TAX NEWS - January 2010

International tax and estate planning for high net worth families

The modern high net worth family can count on two forms of mobility: mobility of family members and mobility of investments and assets. International mobility can lead to a diversification of nationalities, tax residence, marital regimes, property rights, inheritance laws and estate taxes. Increased personal mobility has coincided with a broad expansion of a globally integrated economy with increased cross-border trade and investment, and high-net-worth families are major participants in this international investment.

Income tax consequences for international investments often will depend on the nationality and residence of family members, the nature and location of the investment, the form of investment vehicle, and, from the perspective of the taxing country, whether the investment is inbound or outbound.

International estate planning has elements that mimic those associated with income tax planning, such as nationality or domicile of the decedent and the location or "situs" of assets within a country for estate purposes. But international estate planning also requires an analysis of property rights, inheritance and succession rights, and conflicts of law. And while it is highly desirable to plan one's estate succession, post-mortem tax planning is often of equal or greater importance.

The risk of double taxation, taxation of the same income or the same assets by more than one country, is significant for high net worth families with international connections. With proper planning, however, it is often possible to mitigate this risk.

This article explores some of the key tax and estate planning issues facing U.S.-based families with foreign connections, foreign-based families with U.S. connections and the tax complexities associated with family mobility.


Key income tax issues for U.S.-based families with international investments

There are two key tax principles to keep in mind when considering international investments: (1) qualifying for the most favorable tax rate in the investor's country of tax residence; and (2) avoiding double taxation if the country where the income arises (i.e. is sourced) also taxes that income.

For individual U.S. taxpayers, the most favorable tax rates are reserved for long-term capital gains and qualified dividends, both of which qualify for preferential tax rates. Thus, in structuring international investments and assessing after-tax investment returns, the availability and preservation of favorable tax rates is very important. For the U.S. investor, some, but not all, long-term capital gains derived from the sale of shares in foreign companies will qualify for the preferential tax rates. If the foreign company is classified as a controlled foreign corporation (CFC) or a passive foreign investment company (PFIC), the analysis becomes more complicated, and the capital gains rates will not be available in all circumstances. Similarly, a dividend received on shares of a foreign corporation can be a qualified dividend eligible for the preferential tax rate if the foreign corporation paying the dividend is a tax resident of a country that has concluded a double taxation treaty with the U.S. However, not all tax treaties are effective for this purpose.

The net after-tax return on foreign investment income ultimately will depend on whether that income is also subject to foreign tax, i.e. taxation by the country from which the income derives and, if so, whether the U.S. will allow a credit for the foreign taxes paid.

The source country often will impose withholding taxes on cross-border dividends or interest paid by its own tax residents to tax residents of another country. The U.S. generally allows a credit for these foreign withholding taxes, but the foreign tax credit is subject to a multitude of requirements, which in some cases limit or deny a full credit. Bilateral tax treaties mitigate double taxation by reducing or eliminating withholding taxes on cross-border income or by specifically allowing a credit for taxes paid to the treaty partner country.

Even more problematic are foreign taxes imposed on capital gains derived from the sale of securities realized directly or indirectly (through pass-through entities) by U.S. taxpayers. In most cases, U.S. tax law treats such gains as U.S.-source income, which often has the effect of denying a tax credit for those foreign taxes. Bilateral tax treaties sometimes, but not always, address this problem (e.g. the U.S.-U.K. treaty does, but the U.S.-Spain treaty does not). The U.S. does not have a treaty with every country that, in some circumstances, taxes securities gains realized by nonresidents (e.g. Brazil), so there is a real risk of double taxation in these circumstances.

The U.S. has bilateral tax treaties with Canada, Mexico, nearly all European countries, and most of its key Asian trading partners, such as China, Japan, Korea and Singapore. The U.S. does not have a tax treaty with any South American country (except Venezuela), or with Hong Kong.

Tax treaties can play an important role in reducing or eliminating the double taxation of cross-border income and, therefore, are an important factor to consider in assessing after-tax returns on international investments. Each treaty is different, so tax benefits of investing in a treaty jurisdiction can be assessed only by examining the relevant treaty.


