Tag: tax

Family Office Structure

Posted on by Peter Harper

Family Office Structure

After covering business entities and formations such as LLCs and C corporations, let’s look into the growing industry of family offices, how they are formed, and why.

What is a Family Office?

A family office is any collection of dedicated professionals, whether separate from a family business or not, which provide personal and professional services to a family. This usually includes a broad diversification of services where one individual could manage the operational aspects of the family; for example, travel arrangements and asset collections. Other services, such as professional staff managing accounting, estate planning, tax, legal, philanthropic, investment, and administrative matters, are also rendered. 

The size of a family office can consist of as little as only two people or as many as 300 or more.

What is the Purpose of a Family Office?

Families have the ability to create a family office that can support their overall financial needs after a significant liquidity event, such as the sale of a family business. Every family office must reflect the unique component as s the family it serves.

It can provide a wide range of services, including:

  • Investment strategy and management;
  • Tax planning;
  • Estate planning;
  • Philanthropic planning;
  • Family education & multi-generational planning; and
  • Lifestyle management services.

Historical Family Office Structuring

Before 2018, most family offices could not implement their structures particularly tax-efficiently. Family offices used to be structured as limited partnerships or limited liability companies (“LLCs “) and can provide financial services such as tax, investment management, accounting, and concierge services for family members and various family members entities. 

Often, the family members and entities would pay the family office (collectively, the “Family Clients “) through management fees. 

These management fees were, however, deductible by a Family Client only to the point where the fees exceeded 2% of the Client’s adjusted gross income (“AGI “) for the tax year. Deductions for operating expenses, including salaries, office rentals, and payments to any third-party vendors, were likewise limited for many family offices. 

If structured properly, some family offices often avoided most limitations on deductions by claiming status as an active trade or business, thereby taking their deductions in full. However, taking such a position was seen by the IRS as aggressive tax planning to avoid tax, and the IRS had often challenged attempts by single family offices trying to claim that they were a trade or business.

Sections 212 and 162

Historically, expenses incurred by family offices have been deducted under one of the two provisions of the Internal Revenue Code (IRC) listed as:

Section 162 and Section 212
      • Section 162 deductions are applicable toward any active trade or business. Those said deductions taken under Section 162 are most often permitted in full, as the IRS traditionally views the active trade or business requirement strictly. The IRS requires that entities that claim the deduction must be engaged in a for-profit business through the provision of goods or services toward third parties. In the 1930s, the family office working for Eugene Higgins, who was the wealthy heir to a business fortune, had tried to claim all expenses from managing his fortune as either business or trade deductions. From this, the government successfully challenged Higgins’ family office’s position by arguing that the management of one’s wealth cannot be a valid business or trade. 
      • In response to the claim by the government, Congress enacted Section 212, which recognizes that expenses related to managing and enhancing one’s wealth would be legitimate and must be deductible to an extent. The Code put a limit on those deductions towards amounts that went over 2% of AGI. As seen in the government’s historical dislike for family offices operating as a business or trade, most family offices hadn’t been willing to risk an IRS challenge. Instead, they decided to claim any of their deductions solely under Section 212, resulting in many family office owners and their Family Clients being unable to fully deduct expenses.
Important Developments in 2017

Resulting from two key developments occurring by the end of 2017, traditional family office structures had become less viable. Still, at the same time, new structures provide opportunities for much greater tax efficiency. 

The first significant development was due to case law. It involved the case of Lender Management v. Commissioner, where the Tax Court had ruled that a family office had the option to be treated as a business as long as it met specific criteria. The second included the passage from the 2017 Jobs and Tax Cut Act, which disallowed deductions that fall under Code Section 212 and reduced the national corporate tax rate by 14% (35% to 21%).

Lender v. Commissioner

In the case of Lender’s Bagels, the taxpayer’s role belonged to a family office that gave management services to a collection of investment LLCs owned by the family business’s children, grandchildren, and great-grandchildren (Lender’s Bagels).

