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In Re: Portnoy[1] — a 1996 Bankruptcy case – was the first in a series of decisions with a foreign asset protection trust. As with most foreign trust cases, the fact pattern alludes to several areas of law – asset protection, bankruptcy, conflict of laws and trusts. Here are the relevant events in chronological order.
Two points should be made before discussing the case’s legal reasoning. First, Portnoy formed the trust after becoming aware that MD could not repay the loan. The court specifically noted this timing[2] because it was clearly a fraudulent transfer. Although the court did not connect this fact to specific badges of fraud contained in the Uniform Fraudulent Transfer Act, several are possible. For example, Portnoy concealed the transfer, only revealing it during bankruptcy proceedings 5 years after the trust’s formation.[3] In addition, as part of a unified series of transactions, Portnoy transferred most of his assets to the trust or family members,[4] essentially bankrupting himself in the process.[5] Second, to attract asset protection business, some international offshore financial centers have amended their statutes to be more lenient towards debtors. Hoping to capitalize on the friendlier legal environment, planners add a clause to transactional documents stating offshore laws will govern the transaction. But these clauses aren’t the final choice of law arbiter; that rests with the court using the Restatement of the Conflict of Laws. In fact, several foreign asset protection trust cases – including Portnoy — ruled against the debtor due to the conflict of laws analysis. The court ruled against Portnoy and his structure. The decision contains two important lines of reasoning; the first focused on the choice of law analysis, which required the court to determine whether Jersey or New York law would govern their interpretation. It began with the court noting that settlors are allowed to specify which laws govern their trusts and, that this should not be defeated “…unless this is required by the policy of a state which has such an interest in defeating his intention, as to the particular issue involved, that its local law should be applied.”[6] Later in the case, the court observes, “`[i]t is against [New York] public policy to permit the settlor-beneficiary to tie up her own property in such a way that she can still enjoy it but can prevent her creditors form [sic] reaching it.” The importance of the preceding line of reasoning cannot be overstated: it strongly implies that planners attempts to invoke the laws of a debtor favorable jurisdiction will be defeated if the jurisdiction hearing the case has a public policy preventing a debtor from enjoying his assets at the expense of his creditors. Courts use this rationale in later asset protection trust cases, almost always to the debtor’s detriment. The second important line of reasoning involved the court’s Conflict of Law’s factor analysis used to determine “the state whose interests are more deeply affected” – a factor in a Conflict of Law analysis. Here, the court noted that Portnoy settled the trust in Jersey, and had a Jersey firm administer the trust. But they then observed that all parties were U.S. residents. Additionally, the creditors had no contact with Jersey while Portnoy had extensive U.S contact when he established the trust. Due to the large number of U.S. contacts, the U.S. had the “weightier concern” about the litigation, thereby allowing the court to base its decision on U.S. law. This part of the ruling shows the importance of “home court advantage.” Despite the assets being subject to a foreign jurisdiction, the parties are physically located in the U.S. Just as importantly, the creditors have no contact with trust’s jurisdiction. Here, the court ruled that the large number of U.S. contacts shifted the factual weight, meaning the court ruled for the U.S creditors. Finally, Portnoy’s jurisdictional contact pattern — an individual or group of U.S. based creditors sue a U.S. resident who has assets offshore – is very common in foreign asset protection trust cases. Portnoy’s general reasoning laid a very strong groundwork for future court’s deciding FAPT trust cases. Future courts would decide against FAPT holders on several other grounds, but at the core of future reasoning is a general disdain for debtors who try to structure their affairs in a way to defrauds creditors. It’s simply not a practice that courts want to condone through their decisions. [1] In re Portnoy, 201 B.R. 685 (Bankr. S.D.N.Y., 1996) [2] (“An inference can be drawn that the timing was purposeful, for in June, two months before the trust’s creation, Portnoy knew that Mary Drawers was in trouble and by December of that same year, Mary Drawers had defaulted on its obligations to Marine.”) [3] UFTA §4(b)(7) the debtor removed or concealed assets [4] UFTA §4(b)(5) [5] UFTA §4(b)(9) [6] Portnoy at 698 On March 2nd, we’re offering a free 1-hour CPE course titled “An Introduction to the U.S. Controlled Foreign Corporation Statute.” You can sign up at this link:
A CFC is a foreign corporation where a U.S. shareholder owns “more than” 50% of the offshore company. After passage of the CFC statute, practitioners quickly noted the 50% ownership requirement and correctly deduced that, if a non-U.S. shareholder owned the remaining 50%, the foreign corporation could escape being a CFC. This was the tact taken by the taxpayer in Garlock, a case where a U.S. corporation owned a Panamanian company, formed before passage of the CFC statute. In an attempt to prevent CFC classification, the U.S. parent recapitalized the Panamanian subsidiary with a preferred share which was callable at any time. In addition, the foreign shareholder agreed not to exercise his ownership rights. From the case: “The report mentioned specifically two foreign investors who had been approached and had said that they "understood the situation," and expressed the belief that one of them would "invest" in the new preferred stock