Changing residence involves (too) many tax problems,
both for individuals and companies.
Changing residence is among the most sensitive topics for international tax practitioners. Residence of taxpayers is a key factor in the determination of the jurisdiction to tax: changing it implies fundamental modifications in the taxing power of each state involved. This shows that the states involved have conflicting interests in determining the tax treatment of a change of residence. The result is a multitude of rules and reactions from states to states that largely rely on tax‐ policy reasons. In a few pages, this essay aims to provide readers with an overview of some of the most troublesome and complex consequences from changing residence, both for individuals and companies. Illustration of the variety of state reactions will be given through a selected sample of taxation rules applicable in France or in the United States of America. The first issues appear with the determination of the residence of taxpayers, and the technical difficulties for getting out of a qualification as resident from a state (I). Other troubles come at the time of the transfer of residence since it can trigger emigration taxes protecting the taxing rights of home states (II). After the change of residence, problems arise with respect to the interests kept in the home country (III).
Still, this essay does not cover numerous problems following a change of residence, such as timing‐issues or differences in valuation methods. But in the light of this presentation, one should conclude that without a complete investigation on when, how to prepare and how to document a change of residence, this process could seriously turn into a nightmare.
I – Problems related to the determination of residence
The concept of residence varies for each country: changing residence entails complicated researches and compliance requirements.
A – Domestic and conventional connecting factors used to
determine the residence
1 – For individuals
Individuals seeking to change their residence must first determine the connecting factors of both countries of emigration and immigration for income tax purposes. Countries often refer to their variant of residence as connecting factor determining the extent of the tax liability. But other factors can be found:
The French income tax for individuals uses as connecting factor the fiscal
domicile: this recovers four alternative criteria. Will be considered as having a
fiscal residence in France and therefore will have an unlimited tax liability the individual having in France1:
• A home (“Foyer”), defined as the place where a taxpayer has his habitual abode and his family ties;
• His principal abode: used as criteria only if the home cannot be determined, this is where the taxpayer spent the higher number of days; • His principal professional activity, taking into account the income
generated and the time spent; • His centre of economic interest. The United‐States federal income tax for individuals uses as one of its connecting factor the concept of residence for the application of an unlimited tax liability2. But the concept is more mechanical: First, will be considered as resident of the 1 French Tax Code (FTC), articles 4A and B. 2 U.S. Internal Revenue Code (I.R.C.), §§1, 2(d), 61, 7701(a) and (b).
United‐States any individual meeting the substantial presence test. This generally requires that the individual has been present in the U.S. for more than 31 days during the calendar year, and for more than 183 days taking into account one third of the days of presence of the preceding year and one sixth of the days of presence of the second preceding year3. Second, will be considered as
U.S. resident any individual who is lawfully admitted for permanent residence, such as a green card holder, no matter where he lives.
The United‐States federal income tax also establishes the U.S. citizenship as an independent connecting factor for an unlimited tax liability4.
One could conclude that changing residence may result in a qualification as resident for tax purposes in both countries. Such situation would counter the applicability of a tax treaty. Therefore, tax treaties include an article providing its own definition of residence. The O.E.C.D. model of tax convention makes first a reference to domestic law of contracting states for determining residence. If an individual is resident of both states, tiebreaker rules will determine from where he is considered resident. Thus, he will be considered as resident from the country where he has a permanent home. If he has a home in both states, he will be resident of the state with which his personal and economic relations (center of vital interest) are closer. If it cannot be determined, a “habitual abode” test is applied. In the absence of habitual abode, he will be resident from the state of which he is national. Otherwise, the contracting states promise to try to settle the question by mutual agreement5. 2 – For companies When a company plans to change of residence, this is essential to determine the criteria used by the states involved: among domestic laws, four theories have been encountered as connecting factors for companies: 3 Some days are exempted from the 183‐day test. 4 I.R.C. §7701(a)(30)(A). 5 O.E.C.D. Model, article 4.
• The incorporation theory: where the company is registered;
• The real seat theory: where is located the effective place of management; • The principal place of business;
• The control theory: where the shareholders are located.
