It is quite common for high-net-worth individuals to have income streams from multiple countries. For example, an individual may have an ownership interest in a foreign (i.e., non-U.S.) company, be a beneficiary of a foreign trust, or receive gifts from non-US friends or family members. United States federal tax law imposes cumbersome reporting requirements on U.S. citizens and resident (US Person) recipients of such foreign income. For instance, a U.S. Person that receives distributions from foreign trusts or gifts in excess of $100,000 in the aggregate (not indexed for inflation) from foreign persons must report such distributions and gifts on Internal Revenue Service (IRS) Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts (Form 3520). These reporting requirements, among others, can significantly increase one’s cost of compliance with US federal tax law.
On May 8, 2024, the US Department of the Treasury and the IRS published proposed regulations (Proposed Regulations) (REG-124850-08) that would modify some reporting rules, potentially easing the burden for certain US taxpayers. Specifically, the Proposed Regulations may offer relief for individuals who are residents of both the United States and foreign country, but who qualify for a US tax exemption under an applicable income tax treaty (generally referred to as a “Tax Treaty”).
By way of background, most Tax Treaties include a set of “tie-breaker” rules in the context of determining a taxpayer’s residency, which becomes relevant where the taxpayer, under domestic law (e.g., in the case of the United States, US federal tax law), would be considered a resident of both countries. The treaty tie-breaker exception applies, and an individual who may otherwise be considered a U.S. tax resident will not be treated as such, where such person (i) is treated as a resident of another country under a Tax Treaty between the United States and that country, (ii) does not waive the benefits of such treaty applicable to residents of that country, and (iii) notifies the IRS of the commencement of such treatment.
If a resident alien is classified as a resident of a foreign country under a Tax Treaty tie-breaker provision, then such individual is treated as a nonresident alien of the United States for all purposes of the Internal Revenue Code of 1986, as amended (the “Code”) in calculating his or her U.S. income tax liability. He or she would consequently file IRS Form 1040-NR, U.S. Nonresident Alien Income Tax Return, and disclose the treaty position to the IRS on IRS Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b), by the due date of the person’s U.S. federal income tax return (including extensions).
Under current U.S. federal tax law, certain individuals who elect to be treated as residents of another country under a Tax Treaty will still be treated U.S. residents for purposes of the Code other than computing one’s income tax liability, including, but not limited to Form 3520 reporting obligations. The Proposed Regulations, however, may relieve such individuals from these reporting obligations. Specifically, the Proposed Regulations provide that individuals who qualify for a Tax Treaty tie-breaker exception would also be exempt from Form 3520 reporting (Prop. Reg. § 1.6039F-1(f)(1)). In addition, the Proposed Regulations would index the $100,000 reporting thresholding for inflation (Prop. Reg. § 1.6039F-1(c)(2)(i)(A)).
If the Proposed Regulations become final, certain alien individuals may be able to significantly reduce their cost of U.S. tax compliance, and US Persons would be able to enjoy more substantial gifts and bequests from non-U.S. family and friends without Form 3520 reporting obligations.
