By Anthony Diosdi
Foreign investors generally have the same goals of minimizing their income tax liabilities from their U.S. real estate and business investments, as do their U.S. counterparts, although their objective is complicated by the very fact that they are not U.S. persons. That is, non-U.S. investors must be concerned not only with income taxes in the United States, but also income taxes in their home country. Further, the United States has a special estate tax regime that is applicable to non-resident aliens that must be considered by foreign investors. Specifically, U.S. federal law imposes a transfer tax upon the privilege of transferring property by gift, bequest, or inheritance. This transfer tax takes the form of an estate tax.
The tax is measured against a tax base that includes not only the assets of decedent’s probate estate, but also certain gifts by the decedent during life that are deemed to be the equivalent of testamentary transfers either because the decedent retained an interest or power over the gift. Items included in a decedent’s gross estate are reduced by other items to calculate the decedent’s taxable estate. The estate tax is currently ranging from 18% to 40%. United States citizens and residents receive a credit against the estate tax in the amount of $12,060,000 for the 2022 calendar year. On the other hand, non-residents are permitted a unified credit of $13,000, equivalent to a $60,000 exemption against the estate tax, unless an applicable estate tax treaty allows a greater credit.
The term “residency” for estate tax purposes means “domicile.” When dealing with U.S. federal and state income tax, an individual can have more than one residence. This is not the case with the U.S. federal estate tax. For U.S. federal estate tax purposes, an individual can have only one place of domicile. However, there are exceptions to this general rule when applying estate tax treaties with the Netherlands, France, and the United Kingdom to a decedent’s estate.
The estate and gift tax regulations offer a general indication of what is meant by domicile for estate and gift tax purposes by stating as follows:
“A person acquires a domicile in a place by living there, even for a brief period of time, with no definite present intention of later removing therefrom. Residence without the requisite intention to remain indefinitely will suffice to constitute domicile, nor will intention to change domicile effect such a change unless accompanied by actual removal.” See Treas. Reg. Section 20.0-1(b)(1) and 25.2501-1(b). Thus, to be domiciled in the United States, physical presence must be coupled with the requisite intent to remain indefinitely or permanently, or at least to abandon the old domicile.
If the applicable estate tax credit available to United States citizens or domiciliaries is inappropriately extended to and applied by a non-domiciliary alien decedent’s estate, a significant and heightened disparity in the level of estate tax may result. More specifically, United States citizens and domiciliaries are subject to estate taxation on worldwide property. By contrast, non-resident’s that are classified as non-domiciled aliens are subject to U.S. estate tax on real, tangible, or intangible property that is situated in one of the U.S. states or the District of Columbia at the time of death.
Due to the limited credit equivalent exemption, many non-resident aliens with U.S. situs assets may be subject to a substantial estate tax. However, with proper planning, foreign investors in the U.S. can often avoid the U.S. estate tax. Taking into income tax considerations, below is a partial list of planning opportunities available to non-domiciliaries to mitigate their exposure to the U.S. estate tax:
1. Use of Corporate Ownership Structures- Historically, foreign individuals have placed U.S. situs property in corporate structures to avoid the estate tax. Frequently, a foreign corporation was either the direct U.S. investment owner or was a holding company for a U.S. subsidiary (which, in turn, owned the direct U.S. investment). However, in many cases, the direct ownership of U.S. situs property by foreign corporations is not advisable because of the branch profits tax. The branch profits tax subjects non-U.S. shareholders to a 30 percent withholding tax on the sale of any U.S. situs asset such as the sale of real estate. On the other hand, the branch profits tax typically will be reduced or inapplicable if the non-resident investor is from a favorable U.S. treaty country and the foreign investor utilizes a home treaty company. See IRC Section 884(e)(2)(B); Treas. Reg. Section 1.884-5T. The existence of a home-country treaty with the United States that overrides or limits the branch-profits tax, therefore, may make a critical difference in the U.S. tax planning approaches. Based upon the clarification provided by IRS Notice 87-56, many older U.S. income tax treaties will serve to override the branch profits tax.
In Notice 87-56, 1987-2 C.B. 367, the IRS clarified which treaties would be considered as serving to override the branch profits tax. Rather than limiting this list to those treaties with “nondiscrimination clauses” based upon Article 24(3) of the U.S. 1981 Model Income Tax Treaty (as some have suggested that the 1986 TRA Conference Report at II-650 could be read as so limiting), the IRS has taken the more expansive view that all “nondiscrimination clauses” in the U.S. income tax treaties serve to override the branch profits tax unless the treaty explicitly sanctions the imposition of the branch profits tax. See The U.S. Tax Effects of Choice of Entities for Foreign Investment in U.S. Real Estate and Businesses and the Taxation of Dispositions of U.S. Partnership Interests, Robert F. Hudson, Jr. (2015).
2. Hybrid Structures Benefiting from Entity Characterization Differences- A variation on the direct ownership of U.S. assets by a home-country and treaty company would be the use of a variation on the direct ownership of U.S. assets by a home country entity that qualifies as a “corporation” for U.S. income tax purposes and a “partnership” for home country tax purposes. The possibility of having such a conflicting characterization, coupled with certain predicate treaty provisions, may combine to provide the best overall tax results in both the United States and the home country at the same time, such a structure may avoid the U.S. estate tax on U.S. situs assets. The tax benefits of a hybrid structure may include a single level of U.S. income tax on the U.S. business profits, exemption from home country taxation on any U.S. business profits and, in rare cases, exemption from both U.S. and home-country income tax of amounts paid as interest by the home country treaty “corporation” to its treaty shareholders. In order for this combination of results to be obtained, a number of predicate factors must be present. First, a favorable U.S. income tax treaty that overrides the branch profits tax is still essential because the foreign entity must constitute a “corporation” from a U.S. tax perspective in order to obtain the benefits of the assured U.S. estate tax insulation. In addition, treaty articles providing for the taxation of the U.S. real estate income or other U.S. business income only in the United States is also important (although a basic home-country rule exempting foreign source income from home-country taxation would also suffice for this purpose). The real key to this combination of results, however, lies in the conflicting characterization of the foreign entity as between the U.S. and home-country tax laws, something that has been facilitated by the U.S. “check-the-box” rules. The real key difference to this combination of results, however, lies in the conflicting characterization of the foreign entity has between the U.S. and home-country tax laws, something that has been facilitated by the U.S. “check-the-box” rules. As a result, it would be possible to structure a foreign entity treated as a corporation for U.S. purposes, even though the entity would be viewed as constituting a “partnership” (or other “transparent entity”) under the home-country tax laws.”