Investment vehicles to structure international investments

U.S. high net worth families should focus on investment vehicles that deliver the tax benefits described above: (1) one level of taxation at individual tax rates, especially the preferential rates for long-term capital gains and qualified dividends; and (2) a foreign tax credit for foreign taxes paid. Generally, these goals are achieved if investments are owned by pass-through vehicles, such as partnerships or trusts, and not through domestic corporations or foreign corporations. Only individuals and trusts are eligible for the preferential tax rates for long-term capital gains and qualified dividends. In contrast, a domestic corporation is subject to U.S. corporate tax at rates of up to 35% without any preferential treatment for capital gains, and any foreign taxes paid by the domestic corporation cannot be taken as a credit by the individual shareholder. Furthermore, the use of a domestic corporation implies two levels of taxation because the U.S. individual shareholder also would be taxed upon the receipt of a dividend from the domestic corporation. The one exception is a domestic corporation that has elected to be treated as an S corporation. An S corporation allows for the pass-through of capital gains and foreign tax credits, but is subject to numerous technical limitations, which make it generally undesirable as a holding vehicle for portfolio investments (e.g. the requirements that the S corporation have only one class of stock and no foreign shareholders).

Similarly, the use of a foreign corporation as a holding company for international investments generally will be detrimental from a U.S. tax perspective. The foreign holding company likely would be classified as a CFC for U.S. tax purposes, which means that its investment income would be imputed to the U.S. shareholders at ordinary income tax rates without any tax credit for foreign taxes paid by the foreign holding company. In some cases, it may be desirable to use a foreign corporation as a holding company for a reason specific to the particular country or type of investment. In that case, however, the U.S. owners would likely make an election under U.S. tax law to treat the foreign corporation as a passthrough entity. This type of election is called an entity classification election or check-the-box election. Entity classification planning for foreign entities plays an important role in structuring international investments.

If an investment is made in a foreign collective investment vehicle (e.g. a foreign corporation, foreign limited liability company or foreign unit investment trust), the U.S. investor must carefully consider the impact of the rules relating to PFICs. The PFIC rules are intended to level the tax playing field between U.S. and foreign collective investment vehicles (e.g. mutual funds). For a U.S. investor, dividends and capital gains earned on foreign mutual fund investments are taxed at the ordinary income tax rates, plus an interest charge for U.S. taxes that are deemed to have been deferred on the earnings. Thus, the U.S. investor should approach any investment in a foreign collective investment vehicle with extreme caution in order to verify whether it is a PFIC. In some cases, it may be possible to elect to be taxed annually on the U.S. investor's share of PFIC earnings, a "qualified electing fund" (QEF) election, in which case the availability of the long-term capital gains rate will be preserved. The availability of the QEF election, however, is not guaranteed; it requires the cooperation of the fund itself, which, in many cases, will not be forthcoming. U.S. investment partnerships sometimes invest in PFICs and, in that case, the U.S. investment partnership is responsible for making the QEF election.


Impact of estate or inheritance taxes on structuring international investments

Estate taxes or inheritance taxes can affect the structuring of international investments. The appropriate structure will depend on a number of factors, including the nationality and domicile of the donor and beneficiary, the nature of the asset and the application of a bilateral estate, gift and inheritance tax treaty.

The U.S. imposes estate and gift taxes on the worldwide assets of its citizens (even if the U.S. citizen does not reside in the U.S.) and on foreign nationals who are domiciled in the U.S. In the case of U.S.-based families who invest internationally, the potential for double taxation can arise if the foreign country where the asset is located imposes an inheritance tax on the value of that asset based upon its location. In addition, the potential for double estate or inheritance taxation can arise if a U.S. citizen lives abroad and becomes domiciled in another country. In that case, the U.S. would impose its estate tax based upon U.S. citizenship, and the country where the U.S. citizen lives may impose an inheritance tax based on domicile.

