tax return

Expatriate Taxpayer Not Exempt From Capital Gains Tax Based on Income Tax Treaty

Tax Court ruling may be troubling for U.S. citizens living abroad

The Tax Court, in a recent opinion, upheld an Internal Revenue Service notice of deficiency against an individual who’s a U.S. citizen and a permanent resident of Israel, finds that the Israel-U.S. income tax treaty (the Convention) doesn’t permit the individual to exclude capital gain from his taxable income.

Long-Term Capital Gain

The petitioner in this case, Elazar Cole, moved to Israel in 2009 and became a permanent resident in 2010, while remaining a citizen of the United States throughout 2010. In April 2001, prior to moving to Israel, Cole purchased 3,000 shares of stock for $42,065. He later sold 2,000 shares of the stock in September 2010 and the remaining 1,000 shares in November 2010, resulting in total proceeds of $157,012, realizing a total long-term capital gain of $114,947 ($157,012 – $42,065).

Although Cole timely filed Form 1040, U.S. Individual Income Tax Return, for the 2010 taxable year and attached Schedule D, Capital Gains and Losses, on which he reported the $157,012 proceeds from the sale of the stock, he didn’t include any of the proceeds in his taxable income. In April 2013 Cole submitted Form 1040X, Amended U.S. Individual Income Tax Return, for the 2010 taxable year and attached an explanation that stated that, pursuant to the Convention, no tax should be administered on this transaction.

Notice of Deficiency

On Jan. 28, 2014, the IRS mailed Cole a notice of deficiency for the 2010 taxable year, determining a deficiency of $13,212 in federal income tax and an accuracy-related penalty of $2,642. On March 4, 2014, Cole filed a petition disputing the determination.

In his petition, Cole argued that he’s exempt from such tax under article 15, paragraph 1 of the Convention, which provides that “[a] resident of one of the Contracting States shall be exempt from tax by the other Contracting State on gains from the sale, exchange, or other disposition of capital assets.”1 The IRS, however, contended that Cole’s stock sale proceeds remain subject to federal income tax pursuant to article 6, paragraph 3 of the Convention (the “saving clause”), which provides that “[n]ot withstanding any provisions of this Convention except paragraph (4), a Contracting State may tax its residents and its citizens as if this Convention had not come into effect.”2

Proceeds Subject to Tax

The court rejected Cole’s argument, citing its analysis of similar saving clauses in past cases, holding that the purpose of the saving clause provision is to “reserve the right of the United States to tax its citizens and residents on the basis of the provisions of the Internal Revenue Code,”3 without regard to article 15. Because Cole is a U.S. citizen, he’s not entitled to exclude from taxation the proceeds from his sale of stock pursuant to article 15, paragraph 1 of the Convention and the proceeds are subject to federal income tax under the Convention’s saving clause.

The court also went on to reject Cole’s argument that such exemption under the saving clause effectively nullifies the purpose of the Convention, finding that the clause doesn’t nullify the Convention but rather only nullifies the benefits provided by certain provisions to current citizens and certain former residents and citizens of the United States.

Based on the court’s interpretation of the Convention in this and similar cases, it’s likely we’ll see the number of expatriates renouncing their U.S. citizenship continue to soar, given such unfavorable tax treatment.

Endnotes

1. Elazar M. Cole v. Commissioner of Internal Revenue, T.C. Summary Opinion 2016-22 (May 2016) at p. 6.

2. Ibid.

3. Ibid., at p. 7.

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