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International Tax Issues for the Domestic Estate Planner

International Tax Issues for the Domestic Estate Planner

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International Tax Issues for the Domestic Estate Planner

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  1. International Tax Issues for the Domestic Estate Planner By Richard S. LeVine Estate Planning Counsel of Central Texas May 9, 2016 IRS required statement This written advice was not intended or prepared to be used, and it cannot be used by the recipient, for the purpose of avoiding federal tax penalties that may be imposed on any taxpayer.

  2. The Internationally Connected Client • Increasing investment by foreign persons in U.S. assets • International families with cross-border connections, including spouses, children and businesses • Non-resident non-citizens (otherwise known as “non-resident aliens” or “NRAs”) increasingly look to the U.S. as a safe haven • Correct U.S. structuring can minimize tax and provide legitimacy • Knowledge of the rules can avoid traps for the unwary • Increased international financial transparency mandates correct U.S. and non-U.S. structuring

  3. Three sources of cross-border inheritance cases in a shrinking world

  4. International Triage • Three preliminary questions: • Who is subject to the US Federal estate, gift, generation skipping transfer (“GST”) and income taxes? • Which assets and income are subject to the taxes? • Is there a treaty that overrides the U.S. tax principles?

  5. Who is Subject to the Estate, Gift, and GST Taxes? • These three types of taxes can be imposedon gratuitous transfers of property • But they only apply if the testator or donor: • Is a US citizen; • Is a US domiciliary for estate, gift, and GST tax purposes (different than “residency” for Federal income tax purposes); OR • Is a non-citizen/non-domiciliary who transfers certain assets that are situated in the US

  6. Domiciliaries – Subject to U.S. Transfer Taxes • Two requirements for domicile, Treas. Reg. 25.2501-1(b): • Living in a place, even for a brief period of time • No definite present intention of leaving the place • Difficulty in determining intent • Courts look to many factors (highly subjective): • Location of residences, expensive possessions and investments • Relative amount of time spent at claimed domicile and in other countries • Location of family and friends • Location of church, business activities and club memberships • Jurisdiction of voter’s registration and driver’s license • Declarations or statements of residence or intent (visa applications, wills, trusts, letters, oral statements, tax returns, etc.)

  7. Domiciliaries – Subject to U.S. Transfer Taxes • Effect of a green card on intent • Green card application requires a statement of the applicant’s intention to stay in the U.S. • Case law indicates that holding a green card is not determinative • Estate of Nienhuys, 17 T.C. 1149 (1952) • Estate of Khan v. Commissioner, TC Memo 1998-22 • Estate of Jack v. U.S., 90 AFTR 2d 2002-7580

  8. Who is Subject to U.S. Income Taxes? • Three types of persons are subject to U.S. income tax: • U.S. citizens • U.S. residents • An NRA, but only on U.S. source portfolio type income or net income effectively connected income with a US trade or business

  9. Citizens – Subject to U.S. Transfer Taxes and Income Tax • Typical ways to obtain U.S. citizenship (no passport needed): • Birth within the U.S. • Birth outside of the U.S. to at least one U.S. parent (subject to certain additional requirements depending on DOB) • Naturalization • Important to ask clients about their citizenship and the citizenship of their family members

  10. Residents – Subject to U.S. Income Taxes • Ways to be a resident: • Green card holder (determinative) • First year election to be treated as a resident under §7701(b)(4) • Spousal election under § 6013(g) • Satisfaction of the Substantial Presence Test

  11. Residents – Subject to U.S. Income Taxes • Substantial Presence Test, § 7701(b)(3) • Presence in the U.S. for at least 31 days in the test year, and • Day count: current year days + 1/3 of prior year days + 1/6 of second prior year days >= 183 days • Certain days do not count • “Closer Connection” exception under § 7701(b)(3)(B) • Must be present in US for less than 183 days in the year to qualify

  12. Estate Taxation of NRAs – Overview • Gross Estate • Situs Rules • Deductions • Credits

  13. Estate Taxation of NRAs – Gross Estate • Gross estate of an NRA includes only assets situated in the U.S., §2103 • Transfers where §§2035 – 2038 are applicable will trigger inclusion in the NRA’s gross estate if the assets are U.S. situs assets at the time of the transfer or at the NRA’s death, §2104(b) • Planning note: Do not mix U.S. situs assets with non-U.S. situs assets, and consider carefully retaining “strings” in trusts • Jointly Owned Property – based on actual contributions of joint owners