The planning approach in the first situation, where a U.S. citizen owns an asset located in a foreign country that might be subject to inheritance tax in the country (foreign real estate is a typical example), usually includes one or more of the following elements:

- Verification is needed on whether the estate of the U.S. citizen will receive a tax credit for any foreign inheritance taxes paid;

- If the foreign tax credit will not be available or cannot be fully utilized to offset U.S. estate tax, the planning will focus on changing the situs of the foreign assets, usually by holding the asset through an entity formed outside the country where the asset is located;

- In some cases, a bilateral estate, gift and inheritance tax treaty will provide relief from double taxation, but there are far fewer such treaties than income tax treaties and the usefulness of these treaties often is limited.

The second situation, where a U.S. citizen lives abroad and becomes domiciled in another country, can be more difficult to manage. Since most developed and developing countries impose some form of inheritance tax on the worldwide assets of a person who is domiciled there, double estate, gift and inheritance taxation is a distinct possibility. It may be well advised to focus on pre-immigration transfers of assets (i.e. before becoming domiciled in the foreign country) to remove assets from the inheritance tax base in the foreign country. In other cases, the better course may be to manage the U.S. citizen's affairs so that he/she does not become domiciled in the foreign country. This approach usually involves limiting the number of days of presence in the foreign country and maintaining close social and economic ties to the U.S. Finally, estate, gift and inheritance tax treaties can play a role; certain treaties (e.g. the U.S.-U.K. treaty and the U.S.-France treaty) contain fairly specific rules for resolving conflicts over domicile by assigning the primary right to tax to one country or the other. The move by a U.S. citizen to another country and becoming domiciled there – even if that country has entered into an estate, gift and inheritance tax treaty with the U.S. – will not exempt the U.S. citizen from U.S. estate taxes because the U.S. always reserves the right to tax its citizens wherever they reside.


Tax considerations for non-U.S. families making U.S. investments

Non-U.S. families have considerably more flexibility in structuring their U.S. investments from an income tax and estate tax perspective, but planning must be coordinated with taxation and legal restrictions in their home country.

Fairly broad categories of U.S.-source income earned by non-U.S. persons are exempt from U.S. taxation, including interest on U.S. bank deposits, interest on most corporate and government bonds, and capital gains upon the sale of U.S. stocks and bonds. The major exceptions are (1) dividends paid by U.S. corporations, which are subject to a 30% withholding tax unless reduced by treaty, rental or royalty income from U.S. sources; and (2) gains from the sale of U.S. real estate or shares in U.S. corporations that are classified as U.S. real property holding corporations under the Foreign Investment in Real Property Tax Act (FIRPTA).

The breadth of the U.S. estate tax for non-U.S. persons is also limited. Foreign nationals who are not domiciled in the U.S. are subject to U.S. gift and estate tax only with respect to assets that have a situs within the U.S; in the case of the estate tax, these principally will be shares in U.S. corporations, U.S. real property and tangible personal property located in the U.S. (e.g. art and jewelry). Thus, planning for the foreign person will focus on the situs of assets and an examination of whether ownership of U.S. assets by entities or trusts is preferable from an estate tax and income tax perspective and is otherwise practical from the standpoint of family control and governance.

The structuring of ownership of U.S. real estate, whether for business or personal use, is particularly troublesome in light of the sometimes conflicting estate tax and income/capital-gains tax considerations. And one must never lose sight of the fact that the foreign person will need to coordinate any U.S. estate tax planning with the estate tax system and the laws of inheritance and succession in his/her country of domicile.

But it is family mobility that presents some of the most challenging tax and structuring issues for non-U.S. families, that is, when one or more members of the family move to the U.S. either temporarily or permanently. In those circumstances, expert pre-immigration advice is essential.


Effect of family mobility on investment planning and taxation

Both business and personal transitions can affect a family's wealth and exposure to taxation. Thus, it is important to consider carefully the implications of cross-border moves. Consider the following two examples:

A family owns a valuable closely held business and wishes to expand operations in another country. One of the family members, who is a shareholder in the business, moves to the new country to manage the expansion and becomes a tax resident of that country. This move, motivated by sound business objectives, could dramatically change the taxation of income earned by the business enterprise. In this example, if the family and its business were essentially non-U.S., the U.S. business expansion and the movement of the family member/shareholder to the U.S. often would require a close examination of the CFC rules, the PFIC rules and whether the activities of the family member in the U.S. would cause the foreign business enterprise to have a taxable presence in the U.S. In many cases, it is possible to mitigate these tax issues with proper planning. Similar tax issues often arise in reverse when U.S.-based families send family members or shareholders overseas to expand closely held businesses. These types of tax issues are more typical in certain European countries and in OECD member countries.

