U.S. legislation passed on June 17 imposes stiff new tax penalties on U.S. citizens or long-term residents who expatriate from the U.S.

The Heroes Earnings Assistance and Relief Tax Act of 2008, which provides tax breaks to U.S. military service personnel and their families, also includes provisions that apply to “covered” expatriates. “These affect mainly Canadians who have held green cards for eight of the preceding 15 years,” says Peter Megoudis, lawyer and senior tax manager of global wealth and employer solutions with Deloitte & Touche LLP in Toronto.

It is much more common, he notes, for Canadians to give up their green cards than for Americans to give up their U.S. citizenship: “Expatriation is pretty rare for U.S. citizens because it means giving up their citizenship, which would be a very emotional decision. Canadians, on the other hand, often give up their green cards when they retire from jobs in the U.S. and move back to Canada, or if they get good jobs in Canada.”

Dual citizens who decide to retire in Canada after working in the U.S. may also be affected.

But expatriates will not be considered “covered” under the new legislation and subject to the penalties if they meet the three following criteria: their average net annual income for the five years preceding expatriation does not exceed US$139,000; their net worth does not exceed US$2 million; and they have fully complied with U.S. tax obligations — and paid their income taxes — for the past five years.

“An individual who faces the new penalties is someone whom U.S. presidential contender John McCain would consider wealthy,” Megoudis says. “The vast majority of green-card holders don’t have assets worth US$2 million or haven’t held green cards for eight years.”

Expatriates, then, become non-residents of the U.S. and, unless they pass the “substantial presence” test by spending more than 183 days a year in that country in any calendar year (see accompanying story), they will be taxed only on their U.S.-source income, such as U.S. rental income and dividends on U.S. securities, not on their worldwide income. Upon death, their estates will only be taxed on U.S.-situ assets, such as U.S. real estate and securities.

Prior to June 17, high net-worth expatriates had to disclose their worldwide income and assets every year for 10 years after expatriation, although they were taxed on only their U.S.-source income. And they were subject to capital gains taxes on U.S. securities. Those who expatriated between June 4, 2004, and June 16, 2008, and who subsequently spent more than 30 days a year in the U.S., were considered U.S. residents for the full year and subject to U.S. income taxes, estate taxes and gift taxes for that year.

These provisions have been replaced by a new set of rules. Expatriates are still taxed as non-residents. They no longer necessarily have to file income tax returns in the U.S. for 10 years after expatriation — which, says Murray Shapiro, lawyer and senior manager of high net-worth support with Royal Bank of Canada in Toronto, may have dissuaded them from buying U.S. securities. And they can now spend more than 30 days a year in the U.S.

However, expatriates face a number of costs:

> Departure Tax. On the date of expatriation, “covered” expatriates are generally deemed to have sold all their assets at fair market value, and must pay capital gains taxes on the appreciation above the US$600,000 exemption. “Of course,” Megoudis says, “this only affects individuals with accrued gains. And it is only relevant for the year in which they leave.”

> Taxes On Gifts Or Bequests. They must also pay taxes on gifts or bequests. A covered expatriate can make a gift or a bequest of up to US$12,000 a year to any one U.S. citizen or resident. For amounts above that, the recipient now has to pay taxes at the highest marginal estate or gift tax rate — 45% in 2008 — on the value of the gift or bequest.

Megoudis says some of his firm’s clients have been shocked to learn about this penalty, which, he says, is making people think twice about surrendering their U.S. citizenship or green cards. “True, a client could get insurance to pay his or her heir’s tax hit,” he says, “but we’re talking a lot of money here because the inheritance tax doesn’t have the current US$2-million exemption that U.S. estate taxes do.”

@page_break@Currency exchange rates aside, Megoudis says, if a client is a U.S. citizen and dies holding a $10-million Canadian property that was purchased for $2 million, with the 45% U.S. estate tax on properties of more than US$2 million, the estate taxes will be approximately US$4.5 million. “But because this is a Canadian asset,” he adds, “his or her estate can claim a US$2 million credit for the Canadian capital gains taxes on the deemed disposition upon death under the treaty. So, the client’s net U.S. estate taxes would be about US$2.5 million.”

