Should Foreign Nationals Stay Offshore?
Voluntarily becoming subject to the Federal Tax Code is not necessarily advisable for foreign nationals doing business in the United States
The complexity of planning for a foreign client or company requires an understanding of the tax law of all potentially involved nations, as well as the tax treaties in effect pertaining to transfers between each country. This area of planning often involves the use of entities created in countries such as Switzerland and Liechtenstein, to serve as intermediaries for the transfer of assets and income between two other nations. Every client has different needs and goals, each requiring a tailor-made approach.
Recent IRS probes of the Swiss based financial institution UBS highlights this concern, demonstrating the scrutiny under which foreign tax planning may be viewed under here in the United States. In February, 2009, UBS paid $780 million in outstanding taxes and penalties to the IRS. UBS was found to have assisted U.S. clients in hiding assets and unlawfully avoiding taxes, and its bankers engaged in such tactics as lying to federal officials, hiding information being brought into the country on encrypted computers, and even smuggling assets out of the United States.
The following is an example of the preliminary analysis that would be made for a South American corporation seeking to move assets to a United States Family Trust. Here, the hypothetical client has the primary goal of reducing overall taxes by using the most efficient transfer techniques available:
A South American citizen owns a corporation in her home country. The company pays taxes on its profits in the home country and its source of income is also located within that country. She does business and spends time within the United States. With profits being held by the South American company, the client seeks to move a portion of those profits to a United States trust via an entity established in a third country. The client seeks a method with a more favorable tax treatment than simply having the United States trust own the South American company outright. This analysis looks at the possibility of (1) using a Swiss corporation, (2) using a Swiss corporation and an additional Liechtenstein holding company and (3) having dividends paid directly from the South American corporation to a United States trust (as an owner/shareholder). It also examines the possible United States estate and gift tax consequences that may be imposed on a nonresident holding property in a United States trust.
Double taxation (in the international tax context) is the imposition of tax on the same income item or transfer by two different countries. Depending on the circumstances and countries involved, a person might be required to pay taxes on gain from a distribution in both the country that he resides and the country in which the gain occurred. This will often result in greater tax consequences than if the income or transfer was instead entirely within one nation. In many instances, the burden of double taxation may be alleviated by tax credits or treaties between two countries. Tax treaties vary in terms and coverage, each having different results and degrees of easement for situations that would otherwise result in double taxation. Each particular treaty and situation must be considered individually as to its implications.
Estate Tax Consequences for Property Held in United States Trust
It is also important to be aware of potential estate and gift tax consequences that may arise by creation of a U.S. Trust for a foreign national. United States gift and estate taxes are imposed upon nonresidents based upon whether the situs of the individual's property is treated as within the United States. This is an important aspect to take into consideration when moving property into a United States trust, because, depending on the nature of the property held in trust, it may or may not be considered to have its situs within the United States. Different property receives different treatment. For instance, tangible personal property, real property and the contents of safe deposit boxes are considered to have United States situs if physically located within the United States. Cash, depending on the type of account and purpose for which it is held, may be considered a United States asset. However, life insurance proceeds on the life of a nonresident are treated as having situs outside of the United States. Also, contractual rights (such as patent and trademark licenses) are usually based upon where the license is granted. Furthermore, shares of foreign corporations are treated as having a foreign situs while shares of U.S. corporations are treated as having U.S. situs. Considerations need to be made concerning the type of property to be held by a U.S. trust, as some types of property may result in estate or gift tax for a nonresident while others will not.
Taxation of Transfer of Dividend Income from South American Corporation to Swiss Corporation, its Owner/shareholder
Most South American countries (including, for this hypothetical, the home nation of our corporation) do not have a double taxation treaty with Switzerland. The only South American countries that do have double taxation treaties with Switzerland are Argentina, Ecuador and Venezuela. Thus, a payment of dividends to a Swiss corporate-shareholder from the South American corporation may be taxed fully under each nation's laws. However, while there might be taxes in the South American country on such a transaction, depending on country's tax law, certain corporate structures in Switzerland ensure that there will be no/nominal taxes upon the receipt of dividend income by a corporate-shareholder. The two possible types of entities that should be formed are either a Swiss Holding Company or Swiss Domiciliary Company. Holding Companies are more or less exempt from dividend income (or any income) received. In order to be a Holding Company the corporation bylaws must state the main purpose is to manage investments in affiliated companies, two-thirds of the income must be derived from long-term participation and the company may not be engaged in commercial activity within Switzerland. In comparison, Domiciliary Companies may have only administrative activities in Switzerland and commercial activities must be exclusively or predominately conducted abroad. With Domiciliary Companies, any income derived from foreign sources, or from substantial participation, is tax-exempt. By establishing either a Holding Company or Domiciliary Company in Switzerland, dividend income could be received by the Swiss entity tax-free, meaning that only South American country's law may be potentially applicable.
Taxation of Transfer of Dividend Income from Swiss Corporation to United States Trust
While Swiss law favorably treats dividend income to Holding and Domiciliary Companies as tax-exempt, when a Swiss company in turn makes a distribution to its shareholders taxes may arise. Usually people who establish Swiss corporations do not plan on making distributions because of a potentially high tax.
