Why U.S. deemed income events cause problems for U.S. citizens living in other countries and erode the tax based of the countries where they live

All countries in the world have an interest in the Moore MRT appeal and should file Amicus briefs in support of the Moores.

"The Little Red Transition Tax Book" – Everything you need to know about the 965bmandatory repatriation tax but didn't know to ask. A horrific abuse of #Americansabroad in a @citizenshiptax and #FATCA world! https://t.co/j7v1Asreek

— U.S. Transition Tax – Subpart F and #GILTI (@USTransitionTax) June 26, 2023

The U.S. citizenship tax AKA extraterritorial tax regime applies to ALL U.S. citizens and residents wherever they live in the world. With its very expansive definition of “tax residency”, the United States claims the tax residents of other countries as U.S. tax residents. Those unlucky dual filers are subject to additional administrative fees, additional taxation and the opportunity cost of the inability to effectively engage in retirement and financial planning.

In the Moore MRT appeal the U.S. Supreme Court will consider whether “income” requires the actual receipt of income or whether “deemed income” meets the 16th Amendment test for income. Does the 16th Amendment require objective tests that must be satisfied before “income” can exist? The answer to this question will have profound implications for both the “U.S. citizen” residents of other countries and (2) the countries where they live. As previously discussed, if income does NOT have to be actually received, this opens the door for the U.S. tax the residents of other countries on income they have never received. Often the taxable event in the U.S. will take place before the taxable event in that other country.

The following post describes some examples where the United States is already deeming income to have been received for U.S. tax purposes before income has been received in the other country.

The following post describes how the U.S. deeming income to have been received for U.S. tax purposes prior to income having been received in the other country may result in (1) double taxation to the individual and (2) erosion of the tax base of the other country.

Tax treaties and the problem of deemed income events

Interestingly this problem has been recognized in the Canada/U.S. Tax Treaty since 1980

U.S. Canada Tax Treaty – 1980

The 1980 treaty included Article XIII, paragraph 7 …

7. Where at any time an individual is treated for the purposes of taxation by a Contracting State as having alienated a property and is taxed in that State by reason thereof and the domestic law of the other Contracting State at such time defers (but does not forgive) taxation, that individual may elect in his annual return of income for the year of such alienation to be liable to tax in the other Contracting State in that year as if he had, immediately before that time, sold and repurchased such property for an amount equal to its fair market value at that time

https://www.irs.gov/pub/irs-trty/canada.pdf

The intent was explained in Treasury’s technical interpretation of the treaty as follows …

Paragraph 7 provides a rule to coordinate U.S. and Canadian taxation of gains in circumstances where an individual is subject to tax in both Contracting States and one Contracting State deems a taxable alienation of property by such person to have occurred, while the other Contracting State at that time does not find a realization or recognition of income and thus defers, but does not forgive taxation. In such a case the individual may elect in his annual return of income for the year of such alienation to be liable to tax in the latter Contracting State as if he had sold and repurchased the property for an amount equal to its fair market value at a time immediately prior to the deemed alienation. The provision would, for example, apply in the case of a gift by a U.S. citizen or a U.S. resident individual which Canada deems to be an income producing event for its tax purposes but with respect to which the United States defers taxation while assigning the donor’s basis to the donee. The provision would also apply in the case of a U.S. citizen who, for Canadian tax purposes, is deemed to recognize income upon his departure from Canada, but not to a Canadian resident (not a U.S. citizen) who is deemed to recognize such income. The rule does not apply in the case death, although Canada also deems that to be a taxable event, because the United States in effect forgives income taxation of economic gains at death. If in one Contracting State there are losses and gains from deemed alienations of different properties, then paragraph 7 must be applied consistently in the other Contracting State within the taxable period with respect to all such properties. Paragraph 7 only applies, however, if the deemed alienations of the properties result in a net gain.

https://www.irs.gov/pub/irs-trty/canatech.pdf

Protocol to Canada/U.S. Tax Treaty 2007 – Article VIII – Replacing Article XIII Paragraph 7 in the 1980 Treaty

3. Paragraph 7 of Article XIII (Gains) of the Convention shall be deleted and replaced by the following:

7. Where at any time an individual is treated for the purposes of taxation by a Contracting State as having alienated a property and is taxed in that State by reason thereof, the individual may elect to be treated for the purposes of taxation in the other Contracting State, in the year that includes that time and all subsequent years, as if the individual had, immediately before that time, sold and repurchased the property for an amount equal to its fair market value at that time.

https://home.treasury.gov/system/files/131/Treaty-Canada-Pr2-9-21-2007.pdf

Treasury’s Technical explanation of the 2007 Protocol

Paragraph 3

Paragraph 3 of Article 8 of the Protocol replaces paragraph 7 of Article XIII.

