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Decision to renounce U.S. citizenship should not be tax-based

For American citizens and Green card holders living in Canada, the overwhelming nature of complying with tax filing requirements may lead some to consider the step of renouncing their citizenship — but, as Oakville-based U.S. tax attorney (NY, DC) Alexey Manasuev tells AdvocateDaily.com, this decision should not be based solely on tax concerns.

As Manasuev, principal of U.S. Tax IQ explains, although the requirement for expats to file a U.S. tax return has existed for years, the changes brought by recent American tax reform, including the Foreign Account Tax Compliance Act (FATCA) implemented in 2014 and the Tax Cuts and Jobs Act, enacted in December 2017, have complicated the situation for many individuals.

“There has been a much higher awareness as to the U.S. tax filing and reporting and disclosure obligations that American expats have while they live outside of the United States. The IRS and the U.S. government are enforcing the laws that have been in existence for a long time. The new law does not make it easier. This may have caught many people by surprise. And there has been a huge compliance initiative — people were using the offshore voluntary disclosure program until its recent closure, and the still existing IRS amnesty programs, to become compliant," he says. 

Even in situations where there may be no additional tax to pay, Manasuev says all U.S. citizens or Green card holders may be required to file a U.S. tax return.

“That return is required to include all income from any sources, that means worldwide income, and not only limited to U.S. source income. Once you report that income, the foreign tax credit usually takes care of double taxation, and there is rarely any tax owed.”

In addition, says Manasuev, any American, whether they live in the United States or elsewhere, is required to disclose their foreign bank accounts and certain financial assets when the highest aggregate maximum value or balance on their account during a year is US$10,000.

“If an individual has, say, five accounts which include an RRSP, TFSA, chequing, and savings accounts, and the aggregate value of all those accounts exceeded US$10,000 at any time during the calendar year, they are required to disclose all those accounts, even if some of them had zero balance.

Complications and obligations to report and pay tax can arise in a number of other areas for American expats, such as with the sale of a principal residence in Canada.

“They would qualify under U.S. rules for up to US$250,000 exclusion from the capital gain realized on the sale of the principal residence. In Canada, that sale is not subject to tax. So, even though you are not paying tax in Canada, if your gain exceeds US$250,000, you will be paying capital gain, plus potential net investment income tax of 3.8 per cent in the United States,” Manasuev says.

On top of that, additional concerns for U.S. expats recently brought about by U.S. tax reform include the transition tax or section 965 tax, that is imposed on positive accumulated earnings and profits of specified foreign corporations a special term that includes controlled foreign corporations (CFC).

“A controlled foreign corporation would be any Canadian corporation where a U.S. expat would own more than 50 per cent by vote or value,” says Manasuev.

Several anti-deferral regimes, including the Subpart F regime, can also result in certain categories of foreign income — such as interest, dividends and foreign-based company services income — to be taxed currently to U.S. shareholders, even when they did not receive a distribution from the CFC.

“That is definitely a complication and you have to do certain planning to make sure that you can mitigate the impact of the Subpart F rule and another anti-deferral regime which is making it very difficult for any U.S. expat to make investments outside of the United States. The other anti-deferral regime is known as the passive foreign investment company (PFIC) rules," Manasuev says.

“Under those rules, investments in Canadian mutual funds, for example, if made outside of an RRSP account are considered PFICs, and because of that, there is annual tax on ordinary earnings and net capital gains, within the investment.”

Ultimately, these rules, says Manasuev, result in U.S. expats filing numerous tax returns and forms — with failure to do so on a timely basis resulting in significant penalties.

“For example, the individual U.S. expat is generally required to file Form 5471 to report their ownership in a Canadian corporation. Failure to file that form now under the new law leads to a penalty of US$10,000, and that penalty is imposed automatically, irrespective of any tax liability that may or may not be due.

“Every time a U.S. expat makes an investment outside the United States and in Canada for example, they have to figure out how to treat that account for U.S. tax purposes, whether there is any U.S. tax due, and it is not that simple,” Manasuev says.

“A U.S. expat may spend on annual tax compliance anywhere between $1,000 to more than $5,000. It all depends on their particular situation, how many companies they own, how many accounts they have, what investments they make, how many family members are U.S. persons and other factors."

Manasuev says his firm has seen the number of people with inquiries who want to renounce their American citizenship or abandon their Green card on the rise as a result of recent U.S. tax reform.

In spite of the additional complexity associated with tax compliance, however, Manasuev suggests taxpayers take a step back, and take a proactive and well-thought-out approach as to whether or not renouncing their U.S. citizenship is right for them.

“First of all, we always advise our clients to carefully review their situation and make the decision irrespective of tax concerns because taxes can be handled, tax compliance can be managed. Yes, it may be more expensive, but ultimately, this is not something that anyone should base their decision on,” he says.

“I believe in many cases Americans may want to renounce their U.S. citizenship because of the restriction on their freedom of choice that includes the choice of making investments like other Canadians may make. They must be very selective in terms of what investments they can make. Failure to plan may lead to double taxation and significant penalties for missing required filing or reporting,” says Manasuev.

“Others may have acquired their American citizenship when they were born, but they never lived in the United States. They may not have much of a connection to the United States. They hardly have any family members there. So they got U.S. citizenship at birth, and they kept it, but now that it starts adding so much complexity and potential issues, they are re-evaluating as to whether or not they want to keep it.”

What people need to know, first and foremost, he says, is that there is an immigration side to the process as well as a tax side.

“What the decision to renounce should be based on is whether or not a person wants to give up their U.S. citizenship — this is an irrevocable action. Once it is done, you cannot regain the citizenship. This is something they need to want to do, and considering the effects it will have on their future, this will be something that is good for their situation.”

“And then, after they made the decision, they should make sure that they plan proactively and do not just go to the consulate, set up an appointment and then renounce. Why? Because there are significant complications that they may be facing for two primary reasons. One, under the Reed Amendment, if the U.S. citizen is found to have renounced their citizenship for tax avoidance purposes, then they potentially may be prevented entry into the United States forever."

Second, says Manasuev, if the American expat or Green card holder is considered to be a “covered expatriate,” they will be subject to an exit tax under section 877A of the Internal Revenue Code. If so, they would be subject to tax on a gain from a deemed disposition of their assets. The United States does provide a one-time exclusion from capital gains, which is $713,000 for 2018.

"In order to manage potential exit tax exposure, it is critical to plan pro-actively.

“If your net worth is U.S.$2 million equivalent, then you may be considered a covered expatriate, and you have to deal with the exit tax. There are strategies and tax planning that can help you effectively manage the exit tax exposure, but you need to review these and have a discussion with your qualified U.S. tax advisor,” he says.

Individuals are also required to be tax compliant for five years prior to renunciation, cautions Manasuev — for anyone who is not able to certify under penalties of perjury that they have been in compliance for the last five years, they run a risk of being treated as expatriated for tax avoidance purposes.

For more information on the topic of renouncing U.S. citizenship, click here to register for an upcoming free webinar.

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