Escaping the USA, Exit Tax and Transfer Tax Regimes: Using the “Dual National” Exception

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The economy is not looking good with the stock market dropping sharply, with tech companies being hit most dramatically, dropping by about 40%.  Crypto markets are also in a freefall and liquidity has dried up. As a result, it may be the perfect time for individuals wishing to relinquish green cards held for a long time or wishing to give up their US citizenship to pull the proverbial plug.  For US citizens, it is currently very difficult to find a US Embassy or Consulate providing expatriation services. Whereas, for green card holders, the card can be relinquished by mail. Just make sure it is done right.

Timing is right because the weak market means the individual might escape “covered expatriate” (CE) status by not having enough wealth to meet the “net worth” test of US$2 million (assuming no other test is triggered). If the individual is nonetheless a CE, the reduced wealth will mean a lower “exit” tax is payable. My recent blog post sets out the expatriation rules in a nutshell, for those needing more information.

Some lucky individuals need not worry about their net worth exceeding the US$2 million threshold (similarly, they do not need to worry if their 5 year average income tax liability exceeds the relevant statutory threshold, which is US$178,000 for the 2022 calendar year).  They can be billionaires paying oodles of US income tax each year and still not be subject to the expatriation regime provided they can certify US tax compliance for the 5 year period prior to expatriation.   Certain “dual nationals” are one group of such lucky individuals, and are the subject of today’s blog post.

Some are Lucky: “Dual Nationals”

The expatriation rules contain a so-called “dual national exception” (Internal Revenue Code Section 877A(g)(1)(b)).   Meeting the exception permits the expatriating individual to escape treatment as a so-called “covered expatriate” (thus escaping the exit tax and avoiding US loved ones being hit with imposition of Section 2801 transfer taxes).

In order for an individual to meet the “dual national” exception, he or she must be able to certify full tax compliance for the 5 years prior to the expatriation year and must meet both statutory requirements (I) and (II) below:

(B) Exceptions

An individual shall not be treated as [a covered expatriate] if—
(i) the individual—

(I) became at birth a citizen of the United States and a citizen of another country and, as of the expatriation date, continues to be a citizen of, and is taxed as a resident of, such other country, and 

(II) has been a resident of the United States (as defined in section 7701 (b)(1)(A)(ii)) for not more than 10 taxable years during the 15-taxable year period ending with the taxable year during which the expatriation date occurs, …

This “dual national” exception attempts to carve out a safe haven for a limited class of persons and absolve them from the statutory sanctions for expatriation.  The exemption is meant to offer some shelter to those individuals who at birth are both US citizens and  also citizens of another country; who at the time of expatriation, continue to be a citizen of, and are taxed as a resident of, that other country, and furthermore, lack any meaningful physical presence to the United States for a significant period of time.  Unfortunately, this exception, has a few serious glitches when one tries to put it into practice.  Awareness of these issues is critical since the IRS has an audit “campaign” targeting those who expatriate.  Making a mistake is foolhardy in today’s tax game.

1)  Dual Nationality “At Birth”

I have written before on the fact that many persons who are citizens of another country and living outside of America are just learning that they are also US citizens and what the tax implications of such citizenship mean for them.    Indeed, US citizenship with all of its ramifications, comes as unpleasant surprise to many.   A great number of such individuals wish to renounce their US citizenship and want to rely on the “dual national” exception.

For starters, in order to qualify for this exception, the individual must have acquired dual nationality “at birth”.

There are two general ways by which a person receives American citizenship “at birth”.  The first way is simply by being born within the borders of the United States. This is a common law concept called “jus soli”, or the “law of the soil”  “Jus soli” is a rarity in the modern world with the United States being one of only thirty countries which has it in place as a means for birthright citizenship. An exception is made to the American “jus soli” rule in cases of children born to certain visiting foreign diplomats.  INA301(a) and INA 301(b). See 8 CFR 101.3.

Another general way for people to receive American citizenship at birth is to be born abroad to at least one American citizen parent, who has lived in the United States for a certain period of time.    You can read more about birthright citizenship in the United States at the US Citizenship and Immigration Services website here.  The laws have changed over time and can result is some surprising complexities.

Whether one acquires the nationality of another country “at birth” depends entirely on the nationality laws of the other country involved. Foreign nationality laws can result in some surprises and must be examined very carefully.  For example, some countries grant citizenship when one or both parents are citizens of the country involved, even if the child is born outside of that country. In such cases, one must look to the immigration and nationality laws of the particular country to determine if the grant of citizenship is from the date of birth, or only at a later time (e.g., when the child reaches a certain age and specific action is taken to obtain recognition of the citizenship).  Another harsh example impacting citizenship status is that of discrimination – be it as a result of race or gender. For example, if a black American couple emigrated to South Africa in the 1970s and had children, the children would be US citizens at birth but under South African apartheid, they would be denied citizenship of South Africa. Similarly, until recently many nationality laws provided for rampant gender discrimination — fathers could pass on citizenship, whereas mothers could not.

2)  “Taxed as a Resident of”

Another hornet’s nest swarming with potential discrimination is the requirement that the expatriating individual be “taxed as a resident of” the country of his or her other citizenship. Some countries do not impose taxes, per se, on an individual, preferring to raise revenue through VAT (this is common in the Middle East; for example, the United Arab Emirates).  Other countries may have an income tax but exempt their citizens, taxing only expatriates who come to work in the country (e.g. Saudi Arabia does not impose an income tax on individuals who are Saudi or GCC nationals residing in Saudi. However, non-Saudi and non-GCC nationals are subject to this income tax).  The tax professional should have a thorough understanding of the local tax laws to see whether any planning can be done in order for the expatriate to meet the “taxed as a resident of” requirement.  I have found this approach very beneficial in certain cases.

When expatriating the United States, should citizens of those countries lacking direct taxes on the individual be treated differently from citizens of another country which imposes a direct tax if the individual is resident there?  What if the individual who is expatriating is a citizen of one European country (say, Switzerland), but he has been living, working and paying taxes in another European country (say, Germany). He will be denied the ability to use the dual national exception because he is not being “taxed as a resident of” the country of his other citizenship. Must he leave his employment in Germany, move back to Switzerland and establish tax residency there, simply in order to expatriate the US and use the dual national exception?  Unfortunately, the way the law is currently written, the US has unsurprisingly taken a myopic view of things.  Many European countries are very small and people live and work in contiguous countries all the time.  Sadly, as is often the case in the tax world, there are no clear answers. And in the world of expatriation, some things just don’t make much sense.

3) Limited Physical US Presence

Finally, in order to qualify under the dual national exception, the individual must have had limited physical presence in the US for a significant number of years.  He cannot have been a US resident using the “substantial presence test” for more than 10 taxable years during the 15-taxable year period ending with the taxable year during which the expatriation date occurs.  Here is an example, assuming the taxpayer expatriates on April 1, 2022. He must go back 15 years (i.e., which would include the “stub” year January 1, 2022 – March 31, 2022 back to 2008) and ensure he did not meet the substantial presence test for more than 10 years in that 15-year time frame.

The substantial presence test uses a formula looking at a 3 year time frame and employing a weighted average of days of physical presence in each year.  As a rule of thumb, if the individual spends no more than 121 days a year in the US, he will not meet the substantial presence test.  Full details about this test are at my blog post here.

If you need help with expatriation matters, I have the answers as this has been an area of my expertise since the 1990’s. Reach out for a consultation.

Posted June 16, 2022

 

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