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Superannuations, Noncovered Expatriations, and the Stealth Exit Tax

This week’s question came from new reader Z (her real name does not start with Z), who asked a question about her superannuation. Lightly edited, her question is:

My question relates to the treatment of my Australian self-managed super fund when I expatriate. It is treated as a Grantor Trust and I get taxed on the (paper) gains on its assets each year. I understand that because of this all distributions are tax free as it is considered that tax has already been paid.

Because I came into tax compliance via [the streamlined procedures], there were many years where contributions were made, and gains realised, which occurred prior to any involvement with the IRS. When I expatriate, will I be charged tax on anything to do with my super fund?

(I am hoping to avoid being a covered expatriate).

So let’s start with these basic assumptions:

  • Z will not be a covered expatriate;
  • She is fully compliant for reporting her superannuation activity for the five years preceding the year she renounceds her U.S. citizenship; but
  • For earlier years, the superannuation contributions and earnings were not properly reported according to U.S. tax principles.

Superannuations Generally

For those of you who are not Australians, a superannuation is a retirement account. Your employer contributes to it. You may or may not contribute to it.

Ignore how a superannuation is treated for tax purposes in Australia.

For U.S. tax purposes, it is a pension that gets special treatment as an employees’ trust under IRC § 402(b) and as a compensatory trust under IRC § 672(f)(2)(B), the IRC § 679 regulations, and IRC § 6048 reporting. It’s just not a qualified plan under IRC § 401(a) — which means that the income earned inside the superannuation each year is taxed. (Pension investments grow tax-free and are only taxed when there is a distribution.)

It is a foreign trust. Whether it is a foreign grantor trust or a foreign nongrantortrust depends on the relative amounts of employer and employee contributions to the superannuation. T. Reg. § 1.402(b)-1(b)(6).

Employee Contributes Less Than Employer

If the sum of employee contributions is less than the sum of employer contributions, then the entire superannuation is a foreign nongrantor trust.

Employee Contributes More Than Employer

If the sum of employee contributions is greater than the sum of employer contributions, then the superannuation is partly a foreign nongrantor trust and partly  a foreign grantor trust. See T. Reg. § 1.402(b)-1b)(6), which says:

Treatment as owner of trust. In general, a beneficiary of a trust to which this section applies may not be considered to be the owner under subpart E, part I, subchapter J, chapter I of the Code of any portion of such trust which is attributable to contributions to such trust made by the employer after August 1, 1969, or to incidental contributions made by the employee after such date. However, where contributions made by the employee are not incidental when compared to contributions made by the employer, such beneficiary shall be considered to be the owner of the portion of the trust attributable to contributions made by the employee, if the applicable requirements of such subpart E are satisfied. For purposes of this paragraph (6), contributions made by an employee are not incidental when compared to contributions made by the employer if the employee’s total contributions as of any date exceed the employer’s total contributions on behalf of the employee as of such date.

Consequences of Foreign Trust Characterization

These characterizations have consequences for a U.S. taxpayer who has a superannuation: tax treatment of the contributions to the superannuation, tax treatment of the earnings generated inside the superannuation prior to retirement, and the U.S. tax paperwork required.

I am not going to talk about the technicalities of U.S. tax law as applied to superannuations. For the purposes of this discussion, it is sufficient to make the following assumptions:

  • Z reported everything about her superannuation correctly for her 2011 through 2015 U.S. tax returns; but
  • Z did no U.S. tax filings at all for her superannuations in all years before 2011.

Exit Tax for Noncovered Expatriates

When Z expatriates, she will not be a covered expatriate. This is by assumption.

  • Certification Test. She has carefully used the streamlined procedures (and time or other methods) to ensure that her 2011 through 2015 income tax returns are properly filed, and all tax, penalties, and interest paid.
  • Net Worth Test. She will have a total net worth (including superannuations!) of under US$2 million.
  • Net Tax Liability Test. She will have an average net tax liability for 2011 through 2015 of under $161,000. That’s easy because she will have a big foreign tax credit for Australian income tax paid.

This means that she does not face the “mark-to-market” rules for pretending that she sells everything when she renounces her U.S. citizenship. IRC § 877A(a).

It also means that she does not face the special tax rules applicable to U.S. beneficiaries of nongrantor trusts. IRC § 877A(f). (A superannuation can be a foreign nongrantor trust, remember?)

No Covered Expatriate Status, No Worries? Nope

So our first assumption is that nothing special happens (from a U.S. tax point of view) when Z expatriates. She just does the paperwork, pays no U.S. tax, and she has escaped the gravitational pull of the U.S. tax system. She is a free woman.

Not so fast.

Look Through the Superannuation, Find PFICs

Remember that a superannuation can be a grantor trust in the eyes of the U.S. tax system. This means that the “grantor” (the individual taxpayer) is treated as the true owner of the assets inside the trust. Or in this case, inside the superannuation.

Every superannuation that I have ever seen has its money invested in mutual funds. These are foreign mutual funds from the perspective of the U.S. tax system, so they are Passive Foreign Investment Companies — PFICs, to use the usual acronym.

Z says that her superannuation is a grantor trust (rather than part-grantor trust, part-nongrantor trust). This means that the assets owned by her superannuation are treated by the IRS as if she were the direct owner.

