Firm Wants Proposed Regs on Expat Gifts to Address Treaties

Phone: 323-852-0033

Fax: 310-388-5537

Essentially, what I ask is that the regulations address the interaction of section 2901 with our estate and gift tax treaties. The proposed regulations are silent on this other than referring in some of the examples that the expatriate is or was not a resident of a country with which we have a treaty.

Section 2801 and Tax Treaties

Section 2801, enacted by the Heroes Earnings Assistance and Relief Tax Act of 2008 (the "2008 Act"), provides that if a U.S. citizen or resident receives any covered gift or bequest, it is subject to a tax at the higher of the highest rate of estate tax and the highest rate of gift tax applicable on the date of receipt.¹

A covered gift or bequest is defined as any property acquired (i) by gift directly or indirectly from an individual who at the time of the acquisition is a covered expatriate within the meaning of section 877A(g)(1), which in turn cross refers to an expatriate who meets the requirements of subparagraph (A), (B) or (C) of section 877(a)(2); or (ii) directly or indirectly by reason of the death of an individual who immediately before death was a covered expatriate.

Section 2801 also applies to transfers to domestic trusts by covered expatriates and it applies to distributions by foreign trusts to U.S. citizens or residents attributable to a gift or bequest from a covered expatriate.

An exception is made for gifts and bequests to charities and spouses. It would appear that in the latter case, a gift or bequest to a non-citizen spouse would have to be in a form that would qualify for the marital deduction under the QDOT regime and the other provisions of section 2056(d) and 2056A.

Some additional features of Section 2801 are worthy of note:

• If the highest rate of gift tax is higher than the highest rate of estate tax, it is the gift tax rate that will apply to the covered gift or bequest, even if what is received relates to a bequest.

• Unlike all other transfer taxes imposed by Subtitle B, it is imposed on the recipient, not the donor or the decedent whose assets are the source of the gift.²

• The amount of a covered bequest is determined on the date of receipt, not the date of death.

• While it does not apply to any property included in a gift tax return or an estate tax return, this exclusion applies only to the extent the gift tax return or estate tax return was timely filed. If the return is not timely filed or if the property is omitted, apparently for any reason at all, from a timely filed return, the gift or bequest may be subject to both estate or gift tax and the tax under section 2801.

In this paper, I do not discuss my concerns about the enforceability and administrability of section 2801, including such issues as how the recipient of the covered gift or bequest is to know whether the donor or decedent was a covered expatriate, how the recipient will know whether or not the gift or bequest was included in a timely filed return (and therefore not subject to section 2801), and the difficulties created by the withholding obligations imposed on trustees of trusts funded by covered expatriates. The comments in this paper are concerned with the interaction of section 2801 with treaties entered into by the United States that cover estate taxes and, in some cases, gift taxes as well.

2. Relationship between the Code and Treaties

Section 7852(d) of the Code provides that for purposes of determining the relationship between a provision of a treaty and any U.S. tax law, neither the treaty nor the law shall have preferential status by reason of its being a treaty or law. Section 7852(d) was enacted in its current form in 1988.³ Where a statute overrides a treaty provision, the override will be upheld, even if the override plainly violates international law.⁴ Only the treaty partner can challenge a properly enacted treaty override; a taxpayer has no standing to assert a breach of a treaty obligation.⁵

Section 7852(d) is consistent with Article VI, Section 2 of the Constitution (the Supremacy Clause), which provides that legislation and treaties constitute the supreme law of the land. But it does not resolve a basic clash of principles identified by the Supreme Court. The first is that in the event two laws are inconsistent, the later in time prevails.⁶ The second is that, because Congress should not be presumed to intend a violation of international obligations of the United States, a law should not override a treaty in the absence of an explicit of Congressional intent to override, manifested either in the legislation itself or in legislative history.⁷

These comments are not a forum for an extended discussion of the treaty override issue in general.⁸ I consider below the legislative history of section 2801 so far as it relates to tax treaties.

3. Gift and Estate Tax Treaties

The United States is party to treaties dealing with the estate tax with Australia, Austria, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, Netherlands, Norway, South Africa, Switzerland and the United Kingdom. A limited number of these treaties also deal with gift tax: Austria, Denmark, France, Germany, Japan and the United Kingdom. In the case of Australia, there is a separate treaty dealing with gifts.⁹ Our agreement with Canada relating to the estate tax is contained in the income tax treaty, as Canada does not have an estate tax but does impose tax on capital gains at death.

