International Tax Rules Frequently Encountered in Vermont
By John C. Newman, Esq.
with Ron Morgan, Esq., and Matt Getty, Esq.
Tax and Estate Planning Department
One of the most important functions that a Vermont lawyer who does not concentrate in international tax law can perform when encountering a client with international tax issues is issue spotting. This article intends to highlight ten international tax and legal issues that our firm encounters frequently here in central Vermont. While likely to be the domain of the specialist, having some general notions of the flora and fauna of the international tax menagerie could be useful in advising when the client should seek further advice.
1. FBAR Reporting
The federal requirement annually to report an ownership interest in a foreign bank or financial account on the FBAR form has been around since its creation by the Bank Secrecy Act of 1970 (BSA), but you would be amazed by the number of people who will phone you and ask what to do about that UK bank account that they inherited from their uncle in 1986 now that the UK bank must report the income to IRS under FATCA (no. 2, below). As the IRS Audit Manual (“IRM”) explains,
A United States person must file an FBAR (FinCEN Form 114,Report of Foreign Bank and Financial Accounts) if that person has a financial interest in or signature authority over any financial account(s) outside of the United States and the aggregate maximum value of the account(s) exceeds $10,000 at any time during the calendar year. Failure to file this form may result in civil and/or criminal penalties. The civil penalties may be appealed.1
Since 2009, the IRS voluntary offshore compliance program has provided an avenue for US citizens or lawful permanent residents (LPRs) who have defaulted on their FBAR reporting or tax payment obligations to bring themselves into compliance in exchange for reduced penalties. The most recent IRS explanation of the current program can be found in IRS Notice IR-2014-73, June 18, 2014.2 This IRS document references the various explanatory materials and forms needed to bring a client into this program.
This voluntary compliance program is doubtlessly useful for the client whose failure to comply has been intentional, repeated, and has resulted in substantial tax avoidance. For clients whose failures to report accounts are unintentional and whose unpaid back taxes are rather small relative to their overall reported income, the cost in professional fees, penalties, and interest under the voluntary compliance program is so substantial that many such taxpayers elect to make a “quiet disclosure,” by simply filing their back FBAR reports, back tax returns, and paying any tax, interest, and penalties found due. In general, the open audit period for federal income taxes closes three years after the later of the due date for the return or the actual filing of the tax return, when an understatement of income is not more than 25%. As such, many taxpayers can file late FBARs with an explanation showing that the failure was inadvertent and file federal (and state) tax returns for all open years. So far, experience suggests that quiet disclosures have not yet begun to draw the threatened audits that the Treasury and IRS have announced in an attempt to push taxpayers into the streamlined offshore compliance procedures. A “quiet disclosure” still appears to make sense when the unreported income to be disclosed to IRS is rather small.
Before counseling a client on the consequences of a quiet disclosure, however, the lawyer should notify the client in writing of the risks of prosecution and penalties and compare them with the costs of the potentially more secure voluntary disclosure program. The FBAR penalty for a willful failure to file is the greater of $100,000 or 50% of the balance in the account at the time of the violation. IRS examiners have discretion to reduce this ceiling. Penalty standards are found in the BSA audit manual.3
In our experience, the number of Vermont tax accountants and return preparers who are willing to attempt to manage these issues is rapidly declining. In some cases, we have been forced to seek tax return preparers in major metropolitan areas to prepare back tax returns and to file the back FBAR forms (formerly TDF 90-22.1, now FinCEN Form 114) on behalf of our clients. The electronic filing procedures for this form are very complicated, making it difficult for an attorney to handle. By contrast, the software commonly used by tax return preparers contains a program that allows electronic filing of the FBAR form to occur without having to hire a software engineer.
The Foreign Account Tax Compliance Act of 2010 (adopted as part of the HIRE Act) has inaugurated a new era of international tax compliance throughout the world. Under FATCA (IRS Sections 1471 to 1474), Foreign Financial Institutions (FFIs) and direct reporting Non-US Non-Financial Entities (NFEEs) are required to identify and disclose information regarding their account holders who are US citizens or LPRs. FFIs or direct reporting NFEEs who fail to comply will become subject to a 30% withholding tax on distributions to them of US-source income. To reduce a complicated topic to its simplest expression, FFIs and NFEEs may avoid becoming subject to the 30% withholding rate by being covered by compliance agreements with the Internal Revenue Service by which FFIs and NFEEs agree to report to the Internal Revenue Service on income from accounts owned by US citizens and US tax residents. Most of these agreements will take the form of reciprocal Intergovernmental Agreements (IGAs).
