Treaty Tie-Breaker: Oh the Pitfalls Beware!

The United States is unique in its approach to taxing individuals who are US citizens or lawful permanent residents (green card holders).  Such individuals are taxed on worldwide income regardless of where they may reside.  On account of this taxation approach, US citizens and green card holders who live outside of America may be subject to income tax in the US and in the foreign country of residence at the same time.

Today’s post deals with the green card holder, who while taxed as a US “resident”, may also be resident of a foreign jurisdiction with which the United States has an income tax treaty.  Such a “dual resident” might qualify as a resident of the other country under a tie-breaker rule contained in the treaty. After applying the treaty rules, if the individual qualifies as a “resident” of the foreign country, the individual may compute his US tax liability for all or part of a tax year as if he was a nonresident alien of the US using Form 1040-NR.

It should be noted that not all treaties have treaty tie-breaker rules (see, e.g., the U.S.-China Income Tax Treaty and the U.S.-Pakistan Income Tax Treaty). In these cases, “residency” would be determined under a so-called competent authority procedure involving consultations between the two countries.

Treaty Tie-Breaker Rules – How do they Work?

Specific tests are set forth in the treaty tie-break provision and are applied to determine the individual’s tax residency.

Once dual tax residency is established, the treaty tie-breaker rules are used to determine a single country of residence.  Different treaties contain different criteria and each treaty must be carefully examined.  Typically the treaty tie-breaker rules are contained in Article 4 of the treaty.  Using the 2016 U.S. Model Income Tax Treaty, Article 4, the tie-breaker rules look at the following factors:

  1. The existence and location of the individual’s permanent home;
  2. The individual’s center of vital interests (this involves examining where the individual has stronger personal and economic relations);
  3. The individual’s habitual abode;
  4. The individual’s nationality

The above factors are tested in the order in which they are stated. Once a factor is satisfied with respect to either the US or the treaty country, tax residency is attributed to that jurisdiction.  If the particular factor is met for both countries, or, if it cannot be determined then the next factor is examined.

Notifying IRS – Form 8833

Proper notification must be given to the Internal Revenue Service (IRS) on Form 8833 Treaty-Based Return Position Disclosure, which is attached to the nonresident alien income tax return on Form 1040-NR.  Failing to properly notify the IRS may mean the individual will continue to be treated as a US resident for purposes of computing US income tax.  Some professionals believe that failure to disclose the treaty-based return position should not result in the inability to take it.  (More guidance in the Treasury Regulations Sec. 301.7701(b)-7 here and Sec. 301.6114-1, here).  Clearly, better safe than sorry — file the Form 8833!

Possible Pitfalls

If the individual chooses to be treated as a resident of a foreign country under an income tax treaty, he or she will still be treated as a US resident for tax purposes other than figuring the individual’s US income tax liability (see Treasury Regulations section 301.7701(b)-7(a)(3)), quoted below.

(3) Other Code purposes. Generally, for purposes of the Internal Revenue Code other than the computation of the individual’s United States income tax liability, the individual shall be treated as a United States resident. Therefore, for example, the individual shall be treated as a United States resident for purposes of determining whether a foreign corporation is a controlled foreign corporation …..

Still a US Resident for Other Tax Purposes

What does this mean?  As stated in the Regulation, the individual’s US status will still count for many purposes of the US tax laws. Ownership of shares in a foreign corporation will still be counted for purposes of classifying the entity as a controlled foreign corporation (CFC). In a similar vein, might the shareholder’s US status still count when determining the validity of the S corporation status?  This issue is “reserved” in the Regulations.

What about the excise tax imposed under the Internal Revenue Code on US persons that have foreign life, sickness or accident insurance or a foreign annuity? Generally, an excise tax of 1% is imposed on premiums paid for foreign life insurance, sickness or accident insurance or for a foreign annuity contract when the same is issued with respect to a US citizen or resident.  More details here.

Clearly, tax traps might be tripped in the absence of careful investigation and planning.  In a nutshell and as more fully set out below, I see no benefit for many (if not most) green card holders living abroad to use the treaty tie breaker unless they are looking to return to America and remain there!

Expatriation

Depending on how long the green card has been held, a treaty tie-breaker claim can result in an “expatriation” for US tax purposes.  The tax result is the same as renunciation of US citizenship by a US citizen if the individual is treated as a “long term resident” (LTR) at the time he makes the tie-breaker claim.  One is an LTR if the individual was a lawful permanent resident of the United States in at least 8 of the last 15 tax years ending with the year the status as an LTR ends.  This means possible “exit tax” and “transfer tax” implications under the expatriation tax regime for “covered expatriates” (CE).  You can learn more about these rules in my blog post here.  The individual who is LTR must also file Form 8854, Initial and Annual Expatriation Statement. Don’t be late with filing this one… IRS relief for late Form 8854 filing may not apply!

As a general principle, holding on to the green card is not wise if the individual plans to live abroad with the possible intention to live again in the home country, for example, at retirement.  Holding the green card too long can then become very troublesome and extremely costly when it is time to let it go if the individual will be a CE.  It is easy for the successful individual to fall into the CE category (for example, having a net worth of USD 2 million automatically bestows CE status).  The exit tax and continued impact on any US family members of the CE are harsh. I have seen it happen many times and regret is the order of the day for those who wait.

FBARs and other Information Reporting

Guess what?  Making the treaty tie-breaker means the individual can reduce or eliminate the amount of income tax owed, but that is it.  What about information reporting?  There are special carve-outs, for example, there is an exception for filing Form 8938, as well as an exception from annual Form 8621 PFIC reporting.  Make sure you do all things necessary to meet the carve-out – e.g.,  a timely filing of the relevant Form 1040NR, Form 8833, as well as any schedule if required.

So-called FBARs (Form 114) must still be filed to report any foreign accounts.  As my readers are well aware, Mr. FBAR lurks in every corner and comes as a surprise to many.  This is not an area to overlook.

Risk of Losing the Green Card for Immigration Purposes

If the US Immigration authorities learn of the treaty tie-breaker claim, this would undoubtedly impact the individual’s ability to keep the green card. Taking this position can possibly result in the green card being revoked.  Consultation with immigration counsel is clearly very important.

 

Posted January 12, 2023

 

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