Part 10 – The S. 877A "Exit Tax" and possible treaty relief under the Canada US Tax Treaty

Introduction – The Canada U.S. Tax Treaty Does Not Always Prevent Double Taxation

When countries independently make major changes in tax law, double taxation can occur
The following comment from 5thSwiss on the Isaac Brock Society site explains why and how double taxation can be a reality. It also underscores the dangers of a U.S. citizen leaving the United States.

It’s not obvious that renunciation of citizenship will cure failure to report in the past, or forgive unpaid tax. (“a ‘disposition’ of PFIC shares can occur by redeeming them, selling them, gifting them away, or even by giving up one’s US resident status or citizenship”)
The increasingly complex, expensive and draconian US tax law as applied to “accidental” US Persons might be considered by some a “good thing”. The more draconian – disproportionate – tax laws and penalties become, the more costly it is for ordinary families living abroad to report and pay tax on concessionary funds (such as for minors and disabled dependents, and retirement and tax-sparing funds not envisaged in the relevant bilateral tax treaty) the more impossible of enforcement and outrageous in principle such unilateral and exorbitant laws are seen to be.
And the less likely it is that the country of residence of a noncompliant person deemed to be a US person will assist the USG in collecting tax, prosecuting an individual and pursuing others on the basis of “transferee liability”.
Canadians who faced double taxation of their inheritance in that decade after Canada moved to capital gains taxation of estates based on deemed sale at death vs US imposition of estate duty (there is now a credit of one against the other under a tax Protocol) will understand that individuals are cannon fodder for Governments, who when they negotiate tax treaties are mainly concerned with the interests of multinational firms as represented by lobbyists. It is no wonder that of the 6 million Americans said to be resident abroad (the State Department knows of only half of those), an increasing number, unable to pay for tax advice or preparation, for renunciation of citizenship or the incremental US tax itself, are simply remaining underground. A series of GAO reports has looked at this and found no solution. And, by and large, legislators and bureaucrats (including diplomats) don’t care.
For the time being, the Lord Mansfield Dictum protects. But the hostility towards tax evasion abroad translates into hostility to expatriates generally. That is not a good sign.

5thSwiss describes the creation of  “double taxation” after one country (in this Canada) moved from an Estate Tax to a deemed disposition of assets on death. We now have a problem of the U.S. creating a deemed disposition of assets on expatriation when Canada has no such tax. This is what happens when one country makes a major change to its tax system and the other does not. (In this case there is at a minimum a “timing mismatch” in the taxable event.)

The S. 877A “Exit Tax” and the Canada U.S. Tax Treaty
The primary purpose of this post is to explore whether the Canada U.S. Tax Treaty can be used to mitigate some or all of the effects of the “Exit Tax”. I don’t know the answer. Therefore, this post will “raise an important question”, but not “answer the important question raised”.
U.S. Tax Treaties 101 – The outline
I am also going to use this post to outline some VERY basic aspects of U.S. tax treaties.   There will  four parts to this post:
Part 1 – Tax Treaties and the U.S. Constitution
Part 2 – Tax Treaties and the “Savings Clause”
Part 3 – The S. 877A “Exit Tax” and possible treaty relief
Part 4 – The “Savings Clause” as an argument against “citizenship taxation”

Part 1 – Tax Treaties and the U.S. Constitution
This is a very complex area. I want to begin with two basic points:
1.Beginning with a nice article in Wikipedia:
“The Supremacy Clause is the provision in Article Six, Clause 2 of the United States Constitution that establishes the United States Constitution, federal statutes, and treaties as “the supreme law of the land.”
Note that BOTH federal (not state) statutes and treaties are “the supreme law of the land”.
2.  Since federal statutes and treaties are both “supreme law of the land”, a federal statute WHICH IS LATER IN TIME can override (in effect change the terms) a tax treaty.
To borrow from the words of Professor Anthony Infanti in his article:
Domestic Law and Tax Treaties: the United States

“Even though the U.S. Constitution does not speak directly to the hierarchy of sources of federal law, the federal courts have for more than a century held that treaties and federal statutes are on equal footing under the Supremacy Clause because they are both listed in that clause without any mention of one being superior to the other.[17] Based on this premise of equal status, the federal courts have consistently held that, in the event of a conflict between a treaty and a federal statute, whichever is later in time will prevail. This rule is referred to as the later-in-time or last-in-time rule. Under this rule, a federal statute will prevail over earlier, inconsistent treaty obligations, including tax treaty obligations.”

