Offshore Assets: The Not So Ugly Truth
The financial press has devoted much attention in recent months to efforts by the Internal Revenue Service ("IRS") to crack down on tax-avoidance planning using offshore financial arrangements. Earlier this year, as a result of political pressure particularly on the Swiss banking industry, UBS confirmed the existence of more than 50,000 offshore accounts held by US taxpayers at that bank alone. More recently, UBS has turned over to the IRS details relating to the ownership list of more than 4,000 of those accounts.
Coordinated with the political pressure on the foreign banking industry, the IRS announced a voluntary program on March 23, 2009 allowing domestic taxpayers the ability to disclose and pay taxes on previously unreported offshore financial arrangements with reduced civil penalties and no criminal prosecution. This offshore amnesty program was originally set to expire on September 23, 2009 but was recently extended to October 15, 2009. Any domestic taxpayer with an unreported offshore financial arrangement is strongly encouraged to contact an attorney specializing in these matters and to participate in the voluntary disclosure program lest that taxpayer’s prior unreported activities become subject to additional scrutiny and severe civil and criminal penalties
Much of the current IRS scrutiny of offshore financial arrangements is a direct result of domestic taxpayers’ failure to file a Report of Foreign Bank and Financial Accounts ("FBAR") on Treasury Form 90-22.1. Domestic taxpayers must file Form 90-22.1 annually on June 30th and report accounts in foreign financial accounts of $10,000 or greater owned (or over which the domestic taxpayer has authority) in the previous year. Without relief under the voluntary disclosure program discussed above, civil penalties for non compliance with FBAR range from $10,000 for non-willful violations to the greater of $100,000 or 50% of the account balance for willful violations. Criminal penalties can lead to a fine of $250,000 and 5 years imprisonment.
All of these efforts have been meant to encourage domestic taxpayers to both comply with existing foreign bank account reporting rules and to pay applicable taxes under the threat of civil and criminal prosecution. In a political environment where tax increases are likely, these efforts by the IRS to curtail the use of offshore financial arrangements are likely to be met with little controversy or resistance.
Lost amid the recent negative press coverage, however, are the instances where fully legal offshore financial arrangements fill legitimate asset protection and/or investment optimization roles.
Optimizing Investment Tax Treatment
So, where do legitimate uses of offshore financial arrangements fit in a typical Aspiriant client portfolio? Establishing an offshore financial arrangement is completely legal so long as it is properly reported and US taxpayers pay income tax on their worldwide income. One example is where the specific nature of a foreign investment requires the domestic taxpayer to open a foreign bank account or create a foreign structure. Perhaps it is a direct investment in a non-U.S. financial market, buying foreign real estate or foreign currency diversification. Depending on the nature and location of the investment, there will be both foreign and domestic tax issues that may involve multiple tax jurisdictions and tax treaties. With each investment being fact-specific, it is important to retain qualified domestic and foreign counsel to ferret out the proper structure necessary to minimize taxation and to insure that the investment is properly reported for tax purposes in all governing jurisdictions.
Common examples of a foreign financial arrangement that appears in our clients’ portfolios relate to pension and individual retirement account ("IRA") investments in certain pooled funds that allow clients the opportunity to invest in assets where the size and opportunity of the investment itself would be inappropriate or otherwise unavailable. These pooled funds are designed specifically and fully legally for client investments through a client’s retirement and IRA accounts.
One of the basic principles in determining which of a client’s accounts should house which of that client’s investments is that the least "tax efficient" investments (i.e. they produce the greatest amount of current taxable income in relation to their value) should be held in tax-deferred accounts, such as IRA’s, in order to avoid paying current income tax. Under the Internal Revenue Code, earnings from investments held within an IRA are generally not taxable until such time as those earnings are withdrawn from the IRA. This can result in many years of tax deferral on those earnings, greatly improving the net investment performance of the investment.
