If you have read any of my articles on JD Supra, you know that I graduated from the United States Military Academy (“West Point”) and was a Brazilian and Portuguese major. You may not know why I became a Brazilian and Portuguese major. Here is the answer. West Point is the oldest engineering school in the nation. Somehow I never received that memorandum that I was going to have to take “boat loads” of math and engineering with my average math skills. It was the beginning of the four-year battle with the Dean. Brazilian and Portuguese were the antidotes and friendly balance to my four year struggle with engineering classes.
I believe most significant Brazilian musical artist of all time without any argument is Antonio Carlos Jobim (aka Tom Jobim), the inventor of the Bossa Nova. His song “One Note Samba” has been covered by musicians around the world from Frank Sinatra to the Black Eyed Peas. My favorite is the version by Sergio Mendes and Brazil 66, sung by Lani Hall who did not speak Portuguese but sang beautifully in Portuguese and Brazilian.
This article is will tie together the benefits of using U.S. trusts for certain inbound investments. U.S. trusts deemed to be foreign trusts for tax purposes (is one note). The use of private placement life insurance (“PPLI”) and private placement variable deferred annuities (“PPVA”) are the second note. When PPLI and PPVA are owned by the trust, they generate favorable tax treatment for investments that produce income that is effectively connected income to a U.S. trade or business (“ECI”). Similarly, the purchase of U.S. real estate subject to FIRPTA withholding. Combining PPLI or PPVA owned by the trust with ownership of real estate also owned by a trust is a tax solution for non-resident aliens (“NRA”) investing within the United States.
The Panama Papers
The other thing that you may not know about me is that I grew up in the Panama Canal Zone. My family lived in the Canal Zone for about twenty-five years. In my youth, I noticed that Panama had an exceedingly large number of banks for such a small country, but never imagined that everyone from Latin American dictators to wealthy Europeans were hiding money in Panama.
In March 2016, the Panamanian law firm of Mossack Fonseca suffered a data breach resulting in the unauthorized release of 11.5 million files of shell corporations and tax shelters used by the rich and famous. The prime minister of Iceland resigned his position as a consequence. David Cameron, the former prime minister of Great Britain, had to explain over his family’s use of a Panamanian structure. Nevertheless, it has always been a mystery on how government officials making the equivalent of $50,000 per year, end up with a few million dollars in offshore bank accounts. Not only is the cheese rotten in Denmark, but Russia, Brazil, Argentina, Nigeria and everywhere else for that matter.
Data leaks and the negative media attention on offshore jurisdiction have led foreign clients engaged in offshore planning to re-evaluate their current planning. This analysis will demonstrate the surprising result that clients no longer need to hide their money in a chain of offshore corporations designed to hide the shareholders’ identities. The best option may be to hide the money in plain sight in the least likely of tax havens, the United States.
Recent focus on tax evasion began in the last 200s and featured the United State fighting UBS. This eventually let to the end of the ability of Swiss banks to hide assets.
banking secrecy. The U.S. government in 2016 entered into a 1.3 billion settlement with eighty Swiss banks involving 34,000 American accounts holding as much as $48 billion. Germany settled with 50 Swiss banks. There are similar negotiations between the Swiss banks with France and Belgium.
Global Foreign Account Compliance Act (GATCA)
GATCA refers to the Global Foreign Account Compliance Act. GATCA's foundational document is the Convention on Mutual Administrative Assistance in Tax Matters developed in 1988 by the Organization for Economic Cooperation and Development and the Council of Europe. The Convention is the most comprehensive multilateral instrument available for all forms of tax cooperation on tax evasion and avoidance. It provides for exchange of information on request, automatic exchange of information, spontaneous exchange of information, and simultaneous tax examinations.
The Common Reporting Standard (CRS) is an information standard for the AEOI related to bank accounts on a global level, between tax authorities, which developed in 2014. Its purpose is to combat tax evasion.
All G20 countries, nearly all OECD countries, major financial centers and a growing number of developing countries have signed the Convention and its amending Protocol of 2010. However, the U.S. has not entered, and is unlikely to enter into GATCA in the future. The U.S. Government cannot agree to the GATCA-style reporting requirements without Congressional approval. The political view is that Congress does not want to harm the U.S. banking industry by driving money offshore and destroying the competitive advantage of U.S. banks. A such, the U.S. does not report under CRS any investments by foreigners in the United States.
