Charleston 1998 meeting

Plaintiffs are in search of “deep pockets” (see Royal Brunei). Although a trustee is not in theory to be judged by hindsight (see Nestlé), in practice the Court is apt to be critical, especially of a professional trustee. Alsop Wilkinson indicates three types of dispute – one as to the terms of the trust, one a dispute between beneficiaries, and one a dispute with a third party. The resolution of any such dispute can have the result that the trustee’s duty is not owed to the persons whose interest he thought he was protecting!
A trustee must understand and perform his duties: he must take legal advice or apply to the Court for directions. Above all, he must deal honestly with his beneficiaries – see Kitchen v RAF Associates. A trustee has a duty to explain the trust document to an intending settlor (West v Lazard).

Bartlett illustrates the failure of a professional trustee to carry out its duty of care; in Nestlé , the Court came (just) to the opposite conclusion.

Much litigation has been concerned with disclosure and discovery. These questions were considered in Londonderry’s Settlement and later cases. The Lipkin Gorman case and other cases in the Trust Casebook illustrate the availability to claimants of the remedies of restitution and damage.

Attacks on offshore planning are coming from many directions: there are attacks on jurisdictions and attacks on offshore structures. Attacks on trusts are external as well as internal. The external attacks come mostly after the death of the settlor (except in “asset protection” cases where creditors are chasing assets of the settlor), and the growth of electronic communication has brought the offshore world closer to everyone. Attacks come from aggrieved heirs: in Cayman, and elsewhere, trusts can override the inheritance rights enjoyed by heirs in the jurisdiction of the settlor’s domicile; in Schindler the Bermuda Court even held that the statutory provisions were merely declaratory of the previous law. In Lemos (a dispute fought out in the Cayman Islands and Greece) the trustee was concerned that it might be subject to contradictory orders in different jurisdictions. Portnoy and Brooks (both US cases) are illustrative of attacks by creditors: the Court’s sympathies were clearly with the creditors, and hostile to overseas asset protection trusts. It seems relatively easy for a claimant to get a Mareva injunction – e.g. in the Grupo Torras case (in the Bahamas) and the courts are generally sympathetic to applications for discovery – e.g. in Stolzenberg in England.
Other attacks come from “owners” – e.g. the estate on death, the trustee in bankruptcy – claiming that the settlor did not effectively dispose of the beneficial interest in the trust property – or others claiming to be the true owners of the property which the settlor never beneficially owned. This gives rise to a tracing claim or a constructive trust claim. In the first type of case, it may be claimed that the transaction is a “sham”. The sham may be “formal” (i.e. the terms of the document do not give rise to a trust but amounts to a testamentary disposition) – seePfrimmer (a Manitoba case). The 1998 Cayman and Bahamas laws expressly permit the settlor to retain powers (but not the entire beneficial interest) without jeopardising the integrity of the trust.

The “sham” may take the form of a failure to constitute the trust –notably by failure effectively to add property to the trust. ThePagarini case (a BVI case which may go to the Privy Council) is illustrative. The most common form of sham is “substantive” – i.e. where the reality does not match the documents (seeSnook in England): the Rahman case in Jersey is illustrative.

The fourth kind of sham stems from a failure of intention of the settlor, even though the trustee finally intends that a trust should come into existence – see West v Lazard in Jersey.

In the United States, pre-bankruptcy planning varies from State to State. A “homestead” exemption of significant value is available in Florida or Texas. This has given each of these States the reputation of being a “debtor’s paradise”. This is unlikely to be abolished by Congress. These States also offer exemptions for pension plans.
Bills have been introduced in Congress, at the behest of the credit card companies, to limit these benefits (though none of them have so far been passed) by establishing a maximum of $100,000 for a homestead, or requiring a 2-year minimum period of residence.

Asset protection trust legislation has been enacted in 19 jurisdictions, designed to shift the balance of advantage from the creditors and in favour of the beneficiaries.

In the Stephen Lawrence case in Florida, the Court gave Mr Lawrence the choice of bringing $7 million from his offshore trust and giving it to his trustee in bankruptcy or suffering various penalties – the permanent refusal of discharge from bankruptcy, the surrender of his passport and referral to the FBI. A doctor – in a high-risk profession – who puts his assets out of reach of his creditors is at risk of being treated by the Court as hindering, delaying or defrauding creditors. Such a doctor may create a trust in the Cook Islands, the trust and he operating a partnership to run his practice: the Court has power to set aside transactions and would be willing to do so to recover the US assets owned by the partnership if it is satisfied that the purpose of the structure was to hinder, delay or defraud creditors. This power extends to preventing the bankrupt from leaving the country and to imprisonment for contempt.