It is not only business-related moves that can raise tax issues. Consider the example of a Latin American family that has cashed out of its closely held business and has created a private investment fund open only to its family members. Each family member owns shares in the fund and the fund invests in a diversified portfolio of U.S. and foreign securities. One young member of the family, who has already received her shares in the family investment fund, moves to the U.S. to pursue an MBA at an Ivy League college and may pursue her business career in the U.S. upon graduation. Furthermore, the individual will likely inherit additional shares in the family investment fund upon her father's death. The U.S. income tax and estate planning issues resulting from this individual's decision to move to the U.S. are myriad.


Importance of post-mortem planning upon death of key member of international family

Prompt post-mortem planning and action is of critical importance upon the death of a key member of an international family. There are a number of tax issues that will require immediate analysis and action, such as the following:

- Determine the tax residence of the estate for income tax purposes. In some jurisdictions, such as the U.S., the estate itself is a taxpayer with respect to income and gains arising during estate administration. With residence planning for the estate, it may be possible to reduce income taxes on post-death income arising during estate administration.

- Analyze the tax consequences to trusts funded by the decedent. In some cases, the death of the settlor can result in a change in the tax status (e.g. grantor trust to nongrantor trust) or tax residence of the trust (e.g. domestic trust to foreign trust). There may be significant tax benefits associated with making an election to treat a revocable trust as part of the estate for income tax purposes.

- Analyze the change in tax status of foreign entities. In the case of inbound estates (i.e. non-U.S. decedent with U.S. beneficiaries), the death of the foreign family member may shift the ownership of foreign entities to U.S. persons, whether by means of the joint title to assets, under the laws of inheritance, pursuant to a last will and testament or as trust beneficiaries. Thus, it will be necessary to review the tax status of foreign entities (e.g. under the CFC or PFIC rules) and to take appropriate action if necessary. Entity classification planning (whether to file check-the-box elections for eligible foreign entities and the effective date of the election) is often an important component of post-mortem planning for the inbound international family. Similarly, investments in foreign collective investment vehicles may shift to PFIC status upon the death of the foreign owner with U.S. beneficiaries and it will be necessary to consider any relevant tax election available for interests in PFICs.

- Plan for trust distributions to U.S. beneficiaries. Post-mortem planning where interests in foreign entities are owned by foreign trusts with U.S. beneficiaries presents its own set of issues, such as the attribution of ownership to U.S. persons and the application of a special tax regime for distributions by foreign trusts to U.S. persons (the "throwback tax" and interest charge). It will be necessary to analyze the burdens and benefits of accumulating income and gains in a foreign trust with U.S. beneficiaries compared with other patterns of distribution, or perhaps a domestication of the trust.


Managing investment, legal, tax and accounting issues

High net worth families typically work with independent investment advisory firms on asset allocation and choice of investment managers, but sometimes work directly with investment management firms on both asset allocation and asset management. Often, they structure a family office that may employ a full-time investment manager or managers who will interface with the outside service providers and who will prepare management reports for the family, the family members' trustees and any persons involved in family governance, such as a family investment committee or board of trust protectors. For families with an international investment horizon, the analysis of asset allocation is not limited to the traditional asset classes of equities (e.g. small, medium and large-cap, growth versus value) and bonds (e.g. short, mid and long-term, U.S. government versus corporate, taxable versus tax exempt). Rather, the analysis also should include classes defined by geography, economic development, political risk and, as discussed above, the net after-tax return in light of the source of income and the tax residencies and nationalities of the family members. Thus, the selection of internal and external investment advisors and managers who think globally and who understand the tax position of the family members is critical. Of equal importance is the selection of professional advisors who have deep knowledge and experience in providing professional services to international family offices. This will include legal counsel in each relevant jurisdiction (e.g. jurisdictions where family members reside, where assets are located or where entities are formed or are doing business) and tax advisors who can anticipate the multijurisdictional tax planning and compliance needs of the international high net worth family.