OFFSHORE TRUSTS AND AMERICAN AND ENGLISH COMMON LAW
TRUSTS ARE CREATURES OF CONTRACT LAW
Trusts are creatures of contract under English Common Law. Privacy provided by a trust is determined solely by whether the jurisdiction in which the trust is created requires registration of the trust; permits the use of a non-commercial trustee; and guarantees confidentiality on all matters relating to the trust (refer to the Grupo Torras case in the Bahamas High Court). Asset protection by a trust is determined by whether the jurisdiction has repealed the Statute of Elizabeth; prohibits the enforcement of foreign judgements; and has a custodial infrastructure sufficient that assets conveyed to the trust may be maintained in the trust jurisdiction, not in another where less favourable law might be applied.
Trusts are English Common Law instruments and are recognized almost exclusively in jurisdictions that have inherited this body of law. Only a very few Civil Law jurisdictions recognize trusts.
The Statute of Elizabeth is English Common Law. Only those jurisdictions that are independent from the U.K. Parliament and the Crown of the U.K. have constitutions permitting the repeal of English Common Law, such as this statute or willl permit an argument supporting repeal. Belize is held out to be such a country. Otherwise Crown dependent territories may modify English Common Law, but not repeal it.
Currently no jurisdiction, not even Belize, meets these criteria! While the Cook Islands pioneered legislation in its International Trusts Act (1984) barring foreign civil judgements and repealing the Statute of Elizabeth, the law at the same time assigned enormous power to Crown administrative agencies, which appear to have the statutory authority to confiscate trust assets without a judicial hearing.
Moreover a fundamental problem for U.S. persons and Canadians too, setting up trusts or conveying property or assets to a trust in foreign jurisdictions are the tax penalties their creation may trigger. Amendments in 1996 to the I.R. Code stipulate that all assets conveyed to a foreign trust are subject to a 35% excise tax on unrealised appreciation. In Canada the deemed disposition rules and the reportability of property settled in a foreign trust if in excess of $100,000 have also made such transfers onerous.
TAX PLANNING WITH OFFSHORE TRUSTS: HIGH MARGINAL RATES, ESTATE FOR TRANSFER AND GIFT TAXES
It goes without saying that tax rates in the United States are high. The U.S. estate, gift and generation-skipping transfer ("GST") tax rates are no exception, as outlined briefly in Table 1 below. To add to the pain, the U.S. taxes its citizens (as does Canada) and resident aliens on their worldwide income, and taxes U.S. domiciliaries on their worldwide assets.
Marginal rates of taxation are 39.6 percent for income, 55 percent unified rate for gift and estate transfers, and 55 per cent for GST taxes. Sales of capital assets are taxed at 20 percent for assets held more than 18 months and 28 percent for assets held more than 12 months and less than 18 months.
An "applicable exclusion" amount equal to $65,000 in 1999 and increasing to $1 million by 2006, applies as a deduction in reducing estate and gift transfers. Estate taxes are further reduced by debts, liabilities and administration expenses of the estate. Each person may elect to receive a qualifying $1 million exemption against GST taxes (for gifts or transfers at death).
Assets left outright to a surviving spouse or to a qualifying marital trust are excluded from estate taxation; however, at the surviving spouseís death, such assets are subject to estate taxation, minus the applicable exclusion.
SUPPOSED ADVANTAGES OF OFFSHORE STRUCTURING WITH TRUSTS
There are many advantages to using offshore ("foreign") trusts and other offshore structures in financial and estate planning. Some of them are as follows:
i) Offshore trusts assets are outside the jurisdiction of U.S. courts. Future claims of creditors against the grantor or his family, such as divorce actions against the grantorís lineal descendants, are avoided. Much material has been provided to show that due to the extra-territorial reach of U.S. and Canadian judges, this is often not so.
ii) The trustee of the offshore trust may purchase foreign securities as a non-U.S. person and avoid costly reporting required by the Securities and Exchange Commission.
Often the trustee of an offshore trust forms an international business corporation ("IBC") in order to avoid foreign death taxes (inheritance taxes in Europe) for those countries in which foreign securities are purchased. The inheritance tax laws of most major countries deem the source of ownership to be the foreign stock of the IBC, not the shares of stock purchased by the IBC of companies based in their jurisdiction.
iii) Investments actually made by trustees (with the controlled trust, few are!) are made under the modern portfolio theory. Most states require trustees to invest under the prudent person rule, which requires the trustee to evaluate each trust asset to determine whether each investment will produce reasonable income and is safe in preserving principal.
The prudent investor rule requires the evaluation of all trust assets and the allocation of the assets according to an overall strategy for aligning risk and return objectives with trust objectives. The prudent person rule focuses on preserving principal. The prudent investor rule focuses on increasing principal under modern portfolio investing theory.
iv) The rule against perpetuities is avoided or extended. This rule, in most U.S. states, permits trusts to continue during the lifetime of beneficiaries living at the descendantís death, plus only 21 years for beneficiaries born later. The Bronfman Trust in Canada escaped $800 million taxes by moving trustee locus within 6 days of the end of 21 years.
