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Then there is the passive foreign investment companies exit tax, which some have called the “stealth exit tax.” Under proposed regulations, this tax applies to anyone (including those who are US persons only by the substantial presence test), regardless of wealth, who changes status from US person to nonresident. I would argue that the PFIC exit tax does not apply because the regulations have remained in proposed form since 1992 and the expatriation rules of section 877 have been thoroughly revised several times since then. Nevertheless, proposed PFIC exit tax rules are out there and may cause sleepless nights to some covered expatriates.
If “disposition”, then tax
The problem comes from the PFIC law. If you have a “disposition” of PFIC stock, you have to pay a lot of tax as you may have an “excess distribution” from a “Section 1291 fund”. – Title 26, Section 1291(a)(2):
If the taxpayer disposes of stock in a passive foreign investment company, then the rules of paragraph (1) shall apply to any gain recognized on such disposition in the same manner as if such gain were an excess distribution.
Resident to nonresident = disposition
You, our L-1 or H-1B friend, owned foreign mutual funds (PFIC shares) before you came to the USA to live. You kept the mutual funds the whole time you were living in the United States. You still owned those same mutual fund shares when you left the United States and returned to your home country. The IRS says you dispose of your PFIC shares when you leave the United States and change from a resident taxpayer in the United States to a nonresident taxpayer of the United States. Just by leaving the United States, you have a tax to pay. Sounds like an exit tax, right? The rule comes from Proposed Regulations published in 1992:
If a shareholder of a section 1291 fund becomes a nonresident alien for U.S. tax purposes, the shareholder will be treated as having disposed of the shareholder’s stock in the section 1291 fund for purposes of section 1291 on the last day that the shareholder is a U.S. person. Termination of an election under section 6013(g) is treated as a change of residence (within the meaning of this paragraph (b)(2)) of the spouse who was a resident solely by reason of the section 6013(g) election.
See Prop. Regs. §1.1291-3(b)(2). Important: this rule (“you are treated as having a disposition of a PFIC when you change from resident to nonresident”) is from Proposed Regulations. It is not in the Internal Revenue Code.
The power (?) of Proposed Regulations
The big question is obvious. These are Proposed Regulations. They are not in effect yet. And they have been proposed — but not finalized — for 23 years. So you, a normal person going from nonresident of the United States to resident and back again. Do you take these Proposed Regulations seriously? Or not?
Judges say . . .
Courts generally say that Proposed Regulations are no better than an argument in a legal brief:
- “[P]roposed regulations are entitled to no deference until final.” In re AppleTree Markets, Inc., 19 F.3d 969, 973 (5th Cir. 1994).
- “Proposed Regulations are suggestions made for comment; they modify nothing.” LeCroy Research Sys. Corp. v. Commissioner, 751 F.2d 123, 127 (2d Cir. 1984).
- “Indeed, whatever may be said about “temporary” regulations that have not gained permanent status after 13 years (see n. 9), any notion of ascribing weight to anything that has remained in the “Proposed Regulation” limbo for a like period is totally unpersuasive.” Tedori v. United States, 211 F.3d 488, 492, n. 13 (9th. Cir. 2000). Emphasis added.
IRS says . . . taxpayers need not follow Proposed Regulations
The Internal Revenue Manual admits that taxpayers do not need to follow the rules laid out in Proposed Regulations.
Proposed Regulations provide guidance concerning Treasury’s interpretation of a Code section. * * * Taxpayers may rely on a Proposed Regulation, although they are not required to do so. Examiners, however, should follow Proposed Regulations, unless the Proposed Regulation is in conflict with an existing final or temporary regulation.
See I.R.M. 4.10.7.2.3.3 (01-01-06). Emphasis added.
IRS says . . . examiners should use Proposed Regulations
But what is that alarming sentence from the Internal Revenue Manual? Just after the IRS says that taxpayers need not follow Proposed Regulations, the Internal Revenue Manual says:
Examiners, however, should follow Proposed Regulations, unless the Proposed Regulation is in conflict with an existing final or temporary regulation.
See I.R.M. 4.10.7.2.3.3 (01-01-06). Emphasis added. In the next section of the Internal Revenue Manual, the position is softened a bit:
When no temporary or final regulations have been issued, examiners may use a Proposed Regulation to support a position. Indicate that the Proposed Regulation is the best interpretation of the Code section available.
I.R.M. 4.10.7.2.3.4 (01-01-2006). Emphasis added. Examiners “should” follow Proposed Regulations. Examiners “may” use a Proposed Regulation to support a position. Let me translate this into English. Here is what the IRS just told you:
“Proposed Regulations have no legal power. We know that. You, taxpayer, don’t have to follow them. But we will enforce them if we feel like it.”
AICPA comment from 1992
It is a known problem. When the Proposed Regulations were published in 1992, the AICPA chimed in with comments and suggestions. Here is what they said about the problem discussed in this week’s Friday Edition:
CHANGE OF U.S. RESIDENCE OR CITIZENSHIP. Under the Proposed Regulations, if a shareholder of section 1291 fund becomes a nonresident alien, that shareholder is treated as having disposed of its stock in such a section 1291 fund on the last day the shareholder is a U.S. person. Further, where a nonresident alien individual and that individual’s spouse have made an election under section 6013(g) to treat the nonresident alien as a resident of the U.S., termination of that election is treated as a change of residence of the electing spouse who was resident solely by reason of the election. We believe this rule is too broad in that it operates to impose tax on the full appreciation of shares in a section 1291 fund, much of which may have occurred prior to commencement of a resident alien taxpayer’s U.S. residency. The Proposed Regulation also causes taxable income when there has not yet been a realization event with respect to the shares. This result is beyond the intended scope of the PFIC rules and beyond the specific regulatory authority of section 1291(f) and section 1297(b)(5). We believe U.S. tax should not be imposed on unrealized appreciation that occurred prior to U.S. residency. The Proposed Regulations should be amended to exclude gain attributable to pre-residency appreciation from the excess distribution regime. Additionally, the shareholder’s holding period for purposes of section 1291 should begin on the day the U.S. person first became a U.S. citizen or resident, to prevent an interest charge being imposed on years during which the shareholder was not a U.S. citizen or resident. Alternatively, the regulations, when finalized, should clearly provide Prop. Reg. section 1.1291-3(b)(2) does not apply to section 1291 fund stock acquired during a pre-residency period prior to the effective date of the final regulations.
