August 1996

International Provisions

Small Business Job Protection Act of 1996

Foreign Excess Passive Assets

The Act repeals the 1993 Budget Reconciliation Act’s inclusion for earnings invested in "excess" passive assets of a controlled foreign corporation (CFC).

Effective date: The provision is effective for taxable years of CFCs beginning after 1996, and taxable years of their U.S. shareholders with which or within which the taxable years of those CFCs end.

UBIT on Foreign Captive Insurance Income

The Act imposes the unrelated business income tax on income deemed to be received by tax-exempt organizations from insurance-related activities conducted by their foreign subsidiaries. This rule does not apply to income from insuring:

• The risks of the tax-exempt organization.
• The risks of tax-exempt affiliates.
• The risks of an officer, director, employee, or non-employee, provided the insurance covers primarily risks associated with the individual’s performance of services connected with the tax-exempt organization or an affiliate.

Unrelated tax-exempt hospitals, universities, or university medical centers that jointly form a captive will be treated as affiliates for purposes of these rules.

Effective date: The provision applies to amounts includible in gross income in taxable years beginning after 1995.

Repeal of Puerto Rico and Possession Tax Credit

The Act generally repeals the Puerto Rico and Possession Tax Credit for taxable years after 1995. U.S. corporations who have not made an election for taxable years that include October 13, 1995, or those that add a substantial new line of business to their existing possession operations, will not be allowed to elect to claim this credit.

The Act does provide, however, a set of rules for companies currently qualifying for this credit. Companies who now use either the wage credit method or the income credit method in determining their allowable credit generally will continue to do so, subject to a limit on the amount of business income eligible for the credit (this limit is not applicable to those companies operating in possessions other than Puerto Rico), until the first taxable year beginning in 2006.

Also, the credit will no longer apply to the U.S. tax on qualified possession source investment income earned after June 30, 1996. Thereafter, it will only apply to the U.S. tax on business income earned in a possession.

Effective date: The provision is effective for taxable years beginning after 1995.

Foreign Trust Modifications

• New Rules Applicable to Inbound Grantor Trusts: The Act eliminates the ability of U.S. trust beneficiaries to avoid U.S. tax on distributions from a trust by treating a foreign grantor as the owner of the trust under U.S. grantor trust rules, even though no tax may be imposed on the trust income by any foreign jurisdiction. Under the Act, the grantor trust rules generally apply only to the extent that they result in amounts that currently are included in computing the income of a U.S. person. This rule does not apply to revocable trusts, trusts that can make distributions solely to the grantor or the grantor’s spouse during the lifetime of the grantor, or grantors that are CFCs. Also, this rule does not apply to gifts made by a U.S. beneficiary of the trust (except for those made by a family member of the beneficiary) to the foreign grantor.

Effective date: The provision is effective on the date of enactment.

• New Rules Applicable to Outbound Grantor Trusts: Under the Act, a nonresident alien who transfers property to a foreign trust and then becomes a U.S. resident within five years after the transfer will be treated as if that transfer (along with any undistributed earnings attributable to that property) to the foreign trust was made on the date his U.S. residency begins. As a result, the resident alien may be subject to a 35% excise tax for transferring appreciated property, if any, to a foreign trust. Similarly, when a U.S. grantor trust becomes a foreign trust before the U.S. grantor dies, then that grantor under the Act is treated as having made a transfer of the property he had previously contributed to the trust (along with any undistributed earnings attributable to that property) and may be subject to the same excise tax.

Effective date: The provision applies to transfers after Feb. 6, 1995.

• Other Foreign Trust Rules: For taxable years beginning after 1996, the trust will be a domestic trust if both a U.S. Court exercises primary supervision over the administration of the trust and one or more U.S. fiduciaries of the trust have authority to control substantial decisions of the trust. All other trusts will be treated as foreign trusts. The Act also provides several new reporting requirements related to foreign trusts.

The Health Coverage Availability
and Affordability Act of 1996

Taxation of Expatriates

Prior to the Act, individuals who relinquished U.S. citizenship with a principal purpose to avoid U.S. taxes were subject to special provisions for determining their U.S. tax liability within 10 years of their expatriation from the United States. For each of those 10 years, these expatriates are subject to additional U.S. taxes, if applicable, than the U.S. taxes generally imposed on nonresident aliens. In determining those additional U.S. taxes, special rules apply to expand the categories of income (including gains from the sale of certain property) and allow certain deductions that would not otherwise apply to nonresident aliens in determining their income subject to U.S. tax.

The Act retains but tightens the rules that existed before this legislation. The legislation extends the reach of the expatriation tax provisions by subjecting certain long-term residents who terminate their U.S. residency to these rules.

The Act also expands the scope of the principal purpose test. Certain U.S. citizens who relinquish their U.S. citizenship and certain long-term U.S. residents who relinquish their U.S. residency are presumed to have a tax avoidance motive if (1) their average U.S. income tax liability for the five years ending before they expatriate exceeds $100,000, or (2) their net worth as of their expatriation date is $500,000 or more. These amounts are to be adjusted in the future for inflation. Certain individuals who meet either of these thresholds may apply for a ruling from the Treasury within one year of expatriation demonstrating that they did not have a tax-avoidance motive. Expatriates who do not meet either of these thresholds are subject to existing law standards as to whether they have a tax-avoidance motive.

The Act also encompasses more types of personal property in which the income and gain from their disposition are treated as earned from U.S. sources. Thus, more income would be subject to U.S. tax under these expatriate rules. For example, generally, income from a foreign corporation as well as any gain from the disposition of its stock is treated as U.S. source income (to the extent of its earnings prior to the shareholder’s expatriation) if that shareholder owned more than 50% of that corporation’s stock within two years prior to expatriation.

The Act also provides that long-term residents who expatriate, unless they irrevocably elect otherwise, must use as their tax basis the fair-market-value of any property that they own on the date they became a U.S. resident to determine the amount of gain subject to the U.S. tax under these provisions if that property is sold within 10 years after they expatriate.

The Act provides a credit against the additional U.S. tax imposed under the expatriation tax provisions as modified for any foreign income, gift, estate, or similar taxes paid on any income or gain treated as from U.S. sources under these provisions. Congress intends that these expatriation tax provisions not be overridden by any applicable treaty provision. However, 10 years after the date of enactment, any conflicting treaty provision that remains in force will take precedence over the expatriation tax provisions.

Effective date: The provision is effective for losses of citizenship or terminations of residency that occur on or after Feb. 6, 1995. Expatriates who are eligible to apply for a ruling from the Treasury demonstrating they have no tax avoidance motive under the Act’s rules have 90 days following the date of enactment to do so.