There are four somewhat extra-territorial extensions of the authority of Revenue Canada. There came into effect in 1988 a requirement to provide foreign-based information or documents. Draft legislation has been published, providing new and extensive reporting requirements relating to foreign trusts, foreign bank accounts and foreign affiliates. The Taxable Canadian Property (“TCP”) rules are to be extended: TCP was formerly excluded in computing the “departure tax” because gains from it are taxable in the hands of a non-resident. An interest in a foreign company or a foreign trust owning TCP is itself treated as TCP, if more than 50% of its value is attributable to TCP. The Canadian tax on death is by way of a notional capital gain; the US levies a separate estate tax. The death of a US investor in Canadian real property may cause a double charge to tax, and there is no credit of one against the other. Where the property is held through a Canadian corporation, the ultimate disposal at a profit of the property by the corporation will give rise to a third tax.
Article XXVI A of the Canada/US Treaty makes provision for cross-border enforcement of tax claims by an Applicant State in a Requested State, but it does not apply to a tax-payer who is a citizen of or formed under the laws of the Requested State.
Asset Protection planning is a response to the rise in litigation in the United States. It gives rise to a number of concerns – the creditor’s difficulty and cost of making claims and enforcing judgements on the one hand, the defendant’s wish to maintain control of his assets on the other. Asset protection structures are various and not always as protective as they seem. Domestically, the discretionary trust has been much used, and it may be sufficient that the trustee’s discretion extends only to the timing of distribution. Spendthrift trusts are also used, as are “blind” trusts and “shifting” trusts.
The foreign asset protection trust has further protective features: it appears as less of a target for creditors; to attach it will be more complicated and costly; foreign laws are often not so pro-creditor as those of the United States, though this is not always so; stricter limitation and use of a flee clause may increase a creditor’s difficulties.. Foreign law may permit a settlor to exercise greater control over trust assets.
A prime way of attack by a creditor is to claim that the transfer to the trust is a fraudulent conveyance. Some US States – e.g. California – recognise indirect or constructive fraud; by contrast, some foreign laws are much less restrictive. The transfer of the asset needs to be effected abroad, to take advantage of these laws. Creditors may threaten the debtor with a contempt order in a US court; but if the debtor has no powers to deal with the asset, such an order will not be made. Note that the US Court has jurisdiction over a foreign trustee if the trust has US assets or presence. Note also that a reversionary interest in favour of a settlor is part of the settlor’s estate in bankruptcy proceedings.
A trust is said to be invalid if against public policy – e.g. the self-settled spendthrift trust. Most APT’s are designed to be US tax neutral and to avoid gift tax and many would be invalid if established in the United States. It is difficult for a settlor to retain as much control of a trust as he might wish. In Jersey, the Rahman case held that the control by the settlor made the trust a sham.
A foreign individual investor suffers 30% withholding tax on dividends, interest, royalties and rents. It may be reduced or eliminated by treaty. Interest on portfolio debt is exempt. The non-resident alien or foreign corporation is not in general subject to tax on capital gains, unless they are real property related or arise from a US trade or business. The corporate tax rate is approximately (depending on the state) 38%. The branch profits tax of 30% is payable in addition.
A foreign corporate investor in US real property will generally elect for trade or business status, so as to get deductions for expenses. A similar result follows from the use of a US corporation in place of the branch – i.e. 38% at the corporate and 30% on distributions (unless treaty reduced). However, if distribution is postponed until the corporation is liquidated, the 30% may be avoided. The imposition of the branch tax means that a domestic corporation will generally be preferred to a foreign one.
Alternatively, the use of a partnership exposes the foreign investor to the full impact of US tax – whether non-resident alien individual or foreign corporation.
However, a deceased non-domiciled alien is subject to US estate tax on US assets other than portfolio interest debt (but not stock in a foreign corporation). The rate rises to 55%. The non-domiciled alien gets no marital deduction: he gets a credit of $60,000 – as opposed to $600,000 for a US domiciliary.
It follows that a US investment will generally require a foreign corporation owning a US corporation owning the US property. This provides immunity to estate tax, though it has an income tax price. This price may be reduced by use of portfolio debt; to use this route, no individual must (unless treaty relief is available – e.g. in Canada, the Netherlands, the United Kingdom) have a 10% or greater interest in the project, and thin capitalisation must be avoided.
