The Uses and Abuses of Offshore Trusts
Published by: Journal of Asset Protection; Warren, Gorham & Lamont
Author: Howard Rosen, Esq.
Date of Publication: September/October 1995
An individual wishing both to protect his assets from future creditors and retain a significant beneficial interest in those assets should consider the advantages of the offshore trust.
Trusts have been used since the Crusades to protect assets. The trust concept and case law are deeply embedded in English common law jurisdictions. Domestic trusts — e.g., those trusts established under the laws of a U.S. jurisdiction — provide very limited (if any) asset protection for the settlor if he is also a trust beneficiary or has retained a certain level of control over the trust.
The rules that culminate in the foregoing are largely based on public policy. (1) In order to obtain any significant degree of asset protection for a settlor-beneficiary, one must look to an English common law-based, non-U.S. jurisdiction with favorable trust protection laws. Given an appropriate jurisdiction as the trust situs, and properly structured and used, offshore trusts (APT’s) offer significant asset protection advantages over domestic trusts.
A settlor need not look to an offshore trust to protect his assets from his future creditors where he settles an irrevocable trust for another’s benefit and retains no strings over or beneficial interest in the trust. Such a transaction is essentially no different than an outright gift. However, if a settlor wants to protect his assets from his future creditors while still retaining a significant beneficial interest in them, sophisticated planning and the use of an APT is required.
Advantages of Offshore Trusts
Jurisdiction, Comity, and Retained Interests and Powers. Among the asset protection advantages available through the use of an APT, probably the most significant are derived from the concepts of jurisdiction (the ability of a court to exercise its powers over a party) and comity (the principle by which the courts of one jurisdiction will give effect to the judicial decisions and laws of another jurisdiction).
Public policy in all U.S. jurisdictions prevents a settlor from shielding a retained beneficial interest in a trust from his creditors. This is effected either by rendering such a trust invalid because of extensive retained powers, or by rendering spendthrift and other protective provisions ineffective by granting the creditor access to the trust assets to the extent of the settlor’s maximum potential interest therein. Thus, a U.S. judgment creditor eventually can gain jurisdiction over and reach assets held in a trust established in any U.S. jurisdiction.
Further, among U.S. jurisdictions, the issue of comity is essentially nonexistent– a judgment obtained in one U.S. jurisdiction will typically be enforceable in another. If the settlor-debtor has beneficial ties to a domestic trust, either as a beneficiary–spendthrift, discretionary, or otherwise–or by retaining a power of revocation or similar control, the trust assets will be reachable by his judgment creditor to the extent of the maximum property interest potentially available to the settlor-debtor in those assets under the trust instrument. This may be accomplished, for example, via a court order on the U.S. trustee of a discretionary or spendthrift trust to exercise his maximum discretion under the trust in favor of the settlor-beneficiary, or by declaring the trust invalid where the settlor-debtor retains a power of revocation or other extensive controls over the trust.
Certain offshore jurisdictions do not embrace the public policy just discussed, and some, in fact, have enacted statutes specifically repudiating it. With regard to spendthrift trusts established for a settlor’s benefit, Section 6(4) of the Nevis International Exempt Trust Ordinance, 1994 provides:
Any rule of law or public policy which prevents a settlor from establishing a protective or a spendthrift trust of which he is a beneficiary is hereby abolished.
Similarly, the common law rule that could result in the invalidation of a trust because of extensive controls or powers retained by the settlor is contravened by Section 13C of the International Trusts Act 1984 (Cook Islands), which provides:
Retention of control and benefits by settlor–An international trust and a registered instrument, shall not be declared invalid or a disposition declared void or be affected in any way by reason of the fact that the settlor, and if more than one, any of them, either–
(a) Retains possesses or acquires a power to revoke the trust or instrument;
(b) Retains possesses or acquires a power of disposition over property of the trust or the subject of the instrument;
(c ) Retains possesses or acquires a power to amend the trust or instrument;
(d) Retains possesses or acquires any benefit interest or property from the trust or any disposition or pursuant to the instrument;
(e) Retains possesses or acquires the power to remove or appoint a trustee or protector;
(f) Retains possesses or acquires the power to direct a trustee or protector on any matter;
(g) Is a beneficiary of the trust or instrument either solely or together with others.
A civil action brought to recover assets from a trust established in a jurisdiction that has abolished or otherwise does not recognize our public policy (as represented by the preceding two statutory examples) can only be brought on fraudulent transfer grounds.
