tax solely to the country of residence. The Canadian government's view is that this treaty provision protects only in respect of the gain which accrued after the taxpayer has left Canada as the gain that accrued prior to departure is taxed immediately before departure. Thus, it will insist on collecting tax on the appreciation which accrued before departure. Although the taxable event imposing the exit tax occurs, and the tax is levied, while the taxpayer is a Canadian resident, it is likely, unless specific treaty relief is provided, that double taxation of the gain accrued prior to departure from Canada will occur. Proposed new paragraph 126(2.21) ITA would allow a credit for the foreign taxes paid if the former Canadian resident is resident in a treaty country and the taxes are paid to that treaty country.

A rule, similar to the German approach, was adopted by the U.S. and Canada with respect to the appreciation in the principal residence of an individual (other than a United States citizen) owned by him at the time the individual ceased to be a resident of Canada. The individual can claim a tax basis for such residence on the U.S. that is no less than the fair market value of the residence on the date of the change in residence.⁶⁷ Canadian residents are not taxed on capital gains on principal residences, so this treaty provision preserves the gain, to date of departure, as tax free.

3. French Solution

France, like the U.S., reserves the right to tax capital gains realized by a former resident under its treaties with the United Kingdom, the Netherlands, Canada, and the Philippines, and will grant a credit for the foreign tax under its new exit tax legislation.

4. German Solution

Germany, in its treaties, generally reserves the right to tax the gain on the disposition of a significant interest in a German company, usually for a period of five years after an individual leaves Germany. Under such treaties, the gain that can be taxed by each country is usually limited to the appreciation that occurred while the individual was a resident of such country. Some German treaties, such as with Finland, Italy, Switzerland, and New Zealand, require the new residence country to compute the gain that may be taxed by reducing the sale price by the fair market value assessed by the German tax authorities at the time the individual surrendered his residence in Germany. The treaties do not provide a formula⁶⁸ for allocating the gain between the countries but instead require a retrospective appraisal to determine the amount of the gain that accrued to the date of emigration. The treaty partner is effectively required to grant the new resident a tax basis determined by an entry date valuation for the shares. The new country of residence is permitted to tax the post immigration appreciation, or a greater proportion of the gain if, for any reason, Germany has not taxed all of the gain.⁶⁹ This system, in theory, ensures that the taxpayer can be taxed on the full gain and avoids double taxation, although there is nothing in the treaty that specifically requires the two countries to agree to a common date of entry valuation. Presumably the two treaty partners will reach agreement under the Mutual Agreement provision⁷⁰ on the date of entry valuation and the amount of gain that each can tax.

Where a tax treaty prevents the imposition of Germany's trailing tax, in some treaties the other contracting state limits its right to tax only to the portion of the gain accrued after the taxpayer has emigrated from Germany.⁷¹

5. Netherlands Solution

In its pre-1997 treaties, the Netherlands reserved the right to levy a tax on the gain from the alienation of shares or other corporate rights in Dutch resident companies derived by an individual resident of the other country who has at any time during the five-year period preceding the alienation been a resident of the Netherlands and who at the time of alienation owns, either alone or together with related individuals, a substantial interest in a Dutch company.⁷² In order to avoid double taxation, the Netherlands attempted to negotiate a deduction from the residence tax (a credit) on such gain for the tax levied by the Netherlands, subject to normal foreign tax credit limitations.⁷³ The advantage of this system over the one used by Germany is that it avoids the administrative necessity of valuing the shares of stock on the date that the individual changes residence. One disadvantage of this system is that the state of residence surrenders a tax since it allocates subsequent appreciation to the state of former residence. From the point of view of the expatriate, there can also be an increase in the effective tax rate applicable to the subsequent appreciation where the former country of residence has a higher tax on capital gains than the country of residence. Subsequent to 1996, the Netherlands changed its rules. The tax is accrued when the owner changes his residence with collection deferred, thereby avoiding violation of the European rules on the free movement of individuals in the treaty establishing the European Community.⁷⁴

6. United Kingdom Solution

The United Kingdom gives credit relief for tax on capital gains, both unilaterally and by treaty, where the same gain is taxed in the other state. The tax does not have to arise at the same time or be applied to the same person. The gain must be from sources in the other state. The meaning of this is unclear, but in a treaty case there is a deemed source rule saying that any income or gain which the other state can tax has a source there. Therefore, in treaty cases, the source rule is satisfied. Only residents and, as a result of recent changes in the law, permanent establishments, can claim the credit.

7. United States Solution

The United States follows the OECD Model Treaty and cedes the taxation of capital gains to the country of residence, but retains in its treaties the right to tax a former citizen (and, in the case of some newer treaties, a former long-term resident) on his or her income from U.S. sources for 10 years.

