FOCUS ON INDIA: CURRENT U.S. TAX POLICY WILL CHASE AWAY THE BEST AND THE BRIGHTEST

Heavily entrenched in our tax system is the view that wealth accumulation by any citizen or resident is U.S. based. This view fails to take into account the growing trend that new wealth accumulation will occur at an increasingly rapid rate, not in the U.S., but in Asia.

Faced with U.S. tax burden and erroneous reporting rules on foreign income and wealth that some consider unjustified, many wealthy U.S. citizens and residents of Asian origin are considering doing what a decade ago would have been unthinkable – giving up their green cards or citizenships as a wealth preservation strategy.  Unless the current U.S. tax system is reexamined, the country is in danger of losing some of its best and brightest.

U.S. citizens and residents must report and pay tax on worldwide income.  In addition, tax rules require disclosures of foreign bank accounts and ownership in foreign entities.  This past year we’ve been advising many clients from India who are, in U.S. tax terms, “off the grid”.   These individuals obtained their green cards and U.S. citizenships, some at birth, and have been working and living outside the U.S. for many years.  The scale of the problem is hard to know although the net worth of these noncompliant citizens and residents is in the many billions of dollars.  Merely omitting required disclosures can result in significant civil penalties and possible criminal prosecution under U.S. tax law.  Many offenders living abroad are U.S. citizens and green card holders with Indian origin.  They are corporate executives running large companies that have paid their full amount of Indian taxes.  How will the U.S. deal with these noncompliant “taxpayers?”  The answer is not hard to find.

In December 2010, IRS Commissioner, Doug Shulman, stated that cleaning up abuses and mounting a greater attack on tax evasion is the order of the day.  International tax evasion is the number one offense on the IRS’s top ten areas of tax evasion schemes. Another more recent example is the Department of Justice action.  They issued a summons on the Hong Kong and Shanghai Banking Corporation of India (HSBC India) that requires the bank to turn over information on U.S. residents and citizens who may be using its accounts to evade tax.  Information provided to the Department of Justice indicates that there are approximately 9,000 US persons with accounts in Indian in just this one bank.  After its win with obtaining information from the Swiss banks, the Department of Justice is focusing attention on Singapore, India and Hong Kong.  China may be next.

Background

In the 1970s, 80s and 90s India imposed severe restrictions on travel and on investment outside the subcontinent.  Students from India entered the best American universities, graduated in large numbers with engineering degrees, found jobs, obtained green cards and ultimately obtained their U.S. citizenship.  These engineers, to become entrepreneurs, played a major role in Silicon Valley’s boom.  U.S. citizenship was itself a treasured goal:  it was the escape hatch from restrictions imposed by India on its citizens.  U.S. citizenship also provided an evergreen ticket to sponsor family in India to immigrate to the U.S.  All was fine in the Valley as these “super immigrants” prospered like no other group in American history.  India’s businesses started to flourish in part due to the Silicon Valley training with many returning to India with a green card or a U.S. passport in their pocket.

In 1999, India abolished many restrictions on inbound investment, and the economy rapidly expanded.  Simultaneously, the internet fueled a tech boom in India, turning sleepy cities like Bangalore and Pune into major tech centers.  This fueled huge appreciation in real estate values that accelerated wealth accumulation and turned local businessmen into billionaires in a very short time. Mumbai is now the home of some of the most valuable real estate on the planet.


Today, families in India have joined the global superrich.  The Forbes 400 list of the world’s richest men and women include a growing number of Indian entrepreneurs.  Industries and real estate empires are in the process of being passed to the next two generations - but hold on!  The old family wealth was now being passed down to the sons and daughters and grandchildren that are American citizens.  The engineers from Stanford, MIT, Harvard and Berkeley have been returning home with MBAs in hand to start their own businesses.  India does not impose gift or estate taxes, so estate planning typically followed family traditions without any concern for gift or estate taxes. However, a growing number of these new moguls are U.S. citizens and green card holders, and this new wealth is now trapped inside the U.S. estate tax system with apparently no ability to exit without severe tax costs.  Today, the U.S. gift and estate tax is 35% on amounts in excess of $5 million, as of December 2010.   The problem regarding noncompliance is primarily due to:

1.   All or most of the wealth is in India, not the U.S.

2.   Families and advisors living in India are unfamiliar with U.S. tax rules and have been poorly advised.

3.   To get things back on track, as many wish to do, the penalties due to nonreporting in past years is enough to humble Warren Buffett. 