FATCA was supposed to become effective at the end of 2012, but the actual effective date was progressively pushed back to June 30, 2014. The UK signed an IGA that went into effect on June 30, 2014. While FATCA originally created controversy in the international financial world, the European Union has been moving to impose a similar regime on its member states and well-known offshore banking centers.
In the case of our US citizen who has inherited a UK securities account, the UK bank or financial firm holding the account will commence reporting the income earned on such accounts for calendar year 2014 to the Internal Revenue Service. As has been the case with our own firm’s experience with Swiss banks, the UK institution likely will warn its client of the fact that this reporting is being made. Such communications from foreign banks may lead clients to contact you with questions about how to proceed to handle past non-reporting of income. The task for the Vermont practitioner will be to determine how to bring the individual into compliance before the Internal Revenue Service contacts the taxpayer and commences an audit or other enforcement actions, with the strong likelihood of FBAR penalties as discussed above, and possible criminal prosecution. At a minimum, the IRS has the power to issue a proposed assessment based upon a foreign provided Form 1099 (which is what some UK banks are using) or Form 8966 (which is the general FATCA report).
This explanation here is greatly simplified. The instructions to the 2014 Form 8966 are a concise source of official information on how the reporting system is designed to work in much more detail. Be aware that, if IRS makes an adjustment (seeking income tax, interest, and penalties), periodic reports are then made by IRS to the Vermont Department of Taxes.
Passive Foreign Investment Companies were carved out of the forest of financial products by the Tax Reform Act of 1986 and subjected to a strict compliance system designed to collect tax at ordinary income rates. The definition of PFICs (found at IRC section 1297) is technical, but they are most easily categorized as all non-US based mutual funds. The ownership of such non-US mutual funds by US taxpayers is required to be reported on IRS Form 8621, and the income from a PFIC is subject to a tax rate and deemed interest charge that could well be higher than straightforward taxation of US mutual fund income. In addition, a variety of rather complex elections must be made in a timely manner or their benefits are lost.
In our experience, few Vermont tax accountants and return preparers are willing to learn the complexities of PFIC reporting. Form 8621 has eleven pages of detailed instructions on the eight elections that can be made and their reporting consequences. The cost and complexity of PFIC reporting is not the only problem. An individual who owns securities through a PFIC may well be taxed more severely in many cases than if the stocks and bonds were owned directly by the individual. For example, PFIC rules can make it difficult to obtain capital gains treatment for long-term capital gains that pass through a PFIC.
Prior to FATCA, ownership of PFICs by US citizens and LPRs frequently was ignored or simply reported using regular (non-PFIC) rules. With FATCA, the IRS will now have foreign source reporting forms to set up automatic adjustments. Almost twenty years after their creation, PFIC rules may now begin to really bite into a taxpayer’s pocket book ¾ if not in terms of tax payments, then at least in terms of compliance costs.
4. FIRPTA, Etc.
The Foreign Investment in Real Property Tax Act created a now rather well understood, system for mandatory federal 10% withholding on real estate transactions when the seller is a non-citizen non-resident of the United States. Vermont has a similar regime for sales of Vermont real property by non-Vermont residents. A withholding agent generally collects the FIRPTA and Vermont withholding. Internal Revenue Service regulations (Treas. Reg. 1.1445-2(b)) exempt a closing agent from withholding liability if the transferee (and by extension his lawyer or other agent) obtains a certificate of non-foreign status from the seller of real property in the United States. If the transferee relies on some other form of proof, then the transferee is subject to the withholding tax if it is found due.
Many local practitioners seem to ignore the legal fact that their buyer ¾ and by extension themselves ¾ is best protected by obtaining and then maintaining for five years the certificate of non-foreign status as a standard closing document. The “old saw” in our law firm is that “it is amazing how well some Canadians speak American English.” Vermont practitioners also should be aware that special withholding rules apply to pass-thru entities (such as partnerships) with non-resident alient (NRA) partners. Partnerships with NRAs are subject to more onerous withholding rules on income earned from real estate. Instead of FIRPTA withholding, domestic partnerships with NRAs as partners are subject to withholding at the partnership level at the highest federal tax rate, 39.6% for individuals and 35% for corporations.
