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Treaties Won't Always Help After Expatriation
Phil Hodgen
Attorney, Principal
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This Week
This week’s email started as an answer to a question about a green card holder who wants to file Form I-407 and make a treaty election in 2014 to simultaneously terminate U.S. taxpayer status and prevent the “in 8 of the last 15 years” rule from making her a long-term resident therefore subject to the exit tax. (Yeah, probably you can do that).But it morphed into something far more interesting. Sometimes you, as an expatriate, are going to be subjected to worse U.S. income tax rules than someone who was never a U.S. citizen.This week’s email, then, is all about an esoteric provision in income tax treaties called the “saving clause”.The Saving Clause, Treaties, and Expatriates
The United States has income tax treaties with a bunch of countries. (“A bunch of” is code for “I’m too lazy to look up the exact number”).You, as an expatriate, might think that when you give up U.S. citizenship you will be a full nonresident noncitizen of the United States. (True). And if you live in a country that has a treaty with the USA, you will be entitled to the full benefits of that treaty. (False, depending on where you live).It all depends on the treaty. You, dear former citizen of the United States, who carefully complied with all of the tax requirements imposed on you as an expatriate, who cleaned up your tax returns before expatriation and carefully filed that final year tax return with Form 8854, might be screwed.Let’s take a look.Why Treaties are Nice
When someone can be taxed as a resident of two countries, it is usually possible to invoke the rules of an income tax treaty between the United States and that country to cause the person to be taxed as a resident of one country but not both. This is almost always found in Article 4 of the relevant treaty.This only works for green card holders, because income tax treaties invariably have a second provision in them that says “Haha, just kidding. The United States can tax its citizens and this treaty can’t be used to change that.” This is called the “saving clause” of the treaty.Or maybe you are receiving dividends from a U.S. corporation. Income tax treaties invariably [I don’t know for a fact that all treaties have rules reducing U.S. taxation of dividends, but let’s pretend for a moment, shall we?] reduce the normal U.S. tax rate on dividends paid to nonresident shareholders in U.S. corporations. You want that—you’d rather pay less tax to the United States than more tax.Bad Savings Clause: Switzerland
The United States, being the United States, wants to tax its citizens. Just because. So the United States, being the United States, wangles a provision into every income tax treaty that is called the “saving clause”.Just as an example, so you can see what a “saving clause” looks like, here is Article 1, Paragraph 2 of the USA/Switzerland income tax treaty:Notwithstanding any provision of this Convention except paragraph 3 of this Article, the United States may tax a person who is treated as a resident under its taxation laws (except where such person is determined to be a resident of Switzerland under the provisions of paragraphs 3 or 4 of Article 4 (Resident)) and its citizens (including its former citizens) as if this Convention had not come into effect.Residents of the USA are taxed no matter what the treaty says, unless Article 4 (our favorite treaty provision) says otherwise. But U.S. citizens? Article 4 won’t help them. Article 4 says that “the United States may tax . . . its citizens (including former citizens) as if this Convention had not come into effect."And . . . look at that submarine lurking there—the USA/Switzerland income tax treaty won’t protect former citizens of the United States. They can’t use the tax treaty! There are some exceptions to this rule in Article 1, paragraph 3. But basically, former citizens of the United States who happen to live in Switzerland or be Swiss citizens—they’re screwed. They can only rely on the Internal Revenue Code to determine their tax position in the United States. If the treaty rules are better than the Internal Revenue Code rules, too bad. They are stuck with the Internal Revenue Code rules.The Technical Explanation of the treaty says this about that. (That’s a oblique Nixonian reference. He famously said “Let me say this about that”. Or at least that little phrase has stuck in my head for decades, attached to the sound of his voice.)
Under paragraph 2, the United States reserves its right to tax former U.S. citizens. Such a former citizen is taxable in accordance with the provisions of section 877 of the Code if his loss of citizenship had as one of its principal purposes the avoidance of tax. The United States generally treats an individual as having a principal purpose to avoid tax ifThe Australian income tax treaty with the United States has a similar provision, referencing the U.S. right to tax its former citizens. I haven’t looked at other treaties but I’ll bet you can find similar provisions elsewhere—the United States reserves the right to tax former citizens.(a) the average annual net income tax of such individual for the period of 5 taxable years ending before the date of the loss of status is greater than $100,000, or(b) the net worth of such individual as of such date is $500,000 or more.Although paragraph 2 does not specify a time frame in which this provision may be applied, under the Code rule, the United States retains its right to tax these former citizens for 10 years following the loss of citizenship.
Good Saving Clause: U.K.
In contrast, the treaty between the United States and the United Kingdom does not have the same reserved right allowing the United States to tax its former citizens. Article 1, paragraph 4 says:Notwithstanding any provision of this Convention except paragraph 5 of this Article, a Contracting State may tax its residents (as determined under Article 4 (Residence)), and by reason of citizenship may tax its citizens, as if this Convention had not come into effect.Note that there is nothing said in the U.K. treaty's saving clause about taxing former citizens of the United States. Expatriates are safe.