The tax imposed solely by reason of expatriation is reduced by the amount of any income tax paid to any foreign country on any income of the taxpayer on which tax is imposed solely by reason of expatriation.⁷⁵

For individuals who have changed their residence but retained their citizenship, a complicated foreign tax credit is provided. The U.S. agrees to grant credit for foreign taxes paid to the other country on income from sources in that country and the other country grants the former U.S. citizen a credit for taxes paid to the U.S. on income or gains which, under the internal laws of the other country, has its source in the United States. The tax on income and gains from third countries is not covered so that both the United States and its treaty partner may tax that income. The treaty partner is not required to grant a credit for the third country's tax, unless it does so by internal law or under a treaty with the third country.

8. Special Solution

Another method used by the U.S. to avoid double taxation, where an individual is subject to current tax in one country and deferred tax in another country, is for the latter country to allow the individual to elect to be taxed as if he had disposed of the property immediately before the event giving rise to the tax in the first country. The United States- Canada treaty⁷⁶ permits such an election for a United States citizen where Canada, the country of source, treats an event as a taxable, deemed alienation of property while the U.S. would, in the absence of an election, defer, but not forgive, taxation (because no transfer would be deemed to have taken place).

F. Conclusion

Each of the above described systems has its advocates and its detractors. One common objection to the exit tax system is that it limits the freedom of movement of individuals and, therefore, imposes a restriction on the free exercise of the individual's rights. This is generally a political issue and not a fiscal issue, although in the European Union it is also a legal issue.

The Canadian, Australian, and Dutch systems are the purest from a policy viewpoint. Income, in its broadest sense, including gains, earned by individuals while resident, is subject to tax. Income earned before becoming a resident is not. Foreign source income earned after becoming a nonresident is not. There are two objections to these systems. First, they impose a tax on income and gains that have not yet been realized. This hardship may be ameliorated by the ability to defer payment of the tax on condition of posting a bond or securing the tax obligations. This is an expensive solution, but it is the only way that the taxing jurisdiction can be assured of collecting the tax after the taxpayer is no longer subject to its legal jurisdiction. The second objection is that it may lead to double taxation, as Australia, Canada, and the Netherlands are the only countries whose systems mirror each other and no other country under internal law allows a fair market value basis on entry. Nor, with the notable exception of the United Kingdom, does any country allow a credit for this exit tax under identical law. Obviously, this objection could be fairly directed at the countries that do not have an exit tax and insist on taxing pre-emigration gains.

The U.S. system is exceedingly complex and is, like other trailing tax regimes, to a large extent unenforceable. After an individual leaves the jurisdiction of the United States or any other country with a trailing tax, he may have little incentive to comply with its tax on a subsequent disposition, particularly since the adoption of the Reed Amendment⁷⁷ impeding a former citizen subject to the expatriation rules from returning to the U.S. The system also creates a disincentive to continued investing in the United States, which in light of the large need of the United States for foreign capital seems counterproductive.⁷⁸ An individual who is resident in the U.S. and who contemplates that he may someday leave the U.S., or who wishes to retain that flexibility, has an incentive to invest outside of the U.S. even while residing in the U.S., since non-U.S. assets escape taxation on expatriation. The administrative problems of the trailing tax are enormous.⁷⁹ The United States system does not result in a double tax. The Internal Revenue Code reduces the tax on the expatriate by the amount of any income tax paid to any foreign country on any income or capital gains subjected to tax under the expatriate rule.⁸⁰

The taxes imposed under the other, more limited, trailing tax regimes are more benign, since they affect only major investment.

Where there is a potential for double taxation, each country should address the problems of expatriates in its domestic legislation, its treaty negotiations, or under the mutual agreement procedure of its treaties.⁸¹ Unfortunately, the constituency that desires this reform has little political power and does not negotiate tax treaties, and the OECD is not currently focusing on this issue.

G. Recommendations for Taxpayer

Until the countries from which the individual will be leaving or to which he will be entering have dealt with these problems, a properly counseled individual should consider obtaining an increase in his tax basis without incurring any additional tax prior to his change of residence. For example, a sale to his spouse results in a new basis in some countries. Interposing a new, low tax, country of residence between the date of departure from his country of former residence and before entering into his new country of permanent residence might provide the necessary flexibility. During that sojourn, the individual may be able to adjust his affairs to minimize the tax consequence of a transaction that could step up the basis of his or her assets. This should ameliorate the problem of multiple taxation on the same income and gain.

Taxpayers emigrating from a country with an exit tax to a country without one might consider other self-help techniques, such as entering into transactions that result in a basis step-up in the new country of residence. There are usually a number of ways in which such a result can be accomplished, although a detailed discussion of such methods is beyond the scope of this article.

