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Check it out

  • Author : Anthony Viegas-Haws
  • Author : Darlene Hart
  • Date : March 2010
ABOUT THE AUTHORS: Anthony Viegas-Haws is Senior Tax Manager, Trusts and Estates and Darlene Hart is Chief Executive Officer at US Tax and Financial Services Ltd

In May 2009, the Obama Administration proposed several tax cuts and revenue raisers. Among these proposals is a recommendation to reform the business entity classification rules (‘check-the-box’ rules) as applied to non-US companies. The current check-the-box rules permit an eligible business entity with a single owner, such as a trust, to elect to be treated as a tax transparent entity (‘disregarded entity’) for purposes of US federal income taxes. Under the Administration’s proposed changes, an otherwise eligible non-US company would be authorised to elect disregarded entity status only if it is organised or created in the same jurisdiction as its single owner.

The ability of certain non-US companies to elect disregarded entity status for the purposes of US federal income taxes is a useful US estate tax planning tool in situations involving trusts settled by non-US residents, especially if the trust’s secondary beneficiaries are US persons (citizens or residents1). Thus, the Administration’s proposed changes to the check-the-box rules will have an important impact on non-US resident2 estate planning.

Under current US Treasury regulations, certain eligible business entities may elect their classification for federal income tax purposes. For example, an eligible business entity3 with a single owner may elect to be treated as a corporation or as a disregarded entity. If an eligible entity elects to be treated as a disregarded entity, then the US tax rules deem all tax attributes, i.e. income, credits, deductions, gains and losses, of the disregarded entity to be owned by the disregarded entity’s single owner.

The Obama Administration’s proposed changes to the check-the-box rules are detailed in the US Treasury’s General Explanations of the Administration’s Fiscal Year 2010 Revenue Proposals (the ‘Green Book’). The Green Book explanation indicates that a non-US entity may be treated as a disregarded entity only if it is created or organised in, or under the law of, the foreign country in which its single owner is created or organised. Therefore, a non-US eligible business entity (non-US company) that is organised or created in a country other than that of its single owner would be treated as a corporation for federal tax purposes, and could not elect to be treated as a disregarded entity. This proposal would generally not apply to foreign eligible entities directly and wholly owned by a US person. These proposed changes will have a significant impact on basic estate planning tools used by non-US residents to shield their assets from US estate taxation.

These proposed changes will have a significant impact on basic estate planning tools used by non-US residents to shield their assets from US estate taxation

The extent to which the US estate tax applies to bequests is primarily a question of whether the donor or decedent transferring the property is a US citizen or US resident.4 US citizens and residents are subject to the US estate tax on their worldwide transfers of assets regardless of the location of the property or the specific type of property being transferred, i.e. the transfers apply to real property and personal property. Non-US citizens and non-US residents (collectively ‘non-US residents’) are only subject to the US estate tax on transfers of assets deemed to be situated in the US (‘US-situs assets’).5 The shares of a corporation organised outside the United States are not considered US situs. Hence, a common and relatively simple strategy for limiting the exposure of a non-US resident’s assets to the US estate tax is to transfer all US-situs assets to a non-US company. Upon the death of the non-US resident, the assets he or she owns are the non-US shares, which are excluded from the US estate tax as the shares are non-US situs. In essence, assets that would otherwise be subject to the US estate tax are excluded if they are held by a non-US company.

This strategy is also effective when combined with a trust structure. For example, a common structure utilised for non-US residents with both US and non-US situs assets is a trust with two non-US companies. One company holds and shields the US-situs assets while the other holds the non-US situs assets.6 Because the US situs assets are held by a non-US company, they will be effectively blocked from the US estate tax.7

The necessity for the check-the-box rules comes into play after the death of the trust’s settlor. If a US person acquires a beneficial interest (‘US beneficiary’) in the trust following the settlor’s death, then the US beneficiary would potentially be deemed a shareholder of the underlying non-US holding companies. The result is that the US beneficiary could be subject to the anti-deferral regimes, specifically the controlled foreign corporation (CFC) and passive foreign investment company (‘PFIC) regimes.

