I have heard psychologists refer to pessimists as realists – they say this is a natural survival technique. Personally, I am delighted to think of myself as an optimist, especially when I read depressing news stories about The Great Depression of the Thirties and its parallel today. Does this make me less of a realist? I don’t think so. The Great Depression was suffered at a time when international travel was minimal, when international trade was hampered by trade embargos and import duties and when the sales marketplace was the local inhabitants of a particular country – and if they were out of work, consumer demand stopped. And there was no welfare state then. It bears no resemblance to today’s world.
Even in this downward worldwide spiral, we see signs of interest in new investments from our cash-rich clients, of new ‘greenshoot’ businesses starting up with new ideas demanding intellectual property planning, and even interest in the property market being rekindled as the double whammy of house price falls together with the decline of sterling tempts foreign investors. We do have a worldwide marketplace (and again falls in currencies can help exports), and there are few of the old restrictions to international trade. Companies no longer need to look only at residents of their own countries so that even high unemployment rates may not automatically mean that demand stops as it did 80 years ago. And global consumer demand for those still in work may even be stimulated by lower interest rates. As we all know, the current problem is one of liquidity and how this is going to be addressed by governments through international co-operation, particularly between the US and the EU.
Life is a carousel and its ups and downs are inevitable; that is why the economic valves of exchange rates/interest rates and taxation policy are so important. Now is the time to relax taxation in order to stimulate foreign investment and help maximise returns, encouraging investors to come back into the marketplace. For example, cutting transfer taxes on real estate transactions (stamp duty in the UK) could stimulate the resuscitation in the property market that would cumulatively entice consumer demand. But governments around the world are making tax laws ever more complex, necessitating the creation of international tax efficient structures to achieve the returns required (perhaps this is the reason why I personally remain an optimist!). In this newsletter, I have written a longer article than usual about the source of specific items of income and capital gains in cross border transactions, and how double tax treaty arrangements can serve one of their fundamental purposes, namely the encouragement of international trade.
Our other two articles contributed by our friends Erich Baier of Austria and David Piesing of Praxis in Guernsey describe two entities not yet widely used in international tax planning, the Austrian Private Foundation and the Family Limited Partnership. Both entities are useful in the preservation of family wealth without the tax issues that normally apply infor succession planning.
We are nearing the first day of spring and hey, aren’t we all looking forward to a bit of sunshine and warmth? Let’s hope that this generates a more positive attitude to life in general and the start of the end of the recession.
Find the Source
I am often asked what is the role of international tax consultants, and the nature of the professional advice that we give to clients. This article explains the principal focus of my advice over the past 35 years, namely the mitigation of foreign taxes through appropriate double tax treaty planning.
International tax problems (and also opportunities) can arise either by virtue of the residence of individuals, companies and other entities in one country, or because income or capital gains are deemed to be sourced in another country under the relevant source rules of that country. For the latter issue, the international tax practitioner must consider: (a) does the particular country levy tax on the type of income and capital gains which may arise, and (b) is there a relevant double tax treaty which prevents that source taxation arising, or reduces it to an acceptable level. After all, one of the functions of a double tax treaty is to facilitate international trade, and there are many opportunities afforded by specific treaties to mitigate foreign taxes.
The following ten questions illustrate some examples of items of income or capital gains where planning techniques are important in order to minimise foreign taxes:
Q1: I am selling my shares in a trading company in which I own more than 25% – am I only taxed where I am resident?
A1: No. Certain countries regard a ‘substantial’ shareholding as representing a business interest carried on in that country and therefore a local source. For example, the Netherlands would impose a 25.5% capital gains tax charge on such a non-resident shareholder. A relevant double tax treaty with the Netherlands may blunt the imposition of this tax, and this is why the ownership of Dutch companies must be carefully structured at the outset.
Q2: If capital gains on sale of trading companies are not considered to have a source where the company is located, would this be different if the company’s activities were in real estate?
A2: Maybe. Many countries, including the US and several European jurisdictions, (but not –surprisingly – the UK) treat ownership of real estate companies in the same way as if a non-resident owned real estate direct, and subject capital gains on the sale of such companies to local tax. Again, double tax treaties may prevent this local tax from applying. However, unlike the case where trading companies are sold, modern day treaties generally permit the local taxation of gains in respect of the sale of real estate owning companies as if the gain were made in respect of the real estate itself.
Q3: Does this mean that income and capital gains from a direct ownership of real estate is always taxed where the real estate is located, and would double tax treaties help to prevent local tax in the case of direct ownership?
A3: If the real estate is rented and rental income is derived therefrom, this will always have a local source, and double tax treaties permit this income to be taxed in the relevant country. Similarly, if, under the domestic rules of a country, capital gains made by non-residents on the sale of real estate interests are taxed locally, the country’s double tax treaties would generally reflect this.
