By Anthony Diosdi
In the individual foreign investor setting, inbound tax planning often requires a balancing of U.S. income tax considerations and U.S. federal gift and estate tax considerations. While U.S. federal income tax rates on the taxable income of an individual foreign investor are the same as those applicable to a U.S. citizen or resident, the federal estate and gift tax as applied to individual foreign investors can and often results in a dramatically higher burden on a taxable U.S. estate or donative transfer of a foreign investor than for a U.S. citizen or domiciliary. As a result, for many individual foreign investors, the most important U.S. tax consideration is the U.S. federal estate and gift taxation.
The United States imposes estate and gift taxes on certain transfers of U.S. situs property by “nonresident citizens of the United States.” In other words, individual foreign investors may be subject to the U.S. estate and gift tax on their investments in the United States. The U.S. estate and gift tax is assessed at a rate of 18 to 40 percent of the value of an estate or donative transfer. An individual foreign investor’s U.S. taxable estate or donative transfer is subject to the same estate tax rates and gift tax rates applicable to U.S. citizens or residents, but with a substantially lower unified credit. The current unified credit for individual foreign investors or nonresident aliens is equivalent to a $60,000 exemption, unless an applicable treaty allows a greater credit. U.S. citizens and resident individuals are provided with a far more generous unified credit from the estate and gift tax. U.S. citizens and resident individuals are permitted a unified credit of $12.06 million.
For U.S. citizens and residents that may be subject to the estate and gift tax, there are a number of planning opportunities available to mitigate the harsh consequences of the tax. The article will discuss estate and gift tax planning opportunities available to foreigners who will acquire real property in the United States.
Owning the Real Property Directly
The simplest planning estate and gift tax planning option available to a foreign investor is to own U.S. real property directly and sell the property before he or she dies. The problem is this type of planning depends on one’s ability to predict his or her own death. Although directly holding U.S. is risky, there are planning options available to individual investors that could reduce or eliminate the estate and gift tax.
Use of a Tax Treaty
If possible, the first planning option is to use an estate or gift tax treaty to eliminate the U.S. gift and estate tax consequences associated with holding U.S. real estate. The U.S. presently has treaties with a limited number of countries regarding estate, gift, or generation skipping transfer taxes. These treaties are important for individuals who may otherwise be subject to the U.S. estate and gift tax. If the foreign investor is domiciled in a country which the U.S. has an estate or gift tax treaty, there may be planning opportunities to eliminate the U.S. estate and gift tax. Under the U.S. treaties with Australia, Finland, Greece, Ireland, Italy, Japan, South Africa, and Switzerland, regular domicile rules (discussed above) will continue to apply, subject to each treaty’s special property situs rules. Under the U.S. tax treaties with Austria, Denmark, France, Germany, the Netherlands, and the United Kingdom, a series of tie-breaker tests apply for purposes to determine when an individual is deemed domiciled in both treaty jurisdictions under their own internal laws. See Domicile Is Key in Determining Transfer Tax of Non-Citizens, Estate Planning/January/February 1995, Leslie A. Share.
In general, if an individual is viewed by both treaty countries as a domiciliary thereof, he will be treated as a domiciliary of the treaty country of which he is a citizen if he resided in the other treaty country for fewer than seven of the ten years (or five of the past seven years) prior to the transfer in question. If this test is inapplicable, domicile is determined by: permanent home, center of vital interests, habitual abode, citizenship, or mutual agreement.
Use of Financing to Reduce Exposure to the Estate Tax
If the foreign investor is not domiciled in a country which the U.S. has an estate of gift tax treaty, the foreign investor may make use of nonrecourse financing to reduce his or her exposure to the U.S. estate and gift tax. A foreign investor may potentially reduce his or her exposure to the estate and gift tax through nonrecourse financing (A nonrecourse loan is a secured loan that is secured by a pledge of collateral, typically real property, but for which the borrower is not personally liable) on acquired real property. Property that a nonresident decedent owns at death is subject to the U.S. estate tax, its value enters into the computation of the value of the death. However, this amount is decreased by the value of outstanding debt. In order for nonrecourse financing to be recognized under U.S. tax law, interest must be assessed on the debt. Since such planning typically involves the payment of interest to a foreign party, U.S. withholding rules must be considered.
