By: Eli Doron, Adv; Yaron Tikotzky, Adv, (C.P.A); Dr.Slomo Nass, Adv, (C.P.A)
During the past few years, a growing number of Americans living outside the U.S are renouncing their U.S. citizenship in order to emigrate and take advantage of Israel’s recent tax reform (hereinafter: “The Israeli tax reform”). The Israeli tax reform has significantly broadened the appeal of living in Israel for residents returning to the country to live permanently and new immigrants. The combination of this Israeli legislation and stronger IRS enforcement of U.S. tax code on American citizens living outside the U.S. has encouraged them to renounce their U.S. citizenship and settle in Israel as an ultimate tax haven. Indeed, choosing permanent residence in Israel is actually symptomatic of a larger trend of Americans emigrating to other countries in an effort to escape America’s controversial worldwide inflexible and unforgiving income tax policies (See Expats Lobby For Tax on Residence, Not Worldwide Income).
From a tax perspective, why should a U.S. citizen renounce his citizenship?
The U.S. is one of the few countries in the world that imposes taxes on the world-wide income of citizens and resident aliens, regardless of whether they live in the country or abroad. Thus, for example, a U.S citizen who was born on American soil but has been living in Israel for all of his life is subordinate to the rigid requirements of American tax law, enforced by the IRS. These laws require U.S. citizens living in Israel or elsewhere to report to the IRS their annual incomes and assets. Furthermore, if a U.S. citizen’s Israeli tax liability is lower than his U.S tax liability, he must pay the difference to U.S. authorities. As if this was not enough, the complex U.S tax system makes it difficult for U.S. citizens to fully understand their tax liabilities, including the sanctions that ensue if errors are made. For example, the civil penalty for holding an unreported bank account may be as great as 50% of the total amount in deposit. Even worse, criminal penalties may apply and a warrant issued for the individual’s arrest if he returns to the U.S.
Why is this a good time for a U.S. citizen to renounce his citizenship and immigrate to Israel?
Until recently, the IRS invested little effort in enforcing U.S. tax laws on U.S. citizen living abroad. This policy changed with the U.S. sub-prime crisis. The economic fluctuations and declining tax revenues encouraged the IRS to take significant steps to more rigorously address the tax liabilities of U.S. citizens living abroad. IRS actions included enacting a series of treaties with countries that are known to be tax havens and completing an agreement with a group of Swiss banks compelling the banks to help identify U.S tax evaders. Even more significantly, the U.S. government negotiated a very broad agreement, in effect as of 2013, requiring most banks in the world, including every bank in Israel, to report to the IRS every account held or opened by an American citizen.
The desire to escape these draconian measures is complemented by the attractiveness of a recent amendment to the U.S. expatriation regulations which made it more attractive for American citizens to renounce their citizenship. The amendment declared that the IRS can no longer pursue former citizens in order to collect taxes on U.S.-sourced income. That means that once a U.S. citizen renounces his citizenship and emigrates, all of his future income from non-U.S. sources ceases to be subject to U.S. taxes. Furthermore, assets held outside the U.S. become immune to U.S. estate taxation.
What in the Israeli tax reform made the option to immigrate or return to Israel as a resident and simultaneously renounce U.S. citizenship a lucrative one?
In 2008, Amendment 168 of the Israeli tax code (hereinafter: "The Amendment") embraced broad tax reform granting generous tax benefits for individuals who became Israeli residents for the first time or who are considered to be senior returning residents. The amendment is part of a much broader program aimed at encouraging new immigration, bringing back past emigrants to permanently reside in Israel, and encouraging investments in Israel.
While new immigrants to Israel have long enjoyed tax benefits, for the first time, the amendment gave comparable benefits to senior returning residents. A "New Immigrant" is defined by the Israeli law as an individual that has become an Israeli resident for the first time in his life, whereas a "Senior Returning Resident" is defined as an individual that has returned to Israel after being abroad for at least 10 consecutive years.
The tax benefits granted to senior returning residents include:
• Exemption for taxes on income earned abroad for a 10-year period.
• Exemption for capital gains taxes derived from an asset sold outside of Israel.
• Exemption on income taxes derived from a foreign company managed and controlled by a new immigrant.
• An "adaptation year" in which senior returning residents can enjoy full income tax exemption on income earned abroad and exemption from tax liabilities that apply only to Israeli residents.
• Exemption on income taxes derived from interest gained from a foreign currency bank deposit in Israel.
How does a U.S. citizen renounce his citizenship?
In order to renounce U.S. citizenship, a citizen must voluntarily and with intent to relinquish U.S. citizenship appear in person before a U.S. consular or diplomatic officer in a foreign country (normally at a U.S. Embassy or Consulate); and sign an oath of renunciation. Renunciations that do not meet these conditions have no legal effect.
What are the downsides of renouncing U.S. citizenship?
The most substantial obstacle facing the potential expatriate is the expatriation tax provisions under Sections 877 and 877A of the Internal Revenue Code. The expatriation tax applies to U.S citizens who renounce their citizenship and long-term residents who end their U.S. resident status for federal tax purposes. The rules affect U.S. citizens to whom any of the following apply:
• Having an average annual net income tax for the 5 years ending immediately prior to their expatriation or terminating their residency greater than $147,000 for 2011, $151,000 for 2012 and $155,000 for 2013, adjusted for inflation.
• Having a net worth of $2 million or more on the date of their expatriation or termination of residency.
• Failing to certify on Form 8854 (the Initial and Annual Expatriation Statement) saying that they complied with all U.S. federal tax obligations for the 5 years preceding the expatriation or termination of residency date.
The new rule imposes a mark-to-market regime, meaning that every asset of a covered expatriate (stock portfolios, art, real estate etc.) is taxed on the day of the expatriation as if it was sold at its fair market value on the day before the expatriation date. However, the expatriate can elect to defer the exit tax until he actually sells the property. He may leave the U.S without triggering immediate tax, so long as the IRS is assured that it will collect the tax in the future. In order to defer the exit tax effectively, one must provide adequate securities for the tax liability. Finally, renouncing U.S. citizenship bears one additional risk. If the IRS finds that a U.S. citizen has renounced his citizenship in order to avoid tax liability, he might be denied entry into the U.S. at a later date.
In sum, while these deterrences are significant, they do not discourage many U.S citizens from renouncing their citizenship. Increasingly, U.S. citizens are choosing to cross the Rubicon, renouncing their U.S. citizenship and immigrating to Israel to legally evade the IRS enforcement measures and enjoy the significant tax benefits offered by the new Israeli tax reform.