Non-domiciliary Planning to Remove Assets from US Estate Tax
by Lee Williams
	A significant amount of the world’s private wealth is invested in US portfolio assets and real estate. For investors who are not US citizens or domiciliaries (Non-Domiciled Aliens or NDAs), techniques are readily available to hold and transfer this wealth to US or foreign family members without US gift, estate or generation skipping transfer (GST) taxes. For individuals who choose not to take appropriate measures there can be a high cost, including estate taxation at rates of up to 48% (2004). Further, bank custodians and trust fiduciaries are personally liable for ten years for any unpaid US gift and estate taxes of their clients.
In this chapter we discuss planning techniques whereby NDAs, wherever resident, can remove assets from US transfer taxes (gift, estate and GST). In addition, we focus on planning for UK domiciled clients – where the primary objective is either to mitigate US estate tax or match US estate tax exposure with creditable UK inheritance tax. For the well advised, US and UK gift taxes can be easily avoided.
UK domiciliaries are generally, under the 1979 US/UK Estate and Gift Tax treaty (the ‘US/UK treaty’), only subject to US transfer taxes with respect to US real estate and business property. In addition, the US/UK treaty caps the US estate tax imposed on a UK national (whether or not UK domiciled) at no more than would have been imposed on a US domiciliary; this can be of particular benefit to smaller estates by effectively exempting the first $1.5m of assets ($3.5m as of 2009) from US estate tax. UK resident but non-domiciled clients are generally subject to US estate tax on all US sited assets, including US real estate, equity securities, tax exempt bonds and mutual funds.
Married clients can defer or avoid US estate tax by bequeathing US sited assets outright or in a qualified life interest marital trust to a surviving spouse. This is limited in the case of a non-US citizen donee spouse to an indexed $114,000 annual gift tax exclusion for lifetime gifts and to testamentary Qualified Domestic Trust transfers. Lifetime and testamentary transfers to US citizen spouses are exempt from gift and estate tax. Greater relief is available in the UK to spouses subject to UK Inheritance tax (IHT) as all spousal transfers are exempt, except if made by a UK IHT domiciled spouse in favour of a non-UK IHT domiciled spouse. Even in the excepted case, a lifetime outright transfer or a transfer to an interest in possession trust for such a spouse is potentially exempt from IHT (and fully exempted if the donor spouse survives the transfer by seven years).
The basic structuring to mitigate US estate tax involves holding US assets through an appropriate foreign trust or foreign company. For larger estates and income tax planning for family members, a trust is usually preferable. A trust may be also be preferable for holding US real estate in that FIRPTA gains are currently taxable to the trustees at only 15% as opposed to corporate tax of 34% to 35%. In the case of a trust there are a variety of UK anti-avoidance provisions which may be relevant to trigger taxes on a settlor or beneficiary of a trust, depending on whether he is UK resident and domiciled, or just UK domiciled, or just UK resident.
In the case of using a company alone, there are also UK issues to consider in that the UK Inland Revenue takes the view that enjoyment of company-owned assets gives rise to a an income tax charge on the shareholder in certain circumstances, whether or not he is also a director of the company. There are also issues to consider in the context of the tax residence of the company itself and whether or not management and control can properly be said to be conducted outside the UK. If not, the company may, in principle, be taxable in the UK as well as the US.
For an individual who is UK resident but non-UK domiciled, rent free use of an offshore company owned US residence may not have UK imputed income tax exposure nor US constructive dividend consequences (as long as the company has no realized profits). For such clients, the higher FIRPTA corporate tax cost of selling the residence may be small in comparison to the estate tax savings. However, in appropriate cases the UK Inland Revenue may still seek to argue that income tax applies in that the deemed employment to which the taxable benefit of occupying the property attaches, is being exercised in the UK. Furthermore, the same issues arise as to management and control of the company itself and whether or not it might be argued to be UK resident (and hence UK taxable).
For portfolio assets, a properly managed offshore company works well from a US tax perspective as the only US tax is the 30% withholding tax on dividends. The investor would suffer this tax anyway if he held the assets as an individual, subject to treaty relief; but if the investor is subject to foreign income tax, there will be no credit for the US withholding tax suffered by the offshore company. Some US international tax advisers are proactively using foreign partnerships not engaged in a US trade or business as a holding vehicle for avoiding US estate tax, as well as achieving a date of death market value re-basing of partnership assets under a partnership election available on death of a partner. This is an evolving area involving whether an entity or aggregate (‘look through’) approach should apply to partnerships for estate and gift tax purposes. Although the IRS refuses to rule in the area, the limited historical precedent evidences a 50-year-old IRS ‘entity’ approach and any rationalization of the law in this area may well be prospective only in application.
Where income producing US real estate is involved, the estate plan should take into account US and UK income/gains tax exposure. At Section G (14.117 et seq) there is a discussion on the alternatives for holding such real estate. Relevant issues include a potential trade off between estate and capital gains taxation (FIRPTA), differences in corporate, grantor and non-grantor trust income tax rates, second-tier withholding and branch profits taxes and foreign tax credit relief.