In the United‐States, the residency test for corporations relies on the incorporation principle. Domestic corporations, meaning corporations created or organized in the United‐States or under the laws of the United‐States6, are taxed on their worldwide taxable income7. France uses a variant of the real seat principle. First, the company is resident of the state where it is registered. If this legal seat is a sham, the real seat prevails8. Nevertheless, the French income tax for corporations respects the territoriality principle and does not include income earned in the habitual exercise of an activity out of France9.
The O.E.C.D. model also proposes a tiebreaker rule for companies: the place of their effective management. The U.S. model of tax treaty proposes the place of incorporation as first tiebreaker. If this cannot solve the double residency and the contracting states do not reach a compromise, the company will not be treated as a resident of either contracting state.
B – A complicated process for getting out of a qualification
as resident
1 – A need to break all ties with the emigration state for individuals
Catchall rules for residency of individuals often require that the individual cut every tie with his former home country. Individuals must therefore change their 6 I.R.C. §7701(a)(3) and (4). 7 I.R.C. §§11, 61. 8 Official Guideline DB4H1413. 9 FTC, article 209‐I.
factual situation rather than merely try to fit into legal criteria: this can be a heavy problem for them.
With respect to French residency rules, one shall be advised to avoid any element having been taken into account by the authorities for the determination of residence. For instance, leaving any family member in France is risky. Individuals shall sell or reorganize their ownership of French assets, in particular for real estate since the administration could consider even a secondary house as a permanent home if it is at the disposal of the individual. Also, all bank accounts, life insurance policies etc. must be closed and moved to the host country. Name must be withdrawn from all public election lists or electoral rolls, and the social security administration shall be informed of the change of address. Any executive positions in companies based in France shall be resigned from. Also, one should keep in mind that cell phones are an easy way to track users’ location10. Even though the United‐States’ rules are more mechanical, individuals seeking a change of residence might face hard choices, such as giving up their citizenship or their green card. However, an American can give up his citizenship while his spouse maintains his citizenship. Thus, he is allowed to get a visa to freely enter and exit the U.S., he could live in another country and maintain a home in the United‐States. The main consideration would be to cautiously respect the substantial presence test11.
Individuals could enjoy more flexibility if they move between contracting states of a tax treaty: the tiebreaker rules of the O.E.C.D. model are subject to a hierarchy. So long as both states respect this hierarchy principle, a change of residence with respect to the first connecting factor (usually the permanent home) might be sufficient. Nevertheless, any remaining factor in the home country is a decrease in certainty for the individual’s residency status. Interestingly enough, the U.S. model of tax convention “saves” the right to tax its
10Bernard Chesnais, France: moving tax residence, BNA International, 2010.
11Reuven S. Avi‐Yonah, International Tax as International Law: An Analysis of the International
citizens on their worldwide income even though they would be qualified as non‐ residents12.
2 – The tax treatment subordinated to legal constraints for companies
Unlike individuals, companies are legal creatures which life and acts must be described by law. As a consequence, the organization of a change of residence has to fit legal mechanisms described by applicable laws of the company, both in home and host countries. Now, the tax consequences of a transfer of residence, as well as the survival of tax attributes, may largely depend on the types of legal mechanisms authorized in the countries at stake. If no legal tools correspond to a planned change of residence, the company might not have any other choice than winding up in the home country and reincorporate. If the legal environment allows certain types of operations having the effect of a change of residence, it remains crucial for tax purposes to determine the extent of allowances and the technical constraints they imply.
When France is the home country, the company law allows shareholders to change the residence of SARL13 companies without a loss of legal personality.
However, other types of companies may have to wind up and reincorporate14.
But in European Community law, the regulation on the European Company (so‐ called SE) states that the registered office of an SE may be transferred to another Member State, without resulting in the wind‐up of the SE or in the creation of a new legal person15. French rules transposing this regulation state that when a
company transfers its seat in another member state, whether or not the company looses its legal personality, this do not lead to treat it as winding up for tax purposes16. Therefore, from France to another member state, an SE or a French company can change of residence without having to bear the tax consequences of 12 U.S. model, article 1§4. 13 Société à responsabilité Limitée. 14 French Commercial Code, articles L223‐30 and L225‐97. 15 Council Regulation 2001/2157/EC, article 8§1. 16 FTC, article 221.
winding up. Also, the Merger Directive17 provides substitute methods for
planning a change of residence of a company in the European Community, using operations that can claim the benefits of the directive, such as a merger or a transfer of assets.
