A Deep Dive Into U.S. Estate and Gift Tax Treaties | SF Tax Counsel (2024)

06Jan 2021 by Pat Geddie

In the individual foreign investor setting, inbound tax planning often requires a balancing of U.S. income tax considerations and U.S. federal gift and estate tax considerations. While U.S. federal income tax rates on the taxable income of an individual foreign investor are the same as those applicable to a U.S. citizen or resident, the federal estate and gift tax as applied to individual foreign investors can and often results in a dramatically higher burden on a taxable U.S. estate or donative transfer of a foreign investor than for a U.S. citizen or domiciliary. As a result, for many individual foreign investors, the most important U.S. tax consideration is the U.S. federal estate and gift taxation.

The United States imposes estate and gift taxes on certain transfers of U.S. situs property by “nonresident citizens of the United States.” In other words, individual foreign investors may be subject to the U.S. estate and gift tax on their investments in the United States. The U.S. estate and gift tax is assessed at a rate of 18 to 40 percent of the value of an estate or donative transfer. An individual foreign investor’s U.S. taxable estate or donative transfer is subject to the same estate tax rates and gift tax rates applicable to U.S. citizens or residents, but with a substantially lower unified credit. The current unified credit for individual foreign investors or nonresident aliens is equivalent to a $60,000 exemption, unless an applicable treaty allows a greater credit. U.S. citizens and resident individuals are provided with a far more generous unified credit from the estate and gift tax. U.S. citizens and resident individuals are permitted a unified credit of $11,580,000 (for the 2020 calendar year).

For U.S. citizens and residents that may be subject to the estate and gift tax, there are a number of planning opportunities available to mitigate the harsh consequences of the tax. Probably the most common planning option to mitigate the estate and gift tax is the use of a marital deduction. A marital deduction allows an individual to transfer an unrestricted amount of assets to his or her spouse at any time, included at the death of the transferor, free from estate taxes. The rules regarding marital deductions are significantly different for nonresidents. Even if the decedent is a U.S. citizen, the current unlimited marital deduction for property passing to the spouse at death does not apply to property passing to a noncitizen spouse unless the property passes through a Qualified Domestic Trust (“QDOT”) device.

The consequence of a QDOT is that a tax is payable by the trust on distributions at the surviving spouse’s death, and on distributions of principal during the surviving spouse’s life (whether to the spouse or anyone else), calculated as if the distributed amount and any earlier amounts distributed from the QDOT had been added to the original decedent’s estate. If the trust ceases to qualify as a QDOT, the estate tax becomes due and payable. In contrast, for a U.S. citizen surviving spouse, the marital deduction totally defers the estate tax on the first decedent property passing to the surviving spouse until the death of the surviving spouse, and does not impose tax at all on such property to the extent that the surviving spouse spends it or otherwise disposes of its prior to death. The QDOT is a relatively poor equivalent of the marital deduction, but for taxable estates it may be the only alternative to immediate taxation where a favorable treaty does not apply.

Do all Foreign Investors Need to be Concerned About the U.S. Estate and Gift Tax?

Given the low threshold at which the estate and gift tax may be imposed, any foreigner investing in the U.S. must determine if they can be subject to the tax. In order for foreign investors to understand if they could be subject to the U.S. estate and gift tax, they must first understand the terminology and definitions associated with this extremely harsh tax. The most important concept which a foreign investor must understand for purposes of the estate and gift tax is “domicile.” A foreigner will not be taxed as a nonresident for purposes of the estate and gift tax if they are domiciled in the U.S. For U.S. estate and gift tax, the term “residency” means “domicile.” While the U.S. federal income tax concept of residency relates only to physical presence in a place for more than a transitory period of time, domicile relates to a permanent place of abode. For U.S. federal estate tax purposes a person can only have one place of domicile, while for U.S. federal income tax purposes there may be more than one place of residence.

While an alien may be classified as a (permanent) resident alien for immigration purposes and treated as a resident for U.S. federal tax purposes, these classifications are not determinative of the alien’s domicile for U.S. federal estate and gift tax purposes. Although the definition of residency for income tax purposes has been made substantially objective, the concept of domicile still is extremely subjective, focusing on the intentions of the alien as manifested through certain lifestyle-related facts.