The purpose of paragraph 7, in both its former and revised form, is to provide a rule to coordinate U.S. and Canadian taxation of gains in the case of a timing mismatch.

Such a mismatch may occur, for example, where a Canadian resident is deemed, for Canadian tax purposes, to recognize capital gain upon emigrating from Canada to the United States, or in the case of a gift that Canada deems to be an income producing event for its tax purposes but with respect to which the United States defers taxation while assigning the donor’s basis to the donee. The former paragraph 7 resolved the timing mismatch of taxable events by allowing the individual to elect to be liable to tax in the deferring Contracting State as if he had sold and repurchased the property for an amount equal to its fair market value at a time immediately prior to the deemed alienation.

The election under former paragraph 7 was not available to certain non-U.S. citizens subject to tax in Canada by virtue of a deemed alienation because such individuals could not elect to be liable to tax in the United States. To address this problem, the Protocol replaces the election provided in former paragraph 7, with an election by the taxpayer to be treated by a Contracting State as having sold and repurchased the property for its fair market value immediately before the taxable event in the other Contracting State. The election in new paragraph 7 therefore will be available to any individual who emigrates from Canada to the United States, without regard to whether the person is a U.S. citizen immediately before ceasing to be a resident of Canada. If the individual is not subject to U.S. tax at that time, the effect of the election will be to give the individual an adjusted basis for U.S. tax purposes equal to the fair market value of the property as of the date of the deemed alienation in Canada, with the result that only post-emigration gain will be subject to U.S. tax when there is an actual alienation. If the Canadian resident is also a U.S. citizen at the time of his emigration from Canada, then the provisions of new paragraph 7 would allow the U.S. citizen to accelerate the tax under U.S. tax law and allow tax credits to be used to avoid double taxation. This would also be the case if the person, while not a U.S. citizen, would otherwise be subject to taxation in the United States on a disposition of the property.

In the case of Canadian taxation of appreciated property given as a gift, absent paragraph 7, the donor could be subject to tax in Canada upon making the gift, and the donee may be subject to tax in the United States upon a later disposition of the property on all or a portion of the same gain in the property without the availability of any foreign tax credit for the tax paid to Canada. Under new paragraph 7, the election will be available to any individual who pays taxes in Canada on a gain arising from the individual’s gifting of a property, without regard to whether the person is a U.S. taxpayer at the time of the gift. The effect of the election in such case will be to give the donee an adjusted basis for U.S. tax purposes equal to the fair market value as of the date of the gift. If the donor is a U.S. taxpayer, the effect of the election will be the realization of gain or loss for U.S. purposes immediately before the gift. The acceleration of the U.S.
tax liability by reason of the election in such case enables the donor to utilize foreign tax credits and avoid double taxation with respect to the disposition of the property.

Generally, the rule does not apply in the case of death. Note, however, that Article XXIX B (Taxes Imposed by Reason of Death) of the Convention provides rules that coordinate the income tax that Canada imposes by reason of death with the U.S. estate tax.

If in one Contracting State there are losses and gains from deemed alienations of different properties, then paragraph 7 must be applied consistently in the other Contracting State within the taxable period with respect to all such properties. Paragraph 7 only applies, however, if the deemed alienations of the properties result in a net gain.

Taxpayers may make the election provided by new paragraph 7 only with respect to property that is subject to a Contracting State’s deemed disposition rules and with respect to which gain on a deemed alienation is recognized for that Contracting State’s tax purposes in the taxable year of the deemed alienation. At the time the Protocol was signed, the following were the main types of property that were excluded from the deemed disposition rules in the case of individuals (including trusts) who cease to be residents of Canada: real property situated in Canada; interests and rights in respect of pensions; life insurance policies (other than segregated fund (investment) policies); rights in respect of annuities; interests in testamentary trusts, unless acquired for consideration; employee stock options; property used in a business carried on through a permanent establishment in Canada (including intangibles and inventory); interests in most Canadian personal trusts; Canadian resource property; and timber resource property.