In the United‐States, applying the incorporation principle, the legal process for changing residence of a company depends on state laws. When the company plans to move from or to a foreign country, there is no simplified form available that merely changes the place of incorporation. However, it is still possible in those situations to realize a change of residence, through the use of substitute methods such as a cross‐border merger. Generally, the tax consequences will depend on the qualification of the operation as reorganization for tax purposes18.
II – Emigration taxes upon the transfer of residence
At the date of a transfer of residence various tax consequences may be triggered. Under the generic name of emigration taxes, Rijkele Betten distinguished five types of emigration taxes under three categories: exit taxes, extended income tax liabilities and clawbacks of deductions19.
A – Transfer of residence may cause the collection of exit
taxes
1 – For individuals
When the home country seeks to protect its tax claim, a final tax upon emigration can be enacted. This final tax might be general, meaning that all unrealized capital gains on taxable sources of income are taxed. In a limited final tax, the tax claim is limited to certain sources of income. 17 Council Directive 90/434/EEC. 18 I.R.C. §368. 19 R. Betten, Income Tax Aspects of Emigration and Immigration of Individuals, IBFD, 1998.
Following the outcome of the de Lasteyrie20 case, France decided to totally repeal
its limited exit tax on individuals21. Indeed, the European Court of Justice (ECJ)
held that the French provision had at the very least a dissuasive effect on taxpayers wishing to establish themselves in another member state, because upon emigration, individuals were subject to tax on a form of income that had not yet been realized. Nevertheless, the ECJ in the N22 case held that the
suspension of payment made subject, for example, to guarantees, constitutes a restrictive effect on the freedom of establishment in that the taxpayer is deprived of enjoyment of the assets given as a guarantee. One can conclude that an exit tax offering a deferral of payment until the actual realization of the gains, not conditioned to guarantees or the designation of a representative in the home state, does not necessarily constitute a restriction to the freedom of establishment. The European Commission confirmed that exit taxes were possible, but “any means of preserving the tax claim must be strictly proportional
to that aim and must not entail disproportionate costs for the taxpayer”23.
The United‐States recently modified the taxation of individuals upon emigration from an extended tax liability system to a general final tax24. This exit tax25 is
targeting US citizens who relinquish citizenship, or long‐term residents who terminate US residency, if they meet a “net income tax liability requirement” ($124.000 adjusted), a “net worth requirement” ($2.000.000), or if they fail to certify that they complied with all US tax obligations for the preceding 5 years26. At the expatriation date, any net unrealized gain in excess of $600.000 (adjusted) on their worldwide property27 is subject to income tax. This Mark‐to‐Market rule offers an election for deferral of payment generally until the date of disposition of the property, upon the furniture of a guarantee and an irrevocable waiver of 20 de Lasteyrie, C‐9/02, ECJ (04/17/2004). 21 FTC, former article 167bis. 22 N v. inspecteur, C‐470/04 (ECJ, 09/07/2006). 23 Communication on Exit Taxation, COM(2006)825 (European Commission 12/19/2006). 24 HEART Act, 06/17/2008. 25 I.R.C. §877A 26 I.R.C. §877(a)(2). See exceptions for citizens in §877A(g)(1)(B).
27 Certain items, such as deferred compensation items, are excluded and subject to different
any tax treaty right that would preclude assessment or collection of the exit tax28. An interest is charged for the deferral period. One can highlight that there is no tax‐avoidance motive requirement and that this tax also covers assets that would otherwise be taxable in U.S. upon their ultimate disposition29. U.S. shareholders of a Passive Foreign Investment Company (PFIC)30 might not
be aware of owning stock of a company falling into this broad definition. It is quite common that no proper election31 was made to minimize the tax
consequences of this anti‐deferral provision. As a result, when this PFIC shareholder emigrates, the individual will be treated has having disposed of the PFIC stock32. The gain will be taxed as if it accrued, pro‐rata, during the years the stock was held. The U.S. tax due equals the yearly taxes due plus interest from each year’s due date. The tax rate applied is the highest tax rate for the owner for the years of deferral33. 2 – For companies A company seeking to change of residence from France to a country outside the European Community could be forced to wind up and reincorporate. The treatment of such a transfer of seat for tax purposes is subject to a winding up regime, leading to the immediate taxation of all profits realized, profits subject to deferred taxation and unrealized gains34. A deemed distribution of all profits of the company to its shareholders is also triggering taxes35. Nevertheless, the European community law did not prohibit member states from enacting exit taxes on companies. According to the ECJ in the Cartesio case, in a situation where a company transferring its seat changes its national applicable 28 I.R.C. §877A(b). 29 Ellen S. Brody & Jason K. Binder, US adopts exit tax upon expatriation, BNA International, 2008. 30 I.R.C. §1297. 31 I.R.C. §§1295 and 1296. 32 U.S. Proposed Regulation §1.1291‐3(b).
