The Tax Cuts and Jobs Act ("TCJA") enacted sweeping changes to U.S. international tax laws, most of which affect traditional planning techniques for multinational companies and U.S. taxpayers with foreign investments. Some of the changes, however, also affect common estate planning structures involving foreign trusts with U.S. investments owned through foreign holding companies that will be inherited by one or more U.S. persons. One such change was the repeal of the "30 Day Rule" for controlled foreign corporations. This article provides an overview of the U.S. tax issues facing trustees, corporate service providers and international private clients due to the repeal of the 30 Day Rule, and summarizes planning techniques that can be utilized to combat these issues.
Planning under Prior Law
Consider a common scenario for a cross-border family. Non- U.S. parent ("Foreign Grantor") with U.S. citizen children ("U.S. Beneficiaries") wants to leave a portfolio of publicly- traded securities to the U.S. Beneficiaries. The portfolio is held in an account in Miami and consists of various assets, including shares of publicly-traded companies incorporated in Delaware. Foreign Grantor creates a revocable Bahamas trust classified as a foreign grantor trust during Foreign Grantor's lifetime so that Foreign Grantor is deemed to own the trust's assets for U.S. federal income tax purposes. The aforementioned trust structure generally produces favorable U.S. federal income tax results during Foreign Grantor's lifetime. Foreign Grantor is subject to U.S. federal income tax only on certain income from U.S. sources (for example, dividends received from a U.S. corporation), and U.S. Beneficiaries could receive trust distributions during Foreign Grantor's lifetime without any U.S. federal income tax consequence (other than reporting obligations).
If Foreign Grantor died while the trust owned the investment portfolio directly, U.S. federal estate tax would be imposed on U.S. situs assets in the investment portfolio (e.g., shares of U.S. companies). To protect against this exposure, the trust would typically form a foreign entity treated as a corporation for U.S. federal tax purposes ("Blocker"), such as a Bahamas IBC, to own the investment portfolio. If Foreign Grantor died while Blocker was in place, Foreign Grantor would be treated as owning the shares of Blocker (a foreign corporation) rather than the underlying investment portfolio. This way, the investment portfolio would not be subject to U.S. federal estate tax provided Blocker was properly administered so that it was respected as a separate entity.
Upon Foreign Grantor's death, the trust would become a nongrantor trust in its entirety, leaving the U.S. Beneficiaries as the indirect owners of Blocker, which would then be a controlled foreign corporation, or "CFC." A CFC is a foreign corporation which is more than 50% owned by "U.S. shareholders." A "U.S. shareholder" means any U.S. person who owns at least 10% of the foreign corporation by vote or value. In determining CFC and U.S. shareholder status, certain attribution rules apply.
The CFC rules eliminate income tax deferral by subjecting U.S. shareholders to U.S. federal income tax on their pro rata share of the CFC's "Subpart F income" each year. Subpart F income generally includes passive income and gain. Due to these anti-deferral rules, Blocker is an inefficient holding structure for U.S. Beneficiaries after Foreign Grantor's death.
Enter the 30 Day Rule
Enter the 30 Day Rule. Prior to the TCJA, a foreign corporation had to be a CFC for at least 30 consecutive days before triggering a Subpart F income inclusion. Under the prior law, Blocker could have made a check-the-box ("CTB") election to be treated as a disregarded entity for U.S. federal tax purposes, thereby avoiding the CFC rules; however, the timing of the CTB election needed to be planned carefully. If such election were made prior to Foreign Grantor's death, it would cause the U.S. situs assets in the investment portfolio to be subject to U.S. federal estate tax as if Blocker never existed. If, instead, the CTB election were made with an effective date that was somewhere between the 2nd and 30th day after Foreign Grantor's death, Blocker would protect against U.S. federal estate tax while simultaneously avoiding taxation for U.S. Beneficiaries under the CFC rules.
If Blocker made a CTB election to change its classification to a disregarded entity, such election would cause Blocker to be treated as liquidating at the end of the day before the effective date of the election. The effects of such election would be: (1) Blocker would be treated as selling its assets for fair market value at the end of the day before the effective date of the election; and (2) Blocker's shareholders would be deemed to have received Blocker's assets in exchange for their shares of Blocker (i.e., as if they sold their shares of Blocker for Blocker's assets).
