Your estate: which country taxes what?

Practice expansion: estate and gift taxation across international borders.

While most CPAs recognize the international aspects of income tax compliance, it's not unusual for little or no attention to be paid to the transfer tax implications of being a foreign executive. As commerce becomes more international in scope, executives must increasingly be mobile on a global scale and be prepared for the possibility that they could die while on assignment in the United States. The U.S. estate and gift tax system applies to either citizens or residents, regardless of where their property is located. The system also taxes property transfers of nonresident aliens if that property has a "situs" or is physically located (situated) within the United States.

This article describes the U.S. estate and gift tax concerns international executives face and offers valuable information CPAs can use to advise this growing segment of the corporate population.

CITIZENS AND RESIDENTS

The determination of whether a person is a U.S. citizen is made under federal nationality and immigration laws. Whether someone is a resident for estate and gift tax purposes, however, is determined by domicile. Under Treasury regulations sections 20.0-1 (b)(1) and 25.2501-1 (b) and applicable state law, a person is domiciled where he or she resides with no definite current intention (the crucial factor) of moving. State laws generally look to things such as location of the principal residence and tangible personal property; memberships in civic, social and religious organizations; place of business; voting registration; financial relationships and driver's license. (See "Factors in Establishing a New Domicile," JofA, Dec.95, page 8.) Before applying these domicile tests, however, any tax treaty between the United States and the other country where domicile may exist should be examined since treaty provisions, if a treaty exists, are determinative.

ESTATE AND GIFT TAXATION OF RESIDENT ALIENS

If a noncitizen is found to be a U.S. domiciliary, then the federal estate and gift tax generally applies to transfers of all property, irrespective of its situs. Obviously, this leads to the possibility of double taxation:

* To the extent property has a situs in a particular country, that country also may impose a tax on that property's transfer.

* A foreign country may tax the worldwide transfers--at death or by gift--of both its citizens and its domiciliaries. Thus, if a person is a U.S. citizen but a foreign domiciliary--or vice versa--each country may assert worldwide taxation.

* Two or more countries could determine that a particular person is a domiciliary or citizen.

In such situations, applicable tax treaties must be consulted. Generally, when a country asserts taxation based only on situs, the country asserting a tax based on citizenship or domicile will allow a credit to the extent of the situs-based tax. When both countries assert a worldwide tax, treaties generally grant a credit that effectively apportions the more burdensome tax between countries proportionate to the tax each would assess independently.

For nonresident aliens, the U.S. estate and gift tax rules apply to estates and gifts having situs within the United States. Under Internal Revenue Code section 2501(a)(2), the gift tax does not apply to transfers of intangible personal property, such as royalties and copyrights, even though such property may have U.S. situs.

Otherwise, application of the situs rules depends on the property's character.

Real property. Real property that is located in the United States has U.S. situs. The determination of whether property is real depends on local lax~; which may vary from state to state for items such as condominiums and longterm leases.

Tangible personal property. If such property is physically located in the United States, it generally has U.S. situs. For example, autos, furniture or equipment an executive brings from his or her home country would have U.S. situs. However, there must be some degree of permanence akin to the notion of domicile for individuals--for there to be U.S. situs. Thus, if a temporary visitor dies in possession of his or her luggage while in the United States, the bags would not have attained U.S. situs. Intangible personal property. For intangible personal property for which the written evidence is treated as the property itself, such as a contract or a stock certificate, the physical location at death determines situs. For other intangible personal property, such as debt obligations, situs is determined according to whether the obligation is issued by or enforceable against a U.S. resident, corporation or government entity. Special rules under IRC section 2104 expand on these general principles.

Corporate stock. Only stock of a corporation organized in the United States will be considered to have U.S. situs. Thus, a foreign executive can shield assets from estate tax by placing them in a foreign corporation--as long as that corporation is not a mere sham--even if the foreign stock is physically located here at the executive's death.

Lifetime trans, vs. In general, all the estate tax inclusion rules apply. Thus, for estates of nonresident aliens, section 2104(b) clarifies that the inclusion rules of IRC sections 2035--2038 relating to certain lifetime transfers apply to transfers when the property is situated in the United States either at the time of transfer or at the executive's death. Debt obligations. For debt obligations, sections 2104(c) and 2105(b) have specific rules for certain forms of obligations that are to be treated as having foreign situs. In general, they relate to obligations whose interest is exempt from U.S. income tax, including

* U.S. bank accounts, if the interest is not connected with a U.S. business and is tax exempt under section 2105(b)(1).

* U.S. bank foreign branch accounts, under section 2105(b)(2).

* "Portfolio interest" obligations under IRC section 871(h)(1) owed by a U.S. obligor, as defined in section 2105(b)(3).

* A debt obligation of a U.S. person or corporation whose income is tax exempt because more than 80% of it was derived from an active foreign business, under IRC sections 2104(c), 861 (a) and 861 (c).

Life insurance. Under section 2105(a), amounts receivable under a policy issued by a U.S. life insurance company insuring a nonresident alien's life are not considered U.S. situs property. Thus, a foreign executive wishing to invest in the United States could buy investment-oriented life insurance contracts and still have the proceeds escape U.S. estate tax at his or her death.

