International Trade and/or Investment Affords Opportunities

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1 Overview of International Estate Planning Issues Affecting U.S. Persons or Non-U.S. Persons with U.S. Sitused Assets 2010 Advanced Tax Institute November 3, 2010 Baltimore, Maryland Elizabeth M. Schurig International Trade and/or Investment Affords Opportunities Allows for acquisition of assets or services that are either unavailable or more costly in the taxpayer s home country Allows taxpayers access to alternative business or legal structures that are unavailable in the taxpayer s home country Schurig Jetel Beckett Tackett 100 Congress Avenue 22nd Floor Austin, Texas Phone Fax Elizabeth M. Schurig* *Much thanks to Amy Jetel and Elliott Murray for their assistance updating this presentation. 1 International Trade and/or Investment Presents Coordination Concerns Bilateral Income and Estate Tax Treaties Each (or all) countries have an interest in collecting a tax from either the trade or the transfer Some countries have disparate taxing systems, making coordination difficult Without coordination, overlapping claims of taxing authority ( juridical double taxation ) can hurt both the taxpayers and the taxing authorities because juridical double taxation will discourage, rather than encourage, foreign trade and investment Juridical Double Taxation issues are typically addressed by the enactment of bilateral income and estate tax treaties The U.S. is a party to more than 50 bilateral income tax treaties but is a party to only 16 estate and/or gift tax treaties. This is because many countries do not have an estate inheritance, and/or gift tax. Australia (1953) Ireland (1949) Austria (1982) Italy (1955) Canada (1980) Japan (1954) Denmark (1983) Netherlands (1969) Finland (1952) Norway (1949) France (1978) South Africa (1947) Germany (1980) Switzerland (1951) Greece (1950) United Kingdom (1978) 2 3

2 Different Taxation Regimes Treaty Application In the international arena there exist different taxation regimes, which are often difficult to coordinate or reconcile. Income Tax Sales Tax Value Added Tax (functions like a sales tax) Net Wealth Tax Stamp Tax or Duty (on sales or transfers) Property Tax Transfer Tax The effect of the taxation rules may be changed by treaty if the individual subject to the applicable tax is a citizen of or resident in another country or if the property or entity subject to the tax is sitused in another country. Therefore, it is very important to ask the pertinent questions regarding residence, citizenship, and/or situs and to ascertain whether there exists a treaty relationship before making any planning recommendation. 4 5 Inheritance Tax vs. Estate Tax Inheritance Tax vs. Estate Tax (cont.) Inheritance Tax: a tax on the receipt of an inheritance that is typically paid by the individual receiving the property Most European countries have an inheritance tax The tax can be levied based upon either domicile of the donor, domicile of the recipient, or situs of the transferred property Many inheritance tax statutes have progressive rates with different tables based upon degree of consanguinity meaning that closer relatives pay less tax than more remote relatives or strangers The gift is reduced by the tax Estate Tax: a tax on the transfer of property that is typically paid by the executor of the estate or the donor of the property U.S. federal transfer tax system is an estate tax The gift is not reduced by the tax unless otherwise specifically charged with the tax by statute or otherwise 6 7

3 U.S. Citizens Who and What is Taxed by the United States? A U.S. citizen is a person who is born or naturalized in the U.S. and subject to its jurisdiction as a citizen (Treas. Reg (c)) Taxed on worldwide income regardless of residence or questions of domicile (IRC 1) Taxed on transfers of worldwide property regardless of residence or questions of domicile (IRC 2001) 8 9 U.S. Residents U.S. Residents (cont.) A U.S. resident for income tax purposes is a person who is one of the following in the calendar year in question (IRC 7701(b)(1)(A)) Lawful permanent resident An individual who is substantially present An individual who has elected to be a resident for that calendar year on his or her personal income tax return A U.S. resident for transfer tax purposes is a person who is domiciled in the U.S. at the time of death or at the time of the transfer This definition is based upon subjective intent and contained only in the regulations (Treas. Reg (b)(1)) and in the case law Because the definition is different for income tax purposes than for transfer tax purposes an individual could be subject to income tax but not transfer tax, or vice versa 10 11

