By Allison Christians
This is a reprint from Tax Analysts of a presentation by Prof. Allison Christians (McGill Law). Politudes published an earlier paper by Prof Christians entitled “Challenging Fiscal Havens and Tax Avoidance by Global Corporations” (see recent posts). This article shows a kind of flipside, the heavy hand of US tax law for individuals born in the USA but not living there.
I would like to tell you a story about the taxpayer’s right to know what the law requires of her and to have the law administered fairly. This is just one story based on things happening now, but it is a common story. I’m telling this story instead of giving an exposition on the underlying legal texts because sometimes the rules are too complicated and too technical for anyone to really understand, even tax lawyers. Moreover, reading the law itself doesn’t explain what isn’t written on the books, which can matter more in how things play out in human terms. As you will see, the implementation of the law gives rise to a taxpayers’ rights issue — one that wouldn’t be clear from reciting the law alone.
The story I am going to tell you is about a woman named Tina. She’s Canadian. She is 62. Tina is nearing retirement age and has been a cautious and diligent person all her life, carefully saving for her old age following the textbook investment advice that tells us we should invest in low-load pooled investment vehicles — mutual funds — and hang onto them for the long term.
Tina isn’t buying and selling investments, following market trends, or taking risks. She doesn’t have time for that. Tina is married with two kids and lives in the family home she bought with her husband some 30 years ago. She’s hanging in for slow and steady, reliable, low-risk growth, planning for retirement in Canada. As a child, Tina occasionally took a trip down to the United States. Visiting Florida in February is still a tempting prospect, given the harshness of Canadian winters, but Tina has only dreamed of that kind of vacation so far. She is careful with her money, plans to live on her savings, and doesn’t want to burden her kids.
One day, Tina finds the following letter in her mailbox. It’s from her neighborhood bank where she has been banking all her adult life, where she has her checking and savings accounts.
In accordance with U.S. law, we have undertaken a review of our files and have discovered indicia that you were born in the United States.
Accordingly, you must furnish us with the enclosed withholding certificate Form W-8BEN signed under penalty of perjury in U.S. law indicating that you are not a U.S. person for U.S. tax purposes. In addition, you must furnish us with a certified copy of your certificate of loss of nationality, or CLN.
If you do not furnish us with these two items within 30 days, we must treat you as a U.S. person and your accounts as reportable accounts for U.S. tax purposes. If your accounts are reportable accounts, you must furnish us with a withholding certificate Form W9 indicating your status as a U.S. person and providing us with your U.S. Social Security number.
Any failure to provide us with your U.S. Social Security number when asked will result in a $100 fine. If you fail to comply with our documentation requests we may be required to withhold tax for remittance to the U.S. Internal Revenue Service.
Continued noncompliance will result in account closure, including cancellation of your mortgage.
In accordance with U.S. law, we will furnish the following information regarding reportable accounts to the Canada Revenue Agency, which in turn will furnish this information to the IRS:
your U.S. Social Security number;
your Canadian social insurance number;
your account numbers;
information regarding any person sharing your accounts;
highest amount in your accounts during the year; and
gross amounts paid into your accounts during the year.
Thank you for your attention to this matter.
Tina reads this letter through a few times and tries to understand it. “Withholding certificate.” “Certificate of loss of nationality.” “U.S. person.” “Reportable account.” “Social Security number.” “Fine.” “Account closure.” “Mortgage cancellation.”
Tina says to herself, “Yes, it’s true I happen to have been born in the United States. But it was while my Canadian parents were exchange students, and I spent only six months there. I’m not really ‘American.’ I’ve never had a Social Security number, voted for president. I don’t have a passport. I’ve only ever been there on vacation. This can’t be for me, right?”
Concerned, Tina calls her bank. Her bank’s employees are all very friendly in that Canadian way and tell her, “Sorry, but the rule is if you’re born in the U.S., you have to provide evidence to the contrary or we must treat you as a U.S. person.” One clerk takes pity on Tina. “Look, I know this is crazy, and it’s catching everyone by surprise. You’re not alone in this, but you need to talk to someone who knows what they’re doing. Maybe find a U.S. accountant?”