  14. Estate Taxation of NRAs – Situs Rules • Real Property • Real Property Interests • Tangible Personal Property – situated where located • Includes currency, jewelry, furnishings, clothing, collectibles • Exceptions for certain artwork on loan to a public facility, on exhibition or in transit to or from an exhibition • Exception for “in transit” tangibles, Delaney v. Murchie, 177 F.2d 444 (1st Cir., 1949)

  15. Estate Taxation of NRAs – Situs Rules – Intangible Personal Property • Domestic corporate stock • Partnership interests • LLC interests (?) • Interests in trusts • Situs of beneficial interest in a trust is determined by situs of underlying assets, Rev. Rul. 82-193 • Life insurance proceeds are not subject to US estate tax, §2105(a) • Debt obligations • Mutual funds

  16. Estate Taxation of NRAs – Situs Rules – Debt Obligations • Debt Obligations Generally • Debt obligations are U.S. situs if the primary obligor is a U.S. person under §7701(a)(30) • Exceptions swallow the rule (mostly) • Certain bank deposits • Deposits and CDs with a U.S. bank (but not brokerage house) • Deposits with a foreign branch of a U.S. commercial bank • Deposits in a U.S. branch of a foreign commercial bank • Certain OID instruments • Portfolio debt

  17. Estate Taxation of NRAs – Situs Rules – Planning Notes • Hold assets with U.S. situs (or assets where situs is in question) in a foreign corporation to avoid estate tax — can create income tax issues • FIRPTA issues if real property is involved • ECI or §367 issues if U.S. trade or business property is involved • Estate tax remote trust is another option

  18. Estate Taxation of NRAs – Deductions • Deduction for Expenses • Deductions are allocated pro rata, based on ratio of U.S. assets to non-U.S. assets • Generally requires disclosure of worldwide assets on Form 706, otherwise lose the deduction • No deductions for debts or expenses associated with property not situated in the U.S.

  19. Estate Taxation of NRAs – Deductions • Deduction for Debts • Recourse debt – allocated pro rata, based on ratio of U.S. assets to non-U.S. assets • Non-Recourse debt – full offset so only net equity is included in the NRA’s gross estate • Example: NRA’s only U.S. property is an apartment in NY worth $5 million, subject to a recourse mortgage of $4 million. NRA has $15 million of non-U.S. property. Value includible in NRA’s estate is $5 million gross minus $1 million allocation of the recourse mortgage, or $4 million. This $4 million is $3 million more than the net equity in the NY residence. The $1 million allocation of recourse mortgage is calculated as follows: $4 million x $5 million gross estate situated in US = $1 million $20 million worldwide gross estate

  20. Estate Taxation of NRAs – Deductions • Marital Deduction • Only allowed for the proportion of U.S. situs assets passing to the surviving spouse (disclosure required) • If surviving spouse is a U.S. citizen, there is an unlimited marital deduction • If surviving spouse is not a U.S. citizen, property must pass to a Qualified Domestic Trust (QDOT) or surviving spouse must form a QDOT or must become a citizen before the filing of Form 706

  21. Estate Taxation of NRAs – Deductions • Charitable Deduction, §2106(a)(2) • Contribution must be of property that is included in the NRA’s gross estate • Contribution must be made to a domestic charity or a trust (domestic or foreign) that will use the donation within the U.S. • No pro rata allocation of the deduction required

  22. Estate Taxation of NRAs – Credits or Exemptions • True credit of $13,000 (equivalent of ~$60,000 exemption) OR possible treaty option for pro rata amount of applicable exclusion amount available to U.S. citizens and residents (based on proportion of U.S. situs assets) • If they have the option, NRAs often choose the $13,000 credit to avoid disclosure • If no treaty option is available, consider arguing that the decedent was a U.S. domiciliary if assets are mostly U.S. situs (seeKhan v. Commissioner, TC Memo 1998-22)