Without additional planning, the result of these regimes would cause negative US income tax results for the US person beneficiary. If the non-US company is treated as a CFC, then passive types of income are deemed ratably distributed annually to the US persons deemed owning 10 per cent or more of the stock. This is true regardless of actual distributions from the non-US company or trust to the US person beneficiary. Thus, a US beneficiary could be obligated to recognise income without necessarily receiving the actual income to pay the associated taxes.

The PFIC regime is in some ways more onerous than the CFC regime. If a non-US company is treated as a PFIC for US income tax purposes then the deemed US shareholders, i.e. US beneficiaries, are subject to negative tax results on certain distributions from the PFIC or gains on sales. A distribution from a PFIC that exceeds 125 per cent of the prior three year average, or gains on the sale of PFIC stock, are pro-rated over the deemed shareholder’s holding period and subject to an interest charge and the highest rate of tax for the applicable year.

In light of these potential negative US tax results, a simple solution for a US person beneficiary is to have the non-US company file a check-the-box election to be treated as a disregarded entity for purposes of US federal taxes. This simple manoeuvre effectively eliminates the application of the anti-deferral regimes discussed above.8 Thus, in the case of a non-US resident settling a non-US trust with a wholly owned non-US company, this strategy has always addressed the problem of both the US estate tax exposure and the implications of the US anti-deferral regimes to US person beneficiaries of the trust.

However, if the Obama Administration’s proposals are enacted by the US Congress, the abilities of a non-US company wholly owned by a trust will be severely curtailed. The probability that the US Congress (or the US Department of Treasury by way of the Treasury Regulations) will enact this proposal is considerable given the Democratic majorities in both the House and the Senate. Additionally, it is unclear if a grandfather clause will be included in the enacted legislation. Thus, estate planners must consider the potential ramifications that this proposal will have on their clients if enacted, and determine alternative solutions.

Given the lack of details in the proposal, it is difficult to provide specific planning techniques at this time. However, certain possibilities are apparent based on the language provided in the Green Book. First, the language of the proposal states that the limitation would not apply where the single owner and the non-US company are organised in the same jurisdiction. For example, the proposal limits the application of the disregarded entity election in circumstances where a British Virgin Islands trust owns a Cayman Islands limited company. An obvious solution in this situation is for the trust and non-US company to be organised in the same jurisdiction. Under the proposal, a Cayman Islands limited company could elect to be treated as a disregarded entity if its single owner trust were also organissed in the Cayman Islands. Once further details are presented by the US Congress or the Obama Administration alternative planning solutions will be apparent.

In summary, the proposed changes to the check-the-box rules would limit the situations in which it is possible to use a non-US company to shield the US-situs assets of a non-US resident from the US estate tax, especially when a trust wholly owns the non-US company. The issue facing wealth planners at this point is when the US Congress might adopt the proposal. Given this uncertainty, wealth planners should evaluate the situations where a proposed change to the check-the-box rules would cause exposure for US beneficiaries to the anti-deferral regimes. Understanding the potential exposure will assist in finding a swift remedy in the event of enactment.

A person is a US resident for purposes of the US federal income tax laws if he or she is a lawful permanent resident, satisfies the substantial presence test, makes an election in the first year of residency or is treated as a US income tax resident under a treaty.
A person is a US resident for purposes of the US estate, gift and generation-skipping transfer taxes (the ‘transfer taxes’) if he or she is physically present in the US with the intent to remain. Generally, a lawful permanent resident will be treated as a US resident for transfer tax purposes.
An eligible entity is any entity that is not classified for federal tax purposes as a corporation. Generally, a ‘limited liability company’ is an eligible entity.
see supra n. 2.
It is important to note that the situs of an asset differs for estate and gift tax purposes. For example, shares in a US company are US-situs for estate tax purposes but non-US situs for gift tax purposes; shares in a non-US company are non-US situs for both estate and gift tax purposes.
Using two companies as opposed to one is simply to separate the US situs assets from the non-US situs assets.
This example assumes that the trust would be a foreign grantor trust during the life of the settlor and a foreign non-grantor trust after the death of the settlor for US federal tax purposes.
However, a US beneficiary of a foreign non-grantor trust must address the accumulation distribution regime.

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