TAX INSIDER

Failure to abandon U.S. residency leads to tax liability

People planning to expatriate can do a number of things to avoid this result.
By Allen Schulman

A German citizen's failure to establish that he was a resident of Germany meant that he was a "covered expatriate" for Sec. 877A purposes and therefore liable for tax on stock sale gains that would otherwise have been exempt under the United States–Germany tax treaty.

At issue in the Tax Court case of Topsnik, 146 T.C. No.1 (2016), was income that the taxpayer did not report on a Form 1040NR, U.S. Nonresident Alien Income Tax Return, for 2010 (the same taxpayer's 2004–2009 tax years were decided in an earlier Tax Court case, Topsnik, 143 T.C. 240 (2014)).

Gerd Topsnik was a German citizen who got his green card in 1977 and had income over several years from an installment sale of shares of a U.S. corporation. He claimed that this income was exempt from U.S. taxation under Article 13 (Gains) of the U.S.–Germany tax treaty because he had given up his green card and expatriated from the United States on Dec. 31, 2009, and therefore he was a German resident entitled to tax treaty benefits for 2010. On Nov. 20, 2010, Topsnik had completed a U.S. Citizenship and Immigration Services (USCIS) Form I-407, Record of Abandonment of Lawful Permanent Resident Status, to formally abandon his green card and lawful permanent resident status. USCIS accepted his surrendered green card.

The IRS, however, asserted that Topsnik was a "covered expatriate" for 2010, not a German resident entitled to tax treaty benefits, since he was a lawful permanent resident who expatriated and had not filed a Form 8854, Initial and Annual Expatriation Statement. Therefore, he was required to recognize gain from the deemed sale of his installment obligation on the day before his Nov. 20, 2010, expatriation, under Sec. 877A.

Residency

Article 4, paragraph 1, of the U.S.-Germany tax treaty defines a "resident of a Contracting State" to include an individual liable for that state's income tax based on his or her domicile or residence (i.e., not based on the source of income). The treaty test for residence in a contracting state is the individual's liability to pay tax to the state as a resident, which, in the case of Germany, means that the individual must be taxable on his or her worldwide income. The Tax Court found that the test for residency under the U.S.–Germany tax treaty can be and in this case is confirmed by the commentary on Article 4 of the Organisation for Economic Co-operation and Development's (OECD's) Model Double Tax Convention on Income and Capital (1977). German residents are taxed on their worldwide income.

Topsnik contended that his German driver's license and passport and his alleged ownership of an inn in Germany were proof of his German residency and connection to Germany. The Tax Court determined that these things alone were not enough to prove country of residence for treaty purposes and that, based on information from the German competent authority, he was not a German resident. The German competent authority had informed the U.S. competent authority that Topsnik was registered for tax purposes in Germany as a nonresident, did not file a German tax return for that tax year, was not registered as a resident of several relevant German towns, did not have a registered residence or habitual abode in Germany, and had since 2000, on occasion, resided in a room at a relative's house in Germany free of charge.

Because there was no evidence in the record to refute the information obtained from German tax authorities, the Tax Court concluded that Topsnik was not a German resident.

Type of income

Per Article 13, paragraph 5, of the treaty, gains from the alienation of intangible property (other than the shares referred to in Article 13, paragraph 2(b)) "shall be taxable only in the Contracting State of which the alienator is a resident." Therefore, if the petitioner was a German resident for 2010 he would be exempt from U.S. income tax and liable only for German tax. In Topsnik's Tax Court case involving tax years 2004–2009, the Tax Court noted that the petitioner and the commissioner both

appear to assume that the right of the United States to tax petitioner's gain on his 2004 sale of GFI stock is governed by article 13, paragraph 5, of the treaty, which grants the country of residence the right to tax gains from the sale of intangible personal property. That assumption implies the parties' agreement that GFI's assets did not consist "wholly or principally of immovable property [i.e., real property] situated in [the United States]", . . . There is no evidence in the record indicating the extent to which GFI's assets consisted of "immovable property". In the absence of such evidence . . . we decide petitioner's taxability on the basis of his residence during the years in issue. [Topsnik, 143 T.C. at 261]

Was Topsnik a covered expatriate?