Most offshore trusts created by US persons are treated as “grantor” trusts for US tax purposes. A trustee in bankruptcy may pass information to the IRS about a trust whose existence has not been declared to the IRS.

In cases where a doctor invests only 10% overseas, to provide a pension for his old age, the Court may approach the matter more sympathetically. Alaska and Delaware are now offering a form of asset protection trust: those who use foreign jurisdictions may be suspected of doing so in order to hinder creditors, though of course there are cases where this is not the settlor’s objective.

Harmful Tax Competition is a new and surprising concept. The OECD has a definition of a kind : tax differentials can affect investment decisions. But the “harm” is hard to locate. The OECD Report concedes that countries have fiscal sovereignty, but talks about compliance with “internationally accepted standards”. What are they?
The Report labels countries as tax havens, preferred tax regimes, and those with a low tax base. The tax havens are regarded as the most harmful: the have no or harmful taxes, secrecy rules, lack of transparency, no requirement for activity to be substantial. The key factors in identifying preferential tax regimes are similar but more numerous.

The Report recommends modification of domestic law (e.g. CFC rules), terminating tax treaties with tax havens (though this may be largely cosmetic), “intensifying international co-operation”, ensuring that links with tax havens do not encourage harmful tax competition.

The European Commission has published a Code of Conduct and the ECOFIN agreed a number of measures in 1997. The EU policy follows that of the OECD. A list of “predatory” regimes is to be published. A minimum 20% tax rate is proposed for capital and income from savings.

The G7 has approved the Report and the EU stance, Gordon Brown calling for international co-operation to counteract the “threats” emanating from the tax havens : “fraudsters” and “honest citizens” are contrasted.

The EU requires the UK to curb harmful tax competition in dependant territories. The Report calls for tighter regulations and greater exchange of information. The UK has announced a review of the Channel Islands and the Isle of Man : a draft report has been leaked via the internet. This report is more even-handed than had been feared.

The OECD Report is biased in favour of the major countries which are its members and seems to offer the existing tax havens no prospect of future existence.

The shaping of offshore laws must be related to its marketing : the perception of the intending user is of crucial importance. The offshore centre, like any other business, needs to identify its consumer needs, and needs to consider whether the product can be developed and distributed, and how quality control can be maintained. It needs also to pay attention to its critics. Some criticisms are jurisprudential – e.g. a bank secrecy law may be intrinsically undesirable. Some criticism relates to macroeconomics and fiscal responsibility, others are expressions of bias against the offshore world. Prejudice, avarice and xenophobia inspire many criticisms, but others carry useful lessons.
Offshore legislation must respect public and private international law, it must conform to the jurisdiction’s responsibilities to other nations, it must be properly presented to potential users ( e.g. the Seychelles immigration law), it should deal with shortcoming which have been identified in similar legislation elsewhere, it should – so far as possible – enjoy enforceability in other countries and it should concentrate on a core business or strength.

Internally, any proposed legislation must fit with existing principles of law and equity, it must be consistent with the provisions of other enactments, it should provide for regulations to ensure the consistent application of the law, it must be designed to be enforceable by the courts and administrative bodies in the jurisdiction itself, it should be freely published and reported, it must be harmonious with other offshore legislation in the jurisdiction and it should provide for a regulatory authority separate from Government.

The business paradigm is useful, but the offshore industry needs, as well as laws, an investment in training and perhaps some international institutions.

The United States tax system does not differentiate between policies issued onshore and offshore; the advantages of offshore insurance lies in the field of regulation and in considerations of cost.
A “variable” policy has a value related to the value of the underlying assets: the profit goes to the policyholder, not the insurance company, as the benefits provided under the policy increase. The assets may be ring-fenced against other creditors of the company: this is provided in the law of some jurisdictions. A “variable” annuity is favourably taxed in the US: there is no tax while “in the bucket” – during the build-up of the fund; but income tax is due on the gain component of any annual payment, even though the fund includes capital gains. A penalty tax is also imposed where the annuitant is less than 59 ½. Certain diversification standards must be met: the regulations are complicated, but there are “safe harbour” provisions. Where the annuity has a guaranteed return, it may be treated (unfavourably) as a debt instrument. The annuity must be owned by a natural person: this may extend to a trust if it is of a “look-through” kind.

