N on-US person (foreign) investors may have in place US investment arrangements, which though US estate tax compliant, are ill-suited in terms of overall US tax considerations. For estate freeze purposes, in the context of a highly depressed real estate market, no better time to effectuate restructuring and correspondingly duly taking these considerations into account, may exist.
As is often typically so, an extant structure may consist of a foreign corporate holding company and one or more domestic corporate subsidiaries, which own US real property interests (USRPIs) and/or ongoing US trade or business activities.
A key problem is that this structure precludes use of individual long-term capital gains rates (currently a maximum of 15 per cent). Instead, the higher corporate level rates (currently a maximum of 35 per cent) plus potentially a second tier shareholder level tax, as well as applicable state and local tax, may collectively drive the overall rate to in excess of 60 per cent.
Conduit structure
One potential solution is to utilise a conduit structure, combining both the partnership and trust concepts. The effect not only allows use of the lower 15 per cent rate, but potentially provides the following additional benefits:
- For a domestic irrevocable nongrantor trust, availability of the portfolio interest exemption on payment of interest, plus deductibility of interest by the trust, in computing trust taxable income.
- The trust may be drafted to be estate tax compliant, thereby providing the certitude of estate tax avoidance lacking in a purely partnership context.
- Reporting, return filing and/or tax payment considerations may be diminished in a trust-partnership collective structure, in contrast to a purely stand-alone partnership structure.
- The revised structure may avoid foreign-based ‘tax haven’ components thereby minimising the potential of noncompliance with applicable blacklists in the foreign investor’s home jurisdiction.
Creation of a partnership-trust collective structure itself presents certain considerations, which must be duly addressed. Firstly, the tests or standards applied in gauging the existence of a trust for US tax purposes must be duly satisfied. Basically this means the arrangement must be formed to protect and conserve property and not to engage as associates in a joint business for profit. In analysing these criteria a number of factors bear consideration, including elimination of boiler plate in the underlying governing instruments, which may otherwise imply the ability to engage in US trade or business activities. An extant structure may consist of a foreign corporate holding company and one or more domestic corporate subsidiaries.
Next, to attain deductibility of interest, the trust must be structured as a nongrantor trust, the applicable obligation must be issued in compliance with the portfolio interest exemption, and the situs of the trust for US income taxation must be domestic rather than foreign. For a trust to be a nongrantor trust, the grantor or creator of the trust must not reserve the power to revoke, and income or corpus must be distributable to someone other than the grantor or the grantor’s spouse. In this event, income will not be attributable and taxed to the grantor, but instead may be taxed directly to the trust itself. The 10 per cent shareholder limitation on portfolio interest obligations, while applicable to corporations or partnerships, is literally inapplicable to trusts. Thus, it should be feasible for a trust to issue such an obligation, and the trust, if domestic, should thereby avoid the 30 per cent withholding tax otherwise applicable to interest paid by US persons to foreign persons.
Correspondingly, to attain deductibility of interest, the situs of the trust must be domestic rather than foreign. This requires satisfaction of both the court and control tests, as set out in the US Internal Revenue Code and its underlying regulations. With satisfaction of both tests, domestic trust situs for US income taxation will be ensured. The interest derived by the trust from the partnership, or LLC of which the trust is a limited partner or a member, should constitute investment interest under the Code. As such, consistent with existence of domestic situs, the interest should be deductible and duly taken into account in the computation of trust taxable income.
In addition to satisfying the nongrantor criteria, the trust must also be drafted to be US estate tax compliant. This means that the foreign investor must hold no retained rights over underlying trust assets, such that the assets could be pulled into the foreign investor’s worldwide gross estate and subjected to US estate taxation. The effect is to redress any absence of certitude involving the situs for US estate taxation of a partnership interest as held by the trust.
If income otherwise taxed to a foreign beneficiary of a trust is accumulated in the domestic trust, the income will be taxed to the trust, which will file its own tax return and report and pay the tax due. The beneficiaries themselves are not required to file a US income tax return and this is so even if the trust is otherwise deemed to be engaged in US trade or business activities. Moreover, on subsequent distribution, the trust beneficiaries are not taxed on the income accumulated within, and taxed to, the trust. The overall effect should be to diminish the level of reporting by the foreign beneficiaries.
Certain jurisdictions have promulgated blacklists, for example: Mexico, Venezuela, etc., designating other jurisdictions for which their residents may be severely penalised if an entity formed in such other jurisdiction is utilised as an integral part of a collective investment structure. Many investors are prepared to incur substantial additional structuring or administrative fees and costs to form exotic structures created solely to avoid the blacklist of their home jurisdictions, for example, Dutch sandwiches, Scottish partnerships, etc. As the revised structure contemplated herein may consist entirely of US-based components, the impact of blacklists should typically be avoided at a much reduced level of complexity and potentially overall expense.
Conclusion
In conclusion, US-based investment structures of non-US persons may be restructured to enhance their overall US tax efficiency, while correspondingly accomplishing other notable objectives as well. Furthermore, it is emphasised that these same principles are equally applicable not only to existing arrangements, as in the case of an estate freeze, but to start-up structures as well.