You should subscribe to the Expatriation Only email list. You’ll get a weekly email that usually answers someone’s question about expatriation. The subject is always expatriation.
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 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.
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.
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 if
(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.
The 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.
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.
Let’s imagine that you are a U.S. citizen. Your net worth is $100, and you have always carefully and scrupulously filed your income tax returns and paid a princely $4 per year of income tax. (Translation: you are not a covered expatriate).
A year after you expatriate, a long-lost uncle dies and leaves you a massive inheritance. You use some of that inheritance to buy Apple stock. Apple pays a dividend to you of $10,000. As a nonresident alien, the default U.S. tax rate is 30%. Apple withholds $3,000 and gives it to the IRS. They send you the other $7,000.
You want to pay less tax to the United States, so you look at the income tax treaty between the USA and your home country to see if you can find something that will help.
If you are a resident of the United Kingdom, you find Article 10, paragraph 2(b). It says that the USA can tax that dividend at a maximum 15% rate. You are happy. You fill in Form W-8BEN, part 2. Apple now withholds $1,500 and sends it to the IRS. Apple sends $8,500 to you.
You are allowed to use Article 10, paragraph 2(b) of the USA/U.K. tax treaty to reduce your U.S. taxes because the saving clause (Article 1, paragraph 4) does not bar its use by former citizens.
Take the same facts, but now you are a former U.S. citizen living in Switzerland.
You look at your $10,000 of dividends from Apple, and you look at the 30% tax being withheld at the source by Apple. You are getting $7,000 and you want more money. You look at the USA/Switzerland income tax treaty and find Article 10, paragraph 2(b) which reduces the tax rate that the USA can charge—down to 15%. Just the same as the U.K. treaty.
Then you take a look at the savings clause in the Swiss treaty. You note that the United States reserves the right to tax its former citizens as if the treaty does not exist.
You are sad. You cannot fill in Form W-8BEN, part 2 to claim a reduced rate of U.S. income taxation on the dividends you are receiving.
You are not permitted to use Article 10, paragraph 2(b) of the USA/Switzerland income tax treaty to reduce your U.S. income tax because the saving clause (Article 1, paragraph 2) says you, a former citizen of the United States, are not allowed to do so.
The moral of the story? You cannot blindly assume that the United States will tax you fairly as a former citizen. You will need to look at the income tax treaty between your home country and the United States to see if the saving clause takes away your right to claim treaty benefits.
This isn’t legal advice to you, of course. Would you make life-altering decisions based on a random email you got from some guy you found on the internet? Nope. Me neither. Go hire someone. March through the analysis and figure out what is best for you.