World’s Best Tax Haven: The United States

Image result for World’s Best Tax Haven: The United StatesYes, you read that right.

Before Jumping Into “How Is This Possible?”

To attain the moniker “best” tax haven, it is probably fitting to say that “it” is not just about taxes.  Take a look at the political upheaval around the world. Ask yourself how much you value the stability of a jurisdiction’s political system, economy, legal system, trust laws, asset protection laws, and infrastructure.  (Boring is a good thing.) Then, there is the practical matter of visiting your trustee should you choose. And, it helps to know how to pronounce the name of your trustee’s location.

(For reference, in planning, “secrecy” has historically meant that no one — not even the government — sees your affairs.  “Privacy” has historically meant that the public can’t see your affairs but the government can. The days of secrecy are dead.  So, we talk about privacy.)

For some, the really big item has been privacy.  For a jurisdiction’s banks to perform international funds transfers — which is a live or die matter for some banks — the jurisdiction’s banking laws and regulations must comply with the requirements of the Bank for International Settlements.  And, in recent years, the Bank for International Settlements has made account ownership and tax disclosure a requirement for participation in the BIS system. Perhaps the primary motivation behind the requirement is to combat money-laundering of criminally derived profits.  But, then, governments have been cooperating with each other in recent years to ensure tax compliance. As a result, jurisdictions known for their “secrecy” have bowed to the BIS. Nonetheless, “hide your money from the government” has never been a good tax strategy. It is better (and more clever) to pay less tax in full view of a tax authority.  So, “privacy” is really the thing you’re after.

In The Old Days

Today In: Money

It seems that forever the U.S. Internal Revenue Code has had clear definitions of humans: a United States person, a resident alien, a non-resident alien with presence in the U.S., and a non-resident alien with no presence in the U.S.  And, taxation of each category happens in its own way. But, we’re not going to get into that side of things in this article.

Turning to trusts . . . in the same way that humans are categorized and taxed appropriately, so were trusts.  There were domestic trusts, foreign trusts with a presence in the U.S., and foreign trusts with no presence in the U.S.  And, taxation of each category happened in its own way.

But, in the old days, Internal Revenue Code did not have clear definitions to say that a given trust fit into a particular category.  And, if a tax dispute arose and it mattered which category of trust one was, a court would have to perform a subjective analysis of the facts and circumstances.  In some cases, unintended and unanticipated interpretations of certain poorly worded trust passages led to harsh tax outcomes.

Something had to be done.  Something was done (in 1996).  And, planning opportunities sprung into life.

Nowadays

In reaction to the above-mentioned harsh outcomes, Congress amended the Internal Revenue Code to clearly define trusts that are “U.S. persons” and foreign trusts.  It is a simple, straight-forward, mechanical test. At the same time, Congress added some golden language:

The taxable income of an estate or trust shall be computed in the same manner as in the case of an individual . . . [and] . . . a foreign trust or foreign estate shall be treated as a nonresident alien individual who is not present in the United States at any time.  [Emphasis added.]

Who Can Create A Foreign Trust?

ANYONE.  But, more importantly, YOU.  Remember, the test is whether a given trust meets the simple, straight-forward, mechanical definition of a foreign trust.  Thus, as long as the trust document is drafted in a manner that meets that definition, it matters not that the trust:

– is created by a United States person, a non-citizen, or a non-resident

– is created under U.S. laws and be subject to U.S. courts (or created under the laws of another jurisdiction)

– has a resident of the U.S. as the trustee

– has beneficiaries inside or outside of the U.S.

– has assets inside or outside of the U.S.

So, if one can structure a trust to meet the simple, straight-forward, mechanic definition of a foreign trust, how would it be taxed?  Recall the above-cited statutory treatment. That being said, read on.

If The Grantor Is Not A U.S. Person

As a non-citizen and non-resident of the United States, can you actually establish a trust in the U.S.?  Yes. There is an international treaty called the “Hague Convention on the Law Applicable to Trusts and on their Recognition.”  In short, you have the ability to create a trust in your jurisdiction of choice AND have the law of that jurisdiction of choice be the law that applies to your trust.  There simply needs to be “nexus” to that jurisdiction and if your trustee is a resident of that jurisdiction, you’re good to go.

So, let’s say that you are a resident of the United Kingdom and create a trust in the U.S.  (To focus on the big issues, we won’t discuss which state within the U.S. But, we will leave it to say that this is an important decision in itself.)  The trust’s income would be taxed by the U.S. government according to the following table:

Not Taxed

Taxed

Potentially Lower Rate

Regular Rate

Foreign Sourced Income Capital Gains on Public SharesX

– Dividends on Public SharesX

– Interest on Public BondsX

– Capital Gains on Private SharesX

– Dividends / Net Income Private SharesX

– Interest on Private Bonds / LoansX

– Capital Gains on Real EstateX

– Net Income on Real EstateX

US-Sourced Income– Capital Gains on Public SharesX

– Dividends on Public SharesX

– Interest on Public BondsX

– Capital Gains on Private SharesX

– Dividends / Net Income Private SharesX

– Interest on Private Bonds / LoansX

– Capital Gains on Real EstateX

– Net Income on Real EstateX

In short, all of the trust’s income would not be subject to U.S. taxation other than interest from non-public bonds and dividends (public or non-public).  It should be noted that special rules apply to a trust whose grantor was not a U.S. person when the trust was created and subsequently became a U.S. person.

If The Grantor Is A U.S. Person (Living Or Died) And The Beneficiary Is Not A U.S. Person

The same as above.

If The Grantor Is A U.S. Person (And Has Died) And The Beneficiary Is  A U.S. Person

The same as above.