Sec. 877(a): Sec. 877A(a) imposes a mark-to-market regime on covered expatriates, meaning that all a covered expatriate's property is treated as being sold for its fair market value on the day before his or her expatriation date.

Expatriate: Under Sec. 877A(g)(2), the term "expatriate" includes: "(A) any United States citizen who relinquishes his citizenship, and (B) any long-term resident of the United States who ceases to be . . . [a lawful permanent resident] of the United States . . ."

Under Sec. 7701(b)(6), being a lawful permanent resident (LPR) means having a green card. Topsnik had a green card, so he was an LPR.

Sec. 877A(g)(5) defines a "long-term resident" of the United States by cross-reference to Sec. 877(e)(2), which provides that a long-term resident is: "[A]ny individual (other than a citizen of the United States) who is a lawful permanent resident of the United States in at least 8 taxable years during the period of 15 taxable years ending with the taxable year . . . [of expatriation]." Topsnik received his green card in 1977, so he was an LPR for the required period.

Covered expatriate: Sec. 877(a)(2)(C) provides that an expatriate is a covered expatriate if "such individual fails to certify under penalty of perjury that he has met the requirements of this title for the 5 preceding taxable years or fails to submit such evidence of such compliance as the Secretary may require." Regulations under Sec. 877 have not yet been issued. Instead, the IRS has released Notice 2009-85, under which a person will be considered a covered expatriate if he or she has not filed a Form 8854 certifying compliance with all of his or her federal tax obligations for the five taxable years preceding the taxable year that includes his or her expatriation date. Topsnik had not filed Form 8854 and had not complied with his tax obligations for the prior five years, so the Tax Court found he was a covered expatriate.

Application of Sec. 877A

To determine which property is subject to the Sec. 877A(a)'s mark-to-market regime, Notice 2009-85 advises that it includes property that is of a type the value of which would be includible in the value of a decedent's gross estate for federal estate tax purposes if the covered expatriate died on the day before his expatriation date. In Gump, 124 F.2d 540 (9th Cir. 1942), the Ninth Circuit held that the fair market value of an installment note received in exchange for a sale of stock was included in a decedent's gross estate. An installment obligation is therefore marked to market on the day before a covered expatriate's expatriation.

Sec. 877A(g)(3) defines the term "expatriation date" as the date an individual relinquishes U.S. citizenship or, in the case of a long-term resident of the United States, the date on which the individual ceases to be a lawful permanent resident. Regs. Sec. 301.7701(b)-1(b)(3) provides: "resident status is considered to be abandoned when the individual's application for abandonment (INS Form I-407) . . . is filed with the INS." Topsnik filed a Form I-407 with the INS on Nov. 20, 2010.

Accordingly, the Tax Court held that petitioner's date of expatriation was Nov. 20, 2010, and that he was required to recognize gain on the deemed-sale of the installment obligation on Nov. 19, 2010.

Lessons learned

A driver's license and passport are not enough to establish residency in a country for tax treaty purposes; what's needed is to show that the person is obligated to pay income tax just like any other resident.

The IRS has promulgated guidance regarding Sec. 877A(i) in Notice 2009-85. The Tax Court is not bound by an IRS notice, but based on the decision in the Topsnik case, will likely follow the rules set out in Notice 2009-85 in future cases.

Property is subject to the mark-to-market regime of Sec. 877A(a) if it is of a type the value of which would be includible in the value of a decedent's gross estate for federal estate tax purposes if the covered expatriate died on the day before his expatriation date.

Allen Schulman is an enrolled agent in Lakewood, N.J. To comment on this article or to suggest an idea for another article, contact senior editor Sally Schreiber at Sally.Schreiber@aicpa-cima.com.

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