If holding U.S. real estate directly by the home-country treaty company will expose that treaty company to home-country income taxation at rates that are higher than those applicable in the United States, then it generally will be preferable to have a treaty company own a U.S. subsidiary company that, in turn, owns the U.S. real estate or U.S. business. The tandem “treaty parent U.S. subsidiary” approach normally will insulate the U.S. real estate income from current home-country income taxation. Also, the tandem “treaty parent U.S. subsidiary” approach may be advisable if the applicable U.S. treaty does not exempt foreign corporations formed in that treaty jurisdiction (e.g., Canada, France, Australia or Switzerland) from U.S. branch profits tax.
3. Partnership Structure- foreign investors may also invest in the U.S. through partnerships and other pass-through entities. However, there is some uncertainty whether or not a partnership is U.S. situs for purposes of the estate tax. For those foreign investors willing to test the parameters of U.S. estate tax for partnerships or other pass-through entities, in certain cases, the foreign investor may be in a much better income tax position as compared to holding U.S. investments through a corporate structure.
With appropriate refinement, the above concepts and structures may be duly implemented by a foreign investor to minimize and potentially avoid U.S. estate tax.
Planning Options with U.S. Estate Tax Treaties
With proper planning, foreign investors in the U.S. may also avoid the U.S. estate tax using an estate tax treaty. The U.S. has entered into a series of bilateral estate tax treaties with “developed” nations. Currently, the U.S. has estate tax treaties with Finland, Greece, Ireland, Italy, the Netherlands, South Africa, and Switzerland. The U.S. has estate and gift tax treaties with Australia and Japan. The estate tax treaty network is limited in comparison to the far greater number of income tax treaties which the U.S. presently has in force. As a result, the ability of many foreign investors to utilize estate tax treaties is relatively restricted. On the other hand, a tax attorney, instructuring a foreign investor’s U.S. investment, must take into account the possibility that in the modern world, the domicile of an individual may change. Many non-residents own assets all over the world, including in the U.S. If a nonresident resides in the U.S. or a treaty country at the time he or she dies, a treaty may substantially affect the ultimate taxation thereof.
Residence and Domicile for Estate Tax Treaty Purposes
The U.S. estate tax treaties with Australia, Finland, Greece, Ireland, Italy, Japan, South Africa, and Switzerland state that domicile is determined in accordance with the internal laws of each country. Thus, the regular U.S. domicile test will apply to these treaties. As for the U.S. estate tax treaties with Austria, Denmark, France, Germany, Netherlands, and the United Kingdom, a different residency test applies. Generally speaking, under these estate tax treaties, if an individual is viewed by both treaty countries as a domiciliary thereof, he or she will be treated as a domiciliary of the treaty country of which he or she is a citizen if that individual resided in the other treaty country for fewer than 7 of the 10 (or 5 of the 7) years prior to the transfer in question. If this test is inapplicable, domicile is determined as follows: 1) permanent home; 2) center of vital interests; 3) habitual abode; 4) citizenship, or 5) mutual agreement. See Estate and Gift Taxation of Nonresident Aliens in the United States, Florida Institute of CPAs (2016), Michael Rosenberg.
Notable, estate planning may potentially be enhanced through application of an appropriate estate tax treaty between the United States and a foreign jurisdiction. To illustrate, Paragraph 5 of Article 8 of the United States- United Kingdom estate tax treaty
provides as follows:
“Where property may be taxed in the United States on the death of a United Kingdom national who was neither domiciled in nor a national of the United States and a claim is made under this paragraph, the tax imposed in the United States shall be limited to the amount of tax which would have been imposed had the decedent become domiciled in the United States immediately before his death, on the property which would in that event have been taxable.”
The IRS Technical Explanation for Paragraph 5 of Article 8 of the United States United Kingdom Estate Tax Treaty provides that U.S. tax imposed on the estate of a national of the United Kingdom, who is neither domiciled in nor a national of the United States, will not be greater than the tax which would have been imposed if the decedent had been domiciled in the United States and taxed by the United States on his worldwide property. This provision could be beneficial to the estates of United Kingdom citizens that can be classified non-domiciliaries for U.S. estate tax purposes. This provision may exempt virtually all United States situs assets from the U.S. estate tax provided the collective value of the non-resident’s worldwide assets does not exceed the applicable credit amount ($12,060,000 for 2022) as available to a United States domiciliary.
Conclusion
The foregoing discussion is intended to provide a basic understanding of the principal planning alternatives in cases of cross-border estate planning. It should be evident from this article, however, that this is a relatively complex subject, especially if the non-resident investor plans to own U.S. real estate or businesses. In addition, it is important to note that this area is constantly subject to new developments and changes, as Congress continually entertains new tax laws, the IRS promulgates new regulations, rulings, announcements and interpretations, and federal courts issue new opinions impacting this subject matter. As a result, it is crucial that foreign investors review his or her circumstances with a qualified international tax attorney.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.