US Tax Law Affecting Offshore Planning
Volume VI, Number 4 – December 1997
U.S. TAX LAWS AFFECTING OFFSHORE PLANNING:
Selected Provisions: What You Should Know
In this issue we need to get a little bit technical: We will be discussing selected U.S. tax laws which affect the formation and operation of certain offshore entities.
FORMATION OF FOREIGN ENTITIES
The 1997 tax legislation changed the way property transfers to foreign entities are treated. Under prior law, transfers of appreciated property to foreign corporations, foreign partnerships, or to foreign non-grantor trusts resulted in the imposition of an excise tax equal to 35 percent of the appreciation element of the property transferred. The typical asset protection trust was always a “grantor trust” and, as such, was excepted from the application of the excise tax.
The new law repealed the excise tax and replaced it with three separate gain recognition provisions. Under one of these provisions, transfers of property to a foreign non-grantor trust will be treated as if the property had been sold to the trust for its fair market value – so that any gain will be taxable. Of course, losses will not be deductible. The new law enhances a similar rule (already in existence) for transfers to foreign corporations, and adds a gain recognition rule requiring regulatory guidance from the Internal Revenue Service for transfers to foreign partnerships.
Note that foreign limited liability companies (LLC’s) might be treated as foreign corporations or as foreign partnerships, and, considering the lack of guidance for the new partnership gain recognition provision, extreme caution is advised in using foreign limited liability companies.
Please do not be misled by persons promoting some new type or “hybrid” entity which they claim will side-step the above-discussed laws – it cannot be done. The Internal Revenue Service is very serious about collecting U.S. tax revenues, and has long-standing regulations on the books classifying all entities as trusts, corporations, or partnerships. If an entity is not a trust or a corporation, it is a partnership, no if’s, and’s, or but’s.
OPERATION OF FOREIGN ENTITIES: CORPORATIONS
Many offshore jurisdiction offer IBC’s (International Business Corporations) which are often promoted as being “tax free“. What this means is that the offshore jurisdiction will not impose an income tax on the earnings of that corporation derived from sources outside that country.The income tax regime from the U.S. perspective is quite different, however.
The U.S. tax law in this area has evolved since 1937 to the point where today, unless you are operating a foreign manufacturing facility with significant hard operating assets, there is essentially no deferral benefit available through the use of a foreign corporation. Your foreign corporation will either be a foreign personal holding company (FPHC), a controlled foreign corporation (CFC), or a passive foreign investment company (PFIC).
The tax law applicable to FPHC’s and to CFC’s essentially requires the U.S. shareholders to report the corporation’s income on their personal tax returns, and the tax law applicable to the PFIC imposes an interest charge on corporate income not currently distributed to U.S. shareholders. Thus, when such prior year corporate income is ultimately distributed to the U.S. shareholder (or when the U.S. shareholder sells his stock), it will be treated as if the tax on that amount was owed all along (since it was earned by the corporation), and, with the interest charge imposed on that deemed liability, all deferral benefits are eliminated.
It should also be noted the name “passive foreign investment company” can be misleading. For example, assume a company earns commission income from services actually rendered. If those earnings are retained (as cash or as securities) in the corporation and constitute 50% or more of the assets, the company will be a PFIC! The PFIC rules are particularly tricky, and can be a trap for the unwary.
OPERATION OF FOREIGN ENTITIES: LLC’S PARTNERSHIPS
Unless an LLC is treated as a corporation, it will be taxed in the same manner as a partnership. As an entity, the partnership pays no tax, but its earnings “flow through” to its partners. This means that the U.S. partners in a foreign partnership will include their share of partnership income, deductions, and credits on their personal U.S. tax returns. Thus, no tax deferral is available through the use of an offshore (or domestic, for that matter) limited partnership or LLC.
OPERATION OF FOREIGN ENTITIES: GRANTOR TRUSTS
Whether a grantor trust is a U.S. trust or a foreign trust, all of its income, deductions, and credits are to be reported on the tax return of the grantor (creator). You should be aware that all persons who contribute or add property to the trust (regardless of who signs the trust as the “grantor”) are grantors for U.S. tax purposes.
Some unscrupulous offshore promoters offer the services of a foreign person to execute a trust instrument with the thought or belief that by so doing, the trust will be viewed as having a foreign grantor, which would purportedly offer some tax benefit to the U.S. person involved. As discussed below, such shams will not work (See also, APN, Vol. VI, No. 2).
OTHER IMPORTANT TAX RULES
Certain long-standing tax principles, not found in the Internal Revenue Code, but developed over many years of tax litigation, serve to keep taxpayers from manipulating the tax law into providing tax results which are just plain unavailable. Two important such rules, the “step transaction doctrine” and the “sham transaction doctrine” are always overlooked by non-professional promoters (i.e., not lawyers or CPA’s) of asset protection trusts and offshore entities.
Under the step transaction doctrine, primarily applied in the corporate tax area, the separate steps of an integrated transaction are “collapsed” and viewed as one step. Some promoters offer schemes involving numerous elaborate steps and entities to achieve a tax goal…. under the step transaction doctrine, these steps would be collapsed and viewed as one, and the tax result sought would disappear into thin air.
The sham transaction doctrine is a more broadly applied tax principle which serves to “undo” a transaction or a series of transactions which purport to derive a tax benefit which would not otherwise be available given the parties and the circumstances involved. Examples abound, and we refer the reader to APN, Vol. VI, No. 2 for a further discussion. The material discussed in this issue was quite a bit to take in, and we didn’t even get to a discussion of any of the extensive reporting rules applicable to interests in foreign entities…. Another issue will address those rules.
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