Introduction
One issue that comes up quite frequently from Australian nationals in the U.S. is the fear that the U.S. will tax capital gains from the sale of their home in Australia. As most people know, the U.S. inherits the taxability of built-in gains in worldwide assets upon becoming a U.S. tax resident.
Without pre-immigration tax planning, by default, it’s taxable; however, the treaty changes the answer. Under the treaty, it’s effectively exempt.
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Background
Unlike the U.S. that has a limited capital gain of only $250,000 for a single filer or $500,000 for a married filer under Section 121, Australia has an unlimited capital gain exclusion for the sale of a primary residence. Coupled with a red hot real estate market in Sydney where home values have tripled, this has resulted in situations where even the $500,000 USD exclusion is insufficient to cover the total amount of capital gain.
Thankfully, Article 13(5) of the U.S.-Australia Income Tax Treaty provides relief.
Treaties and Federal Laws
The Internal Revenue Code (herein the “Code”) states that “neither the treaty nor the law shall have preferential status by reason of its being a treaty or law.”[1] As the United States Court of Appeals for the D.C. Circuit has explained, Congress intended to codify the so-called “later-in-time” principle when it enacted Code section 7852(d)(1), which focuses on timing to find which controls regardless of whether there is a conflict.[2] Thus, it’s not the character that controls; it’s the timing.
The D.C. Circuit’s position of an Absolute “Later-in-Time” Rule even in the absence of a conflict or express intent to supersede has led some to believe that it is inconsistent with international law, which generally requires a conflict or clear intent to supersede a treaty.[3] However, although international law generally requires a conflict or intent to supersede, these commentators fail to comprehend another principle of international law: a treaty cannot supersede a nation’s constitution.[4] Pursuant to the Supremacy Clause of the U.S. Constitution, federal laws passed by Congress and treaties ratified by the Senate have equal weight and authority.[5]
In other words, if one views a treaty just like any other law passed by Congress and signed into law by the President, it becomes clear that a future law will only supersede a prior law to the extent that it is more specific than the previous or cannot be reconciled with the prior law.
The Genesis of Article 13, Paragraph 5
In 1983, the United States and Australia concluded U.S.-Australia Income Tax Treaty. It was ratified by the United States Senate and signed into law by President Ronald Reagan. Article 13 only had 4 paragraphs.
In 2001, the United States and Australia concluded “Protocol Amending the Convention Between the Government of the United States of America and the Government of Australia for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income” (herein the “2001 Protocol”). It was ratified by the United States Senate and signed into law by President George W. Bush. The 2001 Protocol added Paragraph 5 to Article 13. Article 13, Paragraph 5, of the U.S.-Australia Income Tax Treaty states “an individual… upon ceasing to be a resident of one of the Contracting States… may elect to be treated for the purposes of taxation in the other Contracting State as if the individual had, immediately before ceasing to be a resident of the first-mentioned State, alienated and re-acquired the property for an amount equal to its fair market value at that time.”[6]
In applying the “later-in-time” rule, protocols (i.e., amendments) to an income tax treaty are effectively disregarded since they relate-back to the original enactment; therefore, only the original effective date of the treaty is relevant, so a proper legal analysis would disregard the protocol ratification date.[7]
U.S.Tax Treatment of the Article 13(5) Election
The Technical Explanations (akin to Treasury regulations) to the U.S.-Australia Income Tax Treaty explain that “[p]aragraph (5) permits an individual who changes residence from Australia to the United States to elect to be treated for U.S. tax purposes as if he had, immediately before ceasing to be a resident of Australia, sold property and reacquired it for an amount equal to its fair market value… Second, the ‘deemed sale and repurchase’ will result in the individual (now a U.S. resident) having a ‘stepped up’ basis equal to fair market value in all assets subject to the deemed sale and repurchase, regardless of whether any U.S. tax was triggered by the deemed sale.”[8] There is no requirement that the election be made in the year of the change in residency. However, it is clear the election can be made only once. If the election is made in a year in which the individual is a U.S. tax resident, gain is calculated “as if” the sale took place “immediately before ceasing to be a resident of Australia,” which will be prior to the individual having established U.S. tax residency.[9] Capital gain is sourced to the country of residence.[10] Therefore, if the election is made in a subsequent year after the change in residency, it triggers no U.S. taxation, which was foreseen in the Technical Explanation that said the deemed sale would be recognized “regardless of whether any U.S. tax was triggered by the deemed sale.”[11] However, if the asset for which the election is being made has already been reported, it must be reported as sold without any resulting capital gain.[12]
As stated in the Technical Explanations, the election applies strictly for “U.S. tax purposes.”[13] Therefore, the election requires no consistency reporting to the Australian Tax Office since it exclusively applies strictly only for U.S. tax purposes.