When determining whether the family office had engaged in a business or trade (therefore fully deducting its expenses), the court noted large amounts of scrutiny if a family relationship had existed between the family office owners and the LLC owners. Despite this, the court had found that the family office could be considered a trade or business. The decision was backed up by several factors that had differentiated the Lender Management operation from other activities conducted by an investor to manage and monitor their own investments:

When reviewing all of the gathered facts that the court discussed (and had led the court ruling in favor of Lender Management), some recommended practices to best treat a Family Office as a business or trade are set out below:

      • The family office must be owned in different percentages and by different people or entities than the assets being managed.
      • The family office manager should be qualified to act as an investment advisor and devote their full time and focus when working for the family office.
      • The family office must continuously operate to make a profit.
      • The family office must always employ full-time employees who are not members of the family, as well as maintain a physical workplace space.
      • Family members must be treated as clients. This includes written client advisory agreements needing to set forth the services to be later rendered and the means of compensation that needs to be executed.
      • The family office must always hold regular meetings with clients and provide transparency during said meetings, including accountings of the office’s investments and other activities.
The Jobs and Tax Cut Act of 2017

Since 2017, The Jobs and Tax Cut Act (also known as the “Tax Act “) has significantly reorganized the federal income tax system for corporations and individuals. For corporations, the income tax rate decreased from 35% to 21%, and for individuals, an enormous number of changes were imposed. Still, the most significant deduction for this discussion and mentioned above was eliminating deduction for expenses that fall under Code Section 212. 

As a result, clients’ payment of management fees towards a family office is no longer considered deductible. Family offices unable to meet Code Section 212’s sufficient criteria will be categorized as a business or trade. They will be given the unappealing inability to receive any deductions for their expenses, even if said expenses are over the 2% of the AGI floor.

Using C Corporations

The corporate tax rate’s recent change has made using a C corporation serving as a family office much more appealing to families. Unlike other optional entities, C corporations are considered to conduct a business or trade as a primary function of its structure. C corporations are able to deduct their expenses if they are under Code Section 162, so long as they are considered necessary expenses from running the corporation as predicted, with no notable additions. As a result, many families consider converting their family office to a C corporation.

As noted earlier, there are two ways in which deductions are no longer permitted concerning family offices: 

      • The payment towards management fees to the family office by the Family Clients; and 
      • The payment towards expenses by the family office if it is not a trade or business. 

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How to Build a Family Office

Now that we’ve looked at what a family office is and its past structure, let’s examine standard methods for building your own family office today.

The Two Types of Family Offices

There are two main kinds of family offices that entrepreneurs choose from for various reasons that best suit their financial goals as a company. They are:

‘Single Family Office’ or a ‘Multi-Family Office’?

Single Family office – Wealth owners who possess investable assets exceeding $100 million can choose to form their own wealth management business, known as a single-family office, which oversees all aspects of their financial and human wealth.

Multi-Family Office – A multi-family office (also known as an MFO) is a wealth management firm that provides integrated and highly customized services towards a limited quantity of clients. Participating families with an MFO will have access to a wide array of integrated services.

Steps to Creating a Family Office

The first and most vital step when creating a family office structure is to state the goals of an individual or multiple family members. A family office formation is similar to forming a regular business entity, where developing an organizational structure is the first move.

The next step would be to determine whether you want to establish the family office in-house or have a third party form the structure, hire personnel, and provide/maintain all essential services the family office offers.

Once that evaluation and decision are made, the third step is to choose which assets shall be managed by the family office or be managed by one or more family members. 

Scope and Costs of a Family Office

Like any other new entity, the family office operation and associated costs will need to be assessed before confirming your next step to opening one. Sizes of family offices range from small to very large, depending on the amount of wealth required for management (such as asset management, risk management, wealth management, investment management, etc.) and the types and diversity of assets the money is invested in.

A small family office usually requires six employees and costs anywhere from $1 to $2 million to operate on an annual basis. 

A medium-sized family office often requires 15 people to best operate, with an annual operating budget of $3 to $4 million minimum. 

On the other hand, a large family office would require about 25 employees with an annual budget of $8 to $10 million. When considering a large family office, however, you’d be talking about 40 to 50 employees, along with an operating budget ideally of $14 to $20 million.

What is a Family Office Structure?

Depending on jurisdiction and purpose, a family office’s legal structure can take various forms. The most popular legal structure for a family office in the US is an LLC, then an S Corp, and 3rd a C Corp. A Private Trust company is the least popular structure used. 

When Does It Make Sense to Create a Family Office?