ESTATE TAX DEDUCTIONS

Some of the usual deductions are available to foreign taxpayers in calculating their U.S. estate tax liabilities. Tax expenses and debts. Expenses, losses, taxes and debts are deductible under IRC sections 2053 and 2054 but only the portion corresponding to the overall worldwide estate that consists of U.S. situs property. Marital deduction. Under IRC section 2106(a)(3), a deceased foreign executive's estate would be allowed a marital deduction under the general marital deduction provisions of IRC section 2056--provided the surviving spouse is a U.S. citizen. Otherwise, the deduction is allowed only if (a) the spouse becomes a citizen after the executive's death but before the estate tax return is filed and has been a U.S. domiciliary from the decedent's death to the time of naturalization or (b) the property is transferred to a "qualified domestic trust" meeting the requirements of section 2056A. These requirements generally have the effect of assuring the trust's U.S. situs at the surviving spouse's death.

Charitable deduction. A charitable deduction is permitted for bequests to U.S. charities, provided the executive's worldwide estate is disclosed under section 2106po).

ESTATE TAX RATES AND CREDITS

The same rates apply for nonresident aliens as for other decedents. Under IP,.C section 2101(b), the tax is computed on the taxable estate plus the total adjusted taxable gifts, less the tentative tax on these gifts. Under IRC section 2102, the unified credit generally is $13,000 which, if no gifts have been made, is equivalent to a $60,000 property exemption. Under certain treaties, the credit may expand to part of the $192,800 credit generally available to U.S. citizens and residents (equivalent to a $600,000 exemption), based on the proportion of the worldwide estate situated in the United States.

Other credits allowed are a modified state death tax credit under section 2102(b) and, when applicable, the IRC section 2013 credit for taxes on prior transfers.

GIFT TAXES

The same rates apply to taxable gifts a foreign executive might make as apply to transfers at his or her death. The $13,000 estate tax credit is available for transfers subject to gift tax. Thus, beginning at the first dollar of taxable gifts (beyond the $10,000 annual exclusion per donor, per donee, under IRC section 250303)) the gift tax--starting at an 18% rate--is payable out of pocket.

Marital deduction. There is no gift tax marital deduction available to a spouse who is not a U.S. citizen. There is, however, a $100,000 annual exclusion for gifts made to noncitizen spouses.

A QUESTION OF COMPLIANCE

Foreign executives who are assigned to extended tours of duty in the United States are subject to U.S. income tax. Typically, they need professional accounting services to help them comply with their annual tax obligations. CPAs should expand the services they offer these individuals to cover the possible application of the U.S. estate and gift tax rules. Foreign executives should not lose sight of the implications of becoming U.S. domiciliaries and the possible need for the substantiation of domicile either within or outside the United States. Such taxpayers also must consider the tax consequences of establishing situs of assets in a country outside the country of their domicile and citizenship. Only with competent tax advice in all of these areas can an itinerant foreign executive's estate planning needs be fully met.

Key Definitions

Key Definitions

Domicile--The place where someone resides with no definite current intention of moving.

Situs--The place where property is physically located or situated.

EXECUTIVE SUMMARY

* WHILE MOST CPAs RECOGNIZE THE international aspects of income tax compliance, little attention may be paid to the estate and gift tax implications of being a globe-trotting foreign executive. As commerce becomes more international in scope, corporate executives are increasingly mobile on a global scale and must be prepared for the estate tax consequences of dying while living abroad.

* THE U.S. ESTATE AND GIFT TAX SYSTEM applies to all persons who are either citizens or residents, regardless of where their property is located. It also taxes property transfers by nonresident aliens if that property has "situs" in the United States.

* A NONCITIZEN WHO IS FOUND TO BE A U.S. domiciliary (someone who resides in the United States with no definite current intention of moving) is subject to estate and gift tax on all transfers, irrespective of the property's situs. This could lead to double taxation because another country may impose a tax on the same property for reasons of citizenship or domicile.

* APPLICATION OF THE SITUS RULES depends on the property's character. Tangible personal property, for example, has U.S. situs if it is physically located in the United States. Life insurance proceeds on a nonresident alien's life will not be considered U.S. situs property under IRC section 2105(a).

DAVID C. HERRICK, JD, LLM, is case development manager for the Nautilus Group, a department of New York Life Insurance Company in Dallas. J. DAVE HUNTER is president of Financial Designs Ltd. in Denver, a member firm of the M Financial Group.

A Planners Roadmap

Here is a planning roadmap CPAs can use to help mobile executives avoid unduly burdensome death taxation.

1. Determine which countries might assess tax on all property--irrespective of situs--based on citizenship or domicile. Tax conventions often will result in the imposition of an overall tax based on the rates of the jurisdiction that imposes the highest tax. Because some countries tax only domiciliaries, not citizens, establishing domicile in a low tax jurisdiction could yield significant tax savings. Review the concept of domicile as it is defined in the countries in question to avoid application of a higher tax or--even worse-- double taxation.

2. Consider maintaining the situs of tangible assets in the country with the lowest tax burden. This will result in tax savings when the country of domicile does not tax assets with a foreign situs.

3. Consider changing the nature of assets from tangible property to intangible property or vice versa. For example, tangible property with situs in a higher tax jurisdiction may be transfigured into intangible property by placing it in a bona fide foreign corporation in the lower tax jurisdiction. (As always, income tax considerations of altering ownership should be taken into account.) Similarly, a U.S. stock portfolio might be converted into a nontaxable asset by liquidating it and reinvesting the proceeds in a variable life insurance contract (where the policy's cash values are invested in U.S. stocks).

4. Consider the alternative of expatriation-relinquishment of citizenship and the attainment of foreign domicile--accompanied by moving assets to non-U.S. situs in certain circumstances. When the country of citizenship imposes a broad-based tax on its citizens, establishing citizenship and domicile in a lower tax country could result in substantial savings, although nontax considerations often will be paramount. Caution must be exercised to ensure expatriation itself does not trigger taxation. (Congress currently is considering a proposal that would have this effect.)