  23. Gift Taxation on Transfers by NRAs – Overview • Situs Rules • Credits and exclusions • Deductions

  24. Gift Taxation on Transfers by NRAs - Situs Rules • Property subject to gift tax • Real and tangiblepersonalpropertysituated in the U.S. • Gift by check? PLR 8210055 • Gifts of U.S. intangibleproperty are not subject to gift tax under §2501(a)(2) • Debt obligations of a US person • Stock of US corporations • Planning Point - Better to gift U.S. intangibles during life (gift tax-free) because if held until death they will be included in the estate of a non-domiciliary

  25. Gift Taxation on Transfers by NRAs – Credits and Exclusions • No unified credit available • Annual exclusion allowed ($14,000 for 2016) • No gift splitting unless both spouses are U.S. citizens

  26. Gift Taxation on Transfers by NRAs – Deductions • Charitable deduction allowed for gifts to U.S. charities or trust using assets in the U.S. • Limited marital deduction for gifts to non-citizen spouses, §2523(i) • No lifetime QDOT available • Expanded annual exclusion for present interest gifts is available ($148,000 in 2016)

  27. GST Tax on Transfers by NRAs • Direct Skips – Subject to GST tax only to the extent that the transfer is subject to estate or gift tax • Taxable Distribution or Taxable Termination – Subject to GST tax only to the extent that the initial transfer by the NRA to the trust was subject to estate or gift tax • GST Exemption – Same as for U.S. citizens and residents ($5.45 million for 2016) • Automatic exemption allocation rules apply • Tax is imposed at the highest rate in effect at the time of the transfer (i.e. no marginal rates)

  28. Which Assets are Subject to GST Tax? • Situs rules at time of transfer control • A transfer by a non-domiciliary transferor is a “Direct Skip” subject to GST Tax only to the extent that the transfer is subject to Federal estate or gift tax (Treas. Reg. §26.2663-2(b)(1)) • The GST Tax applies to a “Taxable Distribution” or a “Taxable Termination” to the extent that transfers of property to the trust were subject to Federal estate or gift tax (Treas. Reg. §26.2663-2(b)(2)) • Planning Opportunities / “Remaining Out of the Net” • Gifts of U.S. situs intangibles avoid GST Tax in addition to gift tax and estate tax • Generally, as long as there is no estate or gift tax on transfers into the trust, there is no GST Tax on transfers out of the trust

  29. Treaty Protections • U.S. has a small number of bilateral estate tax treaties with foreign countries • Treaty provisions in general override U.S. tax law unless U.S. tax law enacted after treaty was signed to override treaty provisions • Bilateral transfer tax treaties generally allow taxation of intangibles only to country of transferor’s residence • Bilateral transfer tax treaties generally allow tax credit to transferor in host country for taxes payable to country where property transfer is taxed to non-domiciliaries

  30. Country of Fiscal Domicile Country of Citizen-ship US Tax UK Personalty UK Realty US Personalty US Realty US US yes yes (credit for UK tax paid) yes yes US UK yes yes (credit for UK tax paid) yes yes UK UK no no no yes UK US yes (credit for UK tax paid) yes (credit for UK tax paid) yes (credit for UK tax paid) yes US-UK Treaty

  31. US Estate Tax ExposureNon-US Citizen Spouse – Transfers at Death • Transfers to non-US citizen spouse estate taxable unless transfer into Qualified Domestic Trust (‘QDOT’) (§2056A) • Timely Election Must be Made • Income Automatically Payable Only to Surviving Spouse • Principal Payable Only to Surviving Spouse During Lifetime • Payout of Principal attracts US Estate Tax Charge • Principal Remaining at Spouse’s Death subject to US Estate Tax • Must Have One ‘US Trustee’ with the power to withhold the tax imposed on distributions from a QDOT – if assets > $2 million must be a bank or must furnish bond or letter of credit • QDOT almost always requires corporate trustee; bond or letter of credit requirement are expensive for individual trustees • Surviving non-US citizen spouse can “self-settle” a QDOT before the filing date of the decedent’s US estate tax return (§2056(d)(2)(B)) • Taxed as part of decedent spouse’s estate

  32. US Estate and Gift Tax Exposure Non-US Citizen Spouse • Jointly Owned Property – Trap for the Unwary • ‘Consideration Provided Rule’ (§2040(a)) - Full value of property included in the US decedent's estate, except to the extent that estate proves consideration was provided by surviving non-US citizen spouse • Depends on Type of Property • Real Estate – Generally no deemed gift on creation of joint tenancy. May have estate tax consequences. Gift upon sale or severance if proceeds are divided • Joint Accounts – Generally deemed gift on purchase of joint property (if non-contributing spouse can “sever” the joint tenancy under applicable law)

