Globalization and Blurred Borders, Part Two: Taxation
Written by David I. Faust, Partner, Gallet Dreyer & Berkey, LLP. Featured in New York Law Journal.
Although international borders are becoming blurred where people, money and commerce move across most of the Western world with ease and dual citizenship is commonplace, there are still at least two areas where the lines on maps remain clear: taxes and succession. The more peoples’ personal and business lives become globalized, the more important it is for them to be aware of tax and succession consequences. In Part One of this two-part series, author David Faust discussed succession. This article deals with taxation.
Globalization is both a business and personal phenomenon. One need not be mega-rich to have homes in more than one jurisdiction. Spouses with different nationalities are not unusual. Children may settle, and become domiciliaries or tax residents, in different countries, often becoming dual citizens. Likewise, business has become global: supply chains, manufacturing, marketing and financing are increasingly complex, without regard to borders.
Such disregard, or blurring of borders, may make practical business sense and may be satisfying personally on many levels, but borders still remain fixed and critical when it comes to taxes.
Taxes may be roughly categorized as corporate, partnership, trust or individual. Individual taxes may further be categorized as income or transfer (estate and gift). Each type of tax has a geographic basis. A taxing jurisdiction can only tax its citizens, residents or domiciliaries and, in some cases, non-citizens, residents or domicilaries owning assets in, or deriving income, within its borders.
In the world of corporate, partnership and trust taxation, enormous effort has been expended structuring and locating entities in jurisdictions to avoid or minimize taxes regardless of where they actually do business, i.e., produce or sell products or provide services.
To counter this, the United States has increasingly stringent tax and non-tax disclosure requirements aimed at uncovering where U.S. persons have assets or business interests. Tax forms include required disclosure of interests in foreign businesses and financial assets. Non-tax forms, per the Bank Secrecy Act and related regulations, include required disclosure of interests in foreign bank accounts and the identity of owners of various entities.
The United States also has entered into a network of treaties with foreign governments calling for mutual assistance on tax matters, even with some countries with which we have no “double tax” treaties. Some countries, concerned about being blacklisted as “tax havens,” have enacted “economic substance” regulations requiring some entities established in such places to justify their being so situated, i.e., demonstrating that their presence has some economic substance beyond favorable tax laws.
The United States is also negotiating multi-national tax treaties which seek to coordinate tax laws with a view to insuring that multi-national business entities pay taxes in those places where they actually do business—employ people and produce or sell goods or provide services—and not avoid or minimize taxes by artful choices of places to incorporate or register.
It is well beyond the scope of this article to describe all of the methods used by tax advisors to minimize or avoid their client’s taxes by carefully constructed structures or to describe in detail the efforts of U.S. and other governments to contain these tax strategies. Suffice it to note that the trend is for more international exchanges of information, more international coordination on tax matters and less ability to legally avoid taxes by forum shopping.
Income taxes for individuals vary widely from country to country. The United States taxes its citizens and non-citizen tax residents on their worldwide income, regardless of where earned. A non-citizen can be a tax resident by having a green card (the status test) or by spending more than a prescribed number of days here (the presence test).
Other countries tax only the income earned in that country or the income earned elsewhere but remitted there. The United States also taxes the income of non-citizens/non-residents, but only on their income earned here. Within the United States, some states, like New York, have a state income tax and New York City also has its own income tax. Other states have no such tax, deriving their income from real estate and other taxes.
Individuals who may be subject to income in more than one country may benefit from a web of international “double tax” treaties. However, not all countries are parties to such treaties. Moreover, such treaties to which the United States is a party are not binding on the states.
A non-U.S. tax resident is subject to income earned in the U.S. If that income is in the form of a salary or other payment for services, that income is taxed at the same rates as such income would be taxed to a U.S. taxpayer. Investment income may be either active or passive. If income of a non-tax resident is effectively connected to a U.S. trade or business (ECI), it is taxed the same way it would be taxed to a U.S. tax resident. The gross income is subject to the same deductions that would be available to a U.S. taxpayer and the same rate on net income would apply. Non-ECI is taxed at a flat rate of 30%; such passive income can be rents, dividends, interest, royalties and other such fixed and determinable income (FDAP).
As a general rule, capital gains of non-U.S. tax residents are not subject to U.S. income tax. This exception from tax does not apply to gains from real estate or from assets used in a U.S. trade or business. These exceptions to exceptions are, like much of tax law, contingent upon subjective interpretation.
For example, many non-U.S. persons invest in U.S. real estate. If they do so directly, any net income is subject to income tax and any capital gains are subject to capital gains tax. However, suppose the investment is made in a U.S. entity like a limited liability company.
If the investor takes a role in the management of the LLC, the resulting income may be treated as an ECI; if the investor is purely passive, his or her income would be FDAP. At what point could an investor following up on an investment, asking questions of a manager, making suggestions or even having a vote on specified major matters cross the line from having FDAP income to having ECI? Before determining which result is better, one must do a comparative calculation and consider whether a tax treaty with the investor’s tax home applies to reduce his or her U.S. tax.
The United States has an estate tax on the worldwide assets of US citizen and domicilaries in excess of $12.92M and on the U.S. assets of non-domiciliaries in excess of $60,000. The threshold for U.S. citizen/domiciliaries (but not the one for non-citizen/domiciliaries) is subject to increase annually by an inflation factor but is due to expire in 2026.
There is a related gift tax on gifts over statutory thresholds on all gifts by U.S. citizens and domiciliaries and on gifts of U.S. assets by non-citizen/domiciliaries. The definition of U.S. assets for non-citizen/domiciliaries is complex but differs for gift taxes and estate taxes.
For example, U.S. real estate is clearly a U.S. asset as is stock in a U.S. company. But what if the real estate is owned by a foreign entity along with other U.S. and non-U.S. assets? Intangible assets are included in U.S. assets for estate taxes but not gift taxes for non-U.S. citizen/domiciliaries.
The test of domicile for estate tax purposes, unlike the test of residency for income tax purposes, is complex and highly subjective. It is explored in the prior article in this two-part series.
Some, but not all, states in the United States also have estate and/or taxes. The tax in New York State on estates in excess of $6.58M in 2023 is also to be adjusted annually for inflation. Here too, the United States is party to a number of estate tax treaties which mitigate or eliminate double taxes on the estate of persons subject to estate tax in more than one country, but there are countries with which we have no such treaties.
One example of the issues faced by a married couple with different citizenships is the marital exclusion for estate tax purposes. A U.S. decedent can leave an unlimited amount to a U.S. spouse. If the spouse is not a U.S. citizen, bequests to him or her would count against the decedent’s previously unused lifetime exemption unless it is in the form of a QDOT (Qualified Domestic Trust), the basic purpose of which is to ensure tax is paid when the non-U.S. spouse dies.
Any lawyer advising a client, whether personal or corporate, with income from or assets in more than one jurisdiction, domestic or foreign, must consider the complex U.S. tax laws, rules and regulations, and international treaties to which that client may be subject. The more any person’s business or family structure crosses borders, the more important it is to structure their income, business and personal financial affairs with the various tax authorities jurisdiction in mind.
The above is not, and should not, be construed as tax advice.