Tina goes home and talks with her husband, a Canadian since birth. He doesn’t think any of this sounds right. “How can the U.S. be after you when you’re not really American? How can Canada give your information to the U.S.?” After shaking his head a moment he realizes, “Those are my accounts too, and I’ve got nothing to do with the U.S. Why should they get my information when they have no business knowing it!?” Tina and her husband decide to ask around.
Tina calls one of her kids, who is just as clueless but promises to do a little digging. A trip down the Google rabbit hole is alarming: message boards and blogs buzzing with horror stories about compliance and CLNs and something called “OVDP.” How the U.S. is on a global hunt to find all its hidden citizens using foreign accounts after Congress passed this law called the Foreign Account Tax Compliance Act a few years ago. How that law was supposed to crack down on tax evaders but now ordinary people are getting hit with massive fines and losing access to their savings.
Tina and her family are scared. They know they aren’t tax evaders, but they aren’t sure what to do. Tina doesn’t know what to think about that Form W8, and she doesn’t have a CLN or know how to get one if she wanted it. She and her husband don’t even know where to start. Is Tina really a U.S. person? Even though she never got a Social Security number or passport, never earned income in the U.S., and only ever spent time in the U.S. as a tourist, the blogs say she could be in big trouble.
Tina decides she has to put her mind at ease by speaking to an accountant with U.S. tax expertise. Tina learns from the accountant that unless she has renounced or relinquished her U.S. citizenship, she’s a U.S. person and needs to provide her bank the information it wants because it’s going to send her info to the IRS. But it’s not just tax forms they’re after; they also want these things called FBARs — foreign bank account reports — and there are multiple penalties associated with failure to make any of the required filings.
Tina doesn’t think she has relinquished or renounced her citizenship, but wonders if she could now? After all, she’s not really American by any stretch of the imagination. The accountant says unfortunately she can’t renounce until compliant with U.S. tax rules going back five years.
So, no matter what, Tina the Canadian her finds herself considered American, and she is going to have to get compliant. She’s one of many such accidental or incidental Americans, many of whom live in Canada, but it’s of no matter how she acquired U.S. person status or had it foisted upon her. Only once she is compliant with U.S. laws to which she never knew she was subject can her accountant help her renounce her status.
But renunciation won’t come cheap. The same year that Congress passed FATCA, the U.S. State Department noticed more Americans renouncing their citizenship. In what seems like an effort to discourage that, State introduced a $400 fee for renunciation, only to hike it to $2,350 a few years later. Of course, the fee is on top of all the burdens to renounce, which include a lot of paperwork that can bring with it even more taxes to pay.
Tina’s overwhelmed. She says she’ll cross that renunciation bridge when she comes to it but in the meantime she just needs to comply with the law to avoid anything bad happening.
The accountant reassures Tina that there are a lot of people in her situation: suddenly discovering they are American with tax obligations in a country they don’t call home. Unfortunately, finding out she has U.S. tax obligations is only the start of things for Tina. When she starts to discover all they entail, she’s in for an absolute tailspin.
Tina hasn’t planned her personal or financial life with U.S. law in mind, and it turns out all those low-load mutual funds are something called PFICs. The accountant explains that the rule for PFICs, or passive foreign investment companies, was passed to stop rich Americans from holding their investment portfolios through companies in tax havens, thereby avoiding U.S. tax obligations. But PFIC rules don’t distinguish between tax havens and places like Canada that tax the income from mutual funds and similar investment vehicles. Because none of Tina’s investment savings are in the U.S., the accountant tells her that probably all of her mutual funds will fall under the rules for PFICs.
The bad news is that the PFIC regime is designed to be so harsh that no one would ever knowingly own one unless they were treating it like a partnership, and marking it to market annually with the assistance of sophisticated tax counsel. Because Tina didn’t do that, she’s going to be subject to this harsh tax treatment, which in effect means going back over the entire holding period of each mutual fund, calculating U.S. tax at the highest rate in effect that year, calculating an interest charge for the delayed payment of that tax for each year, and then compounding the interest forward to the present day.