33 Kenneth J. Vacovec & Todd M. Beutler, The Tax Treatment of Transfer of Residence of
Individuals, United‐States report, 56th IFA congress, §1.2.1, 2002. 34 FTC, article 221‐2.
law (lex societatis), the freedom of establishment prevent the home member state from dissuading the conversion into a company governed by the laws of the host member state by requiring the company to wind up or liquidate, unless the home member state could show some mandatory reason in the public interest36. However, if there is no change in lex societatis, the home member state is allowed to require from the company to wind up and reincorporate in the host country, since this situation is outside the scope of the freedom of establishment. Thus, exit taxes are possible, and the European Commission indicated that such mechanism would be also possible in the context of the application of the freedom of establishment provided that it respects the outcome of the de
Lasteyrie case and the N case37.
In the United‐States, a mere change of place of organization of one corporation is covered by the so‐called “type (F)” reorganization rules. Without important change in shareholder’s proportionate interests in the corporation, a reincorporation would easily be qualified as type (F) and could benefit from non‐ recognition provisions38. Other types of reorganization could be used as
substitute method to effectively reincorporate the company. The definition of type (F) reorganizations often overlaps with other reorganizations, but only a type (F) reorganization allows the corporation not to end its taxable year, and to carryback post‐reorganization net operating losses39.
In the international context, a special provision applies in order to impose a toll charge on the transfer of assets in transactions that might otherwise be tax‐ free40. When assets used in the U.S. are transferred to a foreign taxpayer, the
provision might render inapplicable the non‐recognition provisions for reorganizations by denying corporate status to the foreign corporation. Gain inherent in the property is therefore recognized. Roughly, this provision applies to various types of transfers, such as (but not only) a transfer of property by a U.S. person to a foreign corporation in exchange for corporation’s stock, where 36 Cartesio, C‐210/06, (ECJ, 12/16/2008), §110‐113. 37 Communication on Exit Taxation, 12/19/2006. 38 I.R.C. §§354, 361 and 381.
39 Paul R. McDaniel, Martin J. McMahon, Daniel L. Simmons, Federal Income Taxation of
Corporations, chapter 14, 3rd Ed. 40 I.R.C. §367.
the transferor controls the corporation immediately after the exchange41.
Nevertheless this recognition mechanism offers, subjected to strict conditions42,
an exception allowing the non‐recognition treatment if the property is used in the active conduct of a trade or business outside the U.S., when at least 80% of the stock of the transferor domestic corporation is owned by 5 of fewer domestic corporations43.
B – Transfer of residence may trigger extended income tax
liability
In extended tax liability mechanisms, emigrated individuals or companies are treated as a deemed resident even though the rules for residency would conclude not. The extended tax liability can be unlimited, or limited to income and gains from sources in the emigration country.
The French tax law states that government agents working or realizing a mission abroad are subject to an unlimited extended tax liability even though they do not meet the connecting factors used to determine their residence, if they are not subject to income tax in the foreign country44. Also, the tax treaty between
France and Monaco stipulate that individuals of French nationality who transfer their domicile or residence to Monaco are liable in France to the personal income tax and the complementary tax on the same terms as if they had their domicile or residence in France45.