An insurance policy can offer a tax-free exit, under the US tax code. There are two tests. One relates to the size of the death risk. This remains the same throughout the term of the policy. The other is a cash-value test. This varies from time to time. On payout, the death benefit is tax free. Lifetime withdrawals are also tax free if certain conditions are met – notably a spread of premium payments over a number of years, but not otherwise.

An insurance policy is not subject to estate tax if the person taking out the policy has no “incidents of ownership” in it.

There is a grey area – “investor control”: if the policyowner is able to control the way the money is invested, the IRS have claimed to “look through” the policy. Evidently, the IRS will tolerate some measure of investment control. And the doctrine has never been extended to insurance policies – where the risk undertaken by the insurance company is significant.

The variable annuity is cheap, easy, offers tax deferral but has no tax-free exit. A non-US variable annuity suits a non-US citizen who spends a limited time in the United States. The insurance policy suits the taxpayer primarily interested in estate tax planning; the modified version may interest the younger taxpayer, who would like to access some of the fund in a tax-free fashion.

The effect of Art VI of the Constitution is to give a tax treaty the force of law. Where a treaty conflicts with domestic law, the Court seeks to eliminate differences and if that is not possible the later of the two prevails. It used to be policy not to override treaties, but this is no longer so. And the Court has set its face against the use of treaties for “treaty shopping” purposes.
The Aiken Industries case was a turning-point: a Honduras company was substituted for a Bahamian company in order to get the benefit of the then US/Honduras treaty. The Court treated the Honduras company as a mere conduit. This approach is taken in Revenue Ruling 84-152: the interposition of an Antilles company had no business purpose. But the IRS has not always won back-to-back cases.

It is now policy to include a limitation of benefits (“LOB”) provision in a treaty. It started with those with Malta, Cyprus, Luxembourg. The present UK treaty does not have one, nor does that with Japan nor that with Hungary. The LOB basically requires a resident to be a “qualifying” resident, but the language ranges from the simple to the Byzantine. A “publicly traded” company will generally come outside the LOB provisions: its stock must be “regularly” traded, but the precise requirements vary from treaty to treaty. A subsidiary of a publicly traded company also comes outside the LOB provisions; again, the test is not uniform in all treaties.

If a company does not qualify, its income may qualify if the company has a substantial income apart from that for which relief is claimed, the test varying from one treaty to another, and the treaty-protected income must be “connected to” or “incidental” to the main business of the company.

Some new treaties will permit companies controlled by qualifying residents of other treaty countries to qualify – those with Ireland, Luxembourg (proposed), Switzerland and Canada.

New withholding regulations come into force on 1st January 2000. A certificate of beneficial ownership will be required, with an identification number. The number must be certified by I.R.S. This requires furnishing a certificate of residence from home country and affidavit explaining why LOB article has been met.

The concept of electing transparency began with the S Corporation. It has been extended to the LLC. Partnerships are effectively transparent, as is the grantor trust.
A corporation is never transparent, nor is an organisation like an insurance company or a business trust that is treated as an association taxable as a corporation under regulations. An LLC is transparent unless it elects otherwise, as is a partnership. The Regulations list the foreign entities which are treated as non-transparent. If at least one member of an entity has unlimited liability, it will be treated as transparent unless it elects otherwise. If it is not on the list and all members have limited liability, it will be not transparent in the absence of an election otherwise, but it can elect to be transparent.

The election is made by form 8832. This is the “check the box” election. It is to be made not more than 75 days before nor more than a year after the effective date required by the election. An election can be changed every five years.

When a foreign entity is treated for domestic purposes as transparent it will be so treated for treaty purposes, unless the treaty specifically deals with the issue. A domestic entity treated as transparent is so treated for treaty purposes, but to correct what was seen as an abusive use of LLC’s by Canadian investors, new provisions deny treaty relief to payments by transparent entities to treaty country recipients no suffering local tax on the receipt. The IRS wanted to introduce Regulations to counteract the use of check-the-box for avoidance purposes, but Congress is not permitting this; Congress appears to be reaffirming the view that foreign tax planning is a legitimate business purpose, even though US tax planning is not.