The accountant explains that this likely wipes out most of Tina’s return on the investment — which is what PFIC is designed to do. He then explains that selling won’t help and in fact makes it worse because the gain on the sale will also trigger Canadian tax, which isn’t creditable against U.S. tax. In effect, Tina’s looking at a combined tax rate of 70 percent — conservatively speaking — with 100 percent not an unreasonable estimate. All together, the taxes and interest could possibly even eat into her principal. And all of that is the case even though Tina would otherwise fall in the lowest marginal rate bracket, or not even make enough income to be required to file an annual tax return in the first place.
The accountant notes as an aside that Tina’s family home may also generate some tax liability in the future, because in the U.S. some gains on the sale of your home are taxable. That’s too worrisome to think about, so Tina puts that thought aside for later.
I think you can understand why Tina might be more than a little overwhelmed at this point, and that’s even before I tell you that the accountant is going to charge her $15,000 to $20,000 to get her compliant, and that if she had known any of these issues in advance, she surely would have made different choices over the years.
One of those choices would have been to avoid specific kinds of pooled investment vehicles, or at least undertake mark to market reporting to avoid the interest charges. Another would have been to put all of her assets in her non-U.S. spouse’s name. Yes, Tina might well consider divesting from her assets because the reporting and tax consequences are so onerous. This is real advice that real Americans are getting from real accountants all over the world. I’m not quite sure what policy goal that serves, but let’s leave that alone for now.
In any event, Tina didn’t know any of this, and no one told her anything until she found out from her bank teller, some blogs, and an accountant in Canada that now she’s at risk of losing her retirement savings because of a country she’s stepped foot in only a handful of times. Tina doesn’t know where to find the information she needs to confirm her status as a U.S. person, nor the proper treatment of her savings or income under U.S. tax law — and the stories about the IRS imposing monstrous penalties on others who went through voluntary disclosure programs are terrifying.
I would venture to guess that no one thinks this outcome represents good policy choices even if all these rules were adopted with good intentions.
All of this brings me back to the subject of taxpayer rights. When we examine the right to be informed and the right to a fair and just tax system, we confront the question of what is fair for a taxpayer to expect from a government that seeks to tax her? And what can and should tax administrators do to make things OK for the thousands upon thousands of Tinas living through some version of this scenario at this very moment?
First, regarding what a taxpayer has a right to expect from a government that seeks to tax her: I think a taxpayer has a right to learn that a government seeks to tax her from that government itself. Not from a bank employee in another county with no U.S. legal knowledge or expertise. Certainly not from blogs written by those who perhaps understandably feel hard done-by, nor by those who stand to gain by charging for complex tax compliance. If the kind of information flow necessary to fulfill this task is hard or impossible for a government to deliver, then that government should not impose such an impossible situation on an individual to begin with.
Related to that point, I think a taxpayer has a right to learn that her whole financial life is subject to harsh deterrents and penalties solely for the reason that it is not located in the United States, even and especially when she is not located in the United States. Again, I think she has the right to learn that not from blogs or word of mouth, but from the government that seeks to impose these rules on her. I think she’s got a right to be informed about a life-destroying force like PFIC by the government that seeks to unleash that force upon her, and a right to avoid that punishment by making different choices. And if that government can’t or won’t bother to inform her, or address the utter absurdity of stripping a person of their life savings as a consequence of inadequate form filling, I think she’s got a reason to complain that this is a pretty unfair administration of a very complex law — a law designed for millionaires with expensive tax accountants and not for Canadians carefully saving for retirement and not hiding anything from anyone.
There is currently no happy ending to Tina’s story. As written, the U.S. laws applicable to a person in her situation are severe and life-changing. But I want to suggest three things I believe Treasury or State could do today to address the ongoing trauma being unleashed on U.S. persons in Canada and elsewhere.
