Part I – Prologue – A Tweet Worth A Thousand Posts

Part 6 – The 877A Exit Tax: While the non-US pensions of Americans abroad are subject to confiscatory taxation, US based pensions escape intact https://t.co/yBi3RH8nTe via @SEATNow_org

— John Richardson – lawyer for "U.S. persons" abroad (@ExpatriationLaw) February 28, 2023

For a “Readers Digest” version of the post that is to follow, simply click on the link in the above tweet!

To see examples of the deemed income inclusions and the U.S. tax owing click on the links to Appendices, B, C and D below.

Outline And Structure

This post is for the purpose of alerting Americans abroad and their advisors to a particularly difficult and unjust aspect of renouncing U.S. citizenship. The punitive treatment of the non-U.S. pension is a reason for many Americans abroad to consider renunciation earlier (when they are not “covered expatriates”) rather than later (when they may be subject to the confiscatory rules applied to “covered expatriates”).

Part I – Introduction – The General Message
Part II: Relinquishment and the confiscatory case of the “ineligible” (non-U.S.) pension … A Deeper Dive
Part III: Relinquishment and the retention of the “eligible” (U.S.) pension … A Deeper Dive
Part IV – Conclusion
Appendix A – How Internal Revenue Code Sections 877A and 877 Lead To The Confiscation Of The Non-U.S. Pension
Appendix B – Dual Status tax return with a 1 million USD income inclusion on the day before expatriation
Appendix C – Dual Status tax return with a 1 million USD income inclusion on the day before expatriation with a $100,000 tax credit carry forward
Appendix D – Dual Status tax return with (1) a full actual distribution of the pension in Canada on the day before expatriation (generating a foreign tax credit in the current year)

Part I – Introduction – The General Message

The warning! Some Americans abroad who renounce U.S. citizenship can expect to have punitive taxation imposed on the value of their non-US pensions. This is a tax imposed by a “deemed distribution” (not actual) of the the pension. Because there was no “actual distribution” those affected will need to find another source of funds to pay the tax. Significantly, the tax does NOT apply to U.S. pensions. Those renouncing who have U.S. based pensions may NEVER be taxed on the value of those pensions.

Once an individual’s net worth reaches 2 million USD, that individual is generally subject to this tax. This means that renunciation may become very costly. Americans abroad with non-US pensions and their advisors should be aware of (and plan around) this problem.

In this post I am joined by Olivier Wagner who has generously provided excerpts from mock U.S. tax returns which demonstrate how confiscatory the U.S. Exit Tax rules are when applied to non-U.S. pensions (and therefore to Americans abroad). You will find his returns in Appendixes B, C and D at the end of this post.

The mock tax returns show that a U.S. citizen living outside the United States who:

– is a “covered expatriate”

– has a non-U.S. pension with a present value that includes a taxable amount of $1,000,000 USD

will be subject to an immediate tax of $344,963 triggered by renunciation of U.S. citizenship.

Because this tax is NOT imposed on those with U.S. based pensions, this tax applies disproportionately to Americans abroad, who earned their pensions while living outside the United Sates.

Of course, if he had renounced before reaching the 2 million USD net worth mark, he could possibly renounce and pay no exit tax on the value of his pension. Financial planners and other advisors take note!!

The curious and confiscatory case of Americans abroad and their non-US pensions

Some Americans abroad who relinquish their U.S. citizenship are “covered expatriates” and are therefore subject to the U.S. Exit Tax Regime which may be triggered by relinquishment.

The 877A Expatriation Tax regime is found in Sections 877A (deemed income provisions) and Section 2501 (disability from making gifts/bequests to “U.S. persons” provisions) of the Internal Revenue Code.

This post assumes the person is a “covered expatriate” and therefore subject to the Exit Tax rules. An individual will be a “covered expatriate” if he meets any one of the following three tests defined in Internal Revenue Code S. 877:

– the person cannot certify tax compliance for the five years prior to renunciation

– the person has an average U.S. tax liability of for the five years prior to expatriation of approximately $180,000 USD (indexed to inflation)

– the person has net worth of 2 million USD (not indexed to inflation)

A net worth of two million or more will (subject to limited exceptions) result in “covered expatriate” status and will therefore trigger the 877A Exit Tax. Many people do not have disposable cash. Their assets often consist primarily of a home and a pension. Inflation is causing the assets of many people to become closer and closer to the 2 million net worth threshold.