One should recall that the United‐States taxes U.S. citizens on their worldwide income. Moreover, U.S. citizens and long‐term residents who expatriated before June 17th 2008 could be subject to a limited extended tax liability if the
41 Bittker & Lokken, Federal Taxation of Incomes, Estates and Gifts, chapter 71, Revised 3rd Ed. 42 Proposed Regulation §1.367(a)‐7. 43 I.R.C. §§ 367(a)(3)(A) and (a)(5). 44 FTC, article 4B. 45 Tax Treaty between France and Monaco, article 7, 05/18/1963.
expatriation met the tax‐avoidance purpose tests46. Such individuals are subject
to U.S. taxation for a 10‐year period on income from U.S. source.
With respect to companies, a provision47 applying to so‐called inversion
transactions can generate an unlimited extended tax liability. Accordingly, when a company reincorporates as foreign corporation and thereby replaces the U.S. parent corporation of a multinational group with a foreign parent corporation, the parent corporation following such inversion is considered a domestic corporation for U.S. tax purposes, even though it is organized under the laws of a foreign country, if at least 80% of its stock is owned by former shareholders of the inverted domestic corporation48. This provision would not apply if the
foreign parent corporation has substantial business activities in the country of incorporation. Also, an important exit from the scope of this provision can be found in cases of “internal group restructuring”49.
C – Transfer of residence may drive to clawbacks of tax
deductions
Emigration taxes can be on the form of a recapture of deductions or deferrals previously taken. Such mechanisms help to prevent taxpayers from taking the best of both worlds: the tax deduction or deferral and no related taxable income in the jurisdiction thereafter.
For French companies, several tax advantages could cease upon emigration of the taxpayer. For instance, the French corporate income tax is based on a territoriality principle. However, a special provision allows small and medium size companies to deduct temporarily foreign losses occurred by their branches and subsidiaries50. Following a change of residence of the company, previously
deducted losses are recaptured in the year of the transfer, except losses from
46 I.R.C. §877. 47 I.R.C. §7874. 48 Bittker & Lokken, Fundamentals of International Taxation, §66.2, 2010. 49 I.R.C. §7874(c)(2)(A); U.S. Treasury Regulation §1.7874‐1(c)(2). 50 FTC, article 209C.
subsidiaries which stock are included in the portfolio of a French permanent establishment51.
In the context of a change of residence of a company by a reorganization to which U.S. tax law offers non‐recognition treatment, several recapture rules may apply52. For example, since the U.S. taxes its residents on their worldwide
income, the non‐recognition is denied if the transfer is of assets of a foreign branch that sustained net losses before the transfer. Thus, the transferor recognizes gain up to the lesser of the gain on the incorporation transfer or the previously deducted branch losses53.
III – Tax consequences following a transfer of residence
Maintaining any connection to the home country could result on tax liabilities targeting remaining interests or avoidance attempts.
A – Problems arising from the taxation rules of non
residents
1 – Residents and nonresidents may be subject to different taxation rules
As stated above, residence of taxpayers is a classic factor determining the scope of the tax liability. Indeed, non‐residents will often be subject to a tax liability in their former country limited to income from source within this country. Besides, the determination of the taxpayers’ net taxable income, as well as tax rates applicable, may vary for residents and non‐residents. These latter differences could result in a higher effective tax rate for non‐residents compared to the taxation of residents for the same income. As a consequence, the taxation rules
51 Official Guidelines 4‐H‐4‐10.
52 Bittker & Lokken, Federal Taxation of Incomes, Estates and Gifts, chapter 71. 53 I.R.C. §367(a)(3)(C).
applicable to non‐residents are of first importance for taxpayers who emigrated if they maintained some interests in the country of emigration. In particular, awareness of what is included in non‐residents’ tax base and what can be deducted from it is critical.
The French income taxation for corporations is based on the territoriality principle. Thus, the change of residence of a company does not change dramatically the scope of the tax liability. However, an individual becoming non‐ resident limits the scope of his income tax liability from worldwide to French source income54. Moreover, even if residents and non‐residents are subject to
the same rules of determination of French source taxable income, the general deductions from the gross income of taxpayers, such as the deduction for alimonies, are disallowed for non‐resident individuals55.