III. Deferred Payment Sales

A. Background

Not all sales of assets are for cash or property. In many sales, a portion of the purchase price is paid at the time of sale and the balance is payable over a period of years -- a deferred payment sale. This may result (a) from an agreement by the seller to help finance the purchase or (b) because of an inability to determine the full purchase price. The tax treatment of the gain on such deferred payment sales may vary. In some countries there are different rules for the sale of business and nonbusiness assets.

Under one method, the amount paid is offset against the basis of the asset to the extent thereof and the excess taxed as and when received, whether the purchase price had been fixed or contingent. All gain would be treated as capital gain and the basis would be recovered first. This method of offsetting all payments against basis before recognizing any gain is permitted in the United States, on an elective basis, where the payments are contingent and their value at the time of the sale cannot be readily ascertained. A portion of each payment is treated as interest.⁸²

A second method, a pure accrual basis method, taxes the seller on the entire amount paid plus the face amount of the purchaser's indebtedness in the year of sale. This method is required in Belgium, although, if a portion of the price is undetermined at the date of disposal, the gain will be taxed at the time it is determined. France also requires that any gain on the sale of property be recognized in the year of sale.

A third method is for the seller to be taxed on the fair market value of the unpaid consideration rather than the price stipulated in the sale agreement. This method is permitted as an elective method in the U.S. Any payments received in excess of the fair market value of the unpaid amount are taxable as ordinary income in the United States, but as capital gain in the United Kingdom. Where the future consideration is unascertained, Australia,⁸³ Belgium, the Netherlands, and the United Kingdom also use this method. Any gain or loss realized from the valuation is taxed as a further capital gain or loss. In the United Kingdom, where the unascertained consideration for shares consists of shares or debentures of the acquiring company, the gain can be held over as if the consideration consisted of the shares or debentures ultimately issued.⁸⁴

A fourth method is for the seller to report gain or loss in installments proportionately over the term of the note, as payments are made under the note. This method is permitted in Japan and was the method previously permitted in the United States. If the amount of the payments to be received is fixed, the basis of the property is allocated among the payments in proportion to their relative amounts. In the United States, the basis was allocated ratably over the term of the payments (or, if the term was contingent, 15 years). A portion of each deferred payment was treated as interest and if the total amount of the deferred gain exceeded US $5 million, then the seller was required to pay interest on a portion of the deferred tax.⁸⁵ This method was repealed for accrual basis taxpayers, with minor exceptions, for transactions occurring after December 31, 1999.

Under Italian tax law, as a rule, capital gains are taxed on a cash basis. Therefore, a deferred payment results in a deferred tax. The basis of the property is allocated among the payments in proportion to their relative amounts. Basis is not recovered first and no interest income is imputed on the deferral.⁸⁶ The deferred payments are taxable when received, notwithstanding that the individual has changed his residence prior to receipt, provided that the income has an Italian source.

Canada allows deferral of the taxable capital gain (and therefore of tax on the gain) for a maximum of five years, but requires at least 20 percent of the gain to be brought into income each year. If the taxpayer ceases to be a resident, the tax on the deferred gain is accelerated and there is a cessation of deferral. Japan accelerates the tax, also.

A fifth method, utilized by the United Kingdom, is to treat the gain as realized on disposition, but to allow the tax to be paid in installments.⁸⁷ This method is available for any sale where the price is to be paid over a period exceeding 18 months. The tax (plus interest) may be paid in installments over the period of the payment of the purchase price, so long as the period does not exceed eight years.

Sweden has a similar rule. The gain where determinable is taxed on the date of sale, although payment is deferred until the payment is received. In the converse situation, Sweden would not tax an immigrant on a sale prior to arrival.

B. Discontinuities

When a taxpayer emigrates, future payments will be received while he is a resident of his new country of residence. Double taxation will occur unless (a) the new country of residence treats the gain as having arisen while the individual was a nonresident and does not tax the receipt (or grants a tax basis equal to the fair market value of the deferred payments) or (b) the country of source neither accelerates the gain nor taxes future receipts, or (c) the country of new residence grants a credit or exemption for any tax paid to the former country of residence.

Australia, Canada, the Netherlands, and Japan⁸⁸ generally accelerate all deferred gain on departure. They also give the immigrant a new tax basis on arrival. The issue does not arise with respect to immigrants in France, Sweden, or the United Kingdom because all gain is treated as realized at the time of the sale, before the taxpayer became a resident. In the absence of a new basis or a recognition by the new country of residence that the gain or income arose before the taxpayer became a resident, the gain will be subject to a second tax. The OECD Model Treaty does not cover the issue specifically but if a new basis is not granted, or such recognition is not made and the source remains unchanged, it appears that a credit or exemption should be permitted, although there may be a problem of timing that should be clarified in the commentaries to article 23. F

FOOTNOTES