when issued.” The above structure contains two key flaws. The first was that the preferred could called at any time. For the sake of argument, assume the foreign partner exercised its right to participate in management in a way that threatened the U.S. parent. Should that happen, the U.S. company would simply call the stock to remove the threat. The second flaw was the back-door deal between the partners. This fact made the recapitalization a tax sham. Garlock offers planners several lessons. First of all, the attorneys advising the U.S. company correctly interpreted the statute: if a U.S. shareholder owns only 50% of the foreign company, it’s not a CFC. However, this means that the U.S. shareholder must give up control, or at least exercise control on an equal footing with a foreign partner. Second, backroom deals between taxpayers are never a good idea; should the Service investigate, they almost always come to light, thereby giving the IRS ample justification to shut down a transaction. If you're a CPA on CFP, we're offering free continuing education courses on captive insurance, tax treaties, international tax and controlled foreign corporations. While the duty of loyalty could be the subject of its own legal textbook, below are some pithy case law quotes that go a long way to encapsulating its basic tenants. These are taken from Earl Hoover's 1956 article, Basic Principles Underlying Duty of Loyalty     The top chart shows that core and overall CPI are both above 2%. The bottom chart shows that the CPE price deflator -- the Fed's preferred inflation measure -- is rising. We're also seeing inflation increase in other countries: the latest inflation figures from Germany, France, the EU and Canada all indicate that energy prices are rising at strong rates. While these increases have not bled into overall inflation measures yet, it's only a matter of time before companies can no longer absorb these cost increases, forcing them to raise prices. The Prudent Investor Rule (Section 90 of the 3rd Restatement of Trusts) requires trustees to consider inflation when making investment decisions: e. General requirement of caution. In addition to the duty to use care and skill, the trustee must exercise the caution of a prudent investor managing similar funds, in similar circumstances, for similar purposes. See § 77, Comment b. And see discussion in the Reporter’s Note to this Comment e. In the absence of contrary provisions in the terms of the trust, this requirement of caution requires the trustee to invest with a view both to safety of the capital and to securing a reasonable return. See generally § 79 on the duty of impartiality. Safety of capital includes not only the objective of protecting the trust property from the risk of loss of nominal value but, ordinarily, also a goal of preserving its real value--that is, seeking to avoid or reduce loss of the trust estate’s purchasing power as a result of inflation. This objective will also normally tend to protect the purchasing power of the income flow in the future. Therefore, with inflation rising, trustees would be advised to re-evaluate their overall portfolio return and potentially readjusting parts of the their fixed income allocation. On Tuesday, February 7, We're offering a free, 1-hour CPE course for U.S. accountants in controlled foreign corporations. You can sign up at this link.
The ownership rules are at the heart of the controlled foreign corporation statute: (a) General rule: For purposes of this subpart, the term “controlled foreign corporation” means any foreign corporation if more than 50 percent of-- (1) the total combined voting power of all classes of stock of such corporation entitled to vote, or (2) the total value of the stock of such corporation, is owned (within the meaning of section 958(a)), or is considered as owned by applying the rules of ownership of section 958(b), by United States shareholders on any day during the taxable year of such foreign corporation. Majority ownership by a “U.S. shareholder” is key; once a U.S. person owns 50.01% of a foreign company, it’s a CFC. The statute assumes evenly divided ownership between a U.S. and foreign interest creates sufficient management tension to prevent issues from arising. This offers potential planning opportunities. If you'd like to discuss this in more detail, please contact me at 832.330.4101. Or, you can email me at halestewart@halestewartlaw.com TAM 115478-97 Contains a Great Structure That Removes a Foreign Corporation From the CFC Statute1/10/2017
On February 7, we're giving a free course on controlled foreign corporations, which is good for 1-hour of credit. You can sign up at this link. The controlled foreign corporation statute is a very powerful anti-deferral regime. Key to its application is the following definition: For purposes of this subpart, the term “controlled foreign corporation” means any foreign corporation if more than 50 percent of-- (1) the total combined voting power of all classes of stock of such corporation entitled to vote, or (2) the total value of the stock of such corporation, is owned (within the meaning of section 958(a)), or is considered as owned by applying the rules of ownership of section 958(b), by United States shareholders on any day during the taxable year of such foreign corporation. According to the statute, the CFC rules don't apply if the U.S. shareholder owns less than 50% of the foreign company's shares. This allows U.S. residents to keep money overseas outside of the U.S. taxing jurisdiction. The overseas profits will only be taxed when repatriated (this largely explains the why there is currently several trillion dollars outside the U.S. waiting to be repatriated). With that in mind, consider the following fact pattern:  Corp. B is a domestic corporation, while Corp. C and D are foreign. The three companies formed an offshore entity to manufacture an unspecified product. The U.S. company provided technical know-how, for which it received a recurring royalty payment. The companies shared management duties equally.
