Clarifying Subpart F and Pfic Income Inclusion Upon Renunciation of U.s. Citizenship (irc §§ 877a(g), 951, 965, 1291)

• Publication year: 2019
• Author: By Marsha-laine Dungog, Roy Berg, and Liguo Cooper Xu

Clarifying Subpart F and PFIC Income Inclusion Upon Renunciation of U.S. Citizenship (IRC §§ 877A(g), 951, 965, 1291)

By Marsha-laine Dungog,¹ Roy Berg,² and Liguo Cooper Xu³

Synopsis:⁴ A U.S. shareholder of a foreign corporation may be subject to Subpart F income inclusion under Code Section 951 or passive foreign income company ("PFIC") income inclusion under Code Section 1291. Such income inclusion under the Subpart F or PFIC regime comes into play because of the shareholder's status as a "United States person" ("U.S. shareholder") as defined under Code Sections 951(b) and 957(c). In general, Code Section 957(c) defines a U.S. person as a citizen or resident of the United States, a domestic partnership, domestic corporation, and domestic trust. However, for purposes of Code Section 951, such U.S. person must own or is considered as owning, 10 percent or more of the voting stock of a foreign corporation.⁵ For tax years beginning after January 1, 2018, a U.S. shareholder is any U.S. person who owns or is deemed to own, 10 percent or more of the voting stock or total value of all shares of the classes of stock of such foreign corporation.⁶

When a U.S. shareholder of a foreign corporation renounces his U.S. citizenship pursuant to Code Section 877A (g), such U.S. shareholder's status as a "United States person" terminates on the day of renunciation. As a corollary, he also terminates his U.S. shareholder status on that same day since he no longer holds 10 percent of a foreign corporation as a U.S. person. He is then required to file a final U.S. tax return for the taxable year ending on his or her date of renunciation (the "Final Stub Period Return"). Prevailing U.S. tax laws and regulations do not provide any definitive guidance on how to calculate the Subpart F income or PFIC income inclusion (as the case may be) of a former U.S. shareholder for purposes of filing his or her Final U.S. Tax Return.

The recent codification of Code Section 965 under the Tax Cut and Jobs Act of 2017 ("TJCA") creates additional complexity to the Final Stub Period Return of a U.S. shareholder who renounces in 2017 because Code Section 965 imposes a one-time repatriation tax ("Transition Tax"), for the last taxable year of a foreign corporation beginning before January 1, 2018, on a U.S. shareholder's pro rata share of such foreign corporation's accumulated post-1986 deferred foreign income whether held in liquid or illiquid assets form. This provision applies to all specified foreign corporations ("SFC") that are controlled foreign corporations ("CFCs"), other than PFICs, and foreign corporations in which a U.S. person owns a 10 percent voting interest.⁷ The complexity arises because such entities, which include CFCs, must determine their deferred foreign income based on the greater of the aggregate post-1986 accumulated foreign earnings and profits ("E&P") as of November 2, 2017 or December 31, 2017, not reduced by distributions during the taxable year ending with or including the measurement date.⁸ Therefore the issue that arises is whether the Transition Tax would continue to apply to a U.S. shareholder who has renounced either before November 2, 2017 or prior to December 31, 2017 since the renouncing U.S. shareholder will not own any shares of the CFC as of the last day of the CFC taxable year, as otherwise required for a Code Section 951(a) income inclusion altogether.

I. CURRENT LAW AND REASONS FOR SUGGESTED CLARIFICATION

It is no secret that the number of Americans renouncing their citizenship has reached an all-time high since 2015. The Treasury Department has kept a tally on the number of U.S. citizens who renounce. For 2016, the total was 5,410⁹which is approximately up by 26 percent from 2015. And 2015 had a 58 percent hike from 2014 numbers, totaling 4,279¹⁰ renouncers. For 2017, there were approximately 5,132¹¹ renunciations which is still a significant increase of approximately 20 percent from 2015. These spiking expatriation numbers mean that more and more U.S. citizens are leaving the citizenship-based, extraterritorial taxing regime of the United States. After renunciation, there is a

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last chance for the U.S. government to take one more bite out of the proverbial apple—i.e., when the U.S. expatriate files his or her last U.S. tax return to report his worldwide income subject to U.S. tax starting from January 1 and ending on his date of renunciation (i.e., the Final Stub Period Return). It is therefore important for purposes of that Final Stub Period Return for the Treasury Department to provide definitive guidance on the amount of the renouncing U.S. shareholder's Subpart F income inclusion and PFIC "deemed disposition" income inclusion for the Final Stub Period Return.