As a general matter, the United States imposes a 30 percent withholding on U.S. sourced payments to foreign persons if such interest income is not effectively connected with a U.S. trade or business of the payee. In certain cases, a treaty may be used to reduce the 30 percent withholding paid to foreign parties. In other cases, portfolio debt planning can be used to eliminate the 30 percent withholding. Interest paid to foreign persons with respect to certain portfolio debt instruments is not subject to U.S. withholding tax. However, there are three important exceptions to the portfolio debt rules. First, the portfolio interest exemption will not apply to any interest received by a bank. Second, the portfolio debt rules will not apply to interest received by a 10-percent shareholder (If the borrower is a corporation the 10 percent shareholder rule requires that the receipt of the interest not own 10 percent or more of the combined voting power of all classes of stock of such corporation). Finally, the portfolio interest exemption will not apply to any interest received by a controlled foreign corporation (“CFC”).
Use of Self-Canceling Installment Notes to Avoid the Estate and Gift Tax
A foreign investor may also consider transferring his or her interest in U.S. real property to designated beneficiaries through a self-canceling installment note or “SCIN.” If done correctly, a SCIN may be used as a vehicle to transfer property to loved ones without triggering the estate and gift tax.
A SCIN is a technique that is sometimes used to avoid the inclusion of a note receivable in the holder’s estate.
For example, Mom sells Blueacre to Son for a note. Son’s note is for a period of ten years or Mom’s life, whichever is shorter. If Mom dies before the note is fully paid, the note is not technically canceled- rather, it has been satisfied, because all payments required pursuant to its terms have been made. Therefore, there is nothing to include in Mom’s estate. However, in order for Mom not to have made a gift to Son at the outset, the consideration for Blueacre would have had to be more than would have received under a straight 10-year note, to reflect the fact that Son would not have had to pay the whole price if Mom died during the period. In addition, in a case where Mom’s life expectancy is less than the term of the note, the Internal Revenue Service (“IRS”) has taken the position that the transaction will be taxed for income tax purposes as a private annuity.
A SCIN is an installment obligation that terminates on the occurrence of a certain event (often the seller’s death) before it is otherwise due. Through proper planning, a foreign investor may sell his or her real property to designated beneficiaries in exchange for a SCIN and avoid the U.S. estate and gift tax.
Holding U.S. Property Through a Foreign Corporation
Historically, foreign investors have made their direct investments in U.S. property principally through foreign corporate ownership structures. Frequently, a foreign corporation was used as either the direct investment owner or as a holding company for a U.S. subsidiary (which, in turn, owned the direct U.S. real property). Individual foreign investors have frequently preferred use of corporate structures to avoid the U.S. estate and gift tax. While holding U.S. property through a foreign corporation will typically enable the foreign investor to avoid the U.S. estate and gift tax, there are significant U.S. income tax consequences associated with investing in the U.S. real estate through a foreign corporation. We will discuss these consequences in more detail below.
One of the benefits of having a foreign corporation acquire U.S. real estate, rather than having an individual directly own shares of a U.S. company, is the avoidance of U.S. estate and gift tax. This is because for estate and gift tax purposes, the U.S. estate and gift tax is assessed only on U.S. situs assets. Stock of a U.S. corporation is U.S. situs and stock of a foreign corporation is foreign situs, regardless of place of management or location of stock certificates. Since a foreign corporation has foreign situs for purposes of the estate and gift tax, transferring U.S. real property to a foreign corporation enables the foreign investor to avoid exposure to the U.S. estate and gift tax.
For income tax purposes, corporate structures no longer have the benefit of preferential long-term capital gains tax treatment on the sale of the property. Although the 21 percent corporate tax rate is similar to the 20 percent capital gains rate, there is a great deal of uncertainty about the future of the U.S. tax system and corporate tax rates. The cost of losing the preferential capital gains rates is made worse by the branch profits tax. The branch profits tax specifically treats the deemed repatriation of already taxed profits from the United States by a foreign corporation as an occasion to impose a second tax under Section 884. Internal Revenue Code Section 884 describes this second tax as the “dividend equivalent amount” of the “effectively connected earnings and profits” with certain adjustments. This second tax is known as the “branch profits tax.” The branch profits tax is intended to be the functional equivalent of earnings distributed as dividends by a subsidiary either out of current earnings not invested in subsidiary assets or out of accumulated earnings withdrawn from such investment. The branch profits tax imposes a tax equal to 30 percent of a foreign corporation’s dividend equivalent amount for the taxable year, subject to treaty reductions (in limited cases). Based upon the clarification first provided by Notice 87-56, 1987-2 C.B. 367, a number of older U.S. income tax treaties may serve to override the branch profits tax.