The 877A Exit Tax – applied to “covered expatriates” – is composed of the following four separate taxes:

1. Capital gains tax on the seemed sale of property
2. Tax on the income inclusion resulting from the deemed distribution of “tax deferred accounts”
3. Tax on the deemed distribution of “foreign pensions” which cannot qualify as “eligible pensions”
4. Withholding taxes on certain trusts and eligible pension

The purpose of this post is to focus on ONLY the:

Immediate tax payable on the “deemed” distribution of the “foreign” (non-eligible) pension

Eligible vs. Non-Eligible Pensions

“Eligible” pensions are U.S. pensions. Pensions that are NOT “eligible” are typically foreign pensions. For example, a pension paid by the University of California would be “eligible”. A pension paid by the “University of Toronto” would NOT be “eligible”. The consequences/treatment of being “eligible” or “non-eligible” must be understood.

Treatment of NON “eligible” pension: Pensions that are NOT “eligible” are subject to an immediate tax based on the “deemed distribution” of the “present value” of the pension. A “non-eligible” pension is subject to immediate taxation which will erode the value of the pension.

Treatment of “Eligible” pension: An “eligible” pension will NOT be deemed to be distributed. Because there is no “deemed distribution”, an “eligible” pension is NOT subject to immediate taxation. The pension will be subject to taxation only on distributions as they are actually made. The interaction between the residence of the recipient and an applicable tax treaty may result in the pension distributions avoiding ANY U.S. taxation! If the pension is “eligible” the full value of the pension is retained!

Incredibly the “foreign” pension is “deemed” to have been distributed and subject to immediate taxation. This will erode the value of the pension and create an immediate tax liability with no cash to pay the tax. The U.S. pension is (subject to notification requirements) NOT subject to a deemed distribution, immediate taxation or possibly any U.S. taxation!

Americans abroad and their financial planners should be aware of how relinquishment of U.S. citizenship (in the case of “covered expatriates”) can result in the confiscatory taxation of non-US pensions. The confiscatory taxation will result from the deemed distribution of “foreign pensions” which were earned while the person was NOT living in the United States.

Pensions are generally “out of sight and out of mind”. People rarely think about them. (They ARE required to be reported by the taxpayer on Form 8938.) When people do think about their “net worth” they often fail to consider their pensions. For many of the employed, their pensions are their most valuable asset. The pensions will also be their income streams when they retire. Pensions are serious assets and must be taken very seriously! They are often worth far more than people think.

Because the two million dollar threshold for “covered expatriate” status is NOT indexed to inflation, those Americans abroad with pension plans and no plans to return to the United States, should consider renunciation while their net worth is below two million USD!

Part II: Relinquishment and the confiscatory case of the “ineligible” (non-U.S.) pension … A Deeper Dive

Some U.S. citizens living outside the United States who have non-U.S. based pensions appear to be unaware that:

If they have a net worth exceeding two million USD and they relinquish U.S. citizenship they will be “covered expatriates”. Because they are “covered expatriates” they will be subject to a tax based on the taxable portion of the “present value” of their non-U.S. pensions. They are subject to the tax even though they have not received those pensions!

Internal Revenue Code 877A(d)(2)(A)(i) states:

(i) with respect to any deferred compensation item to which clause (ii) does not apply, an amount equal to the present value of the covered expatriate’s accrued benefit shall be treated as having been received by such individual on the day before the expatriation date as a distribution under the plan,

In other words, the “present value” of the pension will be deemed to have been distributed from the plan and received by the taxpayer on the day before renunciation. The amount of the distribution must be divided between “income” and “contributions”. All of the income component will be treated as income received on the day prior to renunciation. This may result in a large income inclusion on which tax is payable even though there has been no actual distribution.

Commenting on the taxation of distributions from “foreign pensions”, the IRS states that:

Just as with domestic pensions or annuities, the taxable amount generally is the Gross Distribution minus the Cost (investment in the contract). Income received from foreign pensions or annuities may be fully or partly taxable, even if you do not receive a Form 1099 or other similar document reporting the amount of the income.