On the buying end of a US-foreign real estate transaction, the Vermont lawyer is well advised to notify the acquiring NRA that the NRA will be subject to a mandatory 30 % withholding tax on gross rental income from the property unless an election to be taxed on a “net basis” is made by a specific statement to this effect on the first year IRS form 1040NR.4 Many Vermont real estate management and rental companies are not aware that they are liable for the withholding tax if it is not paid by the NRA. To escape personal liability, the Vermont rental agency should solicit proof from the NRA owning the property that the “net basis” election has been made, such as IRS Form W-8ECI.
In terms of the NRA seller’s side of the transaction, a Vermont attorney may become aware of unreported US-source rental income when the lawyer explains to the NRA the ability to file a request with the IRS and Vermont for a reduced withholding payment on the sale. The form for the reduced withholdings from sales proceeds asks specifically about past rental activities because the depreciation deduction (whether taken or not) will reduce the real property’s tax basis.
5. NRA Closer Connection Test
If you think about it from a layman’s point of view, the term non-resident alien is rather suggestive of a science fiction creature, so we tend to use the terms “non-resident” or “NRA” with our clients. Most lawyers and Vermont real estate agents know that, for federal tax purposes, if a non-US citizen individual is physically present in the United States for 183 days or more, he or she becomes a US tax resident. What is not well known is that this “days of presence” calculation takes into consideration one-third of the days of US presence in the prior year for which the measurement is made and one-sixth of the days of presence in the second prior year. Therefore, non-US citizen individuals can become US tax residents if they are present in the United States more than 122 days each year over a three year period. Having a tax residence in the US can be very significant because US tax residents are taxed here on their worldwide income.
What is even less well known is that, under federal domestic tax law, an individual who becomes a US tax resident as a result of this particular counting rule can claim a “closer connection” to a foreign state so as to avoid worldwide taxation here, provided that their period of presence in the United States is less than 183 days.5 The claim to a closer connection to another country is made on IRS Form 8840. This should be of particular interest to Canadian “snowbirds,” who are Canadians known to cross the US border sometime in November, not returning to Canada until sometime in May. If Canadian snowbirds spend 150 days a year in the United States in 2013, 2014, and 2015, they are certainly tax residents of the United States in 2015 under the days of physical presence count [150 + (150/3) + (150/6) = 225]. In those situations, the Canadian snowbirds will have to file a timely IRS Form 8840 to avoid becoming liable for US tax on their worldwide income ¾ despite the fact that Canada will also be looking for a tax return on the basis that the snowbird remained a Canadian resident.
At the deepest level of obscure knowledge in this area, the “tiebreaker rules” in US tax treaties may offer a separate escape hatch for Canadian snowbirds (and other NRAs protected by a tax treaty) who may be present in the US for more than 183 days in the calendar year. Under the model US Income Tax Treaty (latest version issued November 15, 2006)6 if an individual is a resident of both the US and the treaty partner, NRAs can claim that they are solely a resident of the foreign treaty partner because their “center of vital interest” is located in the foreign country. The US-Canada treaty contains such a provision. This Article 4 tiebreaker is designed to prevent double taxation when our Canadian snowbird becomes a US tax resident under the days of physical presence test. To take a treaty-based tax return position, however, the Canadian snowbird or other NRA will be required to file IRS Form 8833. Form 8833 cannot be filed by individuals who are not protected by general income tax treaties, such as individuals from Bermuda, the Bahamas, etc.
To summarize, NRAs who spend under 183 days in the United States may file Form 8840 to claim a closer connection to a foreign country regardless of the existence of a tax treaty, and NRAs who spend more than 183 days in the United States and who qualify for treaty protection can file IRS Form 8833 to claim a treaty-based return position that takes them out of the US taxing jurisdiction.
There is folklore that the foreign trust rules in the Small Business Job Protection Act of 1996 were passed after President Bill Clinton discovered that Ross Perot owned property in Bermuda through an offshore grantor trust settled by a Bermuda trustee. Whether this story is true or not, the foreign trust taxation rules in the SBJPA were intended to prevent tax avoidance through the use of foreign trusts, in particular by using the domestic tax rule that the grantor of a US grantor trust is taxed on the income from the trust. The particular rules are complex, but suffice it to say that to prevent tax avoidance that formerly was possible by having the nominal grantor of a foreign trust being a foreign trustee, the Act imposes a broad network of reporting requirements when the beneficiaries of a foreign trust are US tax residents. The rules impose harsh penalties for those who fail to comply with these requirements.