A measure of liability protection may be achieved by using a group of companies; if they are all US corporations, they may in effect be taxed as a single entity. These are favourable rules affecting acquisition of distressed investments and ” like kind” property exchanges.
Individuals with green cards and those who spend more than an average of 122 days a year are taxpayers even though not US citizens and distribution to them out of foreign trusts can have very serious tax consequences – including denial of stepped-up cost basis on distributed assets. This kind of circumstance has given rise to problems for a long time, but the new legislation of last August has made matters worse. It is essential to review trusts from time to time if any of the beneficiaries has a US involvement.
Before the enactment of the new law a grantor trust made by a non-resident alien was a tax-efficient way of making provision for US beneficiaries, and could have asset protection features. The grantor rules are not now to be applied unless – in general – the result is to cause a US tax charge to arise, so that the beneficiaries suffer the distribution tax. There is however a useful exception for the trust which is revocable by the settlor – though this may be difficult to reconcile with asset protection features.
The new rules affect pre-immigration planning: if the grantor (settlor) becomes a citizen of or resident in the US within 5 years, the trust is treated as if made by him while a citizen or resident.
The new law introduces stricter tests for the residence of a trust and makes it clear that the 35% excise tax applies when a domestic trust becomes a foreign trust. The law requires a US person to report foreign gifts of more than $10,000 a year; it introduces a number of other reporting requirements and increased penalties. The new provisions leave a number of issues unresolved and will need to be reconsidered in the light of forthcoming regulations.
The problem of “surplus ACT” has stood in the way of using UK holding companies in a tax-efficient way. The 1994 legislation gave birth to the International Headquarters Company (“IHC”). No advance corporation tax (“ACT”) is payable on the distribution of a foreign income dividend (“FID”). The UK imposes no withholding tax on dividends; it has the benefit of the EU parent/subsidiary directive; it is party to many tax treaties; it has a generous system of foreign tax credits; it affords relief on interest charges and management expenses; its corporation tax level is relatively low; it imposes no ACT on distribution in a liquidation; it has no capital duty or net worth tax; it affords non-domiciled employees a favourable tax regime.
An FID distributed by IHC carries no ACT; a dividend paid by a non-IHC requires payment of ACT, but this may be recovered. An FID carries no tax credit. It needs to be “matched” with “distributable foreign profit” of the payor company or its 51% subsidiary. Computation can be complex. There are “anti-streaming” rules.
There are three categories of IHC – a wholly-owned subsidiary or sub-subsidiary of a foreign quoted company or of “foreign held” company or by a company owned (up to 80%) by non-UK resident individuals or “foreign held” companies (each holding at least 5%). In these last two cases not more than 20% of the ordinary share capital may be in the ultimate beneficial ownership of the resident individuals (on a look-through basis). Where the ultimate beneficial owner is a trust, it can be impossible to say that not more than 20% is ultimately owned by a UK resident: the UK Revenue position is that the burden is on the claimant, but this may be discharged if the trust instrument expressly excludes UK residents from benefit. It should be noted that if the company does not qualify as an IHC, it may still distribute FID’s and the recipients reclaim the ACT.
A UK foreign income trap company is routinely used to maximise foreign tax credits, deductions for charges and interests being taken by its parent. A “mixer company” – e.g. in the Netherlands – is routinely inserted below the income trap company. Greater tax efficiency may require this structure to be duplicated, so that the FID comes out of a stream subject to a higher rate of foreign tax and therefore fully franked with foreign tax credits.
A UK IHC may be useful for investment in the US where the investor’s country has no treaty (e.g. Brazil, Singapore) or whose treaty gives no relief (e.g. Greece, South Africa) or where the treaty cannot be used (e.g. Netherlands, Luxembourg). In using a UK IHC, Articles 10(2)(b)(I), 10(7) (a) and 16(1) of the US treaty need to be noted; but it is submitted that Article 16(1) is not relevant.
The UK offers no exemption from tax on capital gains. There is indexation relief and there are deductions for losses; gains may be reduced or eliminated by a pre-sale declaration of dividend; gains may be sheltered at the foreign level using a sub-holding company; income dividends can be routed via a UK IHC and capital profits via the Netherlands/Antilles or Luxembourg/Malta route.
The effect of the IHC is to route US dividends with a 5% withholding tax and EU dividends without withholding.