In other words, a change in U.S. domestic law can effectively “override a tax treaty.
(Although FATCA IGAs are NOT U.S. domestic laws, Allison Christians has argued that they are another example of a “tax treaty override“.)
In any case, a U.S. Federal Statute, which is later in time, can override a Tax Treaty. Note that this is NOT generally true in Canada, where all Canadian statutes are subject to International Treaties.
This means that when a country enters into a treaty with the United States, that Congress can always override that tax treaty.
Part 2 – Tax Treaties and the “Savings Clause”

The “Savings Clause” and “citizenship taxation”
The “savings clause” has three clear effects.
First: to ensure three that a tax treaty cannot defeat “citizenship taxation”. The “savings clause” operates so that the treaty partner country agrees that the United States can levy taxes on its citizens who live in that country.
Second: by allowing the U.S. to levy taxes on residents of the treaty partner country, the U.S. will be able to impose a “capital tax” on that country.
Third: to ensure that a U.S. citizen resident in the treaty partner country will always pay an amount of tax that is as great as he would pay under the Internal Revenue Code. (Although, some of this total tax payable would be paid to Canada, the U.S. citizen pays a total tax equal to the amount he would pay under U.S. law.)
In other words, the “tax treaty” is of no use to Americans abroad for the purpose of reducing the total tax payable. In fact:
The tax treaty ensures that U.S. citizens abroad will always be subjected to the “worst of both worlds”.
The text of the “Savings Clause” is:

Article XXIX
Miscellaneous Rules
2. Except as provided in paragraph 3, nothing in the Convention shall be construed as preventing a Contracting State from taxing its residents (as determined under Article IV (Residence)) and, in the case of the United States, its citizens (including a former citizen whose loss of citizenship had as one of its principal purposes the avoidance of tax, but only for a period of ten years following such loss) and companies electing to be treated as domestic corporations, as if there were no convention between the United States and Canada with respect to taxes on income and on capital.

What is the significance of the “ten year rule” for “former citizens”?
On June 16, 2008 the U.S. implemented the “Exit Tax”. You will NOTE that S. 877A deems people to have sold all assets on the day BEFORE expatriation. This means that the “Exit Tax” rules take place while the person is STILL a U.S. citizen.
Prior to June 16, 2008, the “expatriation rules” provided that a FORMER citizen would be taxed for ten years after expatriation. Therefore, U.S. tax treaties were amended to provide that “former citizens” could be taxed for ten years.
This raises the issue,  of whether “Exit Taxes” payable, under the current S. 877A rules, are eligible for foreign tax credits.
As Phil Hodgen recently noted:

Also, be very careful about the exit tax you would pay in the United States as a covered expatriate. I suspect you will find it difficult and/or impossible to claim a foreign tax credit in your home country for this tax paid to the United States.

Part 3 – The S. 877A “Exit Tax” paid and possible treaty relief
It’s a problem of double taxation …
In January of 2009, the ABA ran a program on the (what was then) new S. 877A rules. I recommend the notes from the program. The question of how the S. 877A rules interact with tax treaties was considered as follows:

Treaty Interactions – Section 877A
Mark-to-market tax under section 877A imposed on U.S. persons –or, more precisely, imposed on gains deemed recognized while covered expatriate was deemed recognized while covered expatriate was U.S. person
Therefore, tax is covered by typical treaty saving  clause as tax imposed on U.S. citizens and residents
Section 877A will cause double taxation unless other countries allow exemption for exit tax gain
– 5th Protocol to Canada treaty (2007): pre-departure  gain
taxed for alienation of property immediately before taxed for alienation of property immediately before individual’s emigration exempt from taxation in the destination country (Canada has its own departure tax)
How will first $600 000 of gain be treated in Canada?

Is there any provision of the Canada U.S. tax treaty that allows one to claim a credit against Canadian taxes for any payment the “U.S. Exit Tax”?
William Dentino and Christine Manolakas writing in:
The Exit Tax: A Move In the Right Direction, at page 408 note that:

Congress was also silent as to whether the provisions of the HEART Act override existing U.S. tax treaties. 537 As the deemed taxable event occurs prior to expatriation, seemingly, I.R.C. section 877A will not be interpreted to override the provisions of existing tax treaties. 538 Nevertheless, “many of the current U.S. … tax treaties may have to be renegotiated to prevent double taxation stemming from [the mark-to-market regime].” 539 The Fifth Protocol amending the Canada-U.S. Tax Treaty, which was signed in September 2007 and entered into force in December 2008, reflects the exit taxes now employed by both countries.
540 The Fifth Protocol contains amendments to the Canada-U.S. Tax Treaty designed to prevent double taxation of pre-emigration gains accrued by an expatriate prior to relinquishing citizenship or terminating long-term residency.