The United States has not updated any of these treaties since the early 1980s, with the exception of Canada, France and Germany. The treaties with France and Germany were updated by protocols in 1998 and 2004, respectively, and are the only gift and estate tax treaties with a savings clause that refers to former long-term residents.

In part, this rather small number of treaties reflects the fact that many countries with which we have an income tax treaty do not impose taxes on gifts and bequests. In fact, the United States has terminated treaties with countries that have repealed such taxes, most recently our estate and gift tax treaty with Sweden, terminated effective at the beginning of 2008. Nevertheless, our remaining treaties are with countries with which we have significant flows of individuals and investment.

U.S. treaties dealing with transfer taxes generally fall into two broad types:

• Older treaties, which do not explicitly limit the right of either party to impose taxes but have two principal operative provisions: The first, a set of rules that determine the situs of property; the second, provisions confirming that each country will provide tax credits to its domiciliaries for taxes paid to the other country. In some cases, the treaty also requires the situs country to allow to non-domiciliaries (or their estates) an exemption from situs country tax comparable to the one allowed for domiciliaries of the situs country, but usually based on the proportion of the non-domiciliary's assets in the situs country to worldwide assets.

• Newer treaties, which generally explicitly limit situs country taxation of gifts and estates of non-domiciliaries to real property located in the situs country and property attributable to a permanent establishment of the non-domiciliary in the situs country.

4. Treaty Conflict Issues

4.1 Is Tax Under Section 2801 Covered by Our Treaties?

The first question is whether the tax under section 2801 is covered by our treaties.

Fairly clearly, the application of section 2801 to an inter vivos gift would not be affected by a treaty that applies only to the estate tax. (The converse is also true, but it is also moot because there are no countries with which the United States has entered into treaties covering only the tax on gifts but not estates.)

Otherwise, the question is whether the tax imposed by section 2801 is a gift tax or an estate tax or, if not, whether it is covered by the language typically found in treaties concerning other taxes.

The placement of section 2801 within Subtitle B of the Code suggests that the tax is a form of gift tax or estate tax. Other indicators are the fact that section 2801 does not apply to transfers of property included in a gift tax return or an estate tax return -- in other words, section 2801 is an alternative form of gift or estate tax -- and the fact that the rates are coordinated with the gift tax and estate tax rates.

However, even if the tax under section 2801 is not in fact an estate tax or a gift tax, it would appear to be covered by the language contained in most of our treaties to the effect that the treaty is shall apply to "any other taxes of a substantially similar character imposed by either contracting State subsequently to the date of signature of the present Convention".¹⁰ Section 2801 tax falls within this description because it is a tax on the value of property transferred by a donor either as a gift or bequest, directly or through a trust. Section 2801 uses the term "covered gift or bequest" to describe the transfers subject to tax. The coordination, rate features and nomenclature noted above also show an intention to tax the amounts received by U.S. persons from covered expatriates in a manner similar to the taxation of gifts and bequests.

The obvious difference between section 2801 tax and the gift and estate taxes is that the former is imposed on the recipient of the covered gift or bequest, whereas the gift and estate taxes are imposed on the donor or the estate of the donor. In the context of transfer taxes, however, this is not a controlling difference, at least in the case of newer treaties and possibly in the case of older treaties as well. Newer treaties state that they apply to estates and to gifts, without differentiating between taxes that fall on the transferor and those that fall on the transferee. This is not an accident, because our treaty partners in civil law countries typically impose their transfer taxes on donees.¹¹ Older treaties generally do not explicitly state what kinds of transfers they apply to but the clear implication is that they apply to gratuitous transfers of property. Certainly none of the older treaties state that they are applicable with respect to tax only if it is imposed on the donor or the estate of a decedent.

I therefore conclude that section 2801 tax will be a covered tax under all of our treaties.

4.2 Do Savings Provisions Apply?

The next question is whether section 2801 is covered by the savings provision typically found in our newer treaties. Most of our treaties do preserve the right of the United States to impose tax on gifts or bequests of citizens and domiciliaries but not former citizens or long-term residents who are no longer domiciled in the United States.