However, as with most tax rules there are always exceptions. At the risk of some mind-numbing detail, if an IRA holds investments that are leveraged with debt, as private investment partnerships often are, the income that results is referred to as "debt financed income" and does not qualify for tax deferral. If an IRA has "unrelated business taxable income" ("UBTI") as a result of such leverage, it is taxable in the year that it is earned, thereby partially negating the tax deferral benefits of the IRA itself1, let alone causing additional administration costs due to the tax filings required of the IRA trustee.
The pooled funds located offshore come in to help by "blocking" the UBTI. Off-shore investment vehicles are usually organized as foreign corporations. These foreign corporations are legitimate entities that are organized outside the US, are not domestic taxpayers and therefore generally not subject to US tax2. The domestic US client’s IRA invests in shares in the foreign corporation, which in turn holds investments in the private investment partnership that contains the leverage. Because the investment held in the IRA is no longer a domestic taxpayer, the IRA is not taxed currently on the dividends it receives from the foreign corporation. The foreign entity has effectively blocked the UBTI by containing it within the foreign corporation. The final result is that the tax deferral benefits of the IRA are maintained, but the eventual value of the IRA, including the results of the foreign entity, will be taxed as the IRA is distributed over time.
Clients can also use appropriate offshore financial arrangements to help protect and preserve their wealth. Today, clients are faced with a dizzying array of risks from creditors, business claimants, tort liability, regulatory and legislative liability including Sarbanes-Oxley, even ex-spouses. While certain US state jurisdictions offer varying degrees of asset protection, practical realities and the "full faith and credit" doctrine regarding the enforceability of foreign sovereign judgments confirms that the preferred choice in asset protection remains an offshore financial arrangement.
An offshore financial arrangement for asset protection purposes often takes the form of an offshore trust that precludes creditors' access to undistributed trust assets. Unlike domestic trusts that generally do not allow for self-settled "spendthrift" trusts, an offshore trust formed in an appropriate foreign jurisdiction can protect the very person forming that trust. Typically these foreign jurisdictions have narrow laws and very limited statutes of limitations for challenging an alleged fraudulent transfer. Anyone challenging the offshore spendthrift trust is required to litigate the dispute in the foreign country within a limited time, often with no contingency fees and where the loser pays the costs.
Under the "nest egg" approach, the client would fund the offshore spendthrift trust with a limited amount of assets, a sort of disaster fund. Preferably, all of these assets would be physically located offshore and have an independent foreign trustee. As a beneficiary, the client can ask for distributions from the trust and the trustee may or may not grant that request, and most certainly not when the client was being sued or threatened. The client often retains the right to appoint a "trust protector" who has the right to remove and replace the foreign trustee for any reason. On the client’s death the assets of the offshore trust can be incorporated into the client’s estate plan in a number of different ways and either left offshore or brought back into the U.S.
While offshore spendthrift trusts address a number of important client concerns including asset protection, estate planning and economic diversification, the trust itself is fully income and estate tax neutral. As a grantor trust, the client will pay all income taxes on the offshore trust’s income and the offshore trust generally will be included in the client’s estate for estate tax purposes. As always, the client should report the offshore financial arrangement in accordance with FBAR.
Despite the rash of bad press, foreign financial arrangements have many proper uses in our clients' affairs and will likely become even more prevalent as we move to an even more global economy. But recent scrutiny of such arrangements, coupled with very significant penalties, requires proper reporting and the payment of tax on any income from such accounts. Certainly, Aspiriant’s activities for its clients have never engaged in any improper use of any offshore vehicles. Still if any of our clients otherwise engaged in such activities, we would strive to help them remedy that situation. Your client service team stands ready to help if you have any questions or concerns or need assistance with the reporting of a foreign financial arrangement.
Marc Primiani and
1UBTI is also generated if the IRA holds an investment that generates “trade or business” income. This subject is not intended to be addressed here.
2A non-US taxpayer can be subject to US tax, and there could be adverse tax consequences to the IRA in this example, if the foreign corporation were to invest in business activities “effectively connected to the US” or generate gains from "US real property interests". This topic is beyond the scope of this article.