Where an APT is properly established in a foreign country, obtaining jurisdiction over the trust vis-a-vis a U.S. court action will be impossible. In addition, the laws of a carefully selected situs jurisdiction will deny comity for U.S. judgments. A comprehensive example of such a foreign statute is Section 13D of the International Trusts Act 1984, (Cook Islands). The statute clearly and specifically provides in this regard:
Foreign judgments not enforceable– Notwithstanding–
(a) The provisions of any treaty;
(b) The provisions of any statute;
(c ) Any rule of law, or equity;
to the contrary, no proceedings for or in relation to the enforcement or recognition of a judgement obtained in a jurisdiction other than the Cook Islands against either–
(d) An international trust;
(e) A settlor of an international trust;
(f) A trustee of an international trust;
(g) A protector of an international trust;
(h) A beneficiary of an international trust;
(i) A person appointed or instructed in accordance with the express or implied provisions of an instrument or disposition to exercise a function or undertake any act matter or thing in connection with an international trust; or
(j) Property of either an international trust or of a trustee or a beneficiary thereof; shall be entertained by any Court in the Cook Islands if–
(k) that judgement is based upon the application of any law inconsistent with the provisions of this Act;
(l) that judgement relates to a matter or particular aspect that is governed by the law of the Cook Islands.
A virtually identical provision may be found at Section 28 of the Nevis International Exempt Trust Ordinance, 1994.
When faced with such a law, the only possible way a creditor can reach the trust assets would be to bring the action de novo in the offshore jurisdiction, using one or more of its lawyers under its laws and courts system. It is important to note that lawyers in these offshore jurisdictions cannot accept cases on a contingency fee basis. Therefore, if a creditor wishes to pursue litigation in the offshore jurisdiction, he must be prepared to pay the foreign lawyer from his own pocket–usually in advance. As if that were not daunting enough, many jurisdictions require the plaintiff-creditor to post a bond or other surety to guarantee the payment of costs that the court may charge against the creditor if he is unsuccessful. For example, Section 55 of the Nevis International Exempt Trust Ordinance, 1994 provides:
Every creditor before bringing any action or proceeding against any trust property governed by this Ordinance shall first deposit with the Permanent Secretary in the Ministry of Finance a bond in the sum of $25,000.00 from a financial institution in Nevis, for securing the payment of all costs as may become payable by the creditor in the event of his not succeeding in such action or proceeding against the trust property.
Finally, and very often to the utter frustration of the plaintiff-creditor, by the time the case is brought in the foreign jurisdiction, the statute of limitations will have expired.(2)
Fraudulent Transfer Rules
The issue of fraudulent transfers must always be addressed by the responsible asset protection planner. The Statute of Elizabeth,(3) with its lack of a limitations period and progeny of broad judicial construction, has provided the basis for the fraudulent transfer laws of much of the modern world. The broad application of the Statute–often resulting in a finding of a fraudulent transfer where controls were retained over transferred assets–and its lack of a limitations period inject a considerable degree of uncertainty into the asset protection planning process. Even in those U.S. jurisdictions that have enacted the far more specific Uniform Fraudulent Transfer Act (Act), the limitations period set forth therein can continue to be uncertain, and retained controls or interests continue to be elements a court may consider in determining whether a transfer was fraudulent under the Act.
Important protective advantages can be gained through the use of an APT established in a jurisdiction that has enacted a more restrictive and definite fraudulent transfer law.(4) These laws typically repeal or abolish the Statute of Elizabeth, and replace it with specific, workable rules, sometimes requiring an elevated level of proof to establish a fraudulent transfer.
For example, the two-year statutes in both the Cook Islands and Nevis require proof “beyond a reasonable doubt” that a transfer was fraudulent as to the particular creditor bringing the action in order for the creditor to be entitled to relief.(5) If a transfer is found to be fraudulent as to the complaining creditor, it will only be set aside to the extent necessary to satisfy the claim of that particular creditor, thus requiring each creditor to institute a separate action. In addition, both statutes contain provisions specifically negating a presumption of fraud where numerous powers are retained by the settlor, and where the value of the settlor’s property following the establishment of the APT exceeds the value of the creditor’s claim.(6) More than anything else, these laws provide the planner with the certainty required in effective asset protection planning.
Other Protective Factors
The laws of the situs jurisdiction should recognize the “trust protector” concept.(7) Under this concept, properly implemented, the protector–who may be the settlor–has significant powers over the trustee. For example, the protector might have a power to veto discretionary trustee actions and to remove and replace the trustee with or without cause.