If my assumption is right, there are PFICs inside Z’s superannuation.

Therefore, Z owns PFICs. She must compute her U.S. income tax on those PFICs, and file Form 8621 to tell the IRS about them.

  • Warning. Remember that in theory a superannuation can be partly a foreign grantor trust and a foreign nongrantor trust. Z has a pure grantor trust situation. If a superannuation is treated as a nongrantor trust, you will need to look at the indirect ownership rules of IRC § 1298(a)(3) to determine the tax implications of PFIC ownership inside a foreign grantor trust. This is complicated by the fact that there are special rules called the accumulation distribution rules that apply to foreign nongrantor trusts that make distributions to U.S. beneficiaries. This topic is something for another lengthy email, someday.

PFICs – Taxation of “Dispositions”

For a U.S. taxpayer, “disposition” of a PFIC is a taxable event. There are three different ways in which a PFIC can be taxed, but the most likely one for Z is that the PFICs inside the superannuation will be taxed as a Section 1291 fund (i.e., a PFIC that is taxed according to the rules of IRC § 1291).

In that case, a disposition is subject to tax according to the rules of IRC § 1291(a)(2). Let’s ignore the technicalities of how to calculate the tax. Let’s just concentrate on the fact that a “disposition” triggers tax.

“Disposition” Defined

Now we just need to understand the meaning of that word “disposition”.

The word “disposition” is not defined in the Internal Revenue Code, but our friends have taken a stab ad defining it in Prop. Reg. § 1.1291-3(b)(1) as:

any transaction or event that constitutes an actual or deemed transfer of property for any purpose of the Code, and the regulations thereunder, including (but not limited to) a sale, exchange, gift, or transfer at death, an exchange pursuant to a liquidation or section 302(a) redemption, or a distribution described in section 311, 336, 337, 355(c), or 361(c).

Becoming a Nonresident Alien = “Disposition”

Specifically, the Proposed Regulations say that becoming a nonresident alien will be treated as a disposition of PFICs:

If a shareholder of a section 1291 fund becomes a nonresident alien for U.S. tax purposes, the shareholder will be treated as having disposed of the shareholder’s stock in the section 1291 fund for purposes of section 1291 on the last day that the shareholder is a U.S. person. Termination of an election under section 6013(g) is treated as a change of residence (within the meaning of this paragraph (b)(2)) of the spouse who was a resident solely by reason of the section 6013(g) election.

Prop. Reg. § 1.1291-3(b)(2).

(Sidenote: this rule is yet another reason why a nonresident alien spouse should be VERY wary of making an election to be treated as a U.S. taxpayer so he/she can file a joint U.S. tax return with his/her U.S. citizen spouse.)

Therefore, Expatriation = Disposition of a PFIC

If we apply the Proposed Regulations as binding law (this is not necessarily the right thing to do!) we come to an unpleasant conclusion:

  1. Z owns PFICs for U.S. income tax purposes, even though the PFICs are nominally owned by her superannuation.
  2. When Z renounces her U.S. citizenship she will become a nonresident alien for U.S. income tax purposes.
  3. When she becomes a nonresident alien for U.S. income tax purposes, she will be treated as “disposing” of the PFICs (the mutual funds) owned inside the grantor trust portion of her superannuation.
  4. This will trigger an unknown but definite tax cost to Z.

This is a stealth exit tax. Even though Z is not a covered expatriate, she must pay a tax for the privilege of renouncing her U.S. citizenship.

Proposed Regulations: Not Binding

These Proposed Regulations were put in place in 1992, years before the exit tax rules were enacted.

Proposed Regulations are not binding law. See my earlier discussion of the stealth exit tax imposed by PFIC rules.

But The Gain Is Already Taxed, Right?

Z notes that her gain on the superannuation (and by implication, the PFICs inside the super fund) is taxed annually. That should mean, logically, that she has no capital gain to tax when she disposes of her PFICs because of renouncing U.S. citizenship. No taxable gain means there is nothing to tax under the excess distribution rules of IRC § 1291. Right?

Not quite.

Remember: she cleaned up her 2011 through 2015 income tax returns via the streamlined procedures (and presumably other methods as well). But for all tax years before 2011, she did not include the PFIC value growth as part of her taxable income each year, so her basis in the PFICs is less than today’s fair market value.

As a practical matter is it probably impossible for Z to calculate her basis in the PFICs held inside her superannuation.

Therefore, we must assume that there is some taxable gain when she has a disposition of the PFICs inside her superannuation, triggered by her renunciation of U.S. citizenship.

What Does Z Do?

So where does this leave Z? And how should I answer her question?

The simple and true answer to Z is that she can pick her favorite Magic 8-Ball response.

Proposed Regulations do not carry the weight of law. She will need to make a judgment call on how to report the superannuation and the PFICs inside it. Read my earlier discussion about this point on the blog, Z. Do your own research, get your own advice, then take action.

Sorry Z. There is no clean answer. You will need to do some Dirty Harry tax planning. (YouTube).

Disclaimer

This is not legal advice – to you, dear reader, or to Z, who posed the question. It is mildly entertaining (heh) speculation written while listening to streaming trip hop on Spotify on a rainy Sunday afternoon.

Go get some specific legal/tax advice before making a decision.

See you in a couple of weeks.

Phil.