The estate and gift tax regulations offer a general indication of the definition of domicile, stating that:

Utilizing Treaties to Eliminate or Reduce the Foreign Investor’s Exposure to the U.S. Estate Tax

Once it is determined that the foreign investor will be treated as a nonresident for purposes of the U.S. estate and gift tax, the foreign investor must plan to mitigate or avoid the tax. There are a number of options available through the use of trusts and multi-tiered entities. In some cases, the use of trusts or multi-tiered entities are not necessary. Instead, depending on the residence of the foreign investor, he or she may utilize an estate and gift tax treaty to eliminate or reduce his or her exposure to the U.S. estate and gift tax. The United States has estate tax treaties with Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, Netherland, Norway, South Africa, Switzerland, and the United Kingdom. The United States has gift tax treaties (some of which are combined with the estate tax treaty) only with Australia, Austria, Denmark, France, Germany, Japan, and the United Kingdom. The United States had an estate tax treaty with Canada. Although the U.S.-Canada estate tax treaty ceased to have effect with respect to estates of persons dying on or after January 1, 1985, a protocol in the U.S.-Canadian bilateral income tax treaty has far reaching effects upon Canadian individuals owning U.S. situs assets for U.S. estate tax purposes. The treaty provisions contained in these treaties prevail if there is a conflict with any estate or gift tax provision of the Internal Revenue Code. See IRC Section 7852(d).

These treaties generally permit nonresident aliens far more generous unified credits or exemptions against U.S. estate taxes. In some cases, estate and gift tax treaties permit nonresident aliens the ability to plan for the estate and gift tax by claiming a marital credit. The problem is the treaty network of estate and gift taxes is limited in comparison to the number of income tax treaties which the U.S. presently has in force. As a result, not all foreign investors may be able to utilize estate and gift tax treaties to reduce their exposure to the U.S. estate and gift tax.

Below, this article will discuss provisions of some treaties and how these treaty provisions can provide nonresident aliens with significant tax savings. This article will focus on provisions in treaties the United States has with Denmark, the United Kingdom, Germany, Canada, and France.

Treaties and the Marital Deduction

As discussed above, the estates of nonresident aliens are generally not entitled to a marital deduction for U.S. estate tax purposes other than for property passing to a QDOT or when a surviving spouse is a U.S. citizen. With that said, certain treaties include particular terms that a skillful international tax professional can utilize to a foreign investor’s advantage to mimic a marital deduction in some cases. As a result, significant planning possibilities exist for individuals whose estate is projected to be eligible for related benefits under a marital deduction clause of a treaty.

The United States Estate, Gift, and Generation Skipping Tax Treaties with Denmark and the United Kingdom

Denmark and the United Kingdom’s estate and gift tax treaties with the United States provide for an unlimited marital deduction which would have been eligible for such a deduction had the decedent been domiciled in the U.S. at his death. Under these treaties, foreign investors domiciled in Denmark or the United Kingdom can claim a valuable marital deduction for purposes of U.S. estate or gift taxes as if they were U.S. citizens. This offers a significant planning opportunity for mitigating the consequences of the U.S. estate and gift tax. The United States-United Kingdom estate, gift, and generation skipping tax treaty goes one step further and increases the unified credit from $60,000 to $11,586,000, (in 2020) for individuals domiciled in the United Kingdom to the same amount as a U.S. citizen or resident. Article (5) of the United States United Kingdom estate, gift, and generation skipping tax treaty states as follows:

Where property may be taxed in the United States on the death of a United Kingdom National who was neither domiciled in nor a national of the United States and a claim is made under this paragraph, the tax imposed in the United States shall be limited to the amount of tax which would have been imposed had the decedent become domiciled in the United States immediately before his death, on the property which would in that event have been taxable.

The related U.S. Treasury Technical Explanation for this provision states as follows:

[Article 8] Paragraph(5) provides that U.S. tax imposed on the estate of anational of the United Kingdom, who was neither domiciled in nor a
national of the United States, will be greater than the tax which would
Have been imposed if the decedent had been domiciled in the United
States and taxed by the United States on his worldwide property,

Paragraph (5) does not require a formal election; the appropriate Information need only be included in an estate tax return, which is filed or amended within the applicable time period.

This provision is potentially beneficial to the estates of many foreign investors from the United Kingdom. This treaty provision may exempt most if not all U.S. situs assets from the U.S. estate and gift tax as long as the worldwide assets of the investor does not exceed the applicable unified credit ($11,580,000 for 2020).

United States-German Estate Treaty

Not all treaties are as simple and generous as the United States’ treaties with Denmark and the United Kingdom. This is demonstrated by the U.S.-German estate tax treaty. Under the U.S.-German estate tax treaty, interspousal transfers are excluded from a qualifying decedent’s gross estate for U.S. estate tax purposes to the extent that their value does not exceed 50 percent of the value of all property included in the U.S. taxable base. This marital deduction is limited to the amount that would reduce the U.S. estate tax due to what would apply to U.S. citizens or resident aliens. Under the wording of the United States-German estate treaty, the estate would then be subject to U.S. tax in the lower amount of a) the figure determined using the marital deduction; or b) that generally imposed upon nonresident aliens under U.S. law. In general, the treaty provides the following benefits to foreign investors that are residents of Germany:

2. An estate of a German domiciliary is entitled to a marital deduction equal to the value of any “qualified property” passing to the decedent’s surviving spouse so long as such amount would qualify for the U.S. estate marital deduction if the surviving spouse were a U.S. citizen and all applicable elections were properly made, providing that: a) At the time of the decedent’s death, both the decedent and the surviving spouse were domiciled in either the U.S. or Germany; b) If the decedent and the surviving spouse were at the time both U.S. domiciliaries and one or both of them were German citizens; and c) The executor of the decedent’s estate elects to use the marital deduction treaty benefits and irrevocably waives the right to make a QDOT election on behalf of the estate.