Offshore trust laws either abolish this rule or permit trusts to continue for many years. Examples of jurisdictions that have abolished or extended this rule for a long period of time are the Cook Islands, the Turks and Caicos Islands, and St. Vincent.
v) In general, less costly life insurance may be purchased from a foreign life insurance carrier by the trustee (of a foreign non-grantor trust, discussed below) with the U.S. grantor as the insured.
Many foreign life insurance carriers have much lower internal costs than U.S. based insurance carriers. In addition, foreign carriers generally pay fees (such as 1%) to referral sources instead of paying costly commissions as is typical in the U.S.
vi) An offshore trust can be established for non-U.S. relatives.
vii) An offshore trust can be established by non-U.S. persons for the benefit of U.S. beneficiaries on an income tax advantaged basis.
viii) An offshore trust can be established to own and hold interests in foreign enterprises. This technique is primarily used for asset protection purposes so that the shares of the foreign entities are held by a foreign trustee of the offshore trust. One must be careful, however, if business operations are with a foreign country since the formation of the foreign trust will cause the loss of treaty benefits.
ix) An offshore trust can be established in preparation for expatriation.
THE 3 TYPES OF OFFSHORE TRUST CLASSIFIED BY TREATMENT FOR TAX PURPOSES
1. THE FOREIGN GRANTOR TRUST
The FGT, also known as an asset protection trust, includes a U.S. beneficiary and is funded by a U.S. person. The grantor is taxed each year on income earned by this tax-neutral trust. This trust is irrevocable for legal purposes. However, for income tax purposes, the grantor is treated as the owner. Gains are not recognized on transfers of appreciated property to this trust until the property is sold by the trustee. We do not recommend you try and place your existing U.S. assets into a trust of this kind as the IRS rules are extremely complex.
2. THE GST (ESTATE, GIFT AND GENERATION-SKIPPING TRANSFER) TAX TRUST OR "EXEMPT" TRUST
Trust assets exceeding the amount funding the GST trust pass into a non-exempt trust which generally includes provisions avoiding the GST tax and causing, instead, the non-exempt trust to be subject to estate taxation at the deaths of the grantorís children instead of the GST tax.
3. THE FOREIGN NON-GRANTOR TRUST
The FNGT, which includes no U.S. beneficiary during the lifetime of the grantor and his or her spouse lifetimes, is funded by a U.S. person. Distributions, if any, during this period are generally made to a foreign charity. This trust is irrevocable for legal and income, estate and gift tax purposes. The grantor is not taxed on the trust income.
Transfers to this trust are treated as taxable gifts, minus the applicable exclusion. Transfers of appreciated property to this trust are subject to gain recognition. The trustee of the FNGT generally accumulates income and begins making distributions to U.S. beneficiaries one taxable year after the deaths of the grantor and their spouse.
True assets of the FNGT appreciate with no income or capital gains taxation. In addition, after the assets are gifted to the FNGT, appreciation is excluded from estate taxation. To summarize - trust assets on your death (and/or of your spouse) go to your intended heirs in much the same way as your domestic revocable living trust! After the trust is established it often capitalises and controls a foreign corporation. With this established (and you should not be a director!) there are several ways in which you can use the combination. One example only is that of the use of a private annuity.
EXAMPLE: You could sell your personal and U.S. assets to your international structure in return for a private annuity. This is defined as an agreement by your international structure to pay you (and/or your spouse) a certain sum of money beginning at a time in the future and continuing until the time of your death.
The private annuity has two compelling advantages. Assets that are transferred to your offshore structure in exchange for the private annuity are not part of your estate and so are not available for a creditor to seize. As well, any assets transferred have the effect of reducing your estate by the value of the transfer. This is however an excise tax of 1% payable on the value of the assets transferred.
CONTROLLED FOREIGN CORPORATION RULES
The controlled foreign corporation rules cause U.S. persons to be taxed currently on income earned by a foreign corporation. In general, a controlled foreign corporation is one that is owned 50% or more by vote or value by U.S. persons, taking into account those U.S. persons who own 10% or more of the voting shares of the stock. In determining the 10% ownership, "attribution rules" apply in counting family members as one shareholder.
The FNGT, as a non-U.S. tax person, can own interests in a foreign corporation, and possibly avoid the controlled foreign corporation rules and other international tax rules cause U.S. persons to be immediately taxed on foreign income.
As a non-U.S. person, the FNGT may own 50% or more of the foreign corporation, with U.S. persons owning the remaining 50% of the stock.
INTERNATIONAL TAX EXPERTISE: AN ABSOLUTE NECESSITY WHEN DEALING WITH TRUSTS!
Offshore tax planning is extremely complex and requires detailed knowledge of international tax laws and reporting requirements. The proper drafting of the FNGT is critical, as is the proper operation of the trust and the foreign corporation. Otherwise, the controlled foreign corporation rules are easily applicable causing quite possibly horrendous current taxation!
Furthermore, it is imperative that all required tax returns be filed on time with respect to implementing and operating a FNGT as the owner of a foreign corporation.