Given Vermont’s demographics, it is entirely possible that you will be contacted by a son or daughter who is the beneficiary of a trust established by a foreign parent with regard to what the reporting rules might be for such individuals. In our experience, many citizens of the UK, Australia, New Zealand, Bermuda, and the Bahamas with substantial net worth and residing in Vermont are the known beneficiaries of offshore Anglo-Saxon trusts. Given how some Anglo-Saxon trusts are settled, the client may not even know that he or she is the beneficiary of the trust.
The manner in which US income tax is imposed on the US beneficiary of a foreign trust is quite complex. Because of the imposition of the “throwback” rules, plus a deemed interest charge, the tax on foreign trust income can be substantially higher than US income tax on the same dollar distribution from a domestic trust. The penalties for a failure to report such income can be sufficiently stiff that the tax and penalties could absorb almost the entire trust distribution.
It bears mentioning that foreign trust reporting rules need to be considered when establishing an estate plan for a Vermont couple, one of whom is not a citizen of the United States. A standard device used to take advantage of the marital deduction is the QDOT, discussed below.
7. QDOTs and the Gift Tax Marital Deduction
As the narrative goes in Washington, when the US Congress was trying to raise revenue for one of its spending bills in 1988, it decided that it could get a good revenue score by denying an unlimited estate and gift tax marital deduction to US resident individuals who were not US citizens. To avoid a treaty claim that the denial was discriminatory, the deduction was granted if the marital transfer was made to a Qualifying Domestic Trust (QDOT). The logic for giving the QDOT measure a high revenue score was that US residents who were not US citizens could receive property at death or by gift from his US citizen spouse without gift or estate tax and then leave the country. The unlimited marital deduction for non-citizen spouses was perceived to deny the US Treasury the ability to impose its estate or gift tax on such transfers of wealth. International tax practitioners will be aware that the US Congress then proceeded to impose an estate and gift exit tax, which is discussed below, so the QDOT measure may be overkill. In any case, Vermont practitioners should be aware that federal and presumably Vermont law (under the federal/state estate tax conformity rule, 32 VSA §7475) deny an unlimited estate tax marital deduction for a transfer of wealth from a US citizen spouse to a non-citizen spouse unless the marital transfer is structured as a QDOT. A QDOT is a trust that is designed to capture subsequent principal distributions from the QDOT to the non-US-citizen surviving spouse and make them subject to the federal estate tax. Because a QDOT could become subject to some of the foreign trust reporting rules of the SBJPA, drafters should be aware of foreign trust reporting rules when deciding how to settle such a trust.
For federal gift tax purposes, Vermont practitioners should be aware that the normal unlimited gift tax marital deduction is replaced by a $147,000 per calendar year (2015) limit on such lifetime transfers. This annual limit is adjusted for inflation. Under these rules, transfers of property from a US citizen spouse to a non-citizen spouse for estate planning purposes will trigger a federal gift tax if the value received by the non-US citizen spouse exceeds $147,000. A special rule applies to spousal joint tenancies: no gift results upon creation, but on the death of the US citizen spouse, the entire value is deemed to pass to the non-citizen spouse. This transaction may go unnoticed for a considerable period, and the transaction may unravel at the point at which the Form 706 is audited by Vermont or the federal government. Indeed, there may be an inchoate estate tax lien on the real property to cover the collection of the federal or Vermont estate tax that was not paid upon the transfer.
8. Estate Tax Exemption
Vermonter lawyers with NRAs as clients should be aware that the Internal Revenue Code provides for only a $60,000 estate tax exemption in the absence of a bilateral estate tax treaty. The majority of countries in the world do not have bilateral estate tax treaties with the United States, and such treaties generally exist only with our major trading partners, Canada, France, Italy, Germany, etc. Each treaty needs to be examined to decide to what extent the US will accord a larger estate tax deduction than the $60,000 provided for by the Internal Revenue Code. For this reason, the Vermont real estate attorney who handles the acquisition of real property for an NRA should flag this issue for the acquirer. The standard solution to a $60,000 exclusion is to acquire the property in a foreign corporation because the transfer at death of stock in a foreign corporation by an NRA is not subject to the US estate tax because such stock is intangible personal property and therefore exempt. In some cases, however, the anticipated appreciation in the property’s value (which would be taxed as corporate income) could be more expensive than the risk of estate tax at death.