The only thing necessary to avoid reporting under GATCA is the transfer of client assets to a financial institution resident in the U.S. for GATCA purposes. A trust with a U.S. resident trustee but structured as a non-U.S. trust for U.S. tax purposes is the key to solving the problem.
The First Note in the Samba - Tax Structuring to Minimize the Pain and Suffering in the United States for NRAs
Whether a U.S. person or a U.S. entity owns an account within the U.S. is not subject to CRS reporting. However, it will be subject to worldwide taxation. When an NRA owns a bank account in the U.S. whether individually or through an entity that in the U.S., it will (i) avoid CRS. If that same trust is deemed not to be a U.S. trust for U.S. tax purposes it will only be subject to U.S. taxation on U.S. source income.
The only thing necessary to avoid reporting under CRS is the transfer of a NRA client’s assets to a financial institution resident in the U.S.. The solution is the creation of a trust that has a U.S. resident trustee but is structured as a non-U.S. trust for U.S. tax purposes. A trust with a U.S. trustee is outside of CRS.
A foreign trust is one that fails to meet either the “Court” or “Control” tests of IRC Sec 7701(a)(30)(E). The best method to avoid these requirements is to fail the “Control” test, by giving a non-U.S. person control over one substantial decision within the trust. This could include giving the NRA the power to revoke the trust.
If a trust is subject to U.S. law and an NRA has the ability to make one or more of the following decisions, it will avoid treatment as a U.S. person for tax purposes:
- Whether a receipt is allocable to income or principal.
- Whether to terminate the trust.
- Whether to compromise, arbitrate, or abandon claims of the trust.
- Whether to sue on behalf of the trust or to defend suits against the trust.
- Whether to remove, add, or replace a trustee.
All of the trust assets should be booked in the U.S. otherwise the non-U.S. bank or financial institution will have its own CRS reporting obligations.
As foreign governments and the federal government continue to turn the “screws,” a number of domestic jurisdictions heave become wonderful alternatives in regard to privacy, and asset protection. The difference is that none of these options on the prairie, desert or in the Heartland – South Dakota, Nevada or Ohi0- suffer from any of the political baggage of any of the offshore jurisdictions. Furthermore, domestic planning can always be done leaving an escape “hatch” in the event the “going gets tough” legally or politically, and you need to move back into a badly damaged tax haven.
Nevada has a two-year statute of limitations for pre-existing and future creditors. The statute of limitations is shortened to six months after discovery. The jurisdiction also does not have any limitation of benefits for “exception” creditors - spouse, alimony or child support obligations including government agencies. No affidavit of solvency is required for transfer to the trust. Additionally, the legal burden for a fraudulent transfer is clear and convincing evidence. Nevada has no state income taxation for trusts. A multi-generational trust may continue for 365 years. The legal structure for South Dakota, Ohio, and Tennessee trusts are very similar in nature. They may be slightly behind the best of the tax haven trust provisions, but not by much, and without negative optics and scandal.
Improved U.S. tax and trust laws over the last decade have greatly increased the desirability of international families to use the U.S. as their trust jurisdiction. International families may be able to minimize U.S. income taxation especially if there are no U.S. assets. The repeal against of the common law Rule Against Perpetuities in a number of states, would allow family trusts to continue for centuries without estate and generation skipping transfer taxes.
Adding a Second Note to the Samba – Using Private Placement Insurance Products to Minimize Taxation on U.S. Source Income
- Private Placement Life Insurance and Annuities
Life insurance and annuity products receive the greatest amount of tax advantage around the world when compared to other investments, including real estate. I am hard pressed to think of any jurisdiction around the world that does not provide significant tax benefits for life insurance and annuity products. Contrary to the United States, most jurisdictions do not have sophisticated tax definitions of life insurance. The problem in the marketplace has generally been the lack of availability of sophisticated institutionally priced products that provide for customized open architecture investment options for the ultra-affluent.
Most jurisdictions around the world provide for the tax-free buildup of the policy cash value; tax-free policy loans; and an income tax-free death benefit. No other investment category (including real estate) enjoys this preferential tax treatment. What could possible be wrong with structuring passive investments in a manner that receives a statutory exemption from income taxation?
Private placement life insurance products are customized variable insurance products issued to accredited investors or qualified purchasers. These products are generally issued by specialty life insurers specializing in these products. The policies allow for customized investment options. These policies may be issued by offshore or domestic life insurers. Carriers frequently offer both options.