For example:

A professor with a University of Toronto pension with a present value of one million US dollars, could be taxed on the “present value” of that pension even though the pension was never distributed. It’s a U.S. tax based on a “deemed distribution” of the pension.

This “deemed distribution” would create:

1. A U.S. income inclusion of the taxable part of the pension even though the pension was never received

2. A U.S. tax triggered and owing on the taxable part of the pension

3. Probably no taxable event in Canada that would generate tax that could be used as a foreign tax credit against the U.S. tax owing.

(I use the word “probably” because I am mindful of Paragraph 7 of Article XIII of the Canada/US Tax Treaty which although appearing to apply to the alienation of “property” states that:

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.

Could the “deemed distribution” of the Canadian pension meet the test of “having alienated a property” within the meaning of the tax treaty?)

Assuming that no relief under Paragraph 7 of Article XIII of the tax treaty, I suggest that with proper planning the person could:

Use Foreign Tax Credit Carry Forwards: The person may have foreign tax credits that could be carried forward to offset the U.S. tax generated on this fictitious income (those foreign tax credits can be valuable); and/or

Arrange For The Distribution Of The Pension: In this case the person would arrange to time the actual distribution of the pension with the relinquishment of citizenship in order to generate Canadian tax to offset the U.S. tax

Bottom line: This is a significant erosion (frankly a confiscation) of a non-U.S. pension, earned by an individual while he was living outside the United States. On the other hand, U.S. based AKA “eligible” pensions are NOT subject to the same confiscatory regime AND MAY PAY NEVER PAY TAX ON THE DISTRIBUTIONS OF THEIR PENSIONS!

Financial planners take note!!!

Part III: Relinquishment and the retention of the “eligible” (U.S.) pension … A Deeper Dive

Interestingly, had the pension been a U.S. based pension (say from the University of California) the pension would be considered to be an “eligible pension”.

In the case of the “eligible pension” the same professor relinquishing U.S. citizenship (provided certain notice requirements were met):

1. Would NOT be subjected to an income inclusion based on the “present value” of the pension

2. Would be taxed ONLY on the pension distributions as they were paid out at the time of retirement

3. Would be required to agree to a withholding of 30% on the pension distributions taken at retirement

4. Might be able to avoid ANY U.S. income taxation on the pension distributions. This would be true if the professor was at the time of the distributions living in a country with an income tax treaty that sourced the pension income to ONLY the country of residence. In this case the person would have to file a 1040NR to claim a refund of the 30% withholding.

Part IV – Conclusion

The 877A Expatriation Tax rules operate to:

1. Confiscate a significant portion of non-U.S. pensions earned by U.S. citizens when they were NOT living in the United States

2. Not confiscate any portion of a U.S. pension earned by an individual while he was a resident of the United States and possibly allow that individual to avoid ALL U.S. taxation on the pension distributions when made!!!

That’s the bottom line. For those who want to understand the rules and reasoning which lead to this profound injustice and abuse of Americans abroad see the sample tax returns in the Appendices below.

Appendix A – How Internal Revenue Code Sections 877A and 877 Lead To The Confiscation Of The Non-U.S. Pension

The relevant sections of the Internal Revenue Code include:

1. 877A(g)(1)(A) states that: The term “covered expatriate” means an expatriate who meets the requirements of subparagraph (A), (B), or (C) of section 877(a)(2).

2. 877(a)(2) states that: This section shall apply to any individual (including) if— (B)the net worth of the individual as of such date is $2,000,000 or more …

3. 877A(d) states that: In the case of any deferred compensation item which is not an eligible deferred compensation item … an amount equal to the present value of the covered expatriate’s accrued benefit shall be treated as having been received by such individual on the day before the expatriation date as a distribution under the plan

4. 877A(d) states that:

For purposes of this subsection, the term “eligible deferred compensation item” means any deferred compensation item with respect to which—

(A)the payor of such item is—
(i)a United States person, or
(ii)a person who is not a United States person but who elects to be treated as a United States person for purposes of paragraph (1) and meets such requirements as the Secretary may provide to ensure that the payor will meet the requirements of paragraph (1), and
(B)the covered expatriate—
(i)notifies the payor of his status as a covered expatriate, and
(ii)makes an irrevocable waiver of any right to claim any reduction under any treaty with the United States in withholding on such item.