The foreign trust legislation was enacted. A tax on expatriates was proposed. Expatriates were thought to be avoiding capital gains tax and -more importantly – estate tax, which can be often greater than the theoretical 55% by reason of excessive valuation by the IRS. Eventually, the legislation tightened the existing rules and did not introduce a new “departure tax”. The new law is retroactive to February 1995. It is still possible that a departure tax may be enacted.
For now a US citizen or green card holder for 8 out of 15 years, continues to be subject to US tax for 10 years after emigration. An Immigration Act provides that a US citizen who “officially renounces” citizenship for tax avoidance reasons may be excluded from the United States. A new form will require a US citizen to report receipt of gifts from abroad. Other proposals for changes in the law are being made in Washington; it is unsure whether any will see the light of day.
The Treasury has now finalised the US model income tax treaty. A new treaty with Switzerland has been signed. The new expatriate rules affect taxpayers who have an annual tax liability of US$100,000 or net wealth of $500,000. The model treaty provides for them to remain “US citizens” for 10 years. Several changes have been made, and the new limitation of benefits provision is to be found as Article 22.
They consist of three islands, some 50 miles east of Puerto Rico. They were purchased by the US from Denmark in 1917; they have a degree of local autonomy; they are not part of the US customs area. The Internal Revenue code is used, with the substitution of Virgin islands for US – the “Mirror Code”, and an agreement with the US for limited exchange of information. The IRC provides in Code 932 that US citizens living in the Islands are governed by the Mirror Code. A number of local changes to the Code are in effect. US tax treaties do not apply.
An individual resident in and born or naturalised in a US Possession – e.g. the USVI – remains a non-resident alien for estate and gift tax; the USVI imposes no such tax of its own on VI residents. The Immigration Investment Program applies also to the USVI, and the territory offers a 4% tax rate on the investment income.
The USVI offers the “Exempt Company”. It must carry on business abroad and must be at least 90% owned by non-US persons. It pays no income tax, withholding or other tax except $1000 a year franchise tax. It has access to US Courts; it is a US person, and has the benefit of the US treaties of Friendship Commerce and Navigation and Bi-lateral Investment Treaties. It can obtain “N” registration for an aircraft. The law contains provision for company redomiciliation. An Exempt Company can be a captive insurance company and may be used for US employee benefits. The Exempt Company may function as a mutual fund. It may elect to be taxed at 1%. The USVI is not on a tax haven “hit list”.
There are extensive incentives for investment in tourist-related and other businesses. The USVI was one of the first territories to be used as a jurisdiction for Foreign Sales Corporations and stimulated the establishment of banks and professional firms in the territory. The USVI also offers limited partnerships and a number of new provisions – including an LLC statute – are on the way.
Pass-through entities offer US tax advantages. In outbound investment, a Controlled Foreign Corporation passes through to the US investor the benefit of foreign tax payments through a tax credit mechanism. A similar benefit can be obtained by a partnership or joint venture. To be a CFC, US interests must represent more than 50% of the corporation in votes or value.There is no minimum US investment in a partnership, but income (and losses) are attributed to the US partner on a year-by-year basis. The foreign tax credit mechanism is available if a US partner owns at least 10%. A 35% excise tax applies to transfers to a foreign corporation or a foreign partnership of appreciated property.
A Limited Liability Company also functions as a pass-through. This may be used to keep free of US tax a flow of foreign income to foreign partners, limiting the US tax liability to the share of income belonging to the US participant.
Common US pass-through entities are the general partnership, the limited partnership, the S corporation (in which non-resident aliens cannot be members) and the LLC. For an entity to be treated as a pass-through, it must “fail” two of the four tests of corporate nature – continuity of life, free transferability of interests, centralisation of management (in practice hard to avoid) and meaningful limited liability.
If the “check the box” applies, the need to fail corporate criteria evaporates. The “check the box” proposal can be presented as a flow-chart series of questions to determine into which class an entity fits. Is the entity a trust? Is it subject to special rules? Is it automatically a corporation (e.g. if carrying on business as a corporation)? If it is a US entity with two or more members, it will be a partnership unless it elects to be a corporation. If it is foreign, and not on the Treasury list of corporate bodies, then if there is a member with unlimited liability by law or statute, it will be a partnership unless it elects to be a corporation.
Canada regards an LLC as a corporation; this is presently subject to “competent authority” procedure. In Germany, the position seems unclear. It may be wise in such cases to use a limited partnership. A partnership may also be preferable for state tax purposes. The single-member LLC will be a pass-through under the “check-the-box” rules.