4 U.S. Residents (cont.) Non-Resident Aliens Taxed on worldwide income (IRC 1) Taxed on transfers of worldwide property (IRC 2001) Taxed on income effectively connected with the conduct of a U.S. trade or business and on certain types of nonbusiness, fixed or determinable annual or periodical income ( FDAP income) (IRC 871(a)) Interest on bank deposits and on portfolio interest is not subject to tax (IRC 871(h) & (i)) Non-Resident Aliens (cont.) Non-Resident Aliens (cont.) Taxed only on transfers of property situated in the U.S. (IRC 2501(a)(1) and 2511(a)) Property situated in the U.S. (IRC 2104) Real property located in the U.S. (Treas. Reg (a)(1)) Tangible personal property located in the U.S. (Treas. Reg (a)(2)) Stock in a U.S. corporation (IRC 2104(a)) Caveat transfers of stock in a U.S. corporation are not subject to gift tax (IRC 2501(a)(2)) 14 Certain lifetime transfers (IRC 2104(b)) Transfers with a retained life estate Transfers taking effect at death Revocable transfers Certain transfers made within 3 years of death Interests in partnerships that conduct a U.S. trade or business (Rev. Rul , C.B. 836) Debt obligations of U.S. persons and U.S. political entities (IRC 2104(c)) unless the debt qualifies for the portfolio interest exemption under IRC 871(h)(1) (IRC 2105(b)(3)) Bank deposits in a U.S. branch of a foreign bank (Treas. Reg (a)(8)) 15

5 Non-Resident Aliens (cont.) Covered Expatriates Property not situated in the U.S. (IRC 2105) Proceeds of life insurance (IRC 2105(a)) Bank insurance company deposits within the meaning of IRC 871(i)(3) (IRC 2105(b)(1)) The Heroes Earnings Assistance and Relief Tax ( HEART ) Act of 2008 creates a new category of taxed individual called a covered expatriate in new IRC 877A Deposits with a foreign branch of a U.S. bank (IRC 2105(b)(1)) Debt obligations that qualify for the portfolio interest exemption under IRC 871(h)(1) (IRC 2105(b)(3)) Interests in foreign corporations Covered Expatriates (cont.) Covered Expatriates (cont.) Definition: A covered expatriate is any U.S. citizen who relinquishes citizenship and any long-term U.S. resident who ceases to be a permanent resident of the U.S., if the individual: Has an average net income tax liability for the 5 years preceding the date of such expatriation that exceeds $145,000 (adjusted for inflation); or Has a net worth $2 million; or Fails to certify under penalty of perjury that he or she has complied with all U.S. tax obligations for the preceding 5 years Definition of long-term U.S. resident: an individual who was a permanent resident ( green card holder) for at least 8 of the 15 tax years ending with the year that the individual ceases to be a permanent resident within the meaning of IRC 7701(b)(6) Visa holders are not subject to these rules Expatriation results in a recognition event so that the expatriate is treated as if he or she has sold all of his or her assets for their fair market value on the date before expatriating 18 19

6 Covered Expatriates (cont.) Covered Expatriates (cont.) This exit tax gives an exemption for the first $627,000 of net appreciation (adjusted for inflation) and allows for deferral of the payment of the tax on any asset the expatriate elects until the asset is sold or the expatriate dies, whichever happens first, as long as a bond or other security is posted Deferred compensation and tax deferred retirement accounts are exempt from the general exit tax but are subject to withholding of 30% on amounts distributed to the covered expatriate Grantor trusts of which the covered expatriate is the grantor are subject to the exit tax Non-grantor trusts of which the covered expatriate is a beneficiary on the day before expatriation are not subject to the exit tax but the trustee must withhold 30% on all distributions of income to the covered expatriate and distributions of appreciated property to a covered expatriate will cause the trust to recognize gain as if the property were sold to the covered expatriate at its fair market value Covered Expatriates (cont.) Covered Expatriates (cont.) Under new IRC 2801 gifts and bequests from a covered expatriate after expatriation to a U.S. citizen or resident ( covered gifts or bequests ) are subject to tax in the hands of the U.S. citizen or resident at the highest marginal rate then in existence for estate tax (IRC 2001(c)) or, if higher, the highest marginal rate then in existence for gift tax (IRC 2502(a)) (IRC 2801(a) and (b)) Special rules apply to covered gifts or bequests made to trusts (IRC 2801(e)(4)) Gift or bequest to a domestic trust the trust is treated as if it is a U.S. citizen and the trust is required to pay the tax 22 23