  33. Income Taxation of NRAs • U.S. Source Fixed or Determinable, Annual or Periodical (“FDAP”) income • Includes U.S. source interest, dividends, rents, salaries, wages, annuities and debts • Generally does not include interest on portfolio debt • 30% withholding on FDAP, subject to treaty benefits • Income “effectively connected” to a U.S. trade or business (“ECI”) • Income derived from a U.S. trade or business • Generally taxed on a net basis, at regular graduated rates • Treaty benefits may be available • FIRPTA • Generally not subject to tax on capital gains (unless effectively connected with a U.S. trade or business or FIRPTA asset)

  34. FDAP • Subject to a flat 30% gross tax unless reduced by treaty • No deductions • Typically satisfied through withholding at source • Includes dividends, rents, royalties and other investment income Note: virtually all capital gains are excluded and interest income is rarely taxed as FDAP (due to portfolio and bank interest exceptions as well as relevant treaty provisions). However: an additional withholding tax may apply to FDAP income or the gross proceeds upon the sale or disposition of FDAP producing assets unless certain additional reporting requirements are met under FATCA

  35. Effectively Connected Income • ECI – Net tax at graduated rates applicable to individuals, trusts or corporations • Requires a foreign person to have a US trade or business (USTB) • Only income effectively connected to the USTB is taxed • Deductions and credits available against ECI only if a tax return is timely filed (subject to a good faith exception)

  36. FIRPTA – Foreign Investment in Real Property Tax Act • Enacted in 1980 to eliminate the perceived tax advantage of foreigners purchasing U.S. real property over U.S. taxpayers • FIRPTA applies to U.S. real property interests, other than interests held solely as a creditor (“USRPI”) • Also applies to U.S. real property holding corporations (“USRPHC”) if more than 50% of the FMV of the corporation over 5 years is USRPI • Certain exceptions to USRPHC: publicly traded companies, certain REITs, etc. • Gain on the disposition of USRPI is treated as ECI • Must file a U.S. income tax return and pay tax on a net basis at graduated rates • Transferee must withhold 15% of gross sale proceeds (including transferred liabilities), unless an exception applies

  37. Trust Status in International Planning • Foreign or Domestic • Grantor or Non-Grantor • Taxation of trust and beneficiaries is dependent on both characteristics

  38. “Foreign Trust” • A trust is a “Foreign Trust” (§7701(a)(31)) unless: • A Court within US exercises primary supervision over administration of the trust (the “Court Test”); and • One or more US persons have authority to control all substantial decisions of the trust (the “Control Test”) • Watch special power of appointment holders, protectors * If you fail either test then have a Foreign Trust

  39. Taxation of Foreign Non-Grantor Trusts • Income taxation of the trust • Taxed as if the trust were an NRA under income tax rules • Difference in treatment of capital gains if accumulated • Income taxation of NRA beneficiaries • Trust is a conduit, so all items of income are carried out with the same character to each beneficiary, pro rata

  40. Taxation of Foreign Non-Grantor Trusts • Income taxation of U.S. beneficiaries • Distributions carry out DNI; DNI includes capital gains • Distributions in excess of DNI (“UNI”) are subject to the “throwback rules” • Accumulated long-term capital gain income and dividend income are taxed at ordinary rates when distributed • 65-day rule for distribution planning

  41. Foreign Non-Grantor Trusts – Distributions to U.S. Beneficiaries • Indirect Distributions • Indirect distributions are treated as if they were made directly from the foreign trust to the U.S. beneficiary, if for the principal purpose of tax avoidance (conduit rules) • Use of Property • Use of personal property (residences, jewelry, artwork) is deemed to be a distribution at market value of use unless rented for fair rental value • Loans to a U.S. Person • Loans of cash or securities to a U.S. beneficiary, U.S. grantor or U.S. persons related or subordinate to the beneficiary or grantor are treated as distributions • Exception for loans satisfying certain requirements of IRS Notice 97-34 and regulations (qualified obligations)