The U.S. system is unique in its global scope and penalty regime for nondisclosure of sometimes remote and hard-to-find information.  It is by far the most aggressive tax system on the globe when it comes to the reporting of investments outside the U.S.  Many of these wealthy Indians, having resettled back in India, are now being advised about the U.S. expatriation rules.

Procedures exist that allow U.S. citizens to expatriate which has the effect of terminating their ongoing U.S. tax filings.   However, Section 877A of the Internal Revenue Code imposes a “small” catch.   If you’ve held a green card for more than seven of the last 15 years, and if your global wealth exceeds $2 million or your average U.S. taxes for the past five years exceeded $125,000, then the U.S. imposes an exit tax.  Expatriation has the effect of selling one’s assets at their current fair market value, and with the resulting tax.  Giving up citizenship is an emotional issue for some, due to the effort expended in obtaining U.S. citizenship in the first place, as well as ties to family now entrenched in the U.S.  However, many individuals are choosing to give up their U.S. status for purely tax reasons. 

On a recent trip to India, I visited several law firms and financial institutions and consulted with families where the exit taxes were so large that the sums would cripple the individuals’ financial wellbeing and their related family enterprises.   Consider, for example, that contributing assets to a non-US trust could result in a penalty of 25% of the value of the assets if not disclosed on one’s income tax return.  Or consider the potential penalty of 50% of the highest account balance in one’s foreign bank accounts or foreign brokerage accounts merely due to nondisclosure each year on Treasury Form TDF 90-22.1.

Savvy financial institutions and international tax advisors are busy mapping out strategies.  For many wealthy Indians, negotiating these rules is like driving in the streets of Mumbai – you can’t survive merely by following the rules in the motor vehicle code.   In order to properly expatriate and properly exit the U.S. tax system, a person needs to submit five years of properly filed U.S. returns and provide the IRS with complete disclosures on IRS Form 8854.  Since India may one day impose gift and estate taxes, holding U.S. citizenship may still be a good hedge if the tax system in India is radically changed.  However, given the fact that the current government is mostly composed of the upper tier of the high net worth families in India, there’s little likelihood of any major change in this area for some years to come. 

In February, the IRS announced an amnesty program whereby individuals can voluntarily file past returns with the correct tax and discloses. By doing so, potential criminal charges are waived and the 50% penalty on undisclosed foreign accounts will be reduced to 25% for accounts in excess of $75,000.  For example, if one has an undisclosed foreign account of $1 million, even if the additional income and additional tax is minor, the penalty for not filing the annual Treasury Form TDF 90-22.1 is $250,000.  The scope and amount of the penalties are confiscatory and appear unfair to many, since the wealth was generated outside the U.S. and in many instances has already been taxed in India.  In general, even well intentioned people will not comply with laws that on their face appear to be unfair. 

Like it or not, U.S. citizenship has lost much of its luster.  Wealth and talent are mobile and can reside in almost any country.  In the February 6^th issue of the Financial Times, the leading article highlighted changes in U.K. immigration law being implemented specifically to attract the global high net worth person to take on UK residency.  Tax laws in the U.K. are also being liberalized to attract this wealth and talent based on the assumption that capital will follow the individual’s residence.  Other countries are considering similar rules.  Today, high net worth entrepreneurs can move in an out of countries with increasing ease because they are seen by most countries as bringing capital, jobs, and opportunities to the local economy.

 The SolutionCongress might not like to the bitter pill of liberalizing the expatriation rules for a group of high net worth individuals that appear on the surface to be tax evaders.  It will take some reflection and forward thinking to solve the problem in a way that is beneficial to both foreign residents and to the U.S. Treasury. The U.S. Tax Code can stick with assumptions that are no longer valid, or Congress needs to reconsider how to keep all of its citizens and residents within the system.  Otherwise, vast amounts of wealth will stay outside the U.S. - undeclared and untouchable by U.S. tax policy.  Major sources of income taxes will go uncollected and the best and the brightest will bypass the U.S. as a friendly place to call home.

Congress needs to heed the prophetic words from one of Bob Dylan’s songs in the ‘60s:

Come Senators, Congressmen, please heed the call

Don’t stand in the doorway, don’t block up the hall

For he that gets hurt will be he who has stalled

There’s a battle outside and it is ragin’

It’ll soon shake your windows and rattle your walls

Oh, the times they are a-changin’.

DOJ Seeks John Doe Summons for Data on HSBC India Accounts of U.S. Residents