BASIC U.S. TRANSFER and INCOME TAX RULES APPLICABLE to by lht10255

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									BASIC U.S. TRANSFER and INCOME TAX RULES APPLICABLE to NON-RESIDENT ALIENS Virginia F. Coleman Ropes & Gray LLP, Boston One International Place Boston, MA 02110 (617) 951-7000

I.

Introduction A. U.S. transfer tax planning for the nonresident alien ("NRA") is essentially an exercise in structuring the NRA's transactions involving U.S. connections in such a way that 1) any gratuitous transfers during life will not attract a U.S. gift tax, 2) any property includable in the NRA's estate at death, applying U.S. principles, will not attract a U.S. estate tax, and 3) U.S. income taxes are minimized or, if possible, avoided entirely. If the first two criteria are met the GST tax by definition also will not apply. This outline describes the circumstances in which an NRA will be subject to these three taxes, how the tax is computed, and what are the rates. These are thus the ground rules within which planning for the NRA must be done. 1. C. This is not a comprehensive treatment of any of the three taxes, especially the income tax, but rather an outline of the most important rules.

B.

One important variation on the ground rules is outside the scope of this outline, which will deal only with the rules found in the IRC. One must always look also to see how the otherwise applicable rules in the IRC (residence, situs, tax rates, availability of credits etc.) are affected by any estate or income tax treaty between the U.S. and the country of which the NRA is a citizen or resident. Estate tax treaties are currently in effect with the U.K. (1979), Australia (1954-estate; 1953gift), Austria (1983), Denmark (1984), Finland (1952), France (1980), Germany (1986), Greece (1953), Ireland (1951), Italy (1956), Japan (1955), Netherlands (1971), Norway (1951), South Africa (1952), Sweden (1984) and Switzerland (1952). The 1995 Protocol to the U.S.-Canada Income Tax Treaty also deals with the application of the U.S. estate tax to a Canadian NRA, attempting to coordinate the U.S. estate tax with the Canadian gains tax at death. Income tax treaties are in effect with all of the above plus Barbados, Belgium, Bermuda, Czech Republic, Canada, China, Cyprus, Egypt, Hungary, Iceland, India, Indonesia, Israel, Jamaica, Kazakstan, Korea, Luxembourg, Mexico, Morocco,

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New Zealand, Pakistan, Phillippines, Poland, Portugal, Romania, Russia, Slovak Republic, Spain, Thailand, Turkey, Trinidad and Tobago, and Tunisia. 1. Unlike the case in many countries, tax treaties do not automatically override U.S. domestic law to the contrary, except if both the treaty provision and the provision of domestic law were in effect when the 1954 Code was enacted (August 16, 1954). IRC §7852(d)(2). As to subsequent treaties and laws, domestic law is to be "applied with due regard to any treaty obligation of the United States" (IRC §894), but in construing a treaty and domestic law together neither one is to have preferential status over the other. IRC §7852(d)(1). Where §7852(d)(2) does not apply, every effort is made to construe the treaty and domestic law as consistent; for instance, if the domestic law is inconsistent it could be determined that Congress did not intend the law to apply to override a treaty provision to the contrary. If that is not possible, however, generally the last in time of the treaty and the domestic law provision will override, absent Congressional intent to the contrary.

2.

II.

Definition of the NRA for transfer tax purposes. A. Status as a resident or nonresident for transfer tax purposes turns on the individual's domicile, as determined in accordance with traditional common law principles: physical presence plus an intent to remain indefinitely. Reg. §§20.01(b)(1), 25.2501-1(b). In addition, again under traditional common law principles, domicile once established is presumed to continue. 1. The elaborate tests for determining residence for income tax purposes (IRS §7701(b)) have no application in the transfer tax area. See VI, below. In Estate of Jack v. U.S., 54 Fed. Cl. 590 (2002), the Claims Court held as a legal matter, on cross motions for summary judgment, that an alien present in the U.S. on a temporary, nonimmigrant visa (TC and then TN Temporary Professional, renewable annually) could nonetheless be domiciled here. The formation of the requisite intent would have been in violation of the terms of his visa, which required a representation that the stay in the U.S. would be temporary, but the I.R.S. should b permitted to show as a factual matter that this occurred. Even if there was a presumption by reason of the terms of the visa that the decedent did not change his domicile to the U.S., this presumption was rebutted by the “legal presumption of correctness” of the I.R.S. assessment, “presumably made following proper inquiry by the government officials.” -2-

2.

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a.

This holding is consistent with the position taken by the IRS in Rev. Rul. 80-209, 1980-2 C.B. 248, (cited by the court in Jack), that an illegal alien may be a resident for transfer tax purposes. Note that Jack does not hold that the decedent was in fact domiciled in the U.S. – rather that the terms of the visa did not preclude the IRS from trying to show that he was. The decedent was a Canadian veterinarian who came to the U.S. in 1992 to serve as Equine Director of the School of Veterinary Medicine at the University of California at Davis. His contract with the University was extended through December 1996, and during his stay in the U.S. he obtained extensions of his visa as needed, the last extension until November 17, 1996. He died on August 27, 1996 – circumstances not stated. From this very brief statement of facts it is impossible to tell on what basis the Service felt that the decedent did not intend to return to Canada. As a practical matter, it would appear unlikely in the vast majority of cases that the Service would take the position that an individual who was here on a visa that by its terms was temporary, and who was fully compliant with the visa, had nonetheless secretly formed an intent to stay in violation of the visa. It will be interesting to see, assuming the case is adjudicated on the merits, what prompted the Service to take that position in Jack. If a fuller examination of the facts does not reveal any clear basis for the position, the case is sobering indeed.

b.

c.

