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Amid recent and ongoing congressional discussions about imposing an exit tax on U.S. expatriates as if they sold all their assets for fair market value on the date of expatriation, the topic of how those expatriates should be taxed for federal income and transfer tax purposes has suddenly been awakened. Though such legislation was not passed in December as part of the Heroes Earnings Assistance and Relief Tax Act of 2007, H.R. 3997, 110th Cong. (2007), due to a last-minute unrelated delay, the same may yet occur now that Congress has reconvened. Hence, the current expatriation tax rules are still to be applied until otherwise repealed or amended. What is not known, or has possibly been forgotten, by many tax practitioners in this area is a special cross-reference to the current expatriation tax rules published under � 7701(b)(10) of the Internal Revenue Code of 1986, as amended (IRC). In general, � 7701(b)(10) extends (in a retroactive manner) the expanded source rules applicable to expatriates under � 877 of the IRC to certain resident aliens who previously departed the United States. Such extension applies to resident aliens who were once treated as U.S. income tax residents for three consecutive calendar years and within three calendar years of their departure returned to the United States and regained U.S. income tax residency status. What can be called the “special residency rule” can certainly be a trap for the unwary. After more in-depth technical readings of the IRC, a tax practitioner will further find that the special residency rule may indirectly subject the affected individuals to potential U.S. federal gift tax consequences on any transfers of U.S.-situated intangibles during their period of absence, which should have otherwise been exempt from the same. Implications of the rule Consider a scenario in which Miguel Vazquez, a hypothetical citizen and resident of Panama, is a principal investor in several large entities formed throughout the world, including the United States. Annually, Vazquez receives more than $5 million of taxable income from different U.S. sources. Due to political unrest in his home country, on Jan. 1, 2008, Vazquez and his family leave Panama for the United States with the intent to return home when his country is again stable. Taking up a temporary residence in Miami, and becoming a U.S. federal income tax resident of the United States by reason of the substantial-presence test, Vazquez becomes a prominent public figure after contributing some of his good fortune to the establishment of a local charitable organization that helps those who come from countries that are also in political turmoil. In May 2012, Vazquez feels it is safe for him and his family to return to Panama, as the country has become more politically stable. One year after leaving Miami and severing his then-established five-year U.S. federal income tax residency status, Vazquez decides it is time to retire and maybe enjoy some world traveling. In December 2013, Vazquez transfers by gift his shares of stock in certain foreign and U.S. corporations to his children. On Jan. 3, 2014, Vazquez returns to Miami for his charitable organization’s annual board of directors’ meeting. During the meeting, Vazquez discovers that the directors have not been properly attending to the needs of the organization and the administration is in a state of chaos. Vazquez, being very passionate about this organization, remains in Miami for the next seven months, without returning to Panama, in order to make sure the administration is properly restored. The applicable rules Under the current language of � 877, individuals meeting a certain economic threshold who relinquish their U.S. citizenship or terminate their long-term permanent resident status (i.e., green card) are subject to an alternative taxing regime on their U.S.-source income more expansive than those rules generally applicable to nonresident aliens. As compared to U.S. citizens and resident aliens who are subject to U.S. federal income taxation on their worldwide income, nonresident aliens are generally taxed only on U.S.-source income. There is a flat rate of 30% (or a lower treaty rate) on the gross amount of certain types of passive income derived from U.S. sources. See I.R.C. � 871(a) (2007). Net profits effectively connected with a U.S. trade or business, including gains on the sale of U.S. real property interests (which are treated in the same manner), will be taxed at regular graduated rates. See I.R.C. � 871(b), � 897 (2007). U.S.-source income realized by a nonresident alien who does not fall within one of the foregoing categories (e.g., capital gains from the disposition of U.S. securities not effectively connected with the conduct of a U.S. trade or business) are generally not subject to U.S. federal income taxation. For a 10-year period following expatriation, the alternative taxing regime expands the scope of the foregoing U.S.-source income rules and applies the graduated rates to such income, provided the corresponding U.S. federal income tax liability exceeds the tax liability imposed under � 871 of the IRC (relating to the flat 30% tax on passive income not effectively connected with a U.S. trade or business). As discussed above, the disposal of U.S. securities by nonresident aliens is generally exempt from U.S. federal income taxation. However, the expanded U.S.-source rules include as U.S.-source income gains from the disposal of U.S. stock issued by U.S. corporations. See I.R.C. � 877(d)(1)(B) (2007). Accordingly, the expanded U.S.-source rules were intended to prevent U.S. citizens and long-term residents from expatriating in order to achieve a tax advantage generally enjoyed by nonresident aliens. Long-term U.S. residents are any individuals other than U.S. citizens who were lawful permanent residents of the United States or green-card holders in at least eight out of the 15 taxable years ending with the taxable year of expatriation. The special expatriation gift tax rules also appear to apply to individuals who expatriate and are subject to the alternative taxing regime under � 877. Section 2501(a)(1) of the IRC generally provides that a gift tax will be applied to transfers made by gift by any individual, resident alien or nonresident alien. An exclusion from U.S. federal gift taxation is generally granted in the case of the transfer of U.S.-situated intangible property by a nonresident alien as determined for U.S. transfer tax purposes. This U.S. intangible exception does not, however, apply to those donors who, at the time of the transfer, are subject to the alternative taxing regime under � 877. I.R.C. � 2501(a)(3)(A) (2007). In other words, an individual subject to the alternative taxing regime who makes a gift of a U.S.