The protector’s powers, and powers held by any other person, should be subject to a “duress” provision in the trust instrument. The duress provision will make ineffective the attempted exercise of a power by any person other than by the wholly voluntary act of the power holder. For example, absent a duress provision, if a U.S. settlor held a power as trust protector to remove and replace the trustee, a court order could direct him to name a U.S. trustee in the creditor’s jurisdiction as trustee. The court would then have the jurisdiction to issue appropriate orders on that trustee to enable the judgment creditor to reach the trust assets. However, a properly constructed duress provision will require the foreign trustee to ignore the protector’s removal order if issued under duress (such as the order of a court), thus safeguarding the integrity of the trust.
It has been suggested that the U.S. court could hold the settlor-debtor in contempt for failing to comply with its order. Actually, the settlor-debtor will comply with the court’s order and issue the required directives. Such compliance will be ineffective, however, because the foreign trustee will ignore the duress-sourced directives, as required by the trust instrument. Remember, the foreign trustee is subject to the laws of the situs jurisdiction, which require faithful adherence to the legitimate terms of the trust.
The U.S. Supreme Court in both United States v. Rylander (8) and United States v. Bryan (9) has held that a person cannot be held in contempt for failing to do that which is not within his power to do–unless he created the impossibility. The settlor-debtor should not be deemed to have created the impossibility where the trust containing a properly constructed duress provision has been established far in advance of the origination of the creditor’s claim. The lack of a nexus in time between the establishment of the trust and the claim that compliance is impossible will substantially overcome an argument that the settlor-debtor was responsible for the resulting impossibility.
Another notable advantage is available for the APT subject to the laws of a jurisdiction that provide specific governing law rules when those rules are dovetailed with carefully drafted change-of-situs and flight provisions in the APT. Such laws and properly drafted trust provisions can enable the trust to “move” from one country to another in the face of a creditor attack, again to the complete frustration of a creditor.
Abuses of Offshore Trusts
The increasing popularity of asset protection planning has, unfortunately, attracted the usual unscrupulous and unknowledgeable persons who ignore the legal–e.g., fraudulent transfer laws, tax reporting laws, bankruptcy laws–and ethical considerations required to be taken into account in rendering asset protection services. These persons often promote APT’s as offering various tax advantages ranging from nontaxability of the trust’s income to exclusion of the trust corpus from the settlor-beneficiary’s estate for federal estate tax purposes.
However, for a U.S. citizen or resident settlor beneficiary, nothing could be further from the truth. Some of these schemes have been promoted under the guise of “pure trusts,” “pure equity trust,” “pure equity contract trust,” “American common law trusts,” and similar catchy names. Other schemes touted by persons who are obviously unaware of or have chosen to disregard the sham transaction doctrine, (10) have been promoted with the claim that U.S. income taxation under Section 679 can be avoided through the use of a series of offshore trusts, the first one creating the second one and so on, the thought being that the final trust will be a foreign trust established by a “foreign” person for U.S. beneficiaries, thus allegedly providing income tax benefits under current law.
Regardless of the name or scheme by which these trusts are promoted, their use will only result in a serious dilemma for the client, because none of these trusts can offer any legitimate income or estate tax advantage for a U.S. citizen. Moreover, planners must always be cognizant of IRC Section 7212(a), which provides that any individual who
Obstructs or impedes, or endeavors to obstruct or impede, the due administration of [the Internal Revenue Code], shall, upon conviction thereof, be fined not more than $5,000, or imprisoned not more than 3 years, or both.
The real danger is that someday soon one of these bogus programs will self-destruct and result in a lot of bad publicity for legitimate asset protection professionals, with the usual legislative overreaction. As it is, the Clinton Administration has already proposed increased reporting and disclosure rules for APT’s (11). In addition, the proposed legislation would change the rules under which trusts are determined to be U.S. trusts or foreign trusts.
U.S. Tax Considerations
A complete discussion of the U.S. tax considerations surrounding an APT is beyond the scope of this article. An APT can and should typically be structured to be tax neutral for U.S. tax purposes. Tax neutrality in this context implies that the establishment and continuance of the trust will not affect the settlor’s U.S. income, gift, or estate tax “picture.” Thus, the transfers to the APT should be designed to be incomplete gifts for purposes of Subtitle B of the Internal Revenue Code (but effective for creditor protection purposes) and, because of the settlor’s retained beneficial interests in the trust, it should be treated as a grantor trust for U.S. income tax purposes, assuring tax neutrality and relative simplicity of reporting requirements under current law. It is important to note that a grantor trust can be structured as a U.S. grantor trust or as a foreign grantor trust. The latter will not be an eligible shareholder of an S corporation under IRC section 1361(c)(2)(A), and will require the filing of Forms 3520, 3520- A, and 1040NR (and possibly an informational Form 926), and disclosure on Part III of Schedule B of the settlor’s Form 1040.