7 Covered Expatriates (cont.) Covered Expatriates (cont.) Gift or bequest to a foreign trust the tax is not imposed on the trust at the time of the transfer rather, it is imposed at the time that assets attributable to the transfer are distributed to a U.S. person To the extent that the distribution carries out distributable net income ( DNI ) the beneficiary can deduct the tax due under this section from the income tax due Query Will this tax also be deductible from the IRC 668 interest charge on accumulation distributions? Covered gifts or bequests do not include: Property included on a timely filed gift or estate tax return Property that is deductible as a charitable or marital gift under IRC 2055, 2056, 2522, or 2523 (IRC 2801(e)(2)) The tax only applies to the extent that the value of the covered gifts or bequests received by a U.S. person during a calendar year exceeds the annual exclusion amount (IRC 2801(c)) Covered Expatriates (cont.) Are There Tax Havens for U.S. Persons? The tax is reduced by the amount of gift or transfer tax paid to a foreign country with respect to such gift Query How will the coordination of this between countries work? No U.S. citizens, permanent residents, and covered expatriates (at the time of expatriation) are subject to tax on all their assets, regardless of location, subject to very limited exceptions in the business context for income tax. Therefore, all the resources being expended toward stopping tax haven abuse should more properly be spent enforcing the existing laws that are being broken by U.S. taxpayers

8 Gift Tax Gift Tax (cont.) The donor is liable for the gift tax rather than the recipient (IRC 2502(c)) No difference between U.S. citizens and permanent residents with regard to taxability of gifts and availability of deductions Non-resident alien individuals are subject to tax on transfers of tangible property situated in the U.S. no gift tax is due on transfers of intangible property (like U.S. stocks and bonds) (IRC 2501(a)) Gift tax exclusions available to non-resident aliens Annual exclusion (currently $13,000) (IRC 2503(b)) Non-resident aliens not entitled to split gifts with spouses however Educational or medical payments (IRC 2503(e)) Charitable deduction (IRC 2522(b)) Unlimited marital deduction for gifts to U.S. citizen spouse (IRC 2523(a) and (i)) Gift Tax (cont.) Estate Tax Gift Tax deductions not available to non-resident aliens No marital deduction available for gifts to non-u.s. citizen spouse but the annual exclusion is $100,000; adjusted each year for inflation currently $134,000 (IRC 2523(i)(2)) No lifetime gift tax credit is available (IRC 2505) The executor is liable for the payment of the estate tax (IRC 2002) No difference between U.S. citizens and permanent residents with regard to taxability of transfer and availability of deductions Non-resident aliens are subject to estate tax on the value of their assets which are situated in the U.S. (IRC 2101 and 2103). The rate of tax is the same as for U.S. citizens and permanent residents

9 Estate Tax (cont.) Estate Tax (cont.) Non-resident alien unified credit (IRC 2102(b)(2)) $13,000 (or $60,000 worth of assets) For certain decedents who are U.S. citizens but acquired citizenship by being born in a U.S. possession the credit is the greater of: $13,000 ($60,000 in asset value), or That proportion of $46,800 as the value of the decedent's gross estate situated in the United States bears to his entire gross estate, wherever situated (which could exempt as much as $175,000 in value) Pursuant to Sec. 901 of the Economic Growth and Tax Relief Reconciliation Act, after December 31, 2010 this section shall be redesignated as IRC 2102(c)(2) Where permitted by treaty, non-resident alien decedents are allowed the same unified credit as a U.S. citizen or permanent resident (IRC 2102(b)(3)) Pursuant to Sec. 901 of the Economic Growth and Tax Relief Reconciliation Act, after December 31, 2010 this section shall be redesignated as IRC 2102(c)(3) Generation-Skipping Transfer Tax ( GST ) Qualified Domestic Trust ( QDOT ) The GST tax applies to transfers by a non-resident alien of U.S. situs property, with the gift tax situs rules applicable to inter-vivos transfers and the estate tax situs rules applicable to transfers at death (Treas. Reg (b)) In 1988 Congress eliminated the unlimited marital deduction for spouses who were not U.S. citizens but substituted the concept of a special type of marital trust that could be used in that circumstance. This trust was designed to allow for deferral of the estate tax but under conditions that would ensure that the U.S. government could collect the tax when due in the future