Families who want to start a family office will need at least $100M in investable assets and have the goal to: 

        • Maintain control over assets and the overall decision-making process;
        • Benefit from the overall buying power of the family’s combined assets;
        • Preserve their privacy;
        • Keep the family together;
        • Possess a dedicated team that is devoted to giving key services to achieve long-term goals.
Finding Qualified Advisors Who Work with Family Offices

Advisors are key components to any family office as they provide the expertise that is not available internally in a family office.

Services most utilized by family clients are:

        • Accounting;
        • Investment planning; and
        • Integrated planning.

Interestingly, these three most utilized services are provided jointly by the family office and any external providers.

Selecting the ideal advisor team who will understand your unique needs and be able to support your family always needs careful due diligence on the part of the family.

The Importance of a Family Office Governing Board

A governing board is ideal when driving a company’s success. A family governing board is necessary and mandatory for operating a family office and essential for the family enterprise’s preservation.

Wealthy families sometimes need to comprehend the role and need for a financial services board when managing their wealth, assets, net worth, etc. However, there has been an increased awareness of the importance of such a board in the past few years.

What Should I Consider When Setting Up a Family Office?

Working in wealth management often involves more than just hiring money managers to invest the proceeds of the sale. Preserving wealth requires owners to consider the wealth management process a shared family business. 

What is the Objective of Your Family Office?

Managing a family’s wealth successfully is a complex and unique undertaking, so understanding which financial services to look for or provide for that unique case is necessary before moving forward. 

The job of a family wealth manager is to establish a professional structure for private work to best grow and protect a family’s assets for later generations. Examples of success include asset protection and growth and the peaceful transition of control over assets and wealth from one generation to the next. This can be done by a cohesive group of cousins who are collaboratively managing the original family member’s charitable wishes.

Whatever the measures are for the family wealth manager to execute, the work that comes from managing the family wealth can never be underestimated without negative cost to the family and their family office. That is the reason why many families decide to form a dedicated family office, as it means having a professional way to address the challenges that financial families often encounter.

What is the Scope of Your Family Office?

Individual family requirements will dictate the scale and scope of all operations. Principals are also encouraged to use the following functions to inventory what is carried out today on their behalf, as well as what new or expanded procedures might be carried out in the future. This list of typical basic and advanced functions serves only as a guideline.

What is the Family Office’s Role and What Skills are Needed?

A family office’s most basic yet necessary duty is handling wealth, net worth, and investment management for wealthy families or individuals. Such is a common and most often successful way to grow the wealth already created, as well as transferring the wealth across multiple generations through succession planning.

Aside from the necessary technical credentials of a family office (investment, legal, accounting, etc.) and experience that will be required in the family office role, it is essential to have the following professional characteristics when starting and throughout the family office’s time:

        • Privacy
        • Lack of Ego
        • Teamwork
        • Integrity
        • Communication 
How Will Future Decisions About the Family Office Be Made?

Most governing boards for a family office require an average of four members of the family and one member who is not. Families often include independent, non-family members on their board to either provide the professional experience they need or act as an objective party who supports the execution of the family’s vision and strategy.

What Do You Want in a Partner?

Below are seven vital components that your future partner must have or aspires to achieve before you enter a legal agreement with them:

        • To provide a formal structure for the management and governance of the family’s wealth;
        • To promote the family’s legacy, vision, and values;
        • To coordinate, integrate, and consolidate customized services for the family;
        • To manage economic and personal risks for the family
        • To capitalize on economies of scale gained from consolidated family wealth;
        • To accumulation, such as preferential investment access and lower fee rates; and
        • To maintain confidentiality and privacy of family affairs.

A Framework For Evaluating Family Office Options

After answering the questions above and better comprehending what your family office will look like, it’s time to examine current and future contributions to ensure everything can happen in the formation process.

Step 1: Evaluate Current Expenses (Financial Benefit of New Structure)

Families should quantify and evaluate their current costs, including staff, retained legal/accounting services, direct and indirect investment expenses, technology, infrastructure, and others. They should further review their current effective tax rate and then look at how the effective rate could change under a Lender-like structure. State taxes are essential to examine as well.

This first step should help a number of families quickly decide. Every family is different, but when aggregate expenses are less than $1 million, often it may not make financial sense to form or restructure a family office—and for such families, the outsourcing option may now be more attractive than it was a few years ago. Additionally, families that already have operating businesses may find that the incremental deductions are insufficient to justify a change.