It bears mentioning that the definition of “resident” for estate and gift tax purposes is not synonymous with the income tax definition. In addition, the estate tax treaty tie breaker rule may require more years of residence to use the tax treaty’s protective rules. For example, a French LPR could die within three years of establishing residence in the US but still be subject to French succession duties because a five-out-of-seven year tiebreaker rule could apply.7
9. Exit Tax
As is discussed in much more detail in an article on our firm website,8 IRC Sections 877 and 887A impose an exit tax on “covered expatriates.” An LPR who gives up his or her “green card” (properly termed USCIS Form I-551) by filing USCIS form I-407 is a covered expatriate if he or she was a long-term permanent resident, meaning that prior to the date of expatriation the NRA was an LPR during at least eight of the last fifteen years. A US citizen who renounces his US nationality is a covered expatriate in all cases. Fortunately, the exit tax is designed to reach only those individuals with earnings and net worth sufficient to allow them to engage your services to plan for this tax. The exit tax is imposed if the departing individual (i) has an annual tax liability of about $152,000 (2014 figures) for the five years preceding the date of expatriation, (ii) has over $2 million in net worth, or (iii) fails to certify that he or she has complied with all US federal tax obligations in the preceding five years.
We have been asked to handle a few expatriation cases and plan for this tax regime. For example, many UK, French, German, or Bermudian university students achieved US citizenship at their birth in the home country because they had a US citizen parent. It is not unrealistic to assume that no one in their home country has informed them of their US income tax obligations, and they have often failed to file any income tax returns on their worldwide income despite working abroad. Some may discover this lapse when they are hired for a financial service job that requires their tax returns be prepared by a US accounting firm, which then notices their US citizenship. If this individual then files I-407 at the US consulate to renounce US citizenship, the exit tax nevertheless applies due to the simple fact of their previous non-compliance.
10. Investment Survey, Agricultural Land Reporting
The 1976 International Investment Survey Act authorized the US government to engage in a foreign direct investment survey. Foreign direct investment (FDI) reporting was suspended in 2009 but reinstated by a Bureau of Economic Affairs Notice dated November 26, 2014. This reporting requirement applies to a variety of FDIs (acquisitions, investments, expansions). BE-13 forms are used for this report, which exact form to use depending on the type of FDI. For example, BE-13A is used for an acquisition. The purpose of this law is to collect information, but the penalty for a failure to file is not less than $2,500 nor more than $32,500. This declaration must be made by any business located in the United States when a foreign person owns or acquires at least 10% of the voting rights in the enterprise, whether directly or indirectly, and the total cost of the acquisition is more than $3 million.
The Agricultural Foreign Investment Disclosure Act of 1978 imposes a similar reporting obligation on any foreign person who acquires, sells, or holds, directly or indirectly, agricultural land in the United States. The declaration is made on Form FSA-153, which is sent to the Department of Agriculture’s Farm Services Agency. The triggers should be examined by the Vermont attorney for the buyer whenever a foreign person acquires Vermont land. For example, the form must be filed when an acquisition is made of more than ten acres of land, within ninety days following the conclusion of the transaction
As is frequently the case in the international arena, the penalty is vastly disproportionate to the objects sought to be attained by the legislation. The civil penalty cannot exceed 25% of the fair market value of the land acquired on the date that the penalty is imposed.9
Finally, it bears mentioning that the Internal Revenue Code contains a variety of foreign disclosure provisions that could apply to your Vermont clients. In particular, IRS Form 5472 must be filed by a US taxpayer that acquires or holds an interest in a foreign company.
With the recent increase in international commerce and trade, these are the ten issues that we most frequently encounter in central Vermont.
1IRM § 126.96.36.199.2 (02-02-2015).
4Treas. Reg. 1.871-10.
5Treas. Reg. 301.7701(b)-8.
6Available at www.irs.gov, Article 4 (“Resident”).
7See US-France Estate and Gift Tax Treaty, Article 4(3)(b)(i), http://franceintheus.org/IMG/pdf/french_us_estate_tax_treaty.pdf.
8“US Imposes Mark-to-Market Exit Tax,” at http://www.fgmvt.com/us-imposes-mark-to-market-exit-tax.html.
97 C.F.R. §781.4(b)(2).