10 QDOT (cont.) QDOT (cont.) Planning point always ask clients what their citizenship status is (either during the planning stage or after death) because they will not necessarily know that they should alert you to this fact many plans are done incorrectly because citizenship is incorrectly assumed A QDOT must meet the following requirements The Trust instrument (or will creating the trust) must require that: At least 1 trustee be either an individual who is a citizen of the U.S. or a domestic corporation (the U.S. Trustee ); and No distribution (other than a distribution of income) may be made from the trust unless the U.S. trustee has the right to withhold the tax imposed by IRC 2056A The executor of the decedent's estate has elected QDOT treatment QDOT (cont.) QDOT (cont.) The security requirements contained in Treas. Reg A-2(d)(1) are met The QDOT security requirements differ based on size of the QDOT assets Large QDOT (assets > $2M) 2 choices 1. 1 U.S. bank trustee 2. A bond equal to 65% of the fair market value of the trust assets in favor of the IRS Small QDOT (assets $2M) only requirement is that its assets not be comprised of more than 35% in foreign real property There are significant penalties for undervaluation of the trust assets If QDOT provisions were not included in the trust or will of the decedent but assets pass to the non-citizen spouse in a fashion that would otherwise qualify for the marital deduction, the property will be treated as passing to a QDOT if the property is either transferred or assigned to a QDOT by the surviving spouse (or his or her legal representative) before the estate tax return is filed (Treas. Reg A-4(b)(1)) 38 39

11 QDOT (cont.) Foreign Death Tax Credit If the surviving spouse transfers the assets to the QDOT then she is deemed to be the transferor for all purposes (income, estate, gift, and GST tax) If there is no QDOT but the surviving spouse becomes a citizen before the date on which the estate tax return is filed then a regular marital deduction in the estate of the decedent will be allowable (IRC 2056A(b)(12)) Because of the disparity in tax theory and treatment among countries (and sometimes even canons or territories within countries) U.S. persons may find themselves or their assets subject to tax by a foreign jurisdiction either based on personal domicile or the location of assets. When that happens IRC 2014 provides a credit against the estate tax for the amount of the foreign tax Foreign Death Tax Credit (cont.) A Final Note Tripwires for the Unwary There are two limitations to this credit: 1. The credit shall not be an amount that exceeds the ratio that exists between the value of the taxed assets and the value of the assets in that country subject to tax; and 2. The credit shall not be an amount that exceeds the ratio that the foreign property bears to the total U.S. taxable estate Trusts as omnibus dispositive vehicles While an efficient and seemingly benign planning tool from a U.S. standpoint, the use of a trust will, in many countries, be problematic In countries such as the UK, even transfers to fully revocable management trusts often trigger immediate inheritance tax In some countries the legal relationship between the trustee and beneficiaries is not recognized, causing undesirable tax and often creditor difficulties 42 43

12 Tripwires (cont.) Even with a bilateral treaty in place the application of foreign tax to a transfer may result in additional tax being due to a foreign jurisdiction for which there is no U.S. credit or exemption. Beware the promise of tax nirvana because for U.S. taxpayers (whether citizens or permanent residents) nirvana exists only in our own backyard. Summary of Foreign Account Tax Compliance Act (FATCA) Provisions of the 2010 HIRE Act FATCA Withholding Provisions New Withholdable Payments (effective 1/1/13) Withholding agents paying FDAP income to a Foreign Financial Institution ( FFI ) must withhold 30% tax Capital gains on sale of U.S. securities (generally not taxable to foreign persons) paid to FFI are subject to the new 30% withholding tax U.S.-source portfolio interest (generally not taxable to foreign persons) paid to FFI are subject to the new 30% withholding tax Interest paid on deposits with foreign branches of domestic banks is considered to be U.S.-sourced for this purpose (typically it is not considered U.S.-sourced) FATCA Withholding Provisions Exceptions to Withholding Payments of effectively connected income Payments on obligations outstanding on March 18, 2012 Payments to financial institutions organized in a U.S. possession Payments to an FFI intended for certain beneficial owners (e.g., foreign governments, central banks, international organizations) Payments to a non-ffi intended for certain beneficial owners (e.g., publicly traded corporations, entities organized in a U.S. possession, foreign governments, international organizations) Payments to a non-ffi if it, or another non-ffi, is the beneficial owner and certain information is provided to withholding agent and IRS Payments made to FFIs that have entered into agreements with IRS 46 47