Just four do.¹² Article 1(4) of the treaty with France, for example, provides:

The question is whether subparagraph (iii) of the French treaty and its Austrian, Danish and German analogues could preserve the U.S. right to impose tax, at least for a period of ten years, on gifts and bequests of covered expatriates. The problem is that the laws of the United States no longer define the avoidance of tax in the context of expatriation. Section 877, as in effect before its amendment by the Health Insurance Portability and Accountability Act of 1996 (the "1996 Act"),¹³ required that there be a principal purpose of avoidance of income tax or transfer taxes; the 1996 Act retained the purpose test but added a provision that deemed certain individuals to have a principal purpose of tax avoidance if one of the objective tests of annual income tax liability or net worth were met.

However, the changes made in 2004 by the American Jobs Creation Act of 2004 (the "2004 Act")¹⁴ eliminated any reference to a purpose of tax avoidance and applied the law only to individuals who met one or other of the objective tests.¹⁵ The 2004 changes were based on the House version of the legislation, H.R. 4520; the mark-to-market and related proposals that were put forward by the Senate Finance Committee in S. 1637 and indeed were ultimately adopted in the 2008 Act, were rejected in conference. The Conference Report on H.R. 6081, which became the 2004 Act, specifically states that "The bill replaces the subjective determination of tax avoidance as a principal purpose for citizenship relinquishment or residency termination under present law with objective rules."¹⁶ Although the Senate ultimately prevailed in 2008 in replacing section 877 replaced by the section 877A exit tax and getting Section 2801 enacted, the 2008 Act retained the 2004 definition of a covered expatriate and, hence, the elimination of the tax avoidance element remained unchanged.

The new objective rules of 2004 do not bear upon the question of whether there is any purpose of tax avoidance -- they simply establish conditions under which the alternative tax regime of section 877 (and now 877A and 2801) would apply. The 550-page Joint Committee of Taxation Report in 2003 states as much: "The monetary thresholds would serve as a proxy for tax motivation and, unlike present law, no subsequent inquiry into the taxpayer's intent would be required or permitted." The savings clauses in our treaties permit application of our laws to former citizens and, in some cases, long-term residents "whose loss of such status had as one of its principal purposes the avoidance of tax".¹⁷ It is difficult to conceive of these treaty provisions applying where an inquiry into the taxpayer's intent is not permitted under domestic law.

In any event, none of our treaties that do contain savings clauses apply following the expiration of 10 years from the date of loss of status as a citizen or long-term resident. It follows that the treaties with savings clause do not preserve the United States right to impose a covered tax on covered gifts and bequests received beyond that date.

4.3 Does Section 2801 Conflict With Our Treaties?

Let us assume that, as I have previously concluded, tax under section 2801 is a covered tax. Assume further that the tax is not preserved by a savings clause because (i) the treaty does not contain one, (ii) savings clauses as currently worded do not apply, or (iii) the covered gift or bequest takes place outside the ten-year period covered by the savings clause. The question then arises whether the imposition of section 2801 would conflict with our treaties.

I believe this question answers itself in the case of newer treaties. Our newer treaties typically provide that the United States may not impose a covered tax on gifts and bequests by domiciliaries of our treaty partner, unless the property that is the subject of the gift or bequest is U.S. real property or assets forming part of the business property of a permanent establishment of the donor or decedent. A typical newer treaty will provide that, subject to these exceptions, "if the decedent or transferor was domiciled in one of the Contracting States at the time of the death or transfer, property shall not be taxable in the other State."¹⁸ It is clear that this exemption does not depend in any way on whether the tax is imposed on the transferor or estate of the decedent or on the donee or heir.

The position is less clear in the case of older treaties. Our older treaties do not explicitly limit the right of the United States to impose a tax. Instead, their primary function is to provide situs rules and confirm the availability of tax credits. A footnote to a list of treaties contained in the 2003 Joint Committee Report notes that "the general structure of the treaty allows the United States to tax its citizens, provided a foreign tax credit is allowed for tax imposed by the other country on property situated in that other country."¹⁹ I agree, so long as the citizen in question is the donor or decedent.

On the other hand, it would seem illogical to construe our older treaties to permit the United States to impose taxes on property of treaty country domiciliaries if the property is located outside the United States, and especially if it is located in the treaty country. What point would there be in a treaty determining the situs of property if the United States could tax transfers by treaty partner domiciliaries regardless of where the property was situated, simply by imposing the tax on the donee or heir rather than the donor or the estate of the decedent? The underlying intent of the parties seems to be to create a division of taxing jurisdiction, with the United States having the right to tax U.S. situs property, as determined under the treaty, and the treaty partner having the right to tax to tax property situated in the treaty partner. Interpreting section 2801 to permit the United States to impose its tax on gifts and bequests by domiciliaries of a treaty partner would seem to conflict with the reasonable expectations of the negotiators of the treaties.