The use of foreign corporate structures to hold U.S. real estate has a number of significant disadvantages that must be considered by the foreign investor. As indicated above, frequently, a foreign corporation as a holding company for a U.S. subsidiary (which, in turn, owned the direct U.S. real property). Because of the anti-inversion rules, this type of structure is no longer advised. In order to understand how the anti-inversion rules impact the use of a multi-tiered corporate structure, it is important to understand the anti-inversion rules.
Prior to March of 2003, a U.S. corporation could reincorporate in a foreign jurisdiction and thereby replace the U.S. parent corporation of a multinational corporate group with a foreign parent corporation. These transactions were commonly referred to as inversion transactions. Inversion transactions could take many different forms, including stok inversions, asset inversions, and various combinations of and variations on the two. In a stock inversion, a U.S. corporation forms a foreign corporation, which in turn forms a domestic merger subsidiary. The domestic merger subsidiary would then merge into the U.S. corporation, with the U.S. corporation surviving as a subsidiary of the new foreign corporation. The U.S. corporation’s shareholders would receive shares of the doreign corporation and would be treated as having exchanged their U.S. corporate shares for the foreign corporation shares. An asset inversion would reach a similar result, but through a direct merger of the top-tier U.S. corporation into a new foreign corporation.
Inversions were done to remove income from foreign operations from the U.S. taxing jurisdiction. In addition to removing foreign operations from the U.S. taxing jurisdiction, a corporate group was typically able to derive further advantages from an inverted structure by reducing U.S. tax on U.S. source income through various earnings stripping or other transactions.
In 2004, corporate inversion transactions became a prime focus of Congress as a result of several well-publicized inversion transactions during the prior decade (e.g., the inversion transactions involving Tyco Corporation and Cooper Industries). To remove the incentive to engage in corporate inversion transactions, Congress included several provisions in the 2004 JOBS Act aimed at this perceived problem. In particular, Congress enacted Section 7874 of the Internal Revenue Code. Section 7874 defines two different types of corporate inversion transactions and provides a different set of tax consequences to reach each type of inversion transaction.
The anti-inversion rules are designed to prevent corporate inversions by providing different methods of taxation depending on whether the former U.S. shareholders own at least 80 percent of the new foreign corporation or at least 60 percent (but less than 80 percent) of the shares of a new foreign corporation.
The anti-inversion rules apply if pursuant to a plan or series of related transactions: 1) a U.S. corporation becomes a subsidiary of a foreign-incorporated entity or otherwise transfers substantially all of its properties to such an entity in a translation; 2) the former shareholders of the U.S. corporation hold (by reason of holding stock in the U.S. corporation) 80 percent or more (by vote or value) of the stock of the foreign-incorprated entity after the transaction; and 3) the foreign-incorporated entity, considered together with all companies connected to it by a chain of greater than 50 percent ownership (ie., the “expanded affiliated group), does not have substantial business activities in the entity’s country of incorporation, compared to the total worldwide business activities of the expanded affiliated group. The provision denies the intended tax benefits of this type of inversion by deeming the top-tier foreign corporation to be a domestic corporation for all purposes of the Internal Revenue Code.
In determining whether a transaction meets the definition of an inversion, stock by members of the expanded affiliated group that includes the foreign incorporated entity is disregarded. For example, if the former top-tier U.S. corporation receives stock of the foreign incorporated entity (e.g., so-called “hook” stock), the stock would not be considered in determining whether the transaction meets the definition. Similarly, if a U.S. parent corporation converts an existing wholly owned U.S. subsidiary into a new wholly owned controlled foreign corporation, the stock of the new foreign corporation would be disregarded. Stock in a public offering related to the transaction also is disregarded for these purposes.
The IRS is granted authority to prevent the avoidance of the purpose of the proposal through the use of related persons, pass-through or other noncorporate entities, or other intermediaries, and through transactions designed to qualify or disqualify a person as a related person or a member of an expanded affiliated group. In this type of inversion transaction, the anti-inversion rules deny the intended tax benefits by deeming the top-tier foreign corporation to be a U.S. corporation for all U.S. tax purposes.
If U.S. shareholders own at least 60 percent (but less than 80 percent), by vote or value, of the foreign corporation, a different anti-inversion rule applies. Under these rules, the inversion transaction is respected (i.e., the foreign corporation is treated as foreign), but any applicable corporate-level “toll charges” for establishing the inverted structure are not offset by tax attributes such as net operating losses or foreign tax credits. Specifically, any applicable corporate-level income or gain required to be recognized under Internal Revenue Code Sections 304, 211(b), 367, 1001, 1248, or any other provision with respect to the transfer of controlled foreign corporation stock or the transfer of other assets by a U.S. corporation stock or the transfer or license of other assets by a U.S. corporation as part of the inversion transaction or other such transaction to a related foreign person is taxable, without offset by any tax attributes (e.g., net operating losses or foreign tax credits). These measures generally apply a 10-year period following the inversion transaction.