To illustrate how the pro rata unified credit and the marital deduction are applied, the Treasury Department has provided a number of examples in the Treasury Department’s Technical Explanation to the protocol governing estate tax in the United States-German treaty illustrates the operation of the pro rata unified credit and marital deduction. The examples provided by the Treasury Department state as follows: for purposes of these examples, presume that: 1) H (the decedent) and W (his surviving spouse) are German citizen residents in Germany at the time of the decedent’s death; 2) H died in 2016, when the Section 2010 unified credit was $2,125,800 and the related applicable exclusion amount was $5,450,000; 3) the conditions set forth in the Protocol are satisfied; 4) no deductions are available under the Internal Revenue Code in comparing the U.S. estate tax liability.

Example 1.

(i) H has U.S. real property worth $10,000,000, all of which he bequeaths to W. The remainder of H’s estate consists of $10,000,000 of German situs property.

(ii) Pursuant to the existing marital deduction provision of the Germany Treaty [Article 10(4), as modified by the Germany Protocol], the U.S. gross estate equals $5,000,000 [the amount by which the $10,000,000 of U.S. real estate bequeathed to W exceeds $5,000,000 (50 percent of the total value of U.S. property taxable by the United States under the Germany Treaty)]. H’s worldwide gross estate equals $15,000,000 ($5,000,000 plus $10,000,000 of German situs property).

(iii) The $5,000,000 U.S. gross estate is reduced by the $2,500,000 marital deduction of Germany Treaty Article 10(6), resulting in a $2,500,00 U.S. taxable estate. The tentative tax on the taxable estate equals $945,800. H’s estate would also be entitled to the pro rata unified credit allowed by Germany Treaty Article 10(5) of $708,600 [$2,125,800 (the full 2016 unified credit) x $5,000,000/$15,000,000 (the $5,000,000 U.S. gross estate divided by the $15,000,000 worldwide gross estate)]. Thus, the total U.S. estate liability is approximately $237,200 ($945,800 – $708,600 = $237,200).

Example 2.

(i) The facts are the same as in Example 1 except that H bequests $1,000,000 of his real property to W and $9,000,000 of his real property to C, H’s child.

(ii) The $9,000,000 of U.S. real property bequeathed to C is included in H’s U.S. gross estate. Pursuant to the U.S.-Germany Treaty Article 10(4), none of the U.S. real property bequeathed to W is included in the gross estate because such property would be included only to the extent its value (i.e., $1,000,000) exceeded 50 percent of the $10,000,000 total U.S. situs property taxable under the applicable provisions of the Germany Treaty. H’s worldwide gross estate equals $19,000,000 ($9,000,000 plus $10,000,000 of German situs property).

(iii) Because none of the U.S. situs property bequeathed to W is included in the U.S. gross estate, the property is not “qualifying property,” and therefore no marital deduction is allowed with respect to that property under Germany Tax Treaty Article 10(6). The tentative tax on the $9,000,000 gross estate equals $3,545,800. H’s estate would also be entitled to the pro rata unified credit allowed by Germany Treaty Article 10(5), which equals approximately [$2,125,800 (the full 2016 unified credit), multiplied by a fraction equal to the $9,000,000 U.S. gross estate over the $19,000,000 worldwide gross estate. Thus, the total U.S. estate tax liability is $2,538,843 ($3,545,800- $1,006,957).

Although not as generous as the U.S. treaties with Denmark and the United Kingdom, the US-German estate tax treaty significantly increases the unified credit for foreign investors domiciled in Germany. The treaty also establishes a partial marital credit that is unavailable to individual foreign investors domiciled in many other countries. However, in order to claim the unified credit and/or partial marital credit, upon the death of the foreign investor domiciled in Germany, a Form 706-NA Form 8833 will need to be filed with the Internal Revenue Service (“IRS”). In order to determine the unified credit and/or marital credit, the decedent’s estate needs to disclose to the IRS the decedent’s worldwide assets and U.S. assets at the date of the decedent’s death. An allocation will need to be made between the decedent’s worldwide assets and U.S. assets to determine the decedent’s unified credit and/or marital credit.