-situated intangible (e.g., stock in a U.S. corporation) within the 10-year period following expatriation is not eligible for the U.S. intangible exception. Similar to the expatriation income tax rules, the expatriation gift tax rule is designed to prevent U.S. citizens and long-term residents who expatriate from taking advantage of the U.S. intangible exception generally enjoyed by nonresident aliens. The special residency rule Congress enacted the special residency rule so that certain resident aliens could not leave the United States for a short period of time, dispose of certain assets (e.g., U.S. stock) free of U.S. federal taxation and then, again, establish U.S. federal income tax residency status. See H.R. Rep. No. 98-861, at 908 (1984) (Conf. Rep.). Under � 7701(b)(10), if an individual was a resident alien for three consecutive calendar years, then ceases to be considered a resident alien and resumes U.S. federal income tax residency within the three following years and if the tax liability imposed on U.S.-source income under the alternative taxing regime exceeds the tax liability normally imposed under � 871, then the individual will be retroactively subjected to the alternative tax regime described above during the intervening residency period. As compared to the expatriation income tax rule detailed above, this special residency rule is different in several respects. The special residency rule will never subject a residence breaker to the alternative tax regime for more than three calendar years. In addition, a residence breaker during the intervening residency period, if otherwise eligible, may take advantage of benefits as a nonresident alien under the terms of an income tax treaty. What may seemingly be forgotten by most practitioners is that the special residency rule extends the alternative taxing regime to residence breakers who qualify under the substantial-presence test. In other words, the rule applies equally to former U.S. citizens and resident aliens under either the “green card” test or the “substantial presence” test. The substantial-presence test turns on whether nonresident aliens spend 183 days or more in the United States in a given calendar year or during a period of three calendar years averaging more than 121 days per year (but less than 183 days) unless they file a “closer connection” form showing that they have a closer connection to a foreign country. See Treas. Reg. �� 301.7701(b)-1(c) to -2(a). According to � 7701(b)(10), residence breakers under the special residency rule become taxable under the alternative taxing regime. Pursuant to � 2501(a)(3)(A), a donor who is taxable under the alternative taxing regime is removed from the U.S. intangible exception and therefore subject to gift tax on the transfers by gift of U.S.-situated intangibles. A technical reading of the IRC indicates that a residence breaker otherwise subject to the special residency rule by virtue of the substantial-presence test could fall within the expatriation gift tax rule when it otherwise has been thought to apply only to former U.S. citizens and long-term residents (who have established an intent to reside in the United States indefinitely). As compared to the expatriation income tax rule, this result should only subject a residence breaker to the alternative taxing regime for no more than three calendar years between residency periods. Back to the hypothetical What does this mean for Vazquez? Even though Vazquez never obtained U.S. citizenship or a green card, he was a resident alien for at least three consecutive years by virtue of the substantial-presence test (i.e., he was physically present for 183 days or more each year in which he resided in Miami). Within one year of ceasing to be treated as a U.S. federal income tax resident, Vazquez transferred by a gift to his children stock in U.S. and foreign corporations. As a nonresident alien, Vazquez’s transfer of a U.S.-situated intangible would have generally been exempt from U.S. federal gift tax. However, Vazquez’s seven-month stay in Miami caused him to resume his U.S. federal income tax residency, again, under the substantial-presence test. By resuming his residency before the passage of three calendar years since cessation, Vazquez becomes classified as a residence breaker and may have subjected himself to the alternative taxing regime during the intervening residency period. Three things must be true before the alternative taxing regime applies to Vazquez. First, Vazquez must have taxable U.S.-source income. Vazquez annually earns more than $5 million in taxable U.S.-source income. Second, Vazquez’s tax liability on his U.S.-source income must be greater using the graduated tax rates for U.S. citizens and resident aliens as compared to the tax rate applicable under � 871. For instance, if Vazquez’s $5 million qualified as portfolio interest it would be exempt from tax under � 871 (see I.R.C. � 871(h)(1) (2007)) and, therefore, the graduated tax rate system would produce a greater tax liability. Finally, Vazquez must not have claimed benefits under any income tax treaty between the United States and another country. At this time, Panama and the United States have not entered into an income tax treaty such that Vazquez could claim benefits under the same. According to Vazquez’s scenario, he has met the prerequisites for the special residency rule. If by virtue of the special residency rule the alternative taxing regime applies to Vazquez, then it is possible the U.S. intangible exception available to nonresident aliens has been effectively voided. During the intervening residency period, Vazquez may have fallen into a trap that would subject him to U.S. federal gift taxation on the value of the U.S. stock he transferred to his children. This article is intended to raise awareness of the easily overlooked or forgotten special residency rule and to put tax practitioners, especially international tax practitioners, on notice when advising clients in situations similar to that of Vazquez. Contrary arguments and policy reasons can be made against the foregoing U.S. federal gift tax result, given that Vazquez may have never had the intent to reside in the United States indefinitely, thereby becoming a U.S. resident for U.S. federal transfer tax purposes (a subjective test different from the substantial-presence test applicable to the U.S. federal income tax). To date, there has not, however, been any published case law discussing the scope of the special residency rule. Moreover, legislative history on the intended interaction with the U.S. federal transfer tax rules is nonexistent. Until there is guidance on this issue or the exit tax is enacted, the Vazquezes of the world should be advised of the risk when they cease being treated as resident aliens under the substantial-presence test and subsequently decide to make gratuitous transfers of U.S.-situated intangibles. A conservative planning approach should be followed.

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