Q4: Is it possible for profits on the sale of real estate to be considered as not having a local source, and therefore not subject to local tax if a relevant double tax treaty is in place?
A4: This touches on a complex area of tax planning. Where, under the domestic rules of a country, the profits may be considered as being derived from a trade in that country, local taxation can be avoided where a double tax treaty with the country requires there to be a permanent establishment of the company carrying on that trade before local tax can be imposed. In effect, this is why Luxembourg companies have been useful for direct ownership of French and Italian real estate (see our January Newsletter for changes in the French / Luxembourg double tax treaty), and why treaty resident companies have been used for direct ownership of UK real estate.
Q5: What about dividend income that I receive from foreign companies – does this have a local source?
A5: Certainly the underlying profits out of which dividends are payable may be taxed locally since the company is resident in that jurisdiction, but this is not always the case – countries such as Singapore and Hong Kong only levy tax on the profits derived from within the jurisdiction irrespective of the residence status of the company. As regards dividends, some countries consider that non-residents should be subject to an additional secondary tax burden and, rather than imposing on a non-resident the obligation to submit relevant tax returns (which would be cumbersome and impossible to enforce), the country imposes a withholding tax on relevant dividends. Where such withholding taxes can amount to up to 35% of the dividend payment, there are many countries which have now reduced their withholding tax rates to 15% to encourage foreign investment. Double tax treaties, created in part to encourage foreign investment, often further reduce such withholding taxes, perhaps to as low as 5% or even a full exemption. However there are many countries that do not consider corporate dividends paid to non-residents as having a local source, and therefore no withholding tax is imposed – countries such as the UK, Singapore, Cyprus and Malta immediately spring to mind, which often make these good jurisdictions for intermediate holding companies as well. And then there are the multilateral Directives such as the EU Parent–Subsidiary Directive which requires the elimination of withholding taxes on dividend distributions between companies within the EU, subject to certain conditions.
Q6: If I finance an investment through loans rather than equity, will the loan interest have a local source and be subject to withholding tax?
A6: Normally the answer is yes, and withholding taxes on interest payments would normally be levied at the same rate as the local dividend withholding tax (i.e. the basic rate of taxation), subject to double tax treaty exemptions or reductions. However, there are certain countries which consider that the source is where the creditor, rather than the debtor (i.e. the local company that is borrowing the money), resides, and therefore no local withholding tax is imposed. These countries, such as the Netherlands and Luxembourg, are often very useful in which to locate intermediary finance companies to be used within international structures.
Q7: Where a local company makes royalty payments in respect of intellectual property licensed to it by a foreign company, will this always have a local source and be subject to local withholding tax?
A7: Generally, yes, since the royalty is for the use of the intellectual property in that particular country which would usually be classified as a business activity in that country. There are notable exceptions to this, such as the Netherlands and Luxembourg, which is again why these countries are often used in licensing structures. Where local withholding tax is imposed in a country, double tax treaties may again be used to reduce or eliminate this.
Q8: Is income from employment carried on in a particular country always taxed in that country, and could double tax treaty arrangements help?
A8: Certainly the employment income would have a local source and therefore local tax would generally be imposed, subject to the specific legislation of that country. For example, a country’s rules may specify that if the individual is present in that country for less than 30 days in a tax year, the employment income may be exempted. The UK, for example, allows for a mitigation of the local tax liability where the individual is only present in the UK temporarily, with the effect that the employment income can be apportioned between work days in the UK and work days outside the UK. Double tax treaties may help if the remuneration is not borne by a local company but by a foreign company (and not either by a local branch of that foreign company), but only if the individual is present in the relevant country for less than 183 days in a tax year.
Q9: What if I am not employed but a self-employed professional like you?
A9: Generally speaking, I will only be taxed in the foreign country if I have some sort of business operation in that country. Merely advising local residents from my office base in the UK will not constitute a local source – this is the classic distinction between trading with a resident of another country or trading within that country. It helps to have a double tax treaty available in cases where there is some doubt as to whether there are some premises locally that could be deemed to constitute a fixed base of operation for me. Indeed, if I wanted to open a local office to buy products, for example, it would be imperative to have a double tax treaty arrangement which prevents that ‘trade’ from being taxed locally – again one can see why one of the objects of a double tax treaty is to facilitate international trade, and why purchasing local products may be an exempt activity for tax purposes in order to promote the exports of a relevant country.
Q10: Are there any other types of income which can have a local source?