First, when applied to mutual funds in high-tax countries like Canada, the PFIC regime results in — at minimum — a clear instance of double taxation. My idea is that this double taxation can and ought to be fixed right away with a general competent authority agreement under any existing tax treaty. For example, articles 24 and 26 of the current tax treaty between Canada and the United States clearly gives the competent authorities latitude to solve the PFIC problem when it says the competent authorities “may consult together for the elimination of double taxation in cases not provided for in the Convention.” There are plenty of precedents for competent authority arrangements in an equally complex area of law — namely, transfer pricing. Moreover, Treasury is rapidly expanding its use of the competent authority arrangement in connection with its FATCA implementation efforts.
Second, for most nonresident U.S. persons living in high-tax counties like Canada, most U.S. tax results from timing differences in which the tax the U.S. imposes now really belongs to the source country later. That is to say that the PFIC regime often has the U.S. collecting tax on a residence basis before and sometimes to the exclusion of the source country — the country where the U.S. person actually lives. In later years, the source country imposes its own tax, and it falls to the U.S. to credit as the treaty promises. It is therefore safe to exempt most if not all U.S. persons’ local accounts and savings from reporting and tax consequences altogether. Congress could enact this as a same-country exemption as I first suggested several years ago, but Treasury could also make it a treaty-based relief of double taxation.
Treaty-based relief doesn’t fix everything, but it does accomplish two major things: It eliminates pointless administrative costs that burden both the IRS and the taxpayer, and it encourages compliance with U.S. tax law more generally because compliance goes from virtually impossible to fairly manageable for a significant population of taxpayers. It does so with virtually no change in overall revenue in the long term, except for the revenues associated with ruinous penalty and interest traps for the unwary. The IRS can use the saved administrative resources to focus on the targets FATCA was intended to focus on and should focus on — namely, people who are trying to hide things from the IRS. Not retirees with their names and information clearly associated with lifelong savings accounts in high-tax neighboring countries.
Lastly, if none of the above is possible, Treasury and State have got to find a way to allow people like Tina to make a free exit from the U.S. This is a drastic situation and worst-case scenario in my view, and I would much rather see it avoided because it’s so unnecessary. It is not clear what policy rationale explains why it would be in the interest of the United States to push people out of citizenship — even a latent or unexercised citizenship — merely because they live beyond the territory. But if the regulatory burdens on nonresident U.S. persons make it effectively impossible to live with that status, then a release valve seems unfortunately necessary.
To be clear, when I speak of exit costs, I am not talking about exit taxes. Rather, I’m talking about the whole cost of getting into the U.S. tax system solely in order to be allowed to leave the United States all together, and then charged to leave.
The place to start is by repealing that $2,350 renunciation fee. I believe this fee violates another individual right — namely, the right to change one’s nationality. This right is enshrined in U.S. law. It also represents a basic and fundamental tenet of human rights and freedoms. I expect litigation to restore this right will eventually wipe away the renunciation fee altogether. In the meantime, it should at least be possible to remove the fee for the Tinas of this world. The fee was imposed administratively, so presumably it can be revised the same way. Relatedly, the hoops and hurdles for streamlined compliance, another administrative action, can and should be tailored to further accommodate cost- and penalty-free, do-it-yourself feasible compliance and exit for people like Tina.
I hope my story has highlighted how in the United States the issue of taxpayer rights is a global issue. If the words of the taxpayer’s bill of rights have any meaning at all when they talk about the taxpayer’s right to be informed and her right to a fair and just tax system, then we must agree that the Tinas around the world have a right to expect the United States to do a little better by them.
Tina’s case is not one in a million — it’s one of millions. We can do better by this population of individuals abroad adversely and unfairly affected by U.S. tax law. The taxpayer bill of rights says we must do better.
Allison Christians is the H. Heward Stikeman Chair in Tax Law at McGill University in Montreal, where she writes and teaches in the area of national and international tax law and policy. You can follow her on the Tax, Society & Culture blog at taxpol.blogspot.com or on Twitter (@taxpolblog). She delivered this speech at the International Conference on Taxpayer Rights in Washington on November 18. 2015.
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