Conclusion
The APT is inherently more protective than a domestic trust for several reasons, not the least of which is its “foreignness.” Consider the thought processes of the creditor’s attorney contemplating an action to recover assets from a trust in a foreign country. He knows nothing of the country’s geography, laws, procedures, costs, or even its currency. These factors become immediate hurdles in a legal obstacle course on which he is about to embark. Because of these geographical, legal, procedural, and financial hurdles, the APT is not an automatic target of litigation, as its domestic counter-part would likely be.
The domestic trust and its trustees are subject to local (U.S.) jurisdiction, and both are just as easily included in litigation (on some theory or another) as is the settlor. Not so with the APT. The very fact that the APT is an offshore trust will have a significant deterrent effect on the creditor’s decision regarding whether or to what extent to pursue trusts assets.
The trust laws of certain foreign jurisdictions are far more specific and protective than are our domestic trust laws. Therefore, if a creditor is (somehow) undaunted by the geographical, financial, and procedural hurdles of the APT obstacle course, he will be confronted with the brick wall of the foreign legal system as the final hurdle.
Significant asset protection advantages can be realized through the responsible and ethical use of offshore trusts. Practitioners must be watchful for unscrupulous promoters who, in order to make a fast buck, can endanger this area of practice for the true professionals.
1 Restatement (Second) of Trusts section 156(1), and comment d (1957).2 See, e.g., International Trusts Law of 1992, section 3(3) (Cyprus), providing a two-year statute; International Trusts Act, 1984, section 13B (Cook Islands), providing a two-year statute that uses the standard of proof required in the United States to convict a person of a capital offense, by stating: “Where it is proven beyond reasonable doubt by a creditor…” (emphasis added).
3 13 Elizabeth I Ch. 5 (1571).
4 See, e.g., Fraudulent Dispositions Act, 1991 section 4 (The Bahamas), providing a two-year statute of limitations, and section 2 thereof of which, inter alia, defines an “obligation” as an obligation or liability (including a contingent liability) that existed on the date of the transfer, and of which the transferor had actual notice; International Trusts Act 1984 section 13B (Cook Islands), providing a two-year statute; Nevis International Exempt Trust Ordinance, 1994 section 24(3); Bankruptcy (Amendment) Ordinance, 1990, section 42A (Gibraltar), which provides that if the settlor is an individual, and is not insolvent at the date of the transfer, is not rendered insolvent by the transfer, and registers the transfer, then no creditor–existing or subsequent–can set aside the transfer (for purposes of determining solvency under the Gibraltar provision, the settlor’s contingent liabilities of which he had actual knowledge are taken into account).
5 The International Trusts Act, 1984, section 13B(1)(Cook Islands), and the Nevis International Exempt Trust Ordinance, 1994, section 24(1).
6 The International Trusts Act of 1984, section 13B(5)(Cook Islands), and the Nevis International Exempt Trust Ordinance, 1994, Section 24(5).
7 Trusts Act of 1992, section 16 (Belize); International Trust Act of 1984, section 2 (Cook Islands).
10 Gregory v. Helvering, 293 U.S. 465 (1935)(essentially established the rule that transactions lacking economic substance or reality will not be given effect for tax purposes).
11“Tax Compliance Act of 1995,” HB 981, SB 453, 104th Cong.,(1995).
Journal of Asset Protection is published six times a year–January/February, March/April, May/June, July/August, September/October, November/December– By WARREN, GORHAM LAMONT, 31 St. James Avenue, Boston, MA 02116. Subscription: $170.00 a year in the United States, United States possessions, and Canada, elsewhere available upon request. For subscription information or for customer service, call 1-800-950-1205. Second-class postage paid at Boston, MA. Printed in the U.S.A.
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Howard Rosen, JD, CPA, is a shareholder (partner) in Donlevy-Rosen Rosen, P.A., in Coral Gables, Florida, and is the author of BNA’s Tax Mangement Portfolio #810: “Asset Protection Planning.”
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