COMPLIANCE REQUIREMENTS AND TRUSTS
Numerous tax returns are required to be filed by U.S. persons relating to the formation, funding, operations, earnings and distributions by offshore trusts. Failure to file these tax returns may result in several confiscatory trust-type penalties as well as potential criminal consequences.
COMPLIANCE REQUIREMENTS AND THE DOUBLE STANDARD.
A vitally important aspect of international tax planning and asset protection is to comply with any and all applicable reporting requirements of the IRS or other state and federal agencies. Your international structure is so potentially beneficial to you in giving you protection and privacy and unquantifiable tax savings that it is just not worth taking a chance of not reporting a transaction when such is required .... however, just because you must disclose certain types of transactions does not mean that you must automatically pay taxes on it. Tax deferral, often indefinitely, is a legitimate avoidance technique. But this sounds like an attempt to re-awaken guilt and fear in you!
Steve Forbes, Editor-in-chief of Forbes Magazine, wrote in Fact and Comment recently .... "Eyebrows were raised....when the Heritage Foundation, National Review magazine and numerous other conservative groups and publications were audited by the IRS. The Landmark Legal Foundation wanted to find out if these assaults were politically motivated by the Clinton/Gore administration, or if they were just extraordinary coincidences. So the Foundation filed a Freedom of Information Act request with the IRS. The agency high-handedly refused to hand over the documents within the deadlines set by the law. When the IRS was finally forced to turn over the papers, they were so heavily censored as to be useless. The IRS will not release e-mail and telephone records that might show whether or not these audits were politically motivated."
Can you imagine what would happen if a taxpayer responded to an IRS request that way?
UN PAPER PROPOSES OUTLAWING INTERNATIONAL
BUSINESS CORPORATIONS AND RESTRICTING THE USE OF
OFFSHORE TRUSTS IN THE "BATTLE" AGAINST MONEY LAUNDERING!
Vienna: A discussion paper published by the United Nations (UN) has proposed radical action to tackle the money laundering in offshore financial havens.
Among the proposals are international agreements not to recognise International Business Companies (IBCs) and to limit shell banks, limits on offshore asset protection trusts, changes to laws surrounding lawyer-client privilege and a re-evaluation of free-trade zones.
It also suggest the creation of a series of "international crimes" and the international law enforcement machinery to deal with fraud directed against international institutions.
The 72-page paper, Financial Havens, Banking Secrecy and Money Laundering, was commissioned by Pino Arlacchi, Under Secretary General and executive director of the UN Office of Drug Control and Crime Prevention, who says that it is meant to stimulate discussion and does not necessarily reflect the views of the UN.
But the paperís ideas are expected to be considered by the UN members drawing up the new UN Convention in Trans-National Crime, which is due to be reviewed in 2000. The paper argued: "The common denominator in money laundering and a variety of financial crimes is the enabling machinery it creates in the financial havens and offshore centres. What started as a business to service the needs of a privileged few has become a rule of law to match the globalisation of trade and the global movement of people, the questions raised by this hole in the system will have to be addressed."
The paper advocates a number of initiatives. "The mere existence of an agreement is not an appropriate measure of the reality of co-operation. To make information exchange work, there must be political will and a commitment to the rule of law. In a number of cases, governments have agreed to co-operate, but the agreement has been a cosmetic cover to protect the local money laundering industry."
According to the paper, more than 90 jurisdictions say they offer bank secrecy. Some regularly co-operate in money laundering investigations, while others are unwilling to do so. The paper argues that an individualís right to privacy should not extend to "impunity" and that all citizens must be equally accountable for their actions/
The paper gives short thrift to the arguments by financial centres that they cannot enforce the laws of other countries. "The concept of sovereignty as agreed to by the member states of the United Nations and as applied in international law gives the sovereign state control over its territory, its citizens and its residents. A corollary of this concept is that no member state should assist citizens or residents of another state in the violation of the laws of their home country."
There are specific proposals for tackling tax evasion, which is not a criminal offense in some jurisdictions. "One possible approach would be to have member countries agree that any funds derived through criminal activity are funds that can give rise to a charge of money laundering. Using this approach, if tax evasion is a crime in the country where the funds originated and the funds are being hidden because they are a result of tax a crime, hiding the funds and moving them would be money laundering."
According to the paper, IBCs are "at the heart of the money laundering problem" and moves to tackle them could include "international agreements not to recognise corporate identities that do not have full authority to do business in their home jurisdiction". Alternatively, the use of IBCs could be limited to regulated financial institutions, so that, for example, a bank which created an IBC would always know the identity of its beneficial owner.
To curb the abuse of offshore trusts, the paper proposes limiting the scope of protection given to non-residents and non-citizens who establish trusts or at least imposing requirements to enable investigators to identify the beneficial owners of all trusts.
Specialised training is proposed to help tackle financial crime through the establishment of a graduate programme modelled on the MBA for mid-career law enforcement, legal, judicial, and private sector compliance officials.
The Fraud Report
Continued in part nine of ten
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