Step 2: Evaluate Family’s Fact Pattern (Feasibility of New Structure)

If the tax savings under a Lender-like structure would be compelling, the next step is determining if such a structure is practical or feasible. There are several hurdles to clear. 

First, does the family’s situation require the family office structure to have a logical basis? A model similar to Lender will make sense for a family with multiple branches, each containing various generations. It is essential to have independent advice for different family members and outside investors within the family office.

There are additional hurdles to qualification as a “trade or business.” For example, it is only sometimes feasible to compensate staff based on a profits interest in the family office. Further, the ideal structure may come at a cost. Finally, the structure may require new or different management skills, and it is crucial for families to know whether that talent is available at a reasonable cost.

Step 3: Evaluate Likelihood of Success (Durability of New Structure)

Finally, a structure similar to Lender appears both financially and practically attractive and achievable to a family. In that case, the members must still take an honest look at how the office and its structure will likely impact their day-to-day lives and determine whether they are comfortable with adhering to new rules over time. Any new family office structure, as mentioned, will likely require new costs, as well as require new staff and leadership to operate it properly. The extra time to review, hire, and go over financial goals with the office can lead to family members needing to be more entirely unified in taking on these additional requirements. In addition to the new burdens, managing and calculating all the family office’s profits interest is also complicated and may create tension amongst the family. Any changes in how the family members will meet and interact with the family office/each other going forward may also require adjustments.

No two families are financially identical, as every family will react differently to a present or upcoming change in how their investment assets are managed and to any downstream adjustments that will be required to adjust to a new management structure. In every case, a complete understanding of the anticipated changes is necessary for the office’s long-term success.

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5 Rules for Building a Solid Family Office Structure

Now that you’ve built an overall sense of how to build a family office and ideas of what yours would look like, we must go over the five key rules that come to family office formation listed below. Checking off each throughout your company’s process and final stages will help ensure that the structure is stable and can handle a growing number of unique cases.

When a Mistake Can Cost Millions, Developing a Strong Family Structure is Crucial

Below are common company decisions that are avoidable with ways to secure your new system:

Build a Solid Foundation for the Family Office Structure

A successful family office must be formed through close consultation with experienced legal accountants, advisors, and other counsel. Based on various investments, including private equity, debt finance, venture capital, and real estate, a family office will need to address all legal needs and tax strategies. The office should also work closely with tax experts and transactional attorneys so that structure will handle most investments, analyze and negotiate all terms and conditions surrounding an opportunity, as well as minimizing any adverse tax consequences.

Every factor, such as the company’s mission, goals, role, scope, and lines of accountability of the family office, must always be defined at the moment of formation, followed by being incorporated into the structure of the family office, even if it will be changed later on to meet evolving purposes.

Insulate Wealth

A successful family office is required to manage significant traditional assets and, in many cases with Family Clients, oversee unique assets (ex: residential and vacation real estate, hedge funds, fine art, luxury items (e.g., investment vehicles such as cars, boats, planes, and helicopters), and collectibles). The assets must also be insulated from potential liabilities. 

Cultivate Sustainable Wealth

Every successful family office must be responsible for cultivating sustainable wealth for the family’s future generations. Their unique structure needs to accommodate the utilization of significant financial possibilities such as direct private equity-style investments, generation-skipping trusts for real estate purchases, and other alternative investments that would deploy long-term capital. 

Establishment and Utilization of a Management Company

A management company must employ staff to best provide an array of services for their Client (i.e., the family office and their Family Clients). To perform this expectation, said management company will need to administer the operations, execute and/or oversee all of the professional and consulting services, and handle many other matters that the family office will require.

Family Office Compliance

Most importantly, a family office is required always be vigilant about compliance. That way, it can insulate each entity from other holdings incurring any liabilities. Compliance also includes required filing and maintaining all books and records for every family member and any related entities.

With a team of experienced advisors, a successful family office will be able to create and maintain a financial structure that can maximize any short and long-term investment possibilities with little to no exposure to extraordinary liabilities, so family wealth is safeguarded.