https://home.treasury.gov/system/files/131/Treaty-Canada-Pr2-TE-9-21-2007.pdf

2001 Protocol to the U.S. Australia tax treaty

ARTICLE 9

Article 13 of the Convention is amended by:
(a) omitting paragraph (3) and substituting:

(5) Where an individual who, upon ceasing to be a resident of one of the Contracting States, is treated under the taxation law of that State as having alienated any property and is taxed in that State by reason thereof, the individual may elect to be treated for the purposes of taxation in the other Contracting State as if the individual had, immediately before ceasing to be a resident of the first-mentioned State, alienated
and re-acquired the property for an amount equal to its fair market value at that time.

(6) An individual who elects, under the taxation law of a Contracting State, to defer taxation on income or gains relating to property which would otherwise be taxed in that State upon the individual ceasing to be a resident of that State for the purposes of its tax, shall, if the individual is a resident of the other State, be taxable on income or gains from the subsequent alienation of that property only in that other State.

https://home.treasury.gov/system/files/131/Treaty-Australia-Protocol-9-27-2001.pdf

(The Technical Interpretation is lengthy and is included as an Appendix.)

Significantly these paragraphs in the Canada and Australia tax treaties apply to the “alienation” of property. The provision in the Australia treaty appears to be focused on emigration. The provision in the Canada treaty is clearly broader. (Could this be read broadly to include the deemed distribution of pensions or tax deferred accounts?) Both treaties recognize the problem in the mismatches in the timing of realization of income. The recognition of mismatches in the timing of income finds expression in the 2016 U.S. Model Tax Treaty.

Model U.S. Tax Treaty 2016

The following provision first appeared in the 2016 Model Tax Treaty. There is at present no technical explanation discussing the treaty. Therefore, it must be interpreted based on the presumed intent (which can be gleaned in part from the Canada U.S. Tax Treaty). Significantly, this provision is intended to prevent double taxation resulting from the deemed “alienation” of property upon severing tax residency. It is far narrower than the Article XIII – Paragraph 7 of the Canada U.S. Tax Treaty.

Article 13 – Paragraph 7

7. Where an individual who, upon ceasing to be a resident (as determined under paragraph 1
of Article 4 (Resident)) of one of the Contracting States, is treated under the taxation law of that
Contracting State as having alienated property for its fair market value and is taxed in that
Contracting State by reason thereof, the individual may elect to be treated for purposes of
taxation in the other Contracting State as if the individual had, immediately before ceasing to be
a resident of the first-mentioned Contracting State, alienated and reacquired such property for an
amount equal to its fair market value at such time.

https://home.treasury.gov/system/files/131/Treaty-US-Model-2016_1.pdf

Conclusion and recommendation

The inclusion of these “deemed alienation” provisions in the tax treaties is evidence of a recognition of a problem of “deemed” income where no income has actually been realized. Changes in the definition of income in one treaty partner country will change taxation in the other country. Therefore, all other countries in the world have a clear interest in the outcome of the Moore case and should be filing an Amicus brief!

Interested in Moore (pun intended) about the § 965 transition tax?

Read “The Little Red Transition Tax Book“.

Appendix – Technical interpretation of paragraphs 5 and 6 of the U.S. Australia protocol

Paragraph (5) addresses the situation in which a resident of one State emigrates to the other State and, as a result, is subject to special tax rules. Under current law this paragraph would apply only to an Australian resident who expatriates to the United States.

Under Australian domestic tax law, an individual surrendering Australian residence is generally treated as recognizing gain as though he disposed of all assets that do not have the necessary connection with Australia immediately prior to surrendering Australian residence.

Assets that have the necessary connection with Australia are not subject to tax under this deemed sale rule because the individual will be subject to Australian tax on the actual sale or disposition of those assets, i.e., the assets are subject to Australian tax jurisdiction regardless of the owner’s residence. Assets that have the necessary connection to Australia include interests in an Australian private company or trust, Australian real property, property used in the conduct of a business in Australia through a permanent establishment, and holdings of 10 percent or more in Australian public companies and unit trusts.

Paragraph (5) permits an individual who changes residence from Australia to the United States to elect to be treated for U.S. tax purposes as if he had, immediately before ceasing to be a resident of Australia, sold property and reacquired it for an amount equal to its fair market value.