The CTB election would not trigger U.S. federal income tax consequences for Blocker. Importantly, however, the election would "step up" the historical cost basis of the assets in the investment portfolio. Additionally, provided the trust was properly drafted, the trust's basis in Blocker's shares would have also been stepped up to fair market value at the time of Foreign Grantor's death. Accordingly, there would have been little or no gain realized on the deemed sale of Blocker's shares, as only the appreciation that occurred between Foreign Grantor' death and the time of the liquidation would get caught by the U.S. federal tax net.
Planning after the Repeal of the 30 Day Rule
Due to the repeal of the 30 Day Rule, the foregoing planning no longer produces the same results. U.S. shareholders of CFCs are now subject to U.S. federal income tax on their pro rata share of any Subpart F income, even if the foreign corporation has been a CFC for only one day. To compute the amount of the Subpart F income inclusion, a CFC's Subpart F income for the year must be prorated for the number of days that the foreign corporation was a CFC during its taxable year. This calculation takes into account the income and gain of the company for the entire time it was a foreign corporation during the taxable year, including income and gain that was realized during such year before the foreign corporation became a CFC. To illustrate, assume that Foreign Grantor dies on June 30th, survived by two U.S. Beneficiaries who are deemed to indirectly own 100% of Blocker in equal parts upon Foreign Grantor's death. Also assume that Blocker makes a CTB election effective as of July 2nd and realizes $1 million of gain as a result of such election. Blocker is deemed to liquidate on July 1st. Accordingly, Blocker's taxable year consists of 182 days (January 1 to July 1), and Blocker is classified as a CFC for 1 day during its taxable year. The fraction of Subpart F income taxable to U.S. Beneficiaries is therefore 1/182, resulting in only approximately $2,747 of Subpart F income for each of the U.S. Beneficiaries. Even at the top marginal U.S. federal income tax rate of 37%, this results in U.S. federal income tax liability of only $1,016 for each of the U.S. Beneficiaries on the $1 million gain.
As a general observation, a death that occurs later in the year will produce a smaller percentage of inclusion of Subpart F income, while a death that occurs earlier in the year will produce a larger percentage of inclusion of Subpart F income. Likewise, the amount of unrealized gain would need to be significantly higher than $1 million to have a meaningful tax impact unless Foreign Grantor died shortly after the beginning of the taxable year. For instance, if the death occurred on January 15 and the CTB election were made effective as of January 17, the fraction of Subpart F income taxable to U.S. Beneficiaries would be 1/16, resulting in $31,250 of Subpart F income for each of the U.S. Beneficiaries (or $11,562 in actual U.S. federal income tax owed by each of them).
As a result, the U.S. federal income tax consequences of the single foreign holding company structure are dependent upon: (1) the amount of the CFC's unrealized gain; (2) the timing of the death of Foreign Grantor;(3) the timing of the liquidation of Blocker; and (4) the percentage of Blocker owned by U.S. Beneficiaries. Multi-Tier Corporate Structure. In response to the foregoing dilemma, there has been renewed interest in a multi-tier corporate holding structure. In this structure, a foreign corporation ("FC1") owns U.S. situs publicly-traded securities. FC1 is, in turn, equally owned by two foreign corporations, FC2 and FC3, which are each wholly-owned by a foreign revocable trust. Via successive CTB elections, as outlined below, the intended U.S. tax outcomes are as follows.
1. FC1 makes a CTB election to be classified as a partnership, effective prior to Foreign Grantor's death. This election triggers a deemed liquidation of FC1 and produces a step up in basis for FC1's assets. Because the election is effective before Foreign Grantor dies, FC1 never becomes a CFC (because it will not be a foreign corporation after the death of Foreign Grantor). FC2 and FC3 realize gain on the deemed exchange of FC1 shares for FC1's assets; however, such gain is not taxable to FC2 or FC3 (although, as explained below, a portion of this gain may be taxable to the U.S. shareholders of FC2 and FC3).