The United‐States distinguishes two categories of gross income of non‐resident corporations and individuals56: First, the gross income effectively connected with
the conduct of a trade or business within the United‐States: it is subject to the general taxation rules, including the progressive tax rates. Most of deductions are allowed only for this category and to the extent they are connected with it57. Second, the gross income from source within the U.S. and not effectively
connected with the conduct of a trade or business within the United‐States: it is subject to a special set of taxation rules, including in most cases a flat tax rate of 30%58. Usually no deductions or allowances for costs in producing this income are permitted. 54 FTC, article 4A. 55 FTC, article 164A. 56 I.R.C. §§872 and 882. 57 I.R.C. §§873 and 882(c). 58 I.R.C. §§871 and 881.
2 – Various tax incentives for emigration or immigration may apply
Some countries may wish to encourage emigration or immigration of certain taxpayers. Accordingly, tax incentives that may be available for individuals who changed their residence must be scrutinized.
Among the French tax incentives for emigration, workers who are expatriated in a foreign country by their European‐based employer and who kept in France their fiscal domicile, particularly their home, may benefit from an exoneration of French income tax for their wages if they are subject to a significant taxation in the country of expatriation. In several valorized activities, the condition for the exoneration of wages is a sufficiently long expatriation period. Also, bonuses and premiums paid in consideration for the expatriation may not be taxed in France59.
In order to limit double taxation resulting from the worldwide taxation of income of citizens and residents of the U.S., certain U.S. citizens and residents having a tax home in a foreign country may exclude from their gross income an amount up to $80.000 (adjusted) of foreign earned income. A housing cost amount is also excluded60. In practice, this provision allows most of Americans living abroad to pay little in taxes in the U.S61. The United‐States also provides a foreign tax credit mechanism allowing U.S. citizens resident in foreign countries to credit foreign taxes paid on income over the excluded amount62. 59 FTC, article 81A. 60 I.R.C. §911. 61 Reuven S. Avi‐Yonah, International Tax as International Law, 2007. 62 I.R.C. §901(b)(1).
3 – Change of residence may not permit the avoidance of inheritance and gift taxes. Domestic tax laws could use different connecting factor for inheritance and gift taxes instead of the factors used for income tax purposes in order to extend the scope of their worldwide tax liability63.
In France, the inheritance and gift taxes are based on worldwide assets of the deceased or donor if he has his fiscal domicile in France. If the fiscal domicile is in a foreign country, the tax is based on assets located in France. However, the tax is also based on worldwide assets received by recipients who have their fiscal domicile in France at the time of the inheritance or gift and for at least six of the ten years preceding it64.
In the U.S. the estate and gift taxes are based on worldwide assets if the domicile of the deceased or donor, which is where he lives, for even a brief period of time, with no definite intention of moving therefrom65, is in the United‐States. This
concept clearly differs from the concept of residence. Also, the estate tax is imposed on worldwide assets of every decedent who is a U.S. citizen66.
B – Measures taken by the states against tax avoidance
through a change of residence
Changing residence can be motivated by tax avoidance. Countries tend to struggle against these behaviors by enacting mechanisms67 that reduce the tax
benefits when they are considered undeserved. These anti‐avoidance mechanisms are not always expressly directed against a change of residence: this may create problems for their detection. 63 Frans Sonneveldt, Application of Death Taxes in the Emigration and the Immigration Countries, 56th IFA congress, 2002. 64 FTC, article 750ter. 65 U.S. Treasury Regulation §25.2501‐1(b). 66 I.R.C. §§2001 and 2031. 67 Dennis Weber, Tax Avoidance and the EC treaty Freedoms, p.112, Kluwer International, 2005.
For instance, individuals having kept the disposal of houses in France may be subject to income tax on an estimated base of three times their rental value if it is higher than their gross income from French source. This provision would apply if their residence is in a country that do not have a tax treaty with France and if they are subject to an effective taxation in this country not higher than 2/3 than that of France68. The article “limitation on benefit” of the U.S. model of tax treaty describes many situations where benefits are considered undeserved, since a treaty shopping may motivate a change of residence. For example, benefits from the tax treaty are largely reduced for public companies if they have neither their shares traded on a recognized stock exchanges, nor their primary place of management, located in the state of residence69.
Conclusion
Changing residence does entail many types of tax consequences at every step of its process. In order to avoid tax traps or uncomfortable situations, tax consequences of any change of residence should be investigated as early as possible.
68 FTC, article 164 C.