A10: Indeed, the above examples are merely illustrative of what to look out for in international tax structuring centred around the source rules. Another example which comes to mind is pension income which would generally have its source where the employment was carried out or where the pension scheme is located. However, double tax treaties may shift the taxing rights from the country of source to the country of residence if an individual has decided to emigrate and receive his pension whilst resident in another country.
The above question and answer session is only illustrative of the type of issues which IFS, as an international tax practice, deals with on a daily basis. It certainly cannot be relied upon as specific advice in respect of any particular jurisdiction.
I would be very happy to hear from any reader with your comments and experiences of the application of source taxation, and indeed with any additional questions (or amendments to the answers!) which you think should have been included in the above.
The Austrian Private Foundation
The Austrian Private Foundation was written into law in 1993 and has turned out to be an overwhelming success ever since. It is designed to preserve and enlarge wealth for the benefit of a family, although it can also be used for charitable purposes. Its success is a result of its high flexibility, its material tax benefits and the privacy the client can achieve through the Foundation.
An Austrian Private Foundation is a corporate entity formed by notarial deed. However, it does not have shareholders, only beneficiaries. The minimum statutory share capital is € 70.000, which can be either endowed in cash or in kind. Endowments in kind require an expert appraisal proving that the value of the endowment in kind is at least € 70.000. The founder can be a resident or non-resident individual or juridical person. The founder can amend the charter and the non-public by-laws (letter of wishes) whenever and how often he/she wants and, provided the founder is an individual, can have the right to revoke the foundation at any time.
The charter, which is a public document, provides general information about the Foundation, including its name, seat (registered office) and the minimum capital contributed. Contrary to this public document, the by-laws (letter of wishes) are not public. They provide detailed information regarding which additional assets have been endowed to the Foundation, give exact guidelines, based on the wishes of the founder, as to who should benefit, and how much is paid to whom and when.
The Austrian Private Foundation is managed by a board of directors which consists of at least three members, two of whom have to be resident within the European Union.
The rights of the founder of an Austrian Foundation are very far reaching and include the ability:
- To select the first board of management
- To amend the charter and the non-public by-laws at any time
- To determine how much is paid to whom and when
- To determine what happens after he/she has died
- To give guidelines to the management board of how to invest and into what
- To revoke the Foundation at any time
- To determine new beneficiaries at any time
As regards the tax benefits accruing to a Foundation, until 1 August 2008 a one-time 5% gift tax was levied upon the endowments to the Foundation. Since the Gift and Inheritance Tax Act was completely abolished as from that date, this 5% gift tax was substituted by a 2.5% Foundation entrance tax, which is levied upon the net asset value endowed to the Foundation.
Since the Austrian Private Foundation is a corporate entity, it not only has access to all of the more than 80 Double Taxation Agreements Austria has signed with other countries, but for domestic Austrian purposes the income of the Austrian Foundation is taxed at the flat statutory 25% corporate income tax.
But the following tax exemptions make it a perfect tool for families and their businesses:
- No tax on domestic or foreign dividends
- No tax on the sale of domestic or foreign shares (roll-over relief)
- 12.5% tax on domestic or foreign interest income, which can be reimbursed to the Foundation in case of payments to beneficiaries or when the Foundation is revoked
- No inheritance tax when the settlor or founder of the Foundation dies
A special provision in the Austrian Corporate Income Tax Act makes it a perfect tool for bringing offshore untaxed income into a high tax jurisdiction without Austrian taxation. This is because an Austrian Private Foundation does not have to include foreign source income into its tax base if it does not seek treaty protection. Thus, dividends distributed by, for example, a BVI company to an Austrian Foundation are tax exempt in the hands of the Austrian Foundation, since there is no treaty existing between the BVI and Austria.
So, if untaxed income can be brought into an Austrian Foundation without Austrian tax, can it be distributed to non-resident beneficiaries without Austrian withholding tax? In fact, when the Foundation effects payments to beneficiaries resident in Austria, yes it does have to withhold 25% withholding tax which has to be paid to the competent Revenue Office. The beneficiary can then apply for assessment for income tax purposes, and the Austrian Income Tax Act provides that payments received from Foundations are only taxable to 50% of the regular average income tax bracket. This can lead to material tax savings for the Austrian resident beneficiary.
But for the non-Austrian resident beneficiary who is resident in a country with a double tax treaty with Austria, payments effected are generally qualified as “other income” according to the OECD Model Treaty and therefore only the State of Residence of the beneficiary has the right to levy taxes upon such payments. Only a few tax treaties qualify such distributions so that Austria is granted the right to withhold either the statutory 25% withholding tax or a reduced rate.
These are the treaties with Australia, Canada and Germany (where 15% withholding tax applies), and Brazil, Egypt, Japan, Malaysia, New Zealand, Pakistan, Thailand, and Turkey (where the standard 25% rate applies).