The anti-inversion rules do not apply where: 1) the transferee is a foreign partnership; 2) less than substantially all of the assets are transferred; or 3) substantial activities are conducted in the country where the new holding copy is located. The Income Tax Regulations provide that the substantial activities test is met only if the following tests are met:
1. Group employees.
A. The number of group employees based in the relevant foreign country is at least 25 percent of the total number of group employees on the applicable date.
B. The employee compensation incurred with respect to group employees based in the relevant foreign country is at least 25 percent of the total employee compensation incurred with respect to all group employees during a testing period.
2. Group Assets
A. The value of the group assets located in the relevant foreign country is at least 25 percent of the total value of all group assets on the applicable date.
B. The group income derived in the relevant foreign country is at least 25 percent of the total group income during a testing period.
Although there are many variations of inversions, a domestic corporation holding U.S. real estate that merges into a foreign corporation to avoid U.S. estate and gift taxes can be classified as inversion. This is because the U.S. corporation holding the real estate becomes a subsidiary of a foreign corporation and the former shareholders of the U.S. corporation will ultimately hold at least 80 percent (by vote or value) of a foreign corporation by reason of holding stock in the U.S. corporation. Although this type of planning will not likely trigger the recognition of the inversion gain, it will deny the intended tax benefit by treating the foreign corporation as a domestic corporation for all purposes of the Internal Revenue Code.
Section 7874 of the Internal Revenue Code may result in adverse estate and gift tax consequences because the merger of a U.S real property holding corporation or “USRPHC” into a foreign corporation satisfies three requirements discussed above. More specifically, the foreign corporation indirectly acquires all of the properties held by the U.S. corporation; the nonresident who directly owned the shares in the U.S. corporation now owns all of the shares of the foreign corporation, which holds the stock of the U.S. corporation; and, finally, neither the foreign corporation nor any of its affiliated members satisfy the substantial business activities exception because they do not meet the “Group Assets” test discussed above. This is because the majority of domestic and ultimately the foreign corporation’s assets consist of U.S. real property interests. Because this type of planning triggers the inversion rules, the foreign corporation holding U.S. real estate will be treated as a U.S. corporation for all U.S. federal tax purposes. This means, on the date of the foreign investor’s death, he or she will be treated as owning stock in a U.S. corporation (a U.S.-situs asset) rather than stock in a foreign corporation (a foreign-situs asset).
Foreign investors that place U.S. real estate in foreign corporations often overlook the U.S. income tax consequences such planning causes U.S. beneficiaries. Although a foreign corporation will avoid U.S. estate and gift taxes (as long as it is not held by a multi-structured entity), at the death of the foreign investor, U.S. beneficiaries may inherit so-called “cursed” shares in a foreign corporation. Depending on the number of shares inherited, the foreign corporate shares could be taxed as either a CFC or a Passive Foreign Investment Company (“PFIC”).
Holding U.S. Real Property through a Domestic Corporation
Given the disadvantages of playing U.S. real property in a foreign corporation, foreign investors may elect to utilize a domestic corporation to hold U.S. real property. From an income tax point of view, a domestic corporation will be subject to federal income tax on any future capital gain at up to 21 percent. On the sale of the real property, any distribution of the proceeds other than in liquidation of the corporation will be dividend to the extent of the corporation’s E&P and therefore subject to tax at a flat rate of 30 percent or a lower treaty rate. Any amounts distributed from a domestic corporation would likely be subject to withholdings under the Foreign Investment in Real Property Tax Act (“FIRPTA”) and/or Fixed, Determinable, Annual, Periodical Income (“FDAP”) provisions of the Internal Revenue Code.
For gift tax purposes, a foreign investor may make gifts of domestic corporate shares without being subject to U.S. gift tax. The consequence of the death of the foreign owner depends on the structure of the ownership of the domestic corporation. If the foreign corporation is owned directly by the foreign owner, the taxable estate will include the shares, and the estate will be subject to estate tax on those shares upon the owner’s death.