Organizational Structure of Single Family Offices

Typical roles within single family offices include:

Executive Team at Our Single Family Office Organizational Chart

Usually, the core team of a single family office consists of a few partners in key positions. A Chief Executive Officer (CEO) leads the whole investment firm, a Chief Investment Officer (CIO) is responsible for investment decisions, a Chief Financial Officer (CFO) is responsible for tax and financial topics, and a Chief Operating Officer (COO) who is responsible for daily operations. The partners are directly in touch with family members or a representative family board. Smaller single family offices even only consist of the executive team, while larger SFOs with billions of assets under management have several sub-divisions. 

Investment Teams at Single Family Offices

Usually, the specialized investment teams are led by directors who have already served in leading positions at investment firms for many years. They are, in turn, working together with a few talented investment associates and analysts. The Chief Investment Officer (or CEO, depending on the size and structure of the SFO) supervises the investment teams and is in steady exchange with them. Investment decisions are either made or brought to the family investment committee/investment board when the deal size is more extensive.

Which investment teams exist and how they are structured heavily depends on the investment focus of the family office. Very often, the following teams exist:

        • Financial Investments;
        • Real Estate;
        • Private Equity and Venture Capital; and
        • Other Investment Teams – Many more possible asset classes have their own investment teams: renewables, arts, impact investing, etc.
Back Office: Functions at Single Family Offices: Accounting, Public Relations, etc.

The back office supports the family’s daily work and necessary operational functions. Possible teams are:

        • Accounting, Tax, and Risk Management;
        • HR and Operations;
        • Public Relations;
        • Portfolio Management; and
        • IT

FAQs

Let’s reiterate a couple of important family office structure need-to-knows:

How Much Does a Family Office Cost?

The cost of each family office will be dependent on many vital variables, such as the size of the family, the quantity of staff, and the nature of the family’s overall investments.

The complexity of said office is the key predictor of cost for a family office. Receiving an “all in” cost of wealth management must have detailed consideration surrounding the family office’s costs, the fees paid towards ideal advisory firms (e.g., accountants, attorneys, etc.), and towards investment costs (e.g., outsourced CIO, custody, investment management fees, investment consultant, etc.). 

What are Critical Issues to Consider in Managing a Family Office?
        • Balanced leadership and governance;
        • Effective communication;
        • Board oversight;
        • Succession and contingency planning; and
        • Continuous operational improvements.

People Also Want to Know…

How Much Money Do You Need to Have a Family Office?

The recommended starting amount for families who want is at least $100M via investable assets.

What is the Purpose of a Family Office?

Families can create an office to support all of their overall financial needs after a significant liquidity event, with every family office being unique as the family it serves.

How is a Family Office Formed?

Opening and operating a family office, or expanding upon the financial services of an existing family office, requires careful consideration and planning to properly manage and protect a family’s wealth so it can flourish over time. As with any organization, a family office’s relative success or failure relies on effective governance.

 

 

To learn more about family offices, reserve your consultation with one of our advisors, as well as joining us starting next week for the first episode of our Family Office Vlog Series…

–Shaun Eastman

–Peter Harper

U.S. Expats in Australia Taxes

Posted on by Peter Harper

U.S. Expats in Australia Taxes

Whether you’re a U.S. citizen or a green card holder living in Australia, you need to be aware of your tax obligations as a U.S. expatriate in Australia, which can be a complex issue without guidance.  

As a general rule of thumb, a U.S. expat working or living in Australia should assume they have a tax obligation in both the U.S. and Australia.

How U.S. Taxes Work for American Expats in Australia

Working as a U.S. expatriate in Australia can impact your U.S. tax obligations even if your stay in Australia was short-term. 

For instance, if you earn income while on a short-term assignment in Australia, you are required to report that and any other income earned in Australia on your U.S. taxes. 

The longer you reside in Australia and establish closer economic ties you’ll have even more consideration towards your American tax filing.

You may also need to report any foreign financial accounts and assets acquired during your stay. Generally, U.S. taxpayers in Australia with more than $10,000 in a foreign bank or financial accounts (for example, superannuation accounts) are bound by FBAR filing and reporting requirements. You can also be subject to FATCA reporting requirements if you have assets that are valued at $200,000 or higher.

There Are an Estimated 105,000 Americans Living in Australia

All citizens and green card holders from the U.S. whose worldwide income exceeds the IRS’ current minimum thresholds will be required to file a U.S. federal tax return and to pay any taxes to the IRS, no matter where they live or whose income is generated.