IRS – Guidance: Notice 2009-85 confirms this result as follows:

C. Taxation of eligible deferred compensation items

If a deferred compensation item qualifies as an eligible deferred compensation item, the payer must deduct and withhold a tax equal to 30 percent of any taxable payment to a covered expatriate with respect to such an item. Section 877A(d)(1)(B) provides that a taxable payment is any payment to the extent it would be includible in gross income of the covered expatriate if such person continued to be subject to tax as a citizen or resident of the United States. Because the covered expatriate must waive his or her right to claim treaty benefits with respect to an eligible deferred compensation item, the 30 percent withholding tax cannot be reduced or eliminated by treaty. See section 5.E of this notice for rules with respect to an amount of deferred compensation attributable to services performed outside the United States while the covered expatriate was not a citizen or resident of the United States. See section 5.F of this notice for information concerning the application of the withholding rules.

D. Taxation of ineligible deferred compensation items

With respect to any ineligible deferred compensation item described in section 5.B(1)a, 5.B(1)b, and 5.B(1)c of this notice, an amount equal to the present value of the covered expatriate’s accrued benefit is treated as having been received by the covered expatriate on the day before the expatriation date as a distribution under the plan and must be included on the covered expatriate’s Form 1040 (or other schedule, as provided in Treas. Reg. § 1.6012-1(b)(2)(ii)(b)) for the portion of the taxable year that includes the day before the expatriation date.

Within 60 days of the receipt of a properly completed Form W-8CE, the payor of the ineligible deferred compensation item must advise the covered expatriate of the present value of the covered expatriate’s accrued benefit in the deferred compensation item on the day before the expatriation date. See section 8 of this notice for more information concerning Form W-8CE.

In the case of a defined contribution plan described in section 5.B(1)a, until further guidance is issued, the present value of the covered expatriate’s accrued benefit is the account balance. In the case of a defined benefit plan described in section 5.B(1)a, until further guidance is issued, the present value of the covered expatriate’s accrued benefit is determined using the method set forth in section 4.02 of Rev. Proc. 2004-37, 2004-1 C.B. 1099, determined as of the day before the expatriation date. See section 5.E of this notice with respect to an amount of deferred compensation attributable to services performed outside the United States while the covered expatriate was not a citizen or resident of the United States.

With respect to any ineligible deferred compensation item not described in section 5.B(1)a or 5.B(1)d of this notice, until further guidance is issued, the present value of the covered expatriate’s accrued benefit is determined by applying principles in Prop. Treas. Reg. § 1.409A-4, except as provided herein. Where such proposed regulations provide for a determination to be made as of the end of the taxable year, such determination shall be made as of the day before the expatriation date. For the purposes of this section 5.D, the present value of the covered expatriate’s accrued benefit is determined without regard to any substantial risk of forfeiture. See section 5.E of this notice with respect to an amount of deferred compensation attributable to services performed outside the United States while the covered expatriate was not a citizen or resident of the United States.

With respect to any ineligible deferred compensation item described in section 5.B(1)d of this notice, the rights of the covered expatriate to such item will be treated as becoming transferable (within the meaning of Treas. Reg. § 1.83-3(d)) and not subject to a substantial risk of forfeiture (within the meaning of Treas. Reg. § 1.83-3(c)) on the day before the expatriation date. Thus, for example, in the case of property transferred to or on behalf of the covered expatriate in connection with the performance of services that has not become substantially vested as of the expatriation date, such as restricted stock, to the extent that the covered expatriate has not previously taken into account under section 83 or in accordance with section 83 with respect to such transfer, generally such property will be treated as having become substantially vested for purposes of section 83 on the day before the expatriation date. Consequently, the fair market value of such property (determined without regard to any lapse restriction as defined in Treas. Reg. § 1.83-3(i)), reduced by the amount (if any) the covered expatriate paid for the property, generally will be includible in the covered expatriate’s income for Federal income tax purposes as of such date.