Holding Real Property through a Partnership
Although not often considered by foreign investors, the use of a traditional partnership (regardless of whether it is domestic or foreign, general or limited) has the very significant advantage of enabling the individual foreign investor to obtain the benefits of avoiding entity level tax (at the federal level) on all of the U.S. trade or business income being generated. The extent to which the U.S. estate and gift tax rules apply to partnerships and other pass-through entities held by foreign persons is not entirely settled because there is some legal authority which states that partnership interests are U.S. situs property. Because of this perceived uncertainty, many foreign investors and their advisors have avoided testing the parameters of the U.S. estate and gift tax law.
The use of a traditional partnership (regardless of whether it is domestic or foreign, general or limited) has the very significant advantage of enabling the individual foreign investor not to be subject to two layers of tax (as with corporate structures). In addition to the U.S. income tax benefits, foreign investors may make gifts of intangible interests (such as a partnership interest) without being subject to U.S. gift tax. See IRC 2501(a)(2). To the extent to which the U.S. estate tax rules apply to partnerships and other pass-through entities held by foreign investors are not totally free from doubt. There is at least some risk that the IRS might assert that a partnership engaged in a U.S. trade or business will be classified as a U.S. situs asset for purposes of the U.S. estate tax on nonresident alien descendants, regardless of whether it is a domestic or foreign partnership.
However,a partnership holding U.S. real estate formed in a jurisdiction outside the United States (regardless of whether it is engaged in a U.S. trade or business) will not likely be classified as U.S. situs property and avoid the U.S. estate tax. This is because an interest in a foreign partnership has a foreign situs and if under applicable foreign law the partnership is an entity separate from its partners, it will not likely have U.S. situs for purposes of the estate tax. A second argument against U.S. situs of a foreign investor’s partnership interest (regardless where the partnership is domestic or foreign) is based on the common law maxim mobilia sequuntur personam, that intangible property has its situs at the domicile of its owner. This argument posits that since there is no Internal Revenue Code provision overriding the maxim of mobilia sequuntur personam, a foreign investor’s foreign domicile would exempt the alien’s foreign or domestic partnership interests that constitute intangible personal property from U.S. estate tax.
Hybrid Structures
In certain cases, where a favorable tax treaty may be utilized, a foreign investor can utilize a hybrid structure to invest in U.S. real estate. A variation on direct ownership of U.S. real estate by a home-country/treaty company would be the use of a home-country entity that qualifies as a “corporation” for U.S. income tax purposes and a “partnership” for home country purposes. The possibility of having such a conflicting characterization, coupled with certain other predicate treaty provisions, may combine to provide the best overall tax results in the U.S. and the home country of the foreign investor. The real key to this combination of results, however, lies in the conflicting characterization of the foreign entity as between the U.S. and foreign tax laws, sometimes that have been facilitated by the U.S. “check-the-box” rules.” See The U.S. Tax Effects of Choice of Entities For Foreign Investment in U.S. Real Estate and Business and the Taxation of Dispositions of U.S. Partnership Interests, Robert F. Hudson (2015).
Ownership of U.S. Property Through a Trust
Finally, a foreign investor may hold U.S. property in an irrevocable trust. The trust can be domestic of foreign. An irrevocable trust is potentially an attractive vehicle for newly acquired residential property. This type of planning will depend on following the foreign grantor trust rules of Internal Revenue Code Sections 671 through 679. Trusts are taxed at rates applicable to individuals and there is a preferential rate of 20 percent now applicable to long term capital gains.Trusts are taxed at rates applicable to individuals, albeit with essentially no progression through the brackets, and are therefore entitled to the preferential rate of 20 percent now applicable to long-term capital gains.Properly structured, a foreign irrevocable trust will avoid the U.S. estate and gift tax. However, as with foreign corporate entities, a tax trap lucks for trust distributions to U.S. beneficiaries.
U.S. beneficiaries may be subject to a special tax on distributions from a foreign trust known as distribution net income or DNI which could reclassify capital gains into ordinary income. In addition, accumulation distributions from a foreign trust could be subject to Section 668(a) interest surcharge at the floating underpayment penalty interest rates (compounded daily) of Section 6621.
Conclusion
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 they are not U.S. persons. Foreign investors have a number of options when investing in the U.S. real estate market. As in many areas of international tax planning, one size does not fit all. A careful analysis must be done by a qualified tax attorney to determine the best estate and gift planning for each individual foreign investor.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic and international tax attorney, Anthony Diosdi advises both U.S. and international individuals in relation to a broad range of personal taxation and estate planning matters. He has extensive experience of advising on complex cross-border estate planning matters. Anthony Diosdi is a frequent speaker at international tax seminars. Anthony Diosdi is admitted to the California and Florida bars.
provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: 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.