The United States-Canadian Income Tax Treaty

On November 9, 1995, the 1995 Canada Protocol was enacted. This protocol greatly impacts U.S. estate tax planning for Candians investing in the United States. Certain Canadian investors are able to enjoy an estate tax marital deduction and own a greater number of U.S. assets directly without incurring U.S. estate taxes. These Canada Protocol provisions may be summarized through the following points and illustrations:

Point 1. Canadian residents are not subject to U.S. estate tax unless their gross worldwide estate exceeds $10 million (for 2018 calendar year). Below, please see Illustration 1. Which demonstrates Point 1.

Illustration 1.

Justine Lieber owns a vacation home in Florida with a value of $5,000,000, unencumbered by a mortgage. His other worldwide assets amount to U.S. $5,000,000. There will be no U.S. estate tax whether or not Justine Lieber is survived by his spouse.

Point 2. A Canadian citizen who passes away owning U.S. assets is entitled to a credit against his U.S. estate tax liability in an amount equal to that proportion of the U.S. unified credit as his U.S. situated estate bears to his worldwide estate. Below, please see Illustration 2. which demonstrates Point 2.

Illustration 2.

Bryan Bosling, a Canadian resident, owns vacation homes in California and Hawaii with a value of $10,900,000, unencumbered by mortgage, and Canadian property valued at $10,900,000. If Bryan Bosling died, his estate, for U.S. estate tax purposes would be entitled to a credit of U.S. $4,417,800 [the U.S. $4,417,800 (for proration of unified credit for 2018) “unified credit” x [(U.S. assets)/(Worldwide assets) ($10,900,000 + $10,900,000 = $21,800,000]. U.S. Worldwide Assets x $4,417,800 unified credit (2018) = $96,308 Bryan Bosling’s estate tax will be U.S. $96,308 unless Bryan Bosling is married and makes a qualifying transfer to a Qualified Trust. Instead of relying on the rule that allows a deduction for bequests by a Canadian resident to a non-U.S. citizen spouse provided assets are timely transferred to a QDOT, the U.S. will allow an election to be made for an additional nonrefundable marital credit up to the amount of the proportionate credit. The purpose of this limited marital credit was to alleviate, in appropriate cases, the impact of the estate tax marital deduction restrictions enacted by the Congress in the Technical and Miscellaneous Act of 1988 (“TAMRA”). The U.S. negotiators believed that it was appropriate, in the context of the Canada Protocol, to ease the impact of those TAMRA provisions upon certain estates of limited value.

Below, please find Illustration 3, which demonstrates the marital deduction under the U.S.-Canada treaty.

Illustration 3.

The facts are the same as in Illustration 3. Bryan Bosling leaves the U.S. residence to his Canadian spouse. The additional marital deduction “credit” equal to the $10 million “unified credit” will eliminate the $96,38 liability otherwise due, but any excess marital deduction credit does not result in a refund.

Like with the United States-German treaty, utilizing the United States-Canadian tax treaty may also require the decedent’s estate to file an estate tax return and Form 8833 with the IRS. The decedent’s estate may also need to make an allocation between the decedent’s worldwide assets and U.S. assets to claim a unified credit and marital credit. The examples discussed above demonstrate the complexities of compliance requirements.

The United States-France Estate, Gift, and Generation Skipping Tax Treaty

The France Protocol, which entered into force on December 21, 2006, gives French individuals partial marital deduction and U.S. unified credit entitlements similar to those discussed above in the United States-Germany estate, gift, and generation skipping treaty.

Conclusion

Individual foreign investors investing in the United States should understand that his domicile and/or citizenship will have an impact on his or her exposure to U.S. estate and gift taxes. If an individual foreign investor resides in the United States or in a treaty country at the time he or she dies or makes a gift, a treaty may be available to substantially affect the ultimate taxation thereof. With that said, individual foreign investors and spouses of foreign investors must understand that treaty applications are not automatic. Once a nonresident dies owning U.S. situs property, depending on the value of the U.S. situs property, the estate of the nonresident investor may need to file a IRS Form 706-NA entitled “United States Estate (and Generation-Skipping Transfer) Tax Return” and IRS Form 8833 “Treaty-Based Position Disclosure Under Section 6114 and 7701(b).” Foreign investors that may be classified as nonresidents should also consider planning for the U.S. estate and gift tax by contacting a professional tax advisor who is well versed in international taxation. A properly skilled tax advisor can determine the potentially eligible for a marital deduction “credit.” A tax advisor can also put together a comprehensive plan to ensure a foreign investor’s U.S. situs and other assets are titled in a manner that will provide them with the lowest exposure to global tax liabilities.