The concept here is to have a PPLI or PPVA policy that is issued to the trustee of the domestic trust that is treated as a foreign trust for tax purposes. The policy is intended by design to be U.S. tax compliant. The policy should be issued by a domestic life insurer or an offshore life insurer that has made an IRC Sec 953(d) election to be treated as a U.S. taxpayer.
Under the majority of U.S. tax treaties, annuity income is only taxed in the foreign jurisdiction when remitted back to the home jurisdiction. Regardless of tax treaty status, a customized U.S. tax qualified private placement variable deferred annuity can be structured and owned within a U.S. trust, with the U.S. source income converted into tax-exempt annuity income for the trust and its beneficiaries.
- Taxation of Portfolio Income
IRC Sec 871 provides for a 30 percent withholding tax for fixed and determinable or periodic gains (FADP) unless a tax treaty provides for a lower rate of withholding. IRC Sec 871(h) provides an exemption for portfolio interest income. Dividends are frequently taxed at a 15 percent rate under many treaties.
- What is FIRPTA and ECI?
When a foreign person sells a U.S. real property interest, there is FIRPTA withholding system which requires the buyer of the property to deduct and withhold fifteen percent of the gross sales price and remit to the federal government within twenty days of the sale. The rules for FIRPTA are found in IRC Sec 897.
When a foreign person engages in a trade or business in the United States, all income from sources within the United States connected with the conduct of that trade or business is considered to be Effectively Connected Income (ECI). The withholding rate is 37 percent for individuals and 21 percent for corporations. State taxation can also apply.
This applies whether or not there is any connection between the income, and the trade or business being carried on in the United States, during the tax year. The foreign taxpayer is taxed according to the graduated rate structure. Corporate taxation at the state level can also apply.
Paolo Do Povo, is a citizen and resident of Brazil for tax purposes; he is not a U.S. resident for tax purposes. He has about $10 million that he would like to invest in U.S. real estate and private equity. The investments are currently held outside of Brazilian. He is worried about the tax authorities in Spain learning about his foreign assets and taxation on his U.S. investments (real estate and private equity).
Home on the Range Trust Company (“HRT”) is a South Dakota trust company. Pablo creates a foreign grantor trust with HRT as a trustee. Pablo’s brother, Joao, a Brazilian resident is the trust protector. The South Dakota trust is treated as a domestic trust for CRS reporting purposes and foreign trust for tax purposes. Samuel has the ability to replace the trustee.
Acme Investment Management is an investment management organization investing in private equity and commercial real estate. Acme will create a diversified portfolio of real estate and private equity holdings. The private equity holdings will be reflected in ownership of several U.S. operating businesses. Acme’s tax advisor suggests that the investment income will be considered U.S. source income. The real estate will be subject to FIRPTA. The business income will be subject to ECI.
Acme creates an insurance dedicated fund (IDF) with Corona Life, a Bermuda domiciled life insurer, to invest in U.S. real estate and private equity investments. The IDF is structured as a Delaware LLC. The only investor will be Corona Life on behalf of its policyholders and the Corona separate account. The PPVA contract is U.S. tax qualified and will meet all of the requirements of IRC Sec 817(h) and IRC Sec 72. Corona has made the IRC Sec 953(d) election to be treated as a U.S. taxpayer.
HRT as trustee will be applicant, owner and beneficiary of a private placement life insurance contract (“PPLI”). The PPLI contract is U.S. tax qualified. The investment income received within the policy is not taxable or subject to withholding tax. The trustee of the Trust may take tax-fre withdrawals from the policy and distribute them to Paolo and the family on a tax-free basis. No FIRPTA or ECI withholding is applicable under the arrangement. Equally as important, Paolo has no compliance reporting obligation to Brazilian authorities regarding his U.S. trust assets.
The dust has settled in Panama after the Panama Papers fiasco regarding the ability to hold offshore funds in offshore foundations. Pretty much every country on the globe has reporting requirements. Worldwide governments have entered into information exchange agreements. It is an odd result that the U.S. has emerged as the new “go to” jurisdiction in order to dance around the reporting obligations of CRS reporting. Additionally, a number of U.S. states do not require an LLC manager or member to be listed on a public database.
The use of private placement insurance products adds a different dimension to convert U.S. source income into tax-free income using a trust owned PPLI policy. The structuring provides for a combination of important compliance and tax benefits. The trust assets are not subject to reporting in the taxpayer’s home country while providing a vehicle for investment that is not subject to adverse withholding taxes for FIRPTA and ECI converting taxable income into tax-free income.
 Treas. Reg. 301.7701-7