13 FATCA Withholding Provisions The QFFI Agreement To be excepted from the withholding provisions, FFIs must enter into an agreement with the IRS (a Qualified Foreign Financial Institution ( QFFI ) agreement) to: obtain such information on each account holder necessary to determine the U.S. accounts comply with IRS procedures to identify U.S. accounts withhold 30% on passthru payments to recalcitrant account holders and FFIs not entering QFFI agreements annually report to IRS on each U.S. account: the name, address, and tax ID number of account holder or substantial U.S. owner of a foreign entity the number, balance, and gross receipts and withdrawals (a QFFI can avoid reporting this information by electing to be subject to the same broad information reporting as U.S. financial institutions) 48 FATCA Foreign Asset Disclosure Provisions (effective 1/1/11) FATCA adds a new Section 6038D to require information returns regarding individual s interests in specified foreign financial assets with an aggregate value greater than $50,000 A specified foreign financial asset is: Any foreign financial account maintained by an FFI Any stock or security issued by a non-u.s. person Any financial instrument or contract held for investment that has an issuer or counterparty who is a non-u.s. person Any interest in a non-u.s. entity Generally, the return must include the name and address of the FFI or issuer/counterparty, the identifying information for the asset, and value of the asset 49 FATCA Foreign Asset Disclosure Provisions Forms, Presumptions, Penalties, Misc. Issues Though these reporting requirements appear duplicative of current filing requirements, Congress has left it to the Secretary to provide exceptions intended to prevent duplicative reporting If the Secretary determines that an individual has an interest in one or more specified foreign financial assets and does not provide sufficient information to demonstrate the aggregate value, then the value is deemed to exceed the $50,000 threshold $10,000 penalty for failure to comply (unless due to reasonable cause and not willful neglect) Section 6662 is amended to add a penalty of 40% of any underpayment attributable to an undisclosed foreign financial asset (which includes specified foreign financial assets) New Section 6038D applies to individuals, but the filing requirements will apply to domestic entities formed to hold specified foreign financial assets FATCA Foreign Trust Provisions (generally effective 3/18/10) FATCA creates presumption that foreign trusts have U.S. beneficiaries FATCA amends Section 679 to clarify when a trust will be treated as having a U.S. beneficiary: When a U.S. beneficiary has an interest contingent on a future event When the Trustee has discretion to distribute to any person When side agreements may result in distributions to U.S. persons When U.S. persons receive trust loans or below-market use of trust property FATCA amends Section 643 to provide that uncompensated use of trust property will also be treated as a distribution (unless FMV is paid) FATCA amends Section 6677 to provide a minimum penalty of $10,000 for failure to report foreign trust transfers or distributions 50 51

14 FATCA Miscellaneous Provisions Statute of limitations (effective 3/18/10): FATCA amends 6501(e) so that the limitation period of 6 years applies to greater than 25% omissions and omissions greater than $5,000 with respect to specified foreign financial assets (even if below the $50,000 filing threshold) PFIC disclosures (effective 3/18/10): adds a new subsection (f) to Section 1298 that requires each U.S. shareholder of a passive foreign investment company to file an annual information report Dividend equivalent payments (effective 9/14/10): FATCA subjects payments on equity swaps to a non-u.s. person to a 30% withholding Bearer bonds (effective 3/18/12): FATCA subjects foreign-targeted bearer bonds to portfolio interest taxation and to certain tax sanctions 52