Australia’s Taxes at a Glance

You should know a few things about Australia’s taxation process. The essential need-to-know is:

Tax Rates for Australia

Like the U.S., Australia uses a marginal tax rate that is based on a progressive tax system; for example, tax rates for an individual increase as one’s income rises. The present highest marginal tax rate for residents is set at 45%, but that is not without an additional 2% Medicare levy. Differently from the U.S., income taxes in Australia are most often imposed at the federal level but not at levels relating to state or local.

Also, similar to the U.S., all Australian taxpayers are required by tax law to file an income tax return annually with the Australian Tax Office (or ATO). The Australian tax year ends on June 30, unlike the U.S.’s on December 31. Also, Australia’s individual income tax return is required to be “lodged” (i.e., filed) by October 31; in the case of emergencies and such, extensions are available.

Australia has a progressive tax system; the more your income is, the more you will have to pay.

You can also earn up to $18,200 in a financial year and not have to pay taxes. This is known as the tax-free threshold, after which the tax rates kick in.

The lowest rate is 19%, and the highest rate is 45%, which is only charged on income over $180,000. Most Australians sit in the middle bracket.

For the 2022/2023 tax year, all Australian residents shall expect to be taxed on all income over $18,200, no matter where it’s earned.

Non-residents are taxed on all Australian-sourced income, with some exceptions.

What Types of Taxation Does Australia Have?

With everything mentioned above, let’s get into the various kinds of taxes to expect or keep in mind.

Australian Resident Income Tax Rates

The income tax rates for residents are different from that of a non-resident. 

Similar to US taxes, the percentage of tax you pay increases as your income increases. However, the rate ranges are steeper for non-residents, as shown below.

Resident Tax Rates 2022-2023
Tax Rate Income
0% 0-A$18,200
19% A$18,201-A$45,000
A$5,092 with an additional 32.5% A$45,001-A$120,000
A$29,467 with an additional 37% A$120,001-A$180,000
A$51,667 with an additional 45% A$180,001 and up
Foreign Resident Tax Rates

Tax rates for foreign residents for the 2021/22 and the 2022/23 year are:

Taxable income $

 Tax payable $
0 – 120,000 32.5%
120,001 – 180,000 39,000 + 37% of excess over 120,000
180,001+ 61,200 + 45% of excess over $180,000
Capital Gains Tax

Capital gains are taxed in Australia but are considered part of the standard income tax instead of a separate category. Because of that, capital gains are therefore taxed at the same rates as one’s income. 

However, Australia’s capital gains tax does not apply to assets received through an estate transference, and capital gains can only be incurred if you sell the asset you acquired later on. 

Goods and Services Tax

The Goods and Services Tax (also known as GST) is a value-added tax that can be applied to most goods and services transactions, even if relating to goods and services and can be applied at a flat rate of 10%. 

Corporate Tax

In Australia, domestic companies don’t always have to be incorporated, so they can be considered as a corporation to reach specific tax purposes. All that is necessary from the company is that it carries out business in Australia, along with Australian ownership or control. 

All companies in Australia are also subject to a federal tax rate of 30% upon their taxable income. The exception would be for ‘small or medium business’ companies, usually subjected to a reduced tax rate of 25%. 

Social Security

Let’s examine the following key points surrounding the basics of Australian Social Security:

Do I Need to Pay Social Security in Australia?
      • If a U.S. company has assigned you to work in Australia for less than five years, you will pay into U.S. Social Security;
      • If the assignment timeline goes over five years, you will need to pay towards the Australian social security; and
      • If you are working for an Australian employer located in Australia, you will pay towards the Australian social security (contact your local AOT) for information).
Australia’s Social Security Agreement with the United States

Like the U.S., Australia has a social security system so that it can best provide for its citizens and residents. Even a secured system can still confuse expatriates over which system they should contribute to while residing in Australia. Fortunately, the U.S.-Australia totalization agreement establishes rules for social security contributions. 

Self-employed Americans living abroad in Australia may choose to contribute to either social security system. 

Superannuation

Defined as a payment by an employee towards a fund that can evolve in the future as a pension, superannuation can serve Australian taxation for the purposes listed below.

Superannuation Reporting is Important

Superannuation funds can make filing expatriate taxes extra complicated. Anyone who