Current U.S. tax laws do not provide any definitive guidance on how to determine the Subpart F income inclusion and PFIC deemed disposition income or gain amount that is recognized by a U.S. shareholder who renounces his U.S. citizenship for purposes of the Final Stub Year Return. There is also currently no guidance issued to date on how to compute for the Transition Tax, if any, for a U.S. shareholder who renounces his citizenship prior to November 2, 2017 where such shareholder held stock in a CFC with taxable year ending prior to January 1, 2018.

A. Background on Code Section 877A

A review of the legislative history to Code Section 877A confirms that this statute was intended to impose tax on certain U.S. citizens who relinquish their U.S. citizenship and certain long-term residents who terminate their U.S. residency such that these individuals would pay income tax on net unrealized gains on their property, as if the property had been sold for fair market value on the day before expatriation or residency termination ("mark to market tax"). Apparently, "gain from the deemed sale is taken into account at that time without regard to other Code provisions."¹² This deemed sale treatment is supposed to make certain that certain individuals who relinquish their American citizenship or long-term residency who are "covered expatriates" pay their fair share of Federal taxes by ensuring that covered expatriates pay the same tax for appreciation of assets, such as stocks or bonds, as they would pay if they sold them as U.S. citizens or residents.¹³

A covered expatriate is an individual who ceases to be a U.S. citizen or long-term lawful permanent resident of the United States on or after June 17, 2008 and who has income or net worth in excess of certain thresholds or who is unable to certify compliance with his or her U.S. tax obligations.¹⁴ The three principal consequences to a covered expatriate are:

First, a covered expatriate is treated under Code Section 877A as if such individual sold his or her worldwide assets on the day before expatriation. Therefore, net gain from the deemed sale of these assets, in excess of certain thresholds, must be included in the covered expatriate's income for the year of expatriation.¹⁵
Second, under Code Section 877A, distributions to a covered expatriation following such individual's expatriation date from domestic non-grantor trusts and certain deferred compensation plans are subject to a 30 percent withholding tax, to the extent that these distributions would have been taxable had the expatriate been a U.S. person at the time of distribution.¹⁶
Third, a succession tax is imposed under Code Section 2081 on U.S. citizens and residents and domestic trusts that directly or indirectly receive gifts or bequests from a covered expatriate.¹⁷ The tax is imposed on the value of a covered gift or bequest at the highest applicable gift and estate tax rate in effect at the time of receipt of the covered gift or bequest (currently 40 percent). It applies regardless of whether the property transferred was acquired by the covered expatriate before or after the expatriation date.

Taxpayers who relinquish their U.S. citizenship or cease to be lawful permanent residents must file a dual status return in the year of expatriation, attaching Form 8854, Initial and Annual Expatriation Statement.¹⁸ It includes a certification under penalties of perjury by such individual that he or she has been in compliance with all Federal tax laws during the five years preceding the year before expatriation. Failure to provide such certification will cause such individual to be treated as a covered expatriate under Code Section 877(g) whether or not they meet the tax liability test, or the net worth test. ¹⁹ A copy of the Form 8854 must also be filed with Internal Revenue Service (interchangeably, "IRS" or "Service") at the IRS Service Center in Philadelphia, Pennsylvania.

II. WHETHER SUBPART F INCOME ARISES DURING THE FINAL STUB YEAR PERIOD OF THE U.S. SHAREHOLDER IF THE CFC'S TAXABLE YEAR ENDS AFTER THE U.S. SHAREHOLDER'S RENUNCIATION DATE

For taxable years of foreign corporations prior to December 31, 2017, Code Section 951(a) (1) states, in relevant part:

If a foreign corporation is a controlled foreign corporation ("CFC") for an uninterrupted period

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of 30 days or more during any taxable year, every person who is a United States shareholder (defined by Code Section 951(b)) of such corporation and who owns (within the meaning of Code Section 958(a)) stock in such corporation on the last day, in such year, on which such corporation is a controlled foreign corporation shall include in his gross income, for his taxable year in which or with which such taxable year of the corporation ends . . . (A) the sum of (i) his pro rata share (determined under paragraph 2) of the corporation's Subpart F income for such year (ii) his pro rata share (as determined under Code Section 955(a)(3)) as in effect before enactment . . . of the corporation's previously excluded subpart F income withdrawn from investment . . . and (iii) his pro rata share (as determined under Code Section 955(a)(3) ) of the corporation's previously excluded subpart F income withdrawn

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