If your client gives up his or her U.S. citizenship, the U.S. estate taxes are zero. “But the son, who lives in the U.S., has to pay an inheritance tax of US$4.5 million without being able to claim a credit for any Canadian capital gains taxes,” Megoudis notes. “In the meantime, the client’s estate has paid out US$2.5 million in estate taxes. With this double tax hit, not much of the estate would be left for the heir.”

If your client left the U.S. and didn’t qualify to be taxed under the wealth rules, Shapiro adds, but then accumulated a net worth of US$20 million, “a gift or bequest that client now makes to a U.S. citizen will be subject to gift or bequest taxes in the year the gift or bequest is received under the existing rules.”

> Taxes On Individual Retirement accounts. When your client expatriates, he or she is deemed to have received the funds from an individual retirement account as if the plan had been collapsed on the date of expatriation. This deemed distribution will be included as income for that year. So, if the client has US$400,000 in an IRA, he or she will pay U.S. income taxes on this amount, usually about 35%, Megoudis notes. In Canada, the client will also pay Canadian income taxes in, say, Year 5, when the plan is actually collapsed.

“We’re advising clients to collapse their IRAs in the year they expatriate, so they can claim the tax credits available under the Canada-U.S. Income Tax Convention,” Megoudis says. “If a client’s plan is worth US$400,00, the U.S. taxes on the deemed collapse of the plan, at 35%, will be US$140,000. If the plan is collapsed in the year of expatriation, the client will pay Canadian taxes of approximately 50%, or C$200,000. But because this is a U.S.-sourced pension, the client can claim the U.S. taxes paid that year as a credit in Canada against [the Canadian taxes due]. So, C$200,000 minus the US$140,000 U.S. taxes means the client will have a C$60,000 tax hit.”

If your client doesn’t collapse the IRA upon expatriation but does so later, in Year 5, he adds, the Canadians taxes will be due in Year 5. “But the client will have no credits because he didn’t pay U.S. taxes on it in that year, so his net Canadian taxes will still be the full $200,000.”

> Taxes On Deferred Compensation Plans. If your client was a U.S. employee and a member of a Canadian deferred compensation plan (for example, if he or she was working for a U.S. subsidiary of a Canadian company), the client is deemed to have realized all the value in the plan on the date of expatriation.

“This means the client will be taxed in this calendar year, although he hasn’t yet received the assets,” Megoudis says. “And he might have mismatched tax credits because he may be taxed in Canada when he finally receives the assets, but that may not be a year for which he can claim a tax credit for the U.S. taxes [paid in] the year of expatriation.”

But unlike the automatic deemed distribution of IRA assets at the time of expatriation, the client’s employer can elect not to have a deemed distribution. “The employer will have to file an election with the Internal Revenue Service,” Megoudis says, “guaranteeing that when an actual distribution is made, 30% of the employee’s assets will be withheld for the U.S. government.”

> Taxes On U.S. Trust Payouts. Covered expats who are beneficiaries to a U.S. trust are subject to a 30% withholding taxes.

High net-worth clients who have held green cards for at least eight years may trigger the above penalties without even realizing it, Megoudis says: “Expatriation does not occur only when the individual voluntarily gives up a green card; it can also occur involuntarily. For example, if the individual has a green card seized by a U.S. border guard who feels it has expired because of an extended absence from the U.S., such seizures would be considered an expatriation, thus exposing the individual to penalties.”

Green-card holders who return to live in Canada should decide whether to retain or give up their green cards, Shapiro says. Canadians can retain their green cards by keeping them active. This means continuing to file U.S. tax returns and obtaining a U.S. immigration re-entry permit when they leave the U.S. Those who keep their green cards, he adds, won’t have to pay the departure taxes, but will remain liable for U.S. income, estate and gift taxes. And their U.S. heirs may be hit with estate taxes.

Your clients, in deciding whether to retain their green cards, will have to weigh the outcome of one situation against the other, taking into account the size of the capital gains they will face by becoming expatriates and the taxes that will be due on the gains, their U.S. estate tax liabilities and who their heirs are. IE