By CREATIVE PLANNING
March 03, 2022
Transfer Tax Situs Rules, Tax Treaties, and Foreign Tax Credits
Tax Planning Strategies: Cross-Border Pitfalls and Considerations
The transfer tax implications for the expat’s (or non-U.S. person’s) property will depend upon the interplay of:
- The nature or character of the assets;
- The assets’ physical locations;
- The applicability of an estate tax treaty between the U.S. and the country of residence, domicile and/or citizenship;
- The availability of tax credits in the relevant jurisdictions where overlapping taxes are levied.
Understanding the Role of Situs in International Transfer Taxation
What is “Situs”?
Situs is Latin for “position” or “site.” In the law, it is a term that refers to the location of the property for legal purposes.
While U.S. citizens and residents are subject to federal estate tax on worldwide assets, the nonresident alien’s estate is subject to federal estate tax only on U.S. situs assets, consequently “situs” has an important role to play in estate planning for many cross-border families.
Situs generally: The general situs rule is that tangible assets physically located in the U.S. are subject to federal estate tax, but the situs rules for intangible property are somewhat involved and complicated. For instance, an asset can be non-U.S. situs for gift tax purposes but U.S. situs for estate tax purposes. Here are the general situs guidelines for nonresident aliens and their U.S. estate tax exposure:
- Real Property – Land, structures, fixtures, and renovations/improvements located in U.S. are U.S. situs.
- Tangible Personal Property – property physically inside the U.S. is U.S. situs. This includes physical dollars or other currency.
- Intangible Personal Property – U.S. situs will depend on the character of the investment:
- Business Investment Funds – funds used in conjunction with a U.S. trade or business and held in bank or brokerage (including domestic branches of foreign banks), are U.S. situs.
- Personal Investment Funds, including:
- Checking or Savings – demand deposits in U.S. banks are non-U.S. situs, while money market funds or cash in a brokerage account are U.S. situs.
- Qualified Retirement Plans – if funded through U.S. employment are U.S. situs.
- Stock – if issued by a U.S. corporation, are U.S. situs, even if stock certificates are held abroad. (Stock/ADRs in non-U.S. corporations are non-U.S. situs assets, even if purchased and/or held in the U.S.)
- Bonds – The U.S. passed a law in 1989 that created a “portfolio exemption” for publicly traded bonds, including treasuries, so they will not be considered U.S. situs. Privately offered debt instruments issued by U.S. organizations may still be considered U.S. situs.
- Life Insurance and Annuities – if issued by a U.S. licensed insurance company will be considered U.S. situs assets. (Policies issued by foreign-licensed insurance companies abroad will not be U.S. situs assets.)
- Annuities – if issued by a U.S. licensed insurance company will be considered U.S. situs assets (Policies issued by foreign-licensed insurance companies abroad will not be U.S. situs assets).
The U.S. situs rules are particularly instructive for expat families that include non-U.S. persons (e.g., an American abroad married to a foreign spouse), or to non-U.S. persons with investments in the United States. Moreover, while each sovereign has their own rules and interpretations of situs rules, the U.S. regime can be somewhat instructive for other countries’ situs rules. While a country-by-country discussion of the situs rules is beyond the scope of this article, many jurisdictions employ situs rules similar to the U.S.
The Interplay of Tax Treaties and Foreign Tax Credits on Cross-Border Estates
Currently, the United States has estate and/or gift tax treaties with fifteen other countries. As of 2022 the United States has Estate & Gift Tax Treaties: Australia, Austria, Denmark, France, Germany, Japan, and the United Kingdom and Estate Tax (only) Treaties: Canada, Finland, Greece, Ireland, Italy, the Netherlands, South Africa, and Switzerland. These treaties serve several important roles in determining the transfer tax consequences of assets held within the cross-border estate and may provide a meaningful reduction in the estate taxes by mitigating double taxation and discriminatory tax treatment while allowing for reciprocal administration.
The treaty will control which treaty country can assess transfer taxes by either:
- Determining which country is the decedent/donor’s domicile for transfer tax purposes.
- Determining in which country the property is deemed to be located.
Certain estate tax treaties relieve some of the burden that occurs when a surviving spouse is a nonresident upon the death of the U.S. spouse by increasing the marital deduction for nonresident spouses. Moreover, where both countries have a claim and assess taxes, a tax credit regime may operate to eliminate or at least reduce double taxation.
These treaties among the pertinent jurisdictions will alter the path of estate planning. The estate planning team must evaluate the interplay of the relevant transfer tax regimes and the pertinent treaty to determine the transfer tax outcome in consideration of not only the nature of the property and its location, but also the impact of citizenship and domicile on net tax outcomes. It is extremely important to remember that the filer must specify any specific benefit under the treaty that is being claimed in the actual tax filings; otherwise, the presumed benefit is lost.
Importantly the United States does not, unlike in the Income Tax Treaties, make any special claims to negate the treaty based on the citizenship of the decedent or heir.
Estate tax treaty “tiebreakers” and the new/old situs rules: Another key effect of tax treaties is that they establish tiebreaker rules. How those tiebreaker rules operate will depend on whether the treaty follows the newer or the older situs rules in U.S. estate tax treaties.
Generally, more recently ratified U.S. estate tax treaties follow the “new” rules based upon a domicile-based approach. These are the treaties between the United States and Austria, Denmark, France, Germany, the Netherlands, and the United Kingdom. The treaty rules establish taxation priority by first determining which jurisdiction was the domicile of the decedent. The domiciliary country may tax all transfers of property within the entire estate, while the non-domiciliary country may only tax real property and business property with situs in that country. The domiciliary country will then provide foreign transfer tax credits for taxes paid to the non-domiciliary country.
The older treaties (Australia, Finland, Greece, Ireland, Italy, Japan, South Africa, and Switzerland) follow the more elaborate nature/character situs rules described above for nonresident alien property in the United States. Conversely, the situs rules of the foreign jurisdiction will apply to that portion of the U.S. person’s estate that is deemed to have situs in that foreign jurisdiction. These treaties are far from uniform, and some treaties eliminate double taxation better than others. Generally, these older treaties provide for primary and secondary credits to be applied to reduce double taxation: the non-situs country (where the property is not located) will grant a credit against the amount of tax imposed by the country where the property is located. Countries may provide secondary credits where both countries impose tax because of their individual situs laws determine that the property has situs in both, or even in neither, country. These treaties are far from uniform, and some treaties work better at eliminating double taxation than others.
Foreign tax credits in the absence of an estate tax treaty:
In the absence of a treaty (the majority of jurisdictions), the potential for double taxation increases, but foreign transfer tax credits may still provide some relief from double taxation. The availability of a U.S. foreign tax credit will hinge upon:
- Whether the property is situated in the foreign country;
- Whether the property is subjected to transfer/death taxes; and
- Whether the property is properly included in the gross estate.
See 26 U.S. Code § 2014 (Credit for foreign death taxes).
There is also the potential that a foreign transfer tax credit could be unavailable because of a Presidential proclamation based on the foreign country’s failure to provide a reciprocal tax credit to U.S. citizens.
