We don't like to be the bearer of
"bad tidings", but it appears that a great many promoters of offshore
tax benefits for US persons are either ignorant of the many obstacles
that the US tax law imposes or they are intentionally ignoring them.
Here's a very brief summary of the more difficult tax traps and
pitfalls that exist in the US tax code for citizens or residents who
wish to use foreign trusts, corporations or other arrangements to avoid
US taxes.
1. The US
imposes tax on the world-wide income of citizens and permanent
residents. IRC section 61 provides that "Except as otherwise provided
…, gross income means all income from whatever source derived …". The
IRS and the Courts have held that this means the worldwide income of US
citizens and permanent residents.
2. IRC
318 is one of an assortment of code sections that treat stock owned by
certain relatives as if it were owned by the taxpayer - thereby
prohibiting the avoidance of certain stock or partnership ownership
rules by spreading ownership among family members. Trusts or estates
and their beneficiaries are deemed to be related parties as are
corporations and their shareholders or partnerships and their partners.
3.
Normally, shareholders of a corporation can exchange appreciated
property to a corporation on a tax free basis if certain ownership
tests are met. These rules are not permitted for transfers to a foreign
corporation because of IRC 367.
4. IRC
482 grants the IRS the power to reallocate income and deductions among
certain organizations if they are controlled by the same taxpayers.
And, the reference to "control" is very broad - including many kinds of
indirect control through nominees and agents. This section of the tax
code is the primary means by which the IRS prevents taxpayers from
diverting profits from the US to a related party or entity in a tax
haven or other low tax jurisdiction.
5. IRC
Sections 551-558 impose special tax obligations on the US shareholders
of a foreign personal holding company. Essentially, a personal holding
company is one where at least 60% of the gross income is from passive
investment sources such as interest, dividends, rents and royalties. If
a personal holding company is a foreign personal holding company
(FPHC), the US shareholders are required to pay current income taxes on
the income of the FPHC.
6. IRC
679 makes it virtually impossible for a US person to avoid taxation on
the income of a foreign trust with any US beneficiaries. IRC 679
provides: "a US person who directly or indirectly transfers property to
a foreign trust…shall be treated as the owner…of such trust
attributable to such property if…there is a US beneficiary of any
portion of such trust." In order to avoid taxation under IRC 679, the
foreign trust must be a foreign non-grantor trust; that is, one which
has no grantor (no creator) under IRC 671-679. A foreign non-grantor
trust is an irrevocable trust where no power or right is retained by
the grantor under the complex provisions of IRC 671-678. Such an
irrevocable trust results in no income taxation to the US settlor.
However, if the foreign non-grantor trust has US beneficiaries, those
beneficiaries will be taxed on current year distributions of income
from the trust. Or, if income is accumulated for any year, future
distributions to any US beneficiary will be taxed under the extremely
complex provisions of IRC 668, entitled "Interest Charge On
Accumulation Distributions From Foreign Trusts", and IRC 666, entitled
"Accumulation Distribution Allocated To Preceding Years." Essentially,
accumulated income, when distributed, is subject to the nightmarish
"throw back rules" and subject to an interest charge equal to the
under-payment of tax under IRC 6621(a)(2) (the Federal short-term rate,
determined quarterly), plus 3 percentage points. [IRC 6621(a)(1)(A) and
(B)]. Thus, in order to avoid or defer US income taxation to both the
US settlor and any US beneficiaries, the foreign trust must be a
foreign non-grantor trust with no US beneficiaries. Such a trust must
specifically state that under IRC 679(c), no part of the income or
corpus of the trust may be paid or accumulated during a taxable year
for the benefit of a US person, and if the trust were terminated at any
time during the taxable year, no part of the income or principal will
pass to a US person. Furthermore, if any income or principal can be
paid to a US beneficiary within one taxable year of the death of the US
person who created the foreign non-grantor trust, then the US
beneficiary will be subject to the tax under the scheme of IRC 668, 666
and 6621, as required by IRC 679(b).
7. IRC
Section 684 generally treats transfers of appreciated assets to a
foreign estate or trust as a taxable exchange - subject to some
exceptions. Where the foreign trust is treated as a grantor trust under
IRC 679, the taxable event is deferred until the trust is no longer a
grantor trust.
8. IRC
Section 877 establishes that where a US person relinquishes citizenship
or residency for the principal purpose of avoiding taxes, such person
shall be subject to US taxes on certain US source income for a period
of ten years after relinquishing their citizenship or residence. In
1996, the law was amended to provide that where the US person has a net
worth of $500,000 or more or an average tax obligation of more than
$100,000 for the past five years, then it shall be presumed that tax
avoidance is a "principal purpose" of expatriation.
9. IRC
Sections 951-964 impose a current income tax on certain current
earnings of a foreign corporation that is "controlled" by US persons.
Control means ownership of more than 50% of the voting power or value
of the stock of the corporation. The reference to "certain" earnings of
the CFC refers to what is called "sub-part F income" as defined in IRC
Section 952.
10. IRC
Section 1246 denies capital gain treatment on gains from stock in
foreign investment companies if the company is (a) registered with the
SEC and does not elect to make taxable distributions of at least 90% of
its current income, or (b) more than 50% of the company is owned by US
persons.
11. IRC
Section 1248 denies capital gain treatment on gains from the stock of a
controlled foreign corporation by any shareholder who owns (directly or
indirectly) 10% or more of the voting stock.
12. IRC
Section 1249 denies capital gain treatment on the sale of certain
patent rights to foreign corporations that are owned 50% or more by the
taxpayer.
13. IRC
Sections 1441 and 1442 impose a 30% withholding tax on certain 'fixed
or determinable' income paid to non-resident aliens or foreign
corporations unless a lower treaty rate is applicable. However, there
are significant exceptions to this general rule. Foreign corporations
are also subject to US tax on US source income and such income is not
subject to the withholding rule.
14. IRC
Section 1443 imposes a 4% withholding tax on the US source income of a
foreign private foundation.
15. IRC
Section 1445 imposes a 10% withholding tax on the gross proceeds from
the sale of US real property by a foreign person.
16. Non
resident aliens are subject to estate taxes on real, tangible and
intangible property that is deemed to be situated in the US. They are
only allowed a credit of $13,000 for any taxes due.
Vernon
Jacobs and Richard Duke