With respect to a right to a transfer of property in the future (such as a stock-settled stock appreciation right or a stock-settled restricted stock unit), such right will be treated as substantially vested as of the day before the expatriation date and, under the cash-equivalency doctrine (see Cowden v. Commissioner, 289 F.2d 20 (5th Cir. 1961)), the value of such right generally will be includible in the income of the covered expatriate as of such date. Until further guidance is issued, the value of such right is determined by applying principles similar to Prop. Treas. Reg. § 1.409A-4, except that where such proposed regulations provide for a determination to be made as of the end of the taxable year, such determination shall be made as of the day before the expatriation date.

Under section 877A(d)(2)(B), no early distribution tax will be imposed by reason of the treatment resulting from section 877A(d)(2)(A). For purposes of this notice, an early distribution tax is any additional tax that would be imposed under sections 72(t), 220(e)(4), 223(f)(4), 409A(a)(1)(B), 529(c)(6), or 530(d)(4) if the amounts required to be included in the income of the covered expatriate under section 877A(d)(2) had actually been paid or transferred to the covered expatriate on the day before the expatriation date.

Section 877A(d)(2)(C) provides that appropriate adjustments shall be made to subsequent distributions from the plan to reflect the tax imposed by section 877A(d)(2). Thus, when the covered expatriate receives distributions, the amount that was includible in his or her gross income under section 877A(d)(2) will be treated as investment in the contract for purposes of section 72 in cases where such section would apply to such amounts.

In other cases, the covered expatriate may make an appropriate adjustment to the amount that would otherwise be includible in the covered expatriate’s income to prevent amounts previously taxed under section 877A(d)(2) from being includible in income and subject to Federal income tax a second time. With respect to ineligible deferred compensation items to which Prop. Treas. Reg. § 1.409A-4 would apply, such adjustment will be made pursuant to principles similar to Prop. Treas. Reg. § 1.409A-4. With respect to any ineligible deferred compensation items to which section 72 does not apply and Prop. Treas. Reg. § 1.409A-4 would not apply, until further guidance is issued, taxpayers may use any reasonable method to determine the amount of such adjustment, so long as such method: is consistently applied to all such ineligible deferred compensation items with respect to the covered expatriate; does not reduce the amount includible in the covered expatriate’s income with respect to any ineligible deferred compensation item below zero; and does not result in an aggregate amount of such adjustments that, when combined with amounts treated as investment in the contract for purposes of section 72 and pursuant to principles similar to Prop. Treas. Reg. § 1.409A-4, exceeds the amount included in the covered expatriate’s income pursuant to section 877A(d)(2)(A).

Appendix B – Dual Status tax return with a 1 million USD income inclusion on the day before expatriation

Tax Bill: $344,963

The example demonstrates the U.S. tax generated with a deemed $1,000,000.00 USD deemed income inclusion on the day before expatriation. (The present value of the distribution will likely be greater than the amount of the distribution that is treated as income.) Note that this generates a considerable amount of U.S. tax owing with no credit tax credits available to reduce the tax owing. Note also that the person will then be taxed in Canada when the pension is distributed. This is a clear example of double taxation.

AppendixBDistributionOfForeignPension

Appendix C – Dual Status tax return with a 1 million USD income inclusion on the day before expatriation with a $100,000 tax credit carry forward

U.S. Tax Bill: $241,357 USD

The example demonstrates the U.S. tax generated with a deemed $1,000,000.00 USD deemed income inclusion on the day before expatriation.(The present value of the distribution will likely be greater than the amount of the distribution that is treated as income.) In this case the individual has $100,000 of U.S. tax paid available as a tax credit carry forward to reduce the U.S. tax payable. There is still a considerable amount of U.S. tax owing. Note also that the person will then be taxed in Canada when the pension is distributed. This is a clear example of double taxation.

AppendixCDistributionOfForeignPension

Appendix D – Dual Status tax return with (1) a full actual distribution of the pension in Canada on the day before expatriation (generating a foreign tax credit in the current year)

U.S. Tax Bill: $00.00 (but the Canada pension has been liquidated)

The example demonstrates the U.S. tax generated with a deemed $1,000,000.00 USD deemed income inclusion on the day before expatriation. In this case the individual arranges to liquidate his pension. The liquidation is a taxable event in Canada which will generate enough Canadian tax to be used as a credit to offset the U.S. tax. (The present value of the distribution will likely be greater than the amount of the distribution that is treated as income.)

AppendixDDistributionOfForeignPension

Have a question? Contact John Richardson, Citizenship Solutions.