This structure places the foreign company outside the CFC statute. TAM 115478-97: https://www.irs.gov/pub/irs-wd/9914034.pdf Suppose you’ve been made trustee of a trust. While a formal trust document exists, the indenture contains little detail on investment choice, leaving the Uniform Prudent Investor Act to provide guidance regarding investment specifics. Key to that concept is the preservation of capital, which the Restatement of Trusts defines as: Safety of capital includes not only the objective of protecting the trust property from the risk of loss of nominal value but, ordinarily, also a goal of preserving its real value--that is, seeking to avoid or reduce loss of the trust estate’s purchasing power as a result of inflation. This objective will also normally tend to protect the purchasing power of the income flow in the future. Reasonable ²return² refers to total return, including capital appreciation and gain as well as trust-accounting income. Thus, return objectives and safety of capital are at least partially interrelated. The capital-growth element of these return objectives, however, is not necessarily confined to the preservation of purchasing power, but may extend to growth in the real value of principal in appropriate cases. In balancing the return objectives between flow of income and growth of principal, the investment emphasis depends not only on the purposes and distribution requirements of the trust but also on its other circumstances and specific terms, such as the beneficiaries’ tax positions and whether the trustee has power to invade principal. Here are some brief points to consider based on the above two paragraphs: 1. What is the current inflation rate and what are future projected inflation rates? We can use the BLS’ overall CPI rate for the current level. The St. Louis Fed’s FRED system has 4 different measures of future inflation calculated as the difference between the treasury and tips spread of a certain year’s issue:  All assets with an income component should be selected with an eye toward these benchmarks. 2. Assuming two beneficiaries, what is the present value of the final beneficiaries’ potential payout (including income and final principal payouts) and how does that compare to the annual outflows of payments comprised only of portfolio income paid to the first beneficiary? You’ll need multiple calculations usig reasonable return projections to comply with the trustee's duty of impartialty. 3. The need to preserve capital potentially limits portfolio selection to a conservative set of investments as shown in this graph:  The X-axis plots standard deviation – the standard measure for portfolio risk. Points farther away from the origin represent higher risk. While increased risk leads to higher return it also means a higher probability of increased losses. The downside of higher risk leads to a more conservative investment selection, all things being equal.
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Basic US International Tax, Controlled Foreign Corporations, Tax Treaties Captive Insurance. A quick reminder about sending investment portfolios offshore. The U.S. taxes residents on worldwide income. From the Treasury Regulations: In general, all citizens of the United States, wherever resident, and all resident alien individuals are liable to the income taxes imposed by the Code whether the income is received from sources within or without the United States. Sending assets to an offshore trust might create unwanted capital gains: Except as provided in regulations, in the case of any transfer of property by a United States person to a foreign estate or trust, for purposes of this subtitle, such transfer shall be treated as a sale or exchange for an amount equal to the fair market value of the property transferred, and the transferor shall recognize as gain the excess of-- (1) the fair market value of the property so transferred, over (2) the adjusted basis (for purposes of determining gain) of such property in the hands of the transferor. Sending appreciated assets to an offshore corporation creates the same problem; see generally section 367 of the tax code. And that’s before considering the potential implications of the foreign personal holding company rules of the controlled foreign corporation statute contained in section 954. And anytime you use a partnership, the income naturally flows back to the partner due to the partnership's flow-through nature. In short: it’s much more complicated than you might think. Or, in standard parlance: if it sounds too good to be true, it probably is. On Tuesday, December 20th, I'm offering a free 1-hour course on tax treaties. You can learn more here and sign up here.
Assume that company XYZ -- which is domiciled in the US -- wants to sell goods to Germany. While this looks like a great idea on paper it may wind up being counter-productive. Why? Because the transaction may be subject to double taxation. The US taxes income of its residents on a world-wide basis -- meaning that wherever in the world you earn money, you have to pay US tax on the earnings. In addition, Germany will also tax the transaction because it occurs within its geographic borders. So, if the US company sells a good in Germany, it will pay both a US tax and a German tax on the transaction, making this a possibly money losing proposition. Thankfully, this problem of double taxation has long been recognized as a possible impediment to world trade and various parties have sought to prevent its effects from happening. In fact, one of the goals of the original League of Nations was to establish international tax norms (this is where the phrase "permanent establishment" was originally developed). This task eventually fell to the OECD, who issued their first tax treaty in 1963 largely in reaction to the post WWII increase in international trade. This treaty was revised in 1977 and again 1992 when it was released in loose-leaf form, allowing for periodic updates and revisions. The UN issued its model treaty in 1979, which was based on the OECD model, but which was more oriented towards capital importers rather than capital exporters. The US issued their first model treaty in 1977, which was replaced in 1981 and again in 1996. There is a tremendous amount of overlap between the treaties, with the following difference: The US treaty has a "savings clause" which simply means the US reserves the right to continue to tax its "residents" on a world-wide basis. The UN Treaty is considered more beneficial to countries that are capital importers. But aside from these differences, the common ground between the treaties is profound. The avoidance of double taxation is a primary reason why countries sign double tax treaties. There are many others. First, treaties allocate the right tax between jurisdictions, essentially saying, "country A can tax X and country B and tax Y." Second, tax treaties create certainty. When I'm looking at a possible international transaction, my first question is, "does a tax treaty exist between the two countries." If it does, there are already a number of assumptions I can make about the overall environment. Additionally, because of the large number of treaties already in effect, the underlying concepts of these treaties (who can tax what when) have already filtered down into the national structures of most if not all countries. Finally, all of the preceding points have promoted international trade because we have a better idea of what we can expect when money and business involves two or more jurisdictions. There is one more point to mention before moving forward: in order to levy a tax, a "nexus" must exist. According to Dictionary.com, a nexus is "a means of connection; tie; link." There are two ways to establish a taxing nexus: residency and through a permanent establishment. Next time, we'll start with an explanation of residency under the OECD tax treaty. Next time, we'll start to look at some additional basic concepts. To hear some practitioners tell it, a spendthrift trust is a wonderful creation that provides unlimited asset protection. They’ll probably even tell you it cures cancer. But the reality, like most things in law, is far more nuanced. And while spendthrift trusts are helpful in an overall asset protection structure, they also have limitations that are discussed far too little. First of all, a spendthrift trust is a trust that prevents beneficiary from voluntarily or involuntarily transferring his interest.[1] For example, suppose a trust beneficiary is in debt. Without a spendthrift provision, the beneficiary could sign a document transferring his beneficial interest to the creditor. Or, the creditor could sue the beneficiary, obtain a judgement and then seek to attach the beneficial interest. In either situation, the beneficial interest can move from the beneficiary to a creditor. A spendthrift provision prevents alienation, so the beneficiary can’t assign or sell the interest. But there’s a slight wrinkle to this: the Uniform Trust Commentary also states that a creditor “may only attempt to collect directly from the beneficiary after payment is made.” This shifts our discussion to three separate but related U.S. Tax Code sections, beginning with section 11, which provides trust tax rates. These are highly compressed; once trusts have income of just $7,500, they are taxed at a 39% rate. Second, there are two types of trusts; those that distribute all income annually (non-discretionary) and those where the trustee has the discretion to make distributions (discretionary). Each trust distribution is deductible from trust income which are in turn taxed as part of the beneficiary’s income. Therefore, a non-discretionary trust probably won’t be paying a great deal of tax while a discretionary trust may pay an inordinate amount, depending on the trustee’s actions during the taxable year. Let’s combine all these points. A spendthrift trust would be most effective when the trustee has discretion to make distributions. In the event a creditor makes a claim, the trustee can legitimately say there won’t be a distribution. But if the trust has more than $7,500 in income, it’s taxed at a very high rate. Conversely, a trust that distributes all its income can deduct its distributions and lower its tax burden. But in this case, a creditor could simply wait for a distribution from the trust to the beneficiary and attach the payment once it’s outside of the trust’s spendthrift provision. And a planner can’t solve the problem by going offshore due to the grantor trust rules. Section 679 states: A United States person who directly or indirectly transfers property to a foreign trust (other than a trust described in section 6048(a)(3)(B)(ii)) shall be treated as the owner for his taxable year of the portion of such trust attributable to such property if for such year there is a United States beneficiary of any portion of such trust. This provision effectively incorporates offshore trust income into a grantor’s income in a wide array of circumstances. In reality, there are standard structures that planners can utilize to minimize the problems associated with this. But that’s not the point of this post. It’s simply to highlight not only the over-selling that has occurred with spendthrift trusts but also shine a spotlight on the unspoken complexity of this very popular structure. As with all things in law, the nuances offer far more wrinkles than appear on first glance. [1] This is from section 502 of the Uniform Trust Code. |
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