This paragraph has two significant consequences. First, the “deemed sale” rule will result in the individual (still a resident of Australia) triggering gain on assets that the United States is permitted to tax as the source State (e.g., a U.S. real property interest or property part of a permanent establishment). If the individual is subject to U.S. tax on the gain from the deemed sale of the asset, he will be eligible for a foreign tax credit against Australian income tax on the deemed sale (with such resourcing of the gain as is necessary for Australia to provide relief pursuant to Article 22 of the Convention). Second, the “deemed sale and repurchase” will result in the individual (now a U.S. resident) having a “stepped up” basis equal to fair market value in all assets subject to the deemed sale and repurchase, regardless of whether any U.S. tax was
triggered by the deemed sale.

Paragraph (6) addresses the situation in which an individual who is a resident of one State to the other State but elects to defer all or a portion of the tax otherwise due upon expatriation. As with paragraph (5), under current law this paragraph would apply only to an Australian resident who expatriates to the United States.

Although Australian domestic tax law generally requires an individual losing Australian residence to recognize all unrealized gain on assets that do not have the necessary connection with Australia, it permits the individual to defer all or a portion of the gain by electing to treat assets that otherwise lack the necessary connection with Australia as having such necessary connection. As a result of this election, the asset becomes subject to Australian taxing jurisdiction regardless of its location or relationship to Australia, and the former Australian resident will be subject to Australian tax on its actual sale. Under paragraph (6), if an individual changes residence from Australia to the United States and makes this election under Australian domestic law, then only the United States may tax the individual on gain from the assets subject to the election.

The following example illustrates the operation of both paragraphs (5) and (6). An individual emigrates from Australia to the United States. Prior to emigration, the individual has four assets: Australian real property with a basis of $100 and a fair market value of $500, stock in a U.S. company with a basis of $50 and a fair market value of $75, U.S. real property with a basis of $200 and a fair market value of $300, and stock in a New Zealand company with a basis of $200 and a fair market value of $250. Under Australian domestic law, only the Australian real property has the necessary connection with Australia. Because Australia retains taxing
jurisdiction over the Australian property, the Australian property is not covered by paragraph (5) or (6) of this Article.

Unless the individual makes an election under Australian law to treat the U.S. stock, the U.S. real property, and the New Zealand stock as having an Australian connection, the taxpayer upon emigration would be subject to Australian tax on the $25 in unrealized gain on the U.S. stock, the $100 in unrealized gain on the U.S. real property, and the $50 in unrealized gain on the New Zealand stock. Under paragraph (5), the individual may elect to be treated for U.S. tax purposes as if he sold and repurchased the U.S. stock, the U.S. real property, and the New Zealand stock. The United States would tax the $100 in gain on the deemed sale of the U.S. real property pursuant to paragraph (1) of Article 13 of the Convention and section 871 of the Internal Revenue Code. In contrast, the individual would most likely not owe any U.S. tax on the gain of either the U.S. or New Zealand stock. If the individual did incur U.S. tax on the deemed sale of the stock (e.g., because either or both the U.S. and New Zealand stock forms part of the business property of a permanent establishment in the United States), then the individual would owe U.S. tax on the deemed sale of the stock, but he would be able to credit all or a portion of that U.S. tax against his Australian tax arising from the deemed sale of the stock. Accordingly, upon emigrating, the individual would be treated, for U.S. tax purposes, as having a basis in the U.S. real property of $300, a basis in the U.S. stock of $75, and a basis in the New Zealand stock of $250. The individual’s basis in the Australian real property would remain $100
because no gain was triggered pursuant to the emigration.

If the individual elects to treat the U.S. and New Zealand stock as having a connection with Australia, then the individual will not owe Australian tax on the deemed sale of the two assets. If the individual sells the U.S. or New Zealand stock while a resident of the United States, he will not be taxable in Australia on the gain. If the individual sells the Australian real property while a resident of the United States, he will, however, be taxable by Australia on the gain from the sale of the Australian real property (pursuant to paragraph (1) of Article 13 of the Convention). Under Article 27 (Miscellaneous) of the Convention, any income that is derived by a resident of the United States that may be taxed by Australia pursuant to the Convention is resourced as necessary to permit relief from double taxation under Article 22 (Relief from
Double Taxation) of the Convention.

https://home.treasury.gov/system/files/131/Treaty-Australia-Protocol-TE-3-5-2003.pdf

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