  42. Throwback Rules • Throwback rules apply whenever a distribution of accumulated income from a prior year (UNI) is made in excess of the current year’s DNI • Draconian rules aimed to recapture tax that was deferred offshore • Prior accumulations all treated as ordinary income • Capital gains and dividends lose character and are taxed as ordinary income • Interest charge based on accumulated income from past years “thrown back” to year of accumulation on a FIFO basis

  43. Foreign Non-Grantor Trust Accumulation Distribution Planning • Avoid throwback rules by: • Distribute DNI currently • Structure Trust to qualify for “3 gift rule” • Using Total Return Trust – Manipulate FAI vs. DNI • Using offshore Private Placement Variable Universal Life (“PPVUL”) • “Carve-off” undistributed net income (“UNI”) to a new foreign trust and the remainder of the trust can make distributions to US beneficiaries • “Default Method” three year rolling average • Migrate Trust to US

  44. Grantor Trust Status for Foreign Grantors • Section 672(f) - special grantor trust rules apply to trusts with non-U.S. grantors • For non-U.S. grantors, there are generally two ways to create “Grantor Trust” status: • The grantor has the power to revest the property in himself – can require the consent of a related or subordinate party subservient to grantor (power of revocation), or • Distribution of income or principal can only be made during the grantor’s lifetime to the grantor or the grantor’s spouse

  45. Taxation of Foreign Grantor Trusts - Planning Opportunities • If Section 672(f) requirements are satisfied, substantial opportunities for efficient income tax planning for foreign grantors of trusts with US beneficiaries • All income is deemed taxable income of foreign grantor – US beneficiaries can receive distributions free of tax • Foreign grantor only taxed on ECI or US source FDAP, so trust can invest in the US and generate capital gains (excluding FIRPTA gains) and interest income, as well as non-US income, without incurring an income tax burden in the US • Can be US transfer tax free if properly structured • Planning necessary with respect to estate and income tax consequences following grantor’s death • Need to understand taxation of grantor in grantor’s jurisdiction

  46. Planning when Foreign Grantor Dies • Benefits of Foreign Grantor Trust cease when Grantor dies; trust becomes a Foreign Non-Grantor Trust • Plan to avoid the Throwback Rules and reporting requirements • Purge DNI each year (outright or to a “mirror” foreign or U.S. trust) • Domesticate the foreign trust • Plan to avoid CFC and PFIC status • When the grantor dies it may be necessary to make a “check-the-box” election to treat underlying foreign corporations as partnerships or disregarded entities

  47. Overview of Tax Hurdles • Historic Deferral Opportunities • Foreign holding companies • Foreign trusts • Section 679 for U.S. grantors of certain foreign trusts • Section 684 for transfers by U.S. persons to foreign non-grantor trusts • Anti-Deferral for foreign holding companies – CFCs and PFICs

  48. Section 679 – Foreign Grantor Trusts - U.S. Grantor • U.S. person who transfers property to a foreign trust will be treated as the income tax owner of the portion of the trust attributable to that property if: • the trust is an inter vivos trust; and • there is a current, future or contingent U.S. beneficiary of any portion of the trust • Trust agreement should specifically identify class of persons who can receive distributions • Presumption of a U.S. beneficiary for new trusts unless information is submitted to the IRS • Five year look-back period for transfers in trust by a foreign grantor who then becomes a U.S. person if foreign trust has U.S. beneficiaries

  49. Section 679 – Foreign Grantor Trusts - U.S. Grantor • Section 679 creates potential traps for the unwary • Loans of cash or securities by a U.S. person to a foreign trust with U.S. beneficiaries is treated as a contribution, triggering grantor trust status unless qualified obligation is used • Loss of grantor trust status (e.g. no more U.S. beneficiaries) under Section 679 would trigger Section 684 mark to market taxation

  50. Section 684 – Transfers by U.S. Persons to Foreign Non-Grantor Trusts • A U.S. person must recognize gain (but not loss) on transferring property to a foreign trust unless the transferor is treated as the owner of the trust for grantor trust purposes • Indirect transfers through certain third parties • Constructive transfers – paying or assuming an obligation of the trust, or certain guarantees of an obligation of the trust • Applies only if a U.S. person is not treated as the owner of the foreign trust • Does not apply to assets passing at death that are includible in the transferor’s estate