If The Grantor Is A U.S. Person (And Is Living) And The Beneficiary Is  A U.S. Person

While this trust will be categorized as a foreign trust, the grantor will be deemed the owner for U.S. income tax purposes and subject to U.S. income tax on worldwide income.  However, once the grantor dies, it follows the above examples.

Key Advantages For U.S. Persons

This is where the planning comes into play.  When the grantor is a U.S. person and the beneficiaries are U.S. persons, a trust having foreign trust character garners opportunity when the U.S. person grantor has died.  It would be quite easy to draft a trust so as to maintain domestic trust character while the grantor is still alive and then foreign trust character is triggered once the grantor died.

There are two classic opportunities.  The first is when the first spouse dies and a bypass / credit shelter / family / B trust is created.  That trust can easily be converted to a foreign trust — whether immediately after death, 5 years down the road, or 20 years down the road.  The second is when the surviving spouse dies. Second verse same as the first.

But, what if a spouse has already died?  Certain U.S. jurisdictions have trust laws that allow “decanting,” which is a process by which administrative provisions of a trust can be altered . . . including administrative provisions that trigger foreign trust character.

So, if fact, U.S. persons can establish foreign trusts (and enjoy their tax benefits) right here in the United States.  And, your assets stay in the United States.

Key Advantages For Non-U.S. Persons

Okay, aside from just saving taxes, as the Monty Python troupe asked, what have the Romans (or Americans) ever really done for us?  Or, rather, what is it that makes the United States the “best” jurisdiction? Let’s skip the jokes about political stability, economic stability, etc.  It comes down to trust laws . . . which will circle back to taxes.

Whether you are talking about the Cayman Islands or Singapore or Hong Kong or wherever, most tax haven jurisdictions are going to follow the English Common Law rules regarding trusts.  In the case of Switzerland, one can’t create a trust there but, under the Hague Convention, it will respect a trust validly created in another jurisdiction, which will follow those English Common Law rules regarding trusts.

Here’s the tax challenge: When assets are simply passed down from one generation to the next, estate tax is imposed at each generation.  If one were to keep assets in trust, estate tax would be imposed at the first generation only. Trust assets would not re-enter the estate tax system unless and until finally distributed.  So, ideally, one would want to keep family assets in trust for a longer period of time. Distribute the income, of course, but keep the assets in trust. Distributions of income to the beneficiaries would be taxable to the beneficiaries, of course, but not the assets in trust.

Referring to skipping over a tax authority’s ability to impose estate tax at each generation, this concept is called “generation-skipping.”  This table below gives a sense of generation-skipping’s value. Embedded in the table are certain assumptions, such as tax rate, exclusion / nil-rate amount, etc.  But, go with it conceptually.

Without Generation-Skipping

With Generation-Skipping

Death Value

Annual Income

Value

Annual Income

At death of Generation 1 net of estate tax$25,000,000

$25,000,000

During life of Generation 2$1,000,000

$1,000,000

At death of Generation 2 net of estate tax$15,000,000

$25,000,000

During life of Generation 3$600,000

$1,000,000

At death of Generation 3 net of estate tax$9,000,000

$25,000,000

During life of Generation 4$360,000

$1,000,000

At death of Generation 4$5,400,000

$25,000,000

During life of Generation 5$216,000

$1,000,000

Final distribution at death of Generation 5$3,240,000

$25,000,000

So, you can see the power of generation-skipping.

Now, here’s the problem with the aforementioned jurisdictions: they are bound by a legal doctrine called the Rule Against Perpetuities that limits the duration of a trust to (for practical purposes) about 100 years.  After which, a trust must distribute all assets . . . which forces those assets re-enter the estate tax system.

Is it possible to extend the life of such a trust?  Not in these jurisdictions. But, one can in certain states in the United States.  Some states have either abolished the Rule Against Perpetuities or have extended it to hundreds of years.  Imagine keeping your assets out of your home jurisdiction’s estate tax regime for hundreds of years!  Such trusts are referred to as “dynasty” trusts.

For UK Residents

A UK-resident family might employ the strategy of passing assets directly from generation to generation and not use a trust.  If assets are transferred at least seven years prior to the giver’s death, there would be no tax. Until the seventh year passes, such transfers are Potentially Exempt Transfers.  If you know the bus that hits you is on a predictable schedule, then the strategy works. But, if there’s a new driver on that bus route, then your family is exposed to a tax rate of 40% above the nil-band amount (potentially one million pounds for a married couple).

So, it becomes a trade-off between a predictable but smaller inheritance tax up front — but only once — and a series of unpredictable but large impositions of inheritance tax.

Winston Churchill said that the United States and Great Britain were two countries divided by a common language.  In tax planning, it is the reverse. The objectives of tax planning and asset protection planning are the same — but we use different terminology.  Almost all of the considerations in the UK are the same as in the US. Aside from a little tweak here or there, the trust structure an American would is very similar to one a Briton would use.  But, in a way, this is not a surprise. Tax authorities confront the same tax planning strategies — for example, valuation of a gift. And, to counter these same tax planning strategies, tax authorities share notes.  So, a convergence of tax legislation and rules among countries might be expected.

So, That’s Why

When discussing tax havens, most think about income tax reduction.  However, estate / inheritance tax is imposed on all of one’s assets as opposed to just one’s income.  So, planning for estate / inheritance tax is of greater importance. And, the reason the United States earned the title of the “best” tax haven is that its trust law allows for the indefinite suspension of estate tax over many generations, whereas other jurisdictions can’t.  Any questions?

[“source=forbes”]