Structuring foreign investment in the US
March 2015 | SPOTLIGHT | FINANCE & INVESTMENT
Financier Worldwide Magazine
Investment in US real estate or a business should be structured to afford privacy, asset protection and minimisation of US taxation. Due to the US taxing on worldwide income, tax structuring is often a driving force behind a transaction.
Privacy and liability
Most foreign investors are concerned with privacy. To achieve privacy, US assets should be acquired either by a trust, or by an LLC. If using a trust, the investor should not be the trustee and the trust should have a generic name. If using a legal entity, a generic should also be used. Ownership of legal entities is never publicly disclosed in the US, however management often is. In Delaware, the name of the LLC manager is not required to be disclosed and as such it is a preferred state for LLC formation.
Corporations, limited partnerships and LLCs will afford their individual owners a liability shield for any liability arising from the assets or the business of the entity. Interests in limited partnerships and LLCs are not attachable by creditors, making them a more effective asset protection vehicle than corporations. For example, when a creditor obtains a judgment against an individual who owns an apartment building through a corporation, the creditor can force the debtor to turn over the stock of the corporation, resulting in the loss of all corporate assets. If the debtor owns the apartment building through an LLC or a limited partnership, the creditor’s remedy is limited to a charging order – a court order that places a lien on distributions actually made from the LLC or the limited partnership.
A person we might colloquially refer to as a ‘foreigner’ is often referred to as a non-resident alien (NRA) for federal income tax purposes. An NRA is defined as a either a foreign corporation or a person who: (i) is physically present in the US for less than 183 days in any given year; (ii) is physically present in the US for less than 31 days in the current year; (iii) is physically present for less than 183 total days for a three year period (using a weighing formula); and (iv) does not hold a permanent resident status (a green card or an EB-5 visa). A foreigner receiving a green card will become a US tax resident from that day forward. A foreigner who is deemed to be a US tax resident based on the number of days test will be deemed a US tax resident for the entire calendar year in which such test is met.
Income tax rules applicable to NRAs can be quite complex. As a general rule, an NRA pays a flat 30 percent tax on US source fixed or determinable, annual or periodical (FDAP) income that is not effectively connected to a US trade or business, and which is subject to tax withholding by the payor. The rate of tax may be reduced by an applicable treaty to anywhere between 0 and 15 percent.
FDAP income includes interest, dividends, royalties, rents annuity payments and alimony. Note that the NRA is subject to this tax but does not pay it. The 30 percent FDAP tax is withheld by the payor at the time of payment and remitted to the US Treasury. The NRA receives the remaining 70 percent. NRAs are generally not taxable on their capital gains from US sources.
An NRA is taxed on income effectively connected to a US trade or business under the same rules as all other US taxpayers. Income may be reduced by appropriate deductions, connected to the US trade or business, and standard US tax rates apply. An NRA will be engaged in a US trade or business if the NRA is a general or limited partner in a US partnership engaged in a trade or business.
A separate regime known as FIRTPA taxes the disposition of an interest in US real property as if the NRA was engaged in a US trade or business. This means that the traditional income tax rules that apply to US taxpayers will also apply to the NRA. Purchasers who acquire real estate from an NRA are obligated to withhold 10 percent of the amount realised on the disposition, even if the property is sold at a loss.
Estate and gift tax
For estate tax purposes, the test is completely different in determining who is an NRA, as the inquiry focuses on the decedent’s domicile. This is a more subjective test that looks primarily at intent, and will also consider factors such as the length of stay in the US and frequency of travel, size and cost of home in the US, location of family, participation in community activities, participation in a US business, and ownership of assets in the US, as well as voting.
The estate tax, at a 40 percent rate, is imposed only on the part of the NRA’s gross estate which is situated in the US at the time of death. These harsh rules may be ameliorated by an estate tax treaty. The US does not maintain as many estate tax treaties as income tax treaties, but there are estate tax treaties in place with most Western European countries, Australia and Japan.