I would, in any case, urge caution by the Treasury and the IRS in reaching any other conclusion. I would hope that in a case of doubt, the benefit of the doubt would be in favor of preserving rights under treaties until those treaties can be renegotiated.

4.4 Did Congress Intend Section 2801 to Override Our Treaties?

The next question is whether, if section 2801 conflicts with our treaties, Congress expressed any view as to which should prevail, pending the resolution of conflicts through renegotiation or competent authority consultations. Section 2801 and the 2008 Act in general are silent on the question of treaty overrides. So is the legislative history immediately surrounding the 2008 Act. The question therefore becomes what inference we can draw from such silence and whether we can divine Congressional intent from earlier legislation relating to expatriation.

I have already noted the general statutory rule that neither the treaty nor the law shall have preferential status as well as the potential conflict between a later in time rule and a presumption that Congress does not generally intend, by silence, to violate international obligations of the United States. These general rules, by themselves, do not provide definitive guidance.

Congress is and has been well aware of treaty issues in the context of section 877. Although the 1996 Act itself was silent on the point, the Conference Report on the Act indicated that the purposes of the changes made by the Act were not intended to be defeated by any treaty provision. Therefore, Congress anticipated that the Department of Treasury would review all outstanding treaties to determine whether the alternative tax regime, as revised in 1996, potentially conflicts with treaty provisions (such as the saving clauses) and to eliminate any such potential conflicts through renegotiation of the affected tax treaties as necessary. Beginning on the tenth anniversary of the enactment of such changes, any conflicting treaty provisions that remained in force were to take precedence over the alternative tax regime as revised.²⁰ The IRS accordingly stated in Notice 1997-19 that:

I have been unable to find any similar expression of opinion by Congress, the Treasury Department or the Internal Revenue Service on how section 877 (and now section 2801) should interact with out treaties following the 2004 changes. The question is therefore whether the legislative history of the 1996 changes, calling for a 10-year sunset on treaty overrides in the area of covered expatriates, still applies or whether we must interpret Congressional silence, particularly in light of the fact that the 2004 changes were preceded by an extensive 550-page by the Joint Committee report that, in addition to reviewing these issues, included a detailed letter from the Treasury Department to the Committee concerning treaty interactions.²¹

I consider that Congressional silence on treaty interactions, both in 2004 and 2008, and the failure to renew, or even comment on, the approach taken in 1996, indicates that Congress intended to allow treaty interactions to be dealt with by the Treasury Department and the treaty negotiation process, as contemplated by the 1996 legislative history.

5. Summary and Recommendations

I consider that section 2801 conflicts with our newer treaties and may well conflict with our older ones. Further, I believe that treaties should be respected by the executive branch in the absence of a clearer expression of Congressional intent than the silence of the 2004 and 2008 Acts and legislative history, the continuing relevance of the 1996 Act on treaty interactions and the fact that Congress was plainly aware of the potential for conflicts in imposing tax on the income and property of domiciliaries of treaty partners. ²² I therefore recommend to the IRS that its regulations affirm that section 2801 shall not apply to transfers of property by covered expatriates who at the time of the covered gift or bequest were domiciled in a treaty country. This would not exempt such gifts from the application of the gift and estate taxes as currently applicable to domiciliaries of such countries.

The solution to future application of our expatriate tax regime to covered gifts and bequests, as envisioned by Congress in 1996, is renegotiation of our treaties. If the price, as the Treasury has indicated in its 2003 letter to the Joint Committee, is some concession to the other country on another matter, that seems a reasonable price to pay to maintain the integrity of our tax treaty relationships and to preserve our ability to tax covered gifts and bequests, if that is important to us. Section 2801 represents a significant expansion of U.S. taxing jurisdiction compared to section 877 in its prior incarnations and section 877A in its current one.

The treaties in question would in any case profit from modernization -- U.S. gift and estate tax treaties have lagged significantly behind our income tax treaties in this regard. If we want to impose very high rates of tax on gifts and bequests by our former citizens and especially on former residents who become domiciled in treaty partner countries, it would seem reasonable and good policy to obtain our treaty partners' agreement as part of a series of modernized treaties that take into account numerous developments in our estate and gift tax laws over the past three decades and the further changes we can expect as the 2001 gift and estate tax legislation expires in 2011.