3.

Authority in the transfer tax area as to whether a decedent was domiciled in the U.S. or not is sparse and, as one would expect, highly fact-specific. Estate of Edward H. Paquette, 46 T.C.M. 1400 (1983) (Canadian citizen did not acquire U.S. domicile); Estate of Nienhuys, 17 T.C. 1149 (1952) (Dutch citizen and resident, unable to return to Holland due to the war, in U.S. from 1940 to his death in 1946, did not acquire U.S. domicile. He maintained an intent to return to Holland, where he was rich and prominent.); Estate of Anthony H.G. Fokker, 10 T.C. 1225 (1948) (Peripatetic millionaire entrepreneur, Dutch citizen, who traveled frequently and had residences in New York and Switzerland, lived off and on in U.S. from 1927 until death in 1939. In order to re-enter the U.S. he repeatedly claimed permanent residence in N.Y. Decedent’s executor conceded he had acquired U.S. domicile in 1927 but claimed he had abandoned it for Switzerland when he built a residence there in 1934. Tax Court held he retained U.S. domicile.); Estate of Julius Bloch-Sulzberger, 6 T.C.M. 1201 (1947); Fifth Avenue Bank of N.Y., Executor, 36 B.T.A. 534 (1937). -3-

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4.

The most recent case involving this issue, Estate of Barkat Khan, 75 T.C.M. 1597 (1998), is unusual in that the taxpayer estate was arguing in favor of resident status for the decedent, in order to be able to take advantage of the unified credit available to residents. The IRS had assessed an estate tax of $179,278 based on the decedent's NRA status; as a resident there would be almost no tax. The decedent, a Pakistani citizen, was issued a green card in 1985, at age 74, on the basis of his status as parent of a (naturalized) U.S. citizen. He had been trying to obtain a green card since 1975 but could not until his son became a citizen. The decedent's primary business ties were in the U.S., and he had previously lived in the U.S. on various temporary visas from April 1971 to February 1974. The decedent lived in the U.S. as a green card holder from January 1985 to December 1986, when he returned to Pakistan for business reasons, intending to come back to the U.S. However, the business issues took longer than anticipated to resolve, and his health began to fail. As a result, he did not return at all to the U.S., dying in Pakistan in 1991. The Tax Court held that the decedent acquired a U.S. domicile in January 1985 and that he did not abandon it prior to his death.

B.

A special rule applies to residents of U.S. possessions, such as Puerto Rico. Such a resident, even though a U.S. citizen, will be treated as an NRA for U.S. transfer tax purposes if he acquired citizenship solely by reason of (1) his being a citizen of such possession, or (2) his birth or residence within such possession. IRC §§ 2208, 2501(c). See PLR 200303015 (Puerto Rican resident who acquired U.S. citizenship under Nationality Act of 1940 was not an NRA for gift tax purposes.)

III.

The gift tax rules applicable to NRAs. A. Except as provided in B. below, gifts of "intangible property" by an NRA are not subject to U.S. gift tax. IRC §2501(a)(2). 1. The IRS has stated, albeit in dictum in a private letter ruling, that “intangible property” for this purpose includes “corporate stock, bonds, notes, bank deposits, patents, partnership interests, [and] goodwill.” PLR 7737063. See also PLR 8342106 (Gift by NRA of stock in wholly owned domestic corporation not subject to gift tax ). There appears to be little doubt, therefore, that an NRA may freely make gifts of interests in partnerships, regardless of where organized, holding U.S. real estate or tangible personal property. By contrast, the status of partnership interests for U.S. estate tax purposes is much more problematic. See IV G., below. -4-

2.

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B.

This rule does not apply to an NRA who expatriated from the U.S. within the previous ten years and who is subject to § 877(b) for the taxable year in which the gift is made. IRC §2501(a)(3). Special estate and income tax rules will also apply to such an expatriate. 1. Section 877, entitled “Expatriation to Avoid Tax” was substantially amended in 2004, less than ten years after the last substantial amendment in 1995, and this may not be the final development in this area. a. 2. The current version is effective for individuals losing U.S. citizenship after June 3, 2004.

Except as provided in 3. below, an expatriate will be subject to tax under § 877(b) for the 10-year period after expatriation if as of the date of expatriation he had a net worth of at least $2,000,000 or an average net income tax for the five years prior to the expatriation of more than $124,000, or he fails to certify under penalties of perjury that he has met all U.S. tax obligations for the 5 preceding taxable years or fails to submit such evidence of compliance as the Treasury Secretary may require. The $124,000 limit is subject to a cost of living adjustment for years after 2004. IRC §877(a)(2). Section 877(b) will not apply, despite meeting the net worth or income tax thresholds of 2. above, in either of the following circumstances: a. the individual had dual citizenship from birth, continues to be a citizen of the other country, and has had no substantial contacts with the United States – meaning was never a resident of the U.S. for income tax purposes, never held a U.S. passport, and was not present in the U.S. for more than 30 days in any of the 10 years prior to loss of U.S. citizenship. IRC §877(c)(2) the individual is under age 18½ at the time expatriation, became a U.S. citizen at birth, was not present in the U.S. for more than 30 days in any of the 10 years prior to loss of U.S. citizenship, and neither parent was a U.S. citizen when the individual was born. IRC §877(c)(3) Under prior law, the exceptions were not so narrow, but in addition in order not to be subject to §877 it was necessary to obtain a ruling from the IRS that the expatriation did not have tax avoidance as a principal purpose. This latter requirement ultimately proved unsatisfactory for all.

3.

b.

c.

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