US-situs property includes real estate in the US and tangible personal property, like an interest in a US corporation, works of art and cars. US-situs property does not include life insurance proceeds paid on the life of the NRA, bank accounts and shares of stock in a foreign (non-US) corporation.
Advance planning can eliminate or reduce the US estate tax obligations of NRAs. For example, US real estate owned by an NRA through a foreign corporation is not included in an NRA’s estate. This effectively converts US real estate into a non-US intangible asset.
Gift taxes are imposed on the donor. A NRA donor is not subject to US gift taxes on any gifts of non-US situs property gifted to any person, including US citizens and residents. Gifts of US situs assets however, are subject to gift taxes, with the exception of intangibles, such as interests in legal entities, which are not taxable. Tangible personal property and real property is sited within the US if it is physically located in the US.
The primary thrust of estate tax planning for NRAs is through the use of: (i) foreign corporations to own US assets; or (ii) the gift tax exemption for intangibles to remove assets from the US. If the NRA dies owning shares of stock in a foreign corporation, the shares are not included in the NRA’s estate, regardless of the situs of the corporation’s assets. Shares in US corporations and interests in partnerships or LLCs are intangibles. Consequently, real estate owned by the NRA through a US corporation, partnership or an LLC may be removed from the NRA’s US estate by gifting entity interests to relatives gift tax free.
Ownership structures for foreign investors
Direct investment (assets owned by the NRA) is a simple ownership structure and is subject to only one level of tax on the disposition. However, there are a number of disadvantages related to direct investments: they offer no privacy and no liability protection, the NRA will be obliged to file US income tax returns, and if owned at death, the US asset is subject to US estate taxes. Ownership of US assets through a domestic corporation will afford privacy and liability protection, allow lifetime gift tax free transfers, and obviate the foreigner’s need to file US income tax returns. Engaging in a US trade or business requires a US tax return; ownership of stock will not trigger a return filing obligation.
There are three main disadvantages associated with the ownership of US assets through a domestic corporation: (i) corporate level taxes will add a second layer of tax; (ii) dividends from the domestic corporation to its foreign shareholder will be subject to 30 percent withholding; and (iii) the shares of the domestic corporation will be included in the US estate of the foreign shareholder.
Foreign corporation ownership does proffer some advantages, however: (i) liability protection; (ii) no US income tax or filing requirement for the foreign shareholder; (iii) shares in a foreign corporation are non-US assets not included in the US estate; (iv) dividends are not subject to US withholding; (v) no tax or filing requirement are placed on the disposition of the stock; and (vi) no gift tax is applicable to the transfer of shares of stock.
The disadvantages of using the foreign corporation are: (i) corporate level taxes if the foreign corporation is engaged in a US trade or business; and (ii) the foreign corporation will be subject to the branch profits tax, the largest disadvantage of ownership of US real estate through a foreign corporation.
The most advantageous structure for ownership of US assets by NRAs is via the foreign corporation-US corporation structure. Here, the NRA owns a foreign corporation, which in turn owns a US LLC taxed as a corporation. This structure affords privacy and liability protection, escapes US income tax filing requirements, avoids US estate taxes, allows for gift tax free lifetime transfers and avoids the branch profits tax. Distributions from the US subsidiary to the foreign parent are subject to the 30 percent FDAP withholding, but the timing and the amount of such dividend is within the NRA’s control.
Properly structuring foreign investment in the US takes into account corporate law, liability protection, privacy and tax planning. The structure is primarily driven by tax considerations, and an incorrect structure can have catastrophic tax results. In addition to the federal tax consequences discussed above, there may also be state income tax issues, which are beyond the scope of this article. Every investor, and their professional advisers, are strongly encouraged to seek local counsel in the US for structuring and tax advice.
Jacob Stein is a partner with Klueger & Stein LLP. He can be contacted on +1 (818) 933 3838 or by email: firstname.lastname@example.org.
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