To ensure compliance with requirements imposed by the IRS, we inform you that, unless and to the extent we otherwise state, any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

² Section 2801(b).

³ Pub. L. 100-647 (Tax and Miscellaneous Revenue Act of 1988) section 1012(aa)(1)(A). Before amendment by TAMRA, section 7852(d) provided that no provision of the Code was to apply in any case where its application would be contrary to any treaty obligation of the United States in effect on the date of enactment.

⁴ See, e.g., The Cherokee Tobacco, 78 U.S. 616, 621 (1870); see also Chinese Exclusion Case, 130 U.S. 581, 600 (1889); Whitney v. Robertson, 124 U.S. 190, 195 (1888); Head Money Cases, 112 U.S. 580, 599 (1884).

⁵E.g., Diggs v. Shultz, 470 F.2d 461, 464-67 (D.C. Cir. 1972), cert. denied, 411 U.S. 931 (1973).

⁶Reid v. Covert, 354 U.S. 1 (1956); Restatement 2d of Foreign Relations Law, sections 138, 140.

⁷ Ibid., section 140; Cook v. United States, 288 U.S. 102 (1933); Menominee Tribe of Indians v. United States, 391 U.S. 404 (1968) ("the intention to abrogate or modify a treaty is not to be lightly imputed to the Congress", citing Pigeon River Improvement, Slide & Boom Co. v. Charles W. Cox, Ltd., 291 U.S. 138, 160 (1934)).

⁸ For a helpful review of the law relating to the authority of the Treasury Department to promulgate regulations where treaties may potentially be overridden, see "Treaty Override by Administrative Regulation: The Multiparty Financing Regulations", 2 Florida Tax Rev. No. 9, reproduced at 95 TNT 242-45 .

⁹ A helpful table of our estate and gift tax treaties may be found on the IRS website at http://www.irs.gov/businesses/small/article/0,,id=186064,00.html(viewedOctober 24, 2008).

¹⁰E.g., Finland Article 1(2) (old); France Article 2(2) (new).

¹¹ France is an example of a civil law country where transfer taxes fall on the recipient rather than the donor or the estate of a decedent.

¹² Austria, Article 9(1), and Denmark, Article 1(3) (expatriated citizens only); France, Article 1(4) and Germany, Article 11(1) (expatriated citizens and former long-term residents).

¹³ Health Insurance Portability and Accountability Act of 1996, P.L. 104-188, section 511.

¹⁴ American Jobs Creation Act of 2004, P.L. 108-357, section 804.

¹⁵ For purposes of the present discussion, we need not discuss the application of sections 877 and 877A to expatriates and former long-term residents who fail to file the appropriate declaration under penalty of perjury concerning compliance with U.S. tax laws for the preceding five years. See section 877(a)(2)(C).

¹⁶ See Title X, paragraph 4 of Conference Report to accompany H.R. 4520, the American Jobs Creation Act of 2004, H. Rept. 108-755.

¹⁷ See Joint Committee Report, JCS-2-03 (February 12, 2003), at page 206 (hereinafter, the "2003 Joint Committee Report"). The report can be found on the Joint Committee's website at http://www.house.gov/jct/s-2-03.pdf (viewed October 29, 2008).

¹⁸ United Kingdom, article 5(1)(a).

¹⁹ 2003 Joint Committee Report, at A-7.

²⁰ H.R. Rep. No. 496, 104th Cong., 2d Sess. 155 (1996); H.R. Conf. Rep. No. 736, 104th Cong., 2d Sess. 329 (1996).

²¹ See 2003 Joint Committee Report, JCS-2-03 at pages A-20 to A-25.

²²See American Bar Association, Section of Taxation, "Issues Paper on Technical Corrections to the Tax Reform ActOf 1986, Relating to Tax Treaties" (July 1, 1988), reproduced at 88 TNT 146-39 (I was a principal author and editor of this paper); similarly, New York State Bar Association, Tax Section, "Report on the Override of U.S. Tax Treaty Provisions by Amendments to the U.S. Internal Revenue Code" (October 16, 1987), reproduced at 87 TNT 214-28 . See also a letter sent to the Congressional tax-writing committees by the ambassadors of Germany, Belgium, Denmark, Greece, France, Ireland, Italy, Luxembourg, the Netherlands, the United Kingdom, Canada, Japan and Switzerland and the Head of Delegation of the European Commission, dated April 18, 1988, reproduced at 88 TNT 87-29 , opposing treaty overrides and noting alternatives.