As far as making a distribution from a Swiss company to a U.S. shareholder, a double taxation treaty does exist. The 1997 Income Tax Treaty between Switzerland and the United States limits the amount of tax that Switzerland can place upon dividends made by a Swiss Company to a U.S. shareholder. Under Article 10, Section 1, the United States is allowed to tax the dividends as income. Under Article 10, Section 2(b), Switzerland is then also allowed to tax any distribution, however, Switzerland's tax may not exceed 15% of the gross amount of dividends. Finally, applying Article 23, Section 2, the U.S. will give the shareholder a foreign tax credit (I.R.C. §§ 901 - 908) for the amounts paid to Switzerland. One important additional note, on February 24, 2008, Switzerland passed the Corporate Tax Reform II. Among other things, this reform eliminated the 35% dividend withholding tax that had been in effect. This elimination somewhat alleviates the burdens of making a distribution from a Swiss corporation to a U.S. shareholder, as corporations no longer have to pay a withholding tax and then subsequently request a refund.
In any case, a distribution of dividend income from a Swiss corporation to a U.S. shareholder will result in (1) full taxation on dividend income by the United States, (2) possible taxation of the dividend income in an amount no greater than 15% of its total by Switzerland, and (3) a foreign tax credit from the United States in any amount paid to Switzerland.
Use of Liechtenstein Holding Company as an Intermediary
One alternative to using a Swiss corporation as an intermediary is instead using an intermediary jurisdiction such as a Liechtenstein holding company. There are no double taxation treaties between Liechtenstein and either the United States or Switzerland (Liechtenstein's only double taxation treaty is with Austria). The only tax treaties between Liechtenstein and the United States or Switzerland deal with criminal enforcement and cooperation. As in Switzerland, dividends received by certain entities (Holding Companies and Domiciliary Companies) are exempt from income, fortune and revenue taxes from foreign sources. There is only one tax on these companies, an annual tax on capital, invested property and accumulated profits. That tax is at a rate of one franc per 1,000 francs of capital, with a maximum tax of 1,000 francs per year (1 Swiss franc equals $0.97 U.S., Liechtenstein uses the Swiss franc). Under Article 83 of the Liechtenstein Tax Law, a Holding Company may be any entity whose business purpose is the holding or management of shares and participation in other companies. A Domiciliary Company is a company that is domiciled in Liechtenstein but carries on business entirely outside of the country. Other potential entities also exist including a Foundation, Establishment, Company Limited by Shares, Limited Liability Company, Trust and Trust Settlement.
While there are no taxes on dividend income received, when a Liechtenstein company distributes dividends, there is a withholding tax of 4%. A distribution from a Liechtenstein company to a United States trust would result in U.S. taxes on dividend income as well as potential taxes imposed by Liechtenstein. In addition, unlike the case with Switzerland, there is no double taxation treaty imitating the degree to which either nation can tax the distribution. Liechtenstein companies are beneficial for asset protection, however, as far as being used as an intermediary to save taxes, in this situation, a Liechtenstein company may not prove to be beneficial.
Direct Payment of Dividends from South American Corporation to U.S. Trust and Use of Domestic or Foreign Shareholders
A second alternative would be to have a U.S. Trust own the shares of the South American corporation, with dividends being paid outright from the South American corporation to the U.S. trust. Assuming there is no double taxation treaty between the United States and the South American country, if there is a dividend distribution from the South American corporation to a U.S. shareholder, both the South American country and the United States may tax dividend income without treaty limitations under their respective national tax laws. As with the Liechtenstein option, this approach would be impracticable.
While it appears the use of a U.S. Trust is the best planning structure, there is some concern of running into the controlled foreign corporation rules of subpart F of the Internal Revenue Code (I.R.C. § 951 et. seq.). Under this section of the Code, special reporting requirements are imposed if fifty (50%) percent or more of the foreign corporation combined voting power or value is owned by U.S. shareholders that own at least ten (10%) percent of the company. One way to avoid this rule is to have multiple U.S. shareholders (i.e. multiple trusts) owning no more than 9.9% of the entity. Therefore, no shareholders will be aggregated to determine if the 50% rule is satisfied. But, it is possible for the IRS to look through such a structure if the beneficial owners of such trusts are substantially similar.
Another alternative proposed to avoid these reporting requirements is to have the foreign corporation partially owned by foreign asset protection trusts in jurisdictions that do not fall under the fiscal paradise rules. Foreign asset protection trusts are trusts, allowed under the laws of some countries, designed to protect a person's assets entirely from all creditors. Asset protection trust jurisdictions include Ireland, Scotland, and Spain. Furthermore, it may be possible to structure the foreign corporation such that disproportionate distributions are allowed so that any such distributions are limited to the United States.
Depending on the specific circumstances, there may be a tax benefit to using a Swiss corporation as an intermediary between a South American corporation and a United States family trust. Dividends paid from the South American corporation to the Swiss corporation would be tax-free. Then, when distributions are made from the Swiss corporation to the United States trust, while the transfer will be taxed by Switzerland (in addition to the United States), the burden of those taxes will be at least somewhat limited by the U.S. - Swiss Income Tax Treaty. In comparison, with no double taxation treaties in existence between either the United States and the South American country or the United States and Liechtenstein, these options lack the benefits and potential tax savings that the U.S. - Swiss treaty allows (coupled with Swiss laws allowing corporate dividends to be received by a Swiss corporation tax-free). With respect to the use of a U.S. Trust, any structure will need to be carefully analyzed to avoid application of the reporting requirements for shareholders of controlled foreign corporations under Subpart F of the Code. This may require an intermediary jurisdiction by means of a foreign asset protection trust as an additional shareholder in the Swiss corporation.
This analysis and conclusion provides only a general overview and application of the international tax scheme. In order to properly advise a client about the best approach, all of the facts and circumstances must be known in order to examine the situation and give a more detailed and accurate analysis. As can be seen, even a surface overview of a hypothetical South American corporation quickly results in a number of potential issues and methods.