2. FC2 and FC3 make CTB elections to be classified as disregarded entities effective after Foreign Grantor's death, triggering deemed liquidations of FC2 and FC3. FC2 and FC3 remain viable estate tax blockers, but are classified as CFCs after Foreign Grantor's death.
3. There should be minimal gain as a result of the deemed liquidations of FC2 and FC3, assuming the CTB elections are made effective shortly after Foreign Grantor's death, because: (i) the assets of FC1 received a basis step up as a result of the CTB election made by FC1; and (ii) the shares of FC2 and FC3 received a basis step up upon Foreign Grantor's death, assuming the trust included the appropriate language.
While this structure may provide more tax savings and flexibility when compared to other alternatives (discussed below), it adds complexity and may not be necessary. For example, it may cause unnecessary administrative hassles and could be costly and time consuming to implement and maintain. The structure also may not provide any benefit versus having just one foreign holding company. Specifically, gain realized by FC2 and FC3 upon the receipt of assets in the liquidation of FC1 is itself Subpart F income that must be included in the prorated calculation, unless the CTB election made by FC1 causes FC1 to liquidate in the year prior to the year in which Foreign Grantor died. Therefore, even in a multi-tier holding structure, there is likely to be some tax leakage. Accordingly, it is typically worthwhile to consider alternative planning approaches, as outlined below. These techniques are not necessarily "new" and were also available and used sometimes prior to the changes brought on by the TCJA.
Do Not Make Changes
For some clients, having one foreign holding company to own the investment portfolio may be sufficient for various reasons. For example, the investments may never generate a large amount of unrealized gain.
Avoid U.S. Situs Assets
A simple strategy is to avoid investing in U.S. situs assets during Foreign Grantor's lifetime. A foreign holding company would not be necessary in this case, as the non-U.S. situs assets would not be subject to U.S.federal estate tax upon the death of Foreign Grantor. A foreign holding company may still be desirable for non-tax reasons, however. If so, a CTB election to treat the company as a disregarded entity could be made effective prior to Foreign Grantor's death. The foregoing strategy could result in a basis step up for the underlying assets and avoid CFC issues. Careful planning would be required to ensure that the company never owns U.S. situs assets.
Separating U.S. and Non-U.S. Assets
For those clients with U.S. and non-U.S. situs assets, segregating assets in separate foreign holding companies could be useful. This technique would allow for different timing for the CTB elections in order to maximize efficient U.S. federal income tax outcomes. For the company that owns non-U.S. situs assets, a CTB election could be made effective prior to the date of Foreign Grantor's death, producing a basis step up and avoiding CFC issues. For the company holding U.S. situs assets, the CTB election could be made effective as early as two days after Foreign Grantor's death, with the amount of Subpart F income depending in part on the four factors set forth above at the end of the section entitled Planning after the Repeal of the 30 Day Rule. Importantly, however, this structure limits Subpart F income exposure to the appreciation in the U.S. situs assets only. This strategy may be combined with others (such as "churning") to reduce the unrealized gain in the investment portfolio.
To reduce the unrealized gain in the investment portfolio at the time of Foreign Grantor's death, consideration could be given to periodically selling the assets in the investment portfolio and then rebuying them or other assets on the open market. Commonly referred to as "churning" or "cleansing," this technique manually steps up the basis of the portfolio assets. Provided the investment portfolio was properly monitored (i.e., periodic sales and repurchases), the resulting basis increase should result in minimal Subpart F income exposure upon Foreign Grantor's death. This potential tax benefit is typically weighed against market-timing risks and the transaction costs involved.
Although the TCJA may have eliminated planning techniques that were previously available under the 30 Day Rule, plenty of options remain viable. While these options vary in complexity and potential tax savings, advisors and fiduciaries should not discount some of the simpler approaches, which could produce the desired outcomes without incurring unnecessary costs and aggravation.
This article is for general informational purposes only and should not be viewed as legal advice. The views expressed herein are those of the authors and should not be attributed to the authors' firm or its clients. Advisors and their clients should consult with qualified U.S. tax counsel before implementing any of the planning structures discussed herein.