S. 7 of Article XIII of the Canada U.S. Tax Treaty reads as follows:

XIII – 7
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 and the domestic law of the other Contracting State at such time defers (but does not forgive) taxation, that individual may elect in his annual return of income for the year of such alienation to be liable to tax in the other Contracting State in that year as if he had, immediately before that time, sold and repurchased such property for an amount equal to its fair market value at that time.

William Dentino and Christine Manolakas writing in:
The Exit Tax: A Move In the Right Direction, at page 409 continue on:

The purpose of paragraph 7 of Article XIII of the Canada-U.S. Tax Treaty “is to provide a rule to coordinate the taxation of gains by Canada and the United States in the case of a timing mismatch.”543 Mismatching “may occur, for example, where a Canadian resident is deemed, for Canadian tax purposes, to recognize capital gain upon emigrating from Canada to the United States, … [while] the United States defers taxation [by] as-signing the [pre-tax basis to the property].”544
If the individual is a U.S.citizen, the individual can resolve the timing mismatch by electing to be liable to tax in the United States as if the property had been “sold and repurchased … for an amount equal to its fair market value at a time immediately prior to the deemed [disposition].”545
The U.S. citizen or an individual otherwise subject to U.S. tax, is allowed by the election “to accelerate the tax … and allow [a foreign] tax credit to be used to avoid double taxation.”546
If the Canadian resident is not a U.S. citizen or otherwise subject to U.S. tax, under the new paragraph 7 of Article XIII,the effect of the election [is] to give the individual an adjusted basis [in the property] for U.S. tax purposes equal to the fair market value of the property as of the date of the deemed [disposition] … with the result that only post-emigration gain will be subject to U.S. tax [upon actual disposition].547
Thus, unless a U.S. tax treaty contains a provision similar to paragraph 7 of Article XIII of the Canada-U.S. Tax Treaty, a covered expatriate will likely be subject to taxation in the foreign country of residence when the assets subject to the exit tax are actually sold or otherwise disposed after expatriation. Similarly, the foreign country where the asset is located may 543

The possible applicability of paragraph 7 of Article XIII of the Canada U.S. Tax Treaty was also considered by Ward Chisholm, PC as follows:

Perhaps the most essential unanswered question for advisers to clients residing in Canada is whether Paragraph 7 of Article XIII of the Convention between Canada and the United States of America with Respect to Taxes on Income and on Capital (the “Tax Treaty”) may be relied upon by a covered expatriate. This provision of the Tax Treaty appears to offer an opportunity to coordinate the recognition of gain under the revenue systems of both countries so as to make the U.S. exit tax creditable against the Canadian tax liability of a covered expatriate residing in Canada. Presumably, if Paragraph 7 of Article XIII of the Tax Treaty applies to allow gain to be recognized and taxed by Canada in the same year the exit tax under Code Section 877A is imposed by the U.S., there would be a corresponding basis adjustment for the gain recognized.[66] Competent authority relief may ultimately be necessary to determine whether relief from double taxation is available on imposition of the exit tax under Code Section 877A, as well as the transfer tax imposed by Code Section 2801.

Sooner or later someone will argue that paragraph 7 of Article XIII should be interpreted to make the S. 877A “Exit Tax” creditable in Canada. The result will be interesting.
Part 4 – The “Savings Clause” as an argument against “citizenship taxation”
Professor Reuven Avi-Yonah of the University of Michigan Law School comments:

“If we did not tax nonresident citizens, we could abolish section 911. We could also abolish IRC section 877, which has proven ineffective in deterring tax‐motivated expatriations, and simply apply the new IRC 877A (the exit tax on expatriation) to individuals abandoning US residency, like most countries do. Finally, we could give up on the “savings clause” in our tax treaties, which we insist upon to enable us to tax nonresident citizens but which have to pay a price for in treaty negotiations.

Interesting, this is yet another argument for the elimination of “citizenship taxation”.
In conclusion …
Treaty relief for U.S. citizens subject to the S. 877A Exit Tax would be welcome. Does S. 7 of Article XIII of the Canada U.S. Tax Treaty provide that relief? It will be interesting to see. At a minimum, this is an important topic for consideration when the Canada U.S. Tax Treaty is reconsidered.

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