Apart from treaty benefits, provided that an Austrian Private Foundation achieves either domestic or foreign source interest income, this income is exposed to a flat 12.5% interim corporate tax. If such a Foundation with this type of income is revoked after some years, all the interim corporate income tax paid is reimbursed by the Austrian Revenue. So in effect, this leads to totally tax exempt interest income.
Together with a generally friendly tax climate in Austria, the Austrian Private Foundation is a suitable entity for dynastic wealth planning, managing wealth tax-free, preserving assets within a family and obtaining offshore income tax-free, as well as avoiding capital gains tax, income tax and inheritance tax.
IFS would like to thank Erich Baier, MBA, LL.M. (Int’l Tax Law) of Bilanz-Data Wirtschaftstreuhand GmbH for the above article. Should you require any further information, please contact Erich on email@example.com.
Family Limited Partnerships…Offshore or Onshore?
Family Limited Partnerships (“FLPs”) have been extremely popular in the United States as wealth succession planning vehicles for many years. They enable the control of underlying assets to be separated from the economic ownership, thereby facilitating the flexible succession of family wealth.
Until Finance Act 2006, trusts were widely used in the UK to achieve similar objectives in a tax-efficient manner. However, FA2006 not only introduced quite draconian changes to the Inheritance Tax treatment of lifetime gifts to trusts, but also penalised the use of trusts unless wealth was to vest in minors when they attained the age of 18. For prudent families, that is precisely why a trust was considered necessary. Putting the tax issues to one side, many wealthy families prefer substantial wealth not to vest in their children until they are somewhat older, whether that’s aged 21, 25 or even 30, when they are considered to be far better prepared to handle such wealth.
An FLP, which itself is fiscally tax-transparent, can be used to achieve the same controls over the succession of the family wealth. Once the adult members of the family have contributed capital to the FLP as limited partners, they can make lifetime gifts of those limited partnership interests to their children. Such lifetime gifts constitute potentially exempt transfers for Inheritance Tax purposes, and so if the donor survives 7 years then the gift will escape being subject to Inheritance Tax. By contrast, gifts to trusts are no longer able to qualify as potentially exempt transfers. Whilst the gifted limited partnership interest then belongs to the child as the donee, with careful drafting it is possible to ensure that no limited partner can withdraw his capital without the prior consent of all other partners, and/or to draft the partnership agreement so that it cannot be dissolved until after a certain future date which may coincide with a child’s 25th or 30th birthday, for example. Ultimately a limited partnership agreement is a contract, and so the drafting of the agreement can be very flexible.
However, there are many pitfalls for the unwary. A limited partnership is actually a collective investment scheme for UK regulatory purposes and so the duties of the general partner are governed by the Financial Services Act. Non-compliance with the regulatory provisions is a criminal act, but can be overcome either by appointing an FSA-regulated general partner, or by delegating all duties of the general partner to an offshore or overseas third party. There are various quirks of partnership law which need to be considered, as well as nuances of matrimonial law and the laws relating to minors. Care must particularly be taken to address the issue of what rights a child has when holding a limited partnership interest upon attaining the age of 18. Clearly it is undesirable for a child to be able to repudiate the partnership and simply withdraw his/her share of the partnership capital upon reaching majority.
Tax-wise, whether the FLP is set up as an English limited partnership with an offshore general partner and then administered offshore, or as an offshore (say Guernsey) limited partnership with an offshore general partner, makes no difference whatsoever. Both enable the UK’s FSA regulations to be avoided, although it is also important to ensure that the offshore-administered FLP does not instead fall to be treated as a collective scheme in the offshore jurisdiction for local regulatory purposes.
The public disclosure requirements of an English law limited partnership at Companies House are already greater than for an offshore limited partnership and this is likely to become an even more important factor once the UK’s Limited Partnership 1907 is shortly updated. Wealthy families will not wish the public at large to know that young Johnny has just withdrawn £10m from an FLP on his 25th birthday. This factor probably swings the advantage back in favour of offshore FLPs.
By combining an FLP with certain underlying tax deferral vehicles such as insurance bond wrappers or OEICS (open-ended investment companies), it is possible to achieve a very powerful combination of succession planning and long-term tax deferred investment growth. Indeed, this concept has far wider application than just to wealthy UK families. Limited partnerships are recognised all over Europe, far more so than trusts, as indeed are insurance bond wrappers and private family fund vehicles, resulting in enormous scope for the utilisation of such structures.
IFS would like to thank David Piesing for the above article. David is a director of Praxis Fiduciaries Ltd. Further information can be found on their website www.praxisfiduciaries.com.