Proper Treaty Disclosure Method for U.S.Tax Purposes
Code section 6114 requires any person relying on a tax treaty to disclose such position on his or her federal income tax return unless an exception applies.[14] IRS Form 8833 is used to make a disclosure regarding a treaty-based return position.[15] A separate form is required for each treaty-based return position taken by the taxpayer. If the treaty position results in no taxation whatsoever, then IRS Form 8833 must be filed along with a federal income tax return that only includes the taxpayer’s name, address, taxpayer identification number, and signature under the penalty of perjury. This effectively creates a de facto treaty election procedure.
If a taxpayer “fails in a material way to disclose one or more” treaty-based return positions, then a penalty is imposed on each separate payment of income or article of income even if “received from the same” payor.[16] For individuals, there is a $1,000 penalty for each non-disclosure.[17]
There are several items for which reporting is specifically waived.[18]
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[1] See IRC § 7852(d).
[2] See Kappus v. C.I.R., 337 F.3d 1053, 1057 (D.C. Cir. 2003) (citing S. Rep. No. 100-445, at 316-28 (1988).
[3] See Whitney v. Robertson, 124 U.S. 190 (1888); The Chinese Exclusion Cases, 130 U.S. 581 (1889); The Cherokee Tobacco, 78 U.S. 616 (1871); Diggs v. Schultz, 470 F.2d 461 (D.C. Cir. 1972); also see Restatement (Third) of Foreign Relations Law of the United States, § 115(1)(a) (“An act of Congress supersedes an earlier… international agreement as law of the United States if the purpose of the act to supersede the [treaty] is clear or… cannot be fairly reconciled [due to a conflict].”).
[4] See Restatement (Third) of Foreign Relations Law of the United States, § 115(3).
[5] See Ware v. Hylton, 3 U.S. 199 (1796) (because a treaty is the equivalent of a law passed by Congress, a state law conflicting with the treaty was nullified by the U.S. Supreme Court). Although treaty protocols relate-back to the original adoption of the treaty, regulations do not relate-back to the original adoption of the statute, so it’s not possible for treasury to promulgate regulations inconsistent with treaty obligations.
[6] U.S.-Australia Income Tax Treaty, Art. 13, ¶ 5.
[7] See Kappus v. C.I.R., 337 F.3d 1053, 1057 (D.C. Cir. 2003).
[8] Technical Explanation of the U.S.-Australia Income Tax Treaty, Art. 13, ¶ 5.
[9] Id.
[10] See IRC § 865(h), (i)(5)
[11] Technical Explanation of the U.S.-Australia Income Tax Treaty, Art. 13, ¶ 5.
[12] See Dover Corp. & Subsidiaries v. C.I.R., 122 T.C. 324 (2004) (court concluded that pre-residency sales are recognized for U.S. tax purposes giving rise to “check-and-sell” and “check-and-liquidate” tax planning strategies).
[13] Technical Explanation of the U.S.-Australia Income Tax Treaty, Art. 13, ¶ 5.
[14] See IRC § 6114.
[15] See Treas. Reg. § 301.7701(b)-7.
[16] See Treas. Reg. § 301.6712-1(a).
[17] See Treas. Reg. § 301.6114-1(a)(1)(ii).
[18] See Treas. Reg. § 301.6114-1(c)(1)-(8).