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Long ago, attorneys that drafted foreign asset protection trusts (FAPTs) recognized that a court could eventually force their client to disgorge assets. They used several strategies to prevent an actual payout. A “duress clause” – which I discussed in my last post – was one such tactic. Another was to place assets into a family member’s name -- a tactic was used in Solow. But like the taxpayer in Lawrence, Solow lost, invalidating this structure.
The following transactions are at the heart of this case.
The SEC sued Solow, alleging he engaged in a fraudulent trading scheme. After losing, Solow faced $5.2 million in damages. Solow asserted the impossibility defense, arguing he owned no assets. The court ruled against Solow, first noting, “where assets are held in an offshore trust, the ‘burden of proving impossibility as a defense to contempt will be especially high.’” By the time of the Solow decision, courts had come to view these trusts suspiciously, believing they allowed debtors to run up exorbitant debts only to claim poverty when the bill comes due. Not wanting to be seen as aiding unscrupulous behavior, courts had developed a jaundiced view of these structures. The court next concluded that Solow “failed to demonstrate that he had made in good faith all reasonable efforts to comply with the court’s disgorgement order.” Solow had paid the court a little under $3,000 over a six-month period -- a paltry amount in relation to the total judgment. He hoped that by placing marital assets into his wife’s name – and then placing the bulk of those assets into a Cook Island trust -- he could argue he couldn’t satisfy the judgement. While Solow was penniless on paper, he continued to benefit from the assets through his wife; together, the couple was still living the high life. The court easily saw through this charade. But the following reasoning – like the Lawrence case – is Solow’s most important holding: “… an inability defense is unavailable where the inability was created by the defendant.” This is a legal principle with solid grounding in common law precedent. The court is saying, “we won’t let clever trust drafting techniques to allow a debtor to “have his cake and eat it, too.” This reasoning, combined with the already high bar courts place on offshore trusts, neuters a vast majority of plans using an FAPT. Solow’s reasoning directly undercuts most planning using foreign asset protection trusts. Granters now face a two-pronged problem. They have to jump over an “especially high” bar when asserting the impossibility defense. But when they’re responsible for the barrier preventing their compliance, courts will rule against them. The combination of these two points is particularly damaging to FAPT grantors, coming close to invalidating these structures. Long ago, drafters of foreign assets protection trusts (FAPT) realized that courts might hold grantors in contempt because they wouldn’t repatriate assets from a foreign jurisdiction into the U.S. To prevent this outcome, drafters included a “duress clause” in a FAPT document. This clause states that should a court threaten a U.S. grantor with contempt, he will not only be stripped of any power to control the trust, but will also lose all trust benefits. This should allow the US grantor to argue that compliance with the repatriation order is impossible. The Anderson case, which I discussed in my last post, dealt a serious blow to this strategy. Lawrence[1] - the topic of this post - adds another nail in the “duress clause” coffin.
In January 1991, Lawrence funded a Mauritius trust with $7 million dollars. He had the sole power to appoint or remove a trustee. He added a spendthrift provision one month later. In March 1991, Lawrence lost a $20.4 million dollar arbitration award. He added a duress clause two years later in addition to a provision that terminated his beneficial interest if he declared bankruptcy -- which he did two years later. The bankruptcy court eventually ordered Lawrence to turn over the trust assets. Lawrence responded that this was impossible, citing the duress clause. The court disagreed, held him in contempt of court, and placed him in jail pending compliance with its order. The latter few sentences in the preceding paragraph contain the quintessential facts a duress clause is designed to thwart. After being ordered to turn over all trust assets, Lawrence sent a request to the trustee to do so, only to have him cite the duress clause as the reason for non-compliance. Lawrence dutifully went back to the court and said, “I tried.” The court saw through his charade. They first noted that a duress clause violated Florida public policy preventing a trust grantor from forming a self-settled spendthrift trust where the grantor was also a beneficiary. This policy is based on §505 of the Uniform Trust Code whose comments note “… A settler who is also a beneficiary may not use the trust as a shield against the settlor’s creditors.” The court then added, “the sole purpose of this provision appears to be an aide to the settlor to evade contempt while merely feigning compliance with the court’s order.” The court is saying the duress clause allows the grantor to look like he’s complying, when he ultimately has no intention of doing so. The court then delivered a potential knock-out blow to all duress clauses, ruling: “Lawrence’s claimed defense is invalid because the asserted impossibility was self-created.” This is the most damning statement from the decision. The court will overlook clever draftsmanship when it is designed to subvert public policy. No other interpretation of the court’s reasoning is possible. The impossibility defense should be left to truly impossible situations. For example, suppose a grantor funded a trust in a country where a military coup occurs, which is followed by a nationalization of all offshore assets. Here compliance with a repatriation order is truly impossible. However, no court should allow clever draftsmanship to either circumvent judicial power or thwart public policy, which duress clauses are clearly designed to do. For practical purposes, Lawrence had made duress clauses moot. [1] Lawrence v. Goldberg, 279 F. 3d. 1294, (11th Cir. 2002) High net worth individuals are loathe to transfer assets to any entity over which they have no control. This fact creates an unresolvable problem when forming an offshore asset protection trust: so long as a U.S. person can exert even a modicum of control over a foreign entity, a U.S. court has sufficient grounds to rule that a U.S. based debtor can repatriate assets. More importantly, failure to comply with a repatriation order could lead to contempt citation against the U.S. debtor. The facts of Federal Trade Commission v. Affordable Media[1] typify this problem. In 1995, the Andersons formed a Cook Island asset protection trust that had the following three features:
In 1997, the Andersons formed and ran a late-night television Ponzi scheme, which the Federal Trade Commission began attacking one year later. One of the FTC’s first actions was to obtain a temporary injunction against the Andersons, which included a demand that the couple repatriate foreign funds. The Andersons attempted to comply, asking their co-trustee to disgorge assets. However, the co-trustee did not comply. Instead, it determined that the court order was a “duress event,” leading them to remove the Andersons as co-trustees. The couple then told the court they tried to comply with the court’s order, but couldn’t. The preceding paragraph contains a picture perfect fact pattern explaining the purpose of anti-duress clauses. Asset protection planners add these clauses to foreign trust documents, hoping they will be sufficient to blunt a domestic court’s contempt powers; Another common issue is whether the client may someday be in the awkward position of either having to repatriate assets or else be held in contempt of court. A well-drafted asset protection trust would, under such a circumstance, make it impossible for the client to repatriate assets held by the trust. Impossibility of performance is a complete defense to a civil contempt charge.[2] This excerpt perfectly describes what the Andersons did. The court treated the Anderson’s actions more as Kabuki Theater than a serious attempt to follow the court’s instructions. They first noted, “Foreign trusts are often designed to assist the settlor in avoiding being held in contempt of a domestic court while only feigning compliance with the court's orders.”[3] The court continued, With foreign laws designed to frustrate the operation of domestic courts and foreign trustees acting in concert with domestic persons to thwart the United States courts, the domestic courts will have to be especially chary of accepting a defendant's assertions that repatriation or other compliance with a court's order concerning a foreign trust is impossible. Consequently, the burden on the defendant of proving impossibility as a defense to a contempt charge will be especially high.[4] This cite is especially damning to the asset protection planning community. In no uncertain terms, the court is clearly informing planners that judges view duress clauses as illusory concepts devoid of legal substance. They allow a U.S. debtor to feign compliance with a court order, all the while knowing that their actions are meaningless. Although courts have to give duress clauses some weight, they will also enact and use an “especially high” compliance requirement on U.S. debtors who attempt to use them. The court also ruled that because the Andersons were trust protectors, they could remove the trustee and replace them with a more malleable alternative. This was sufficient justification for the court to rule the couple was in contempt, despite their “attempt” to failed effort to repatriate assets from the Cook Islands. The court clearly demonstrated that they would not allow a U.S. debtor to use a well-drafted trust document to thwart a U.S. creditor’s attempts to collect monies owed. In addition to greatly limiting the efficacy of duress clauses, this case also stands for the proposition that so long as a U.S. debtor can exert any influence over an offshore trust -- even if remotely tangential – the court has grounds to rule against the debtor. This creates a large problem for planners, because no U.S. individual will place his assets into an offshore entity without retaining control. But that control will eventually prove fatal should a court rule the grantor is in contempt of court. [1] Federal Trade Commission v. Affordable Media, 179 F.3d 1228 (9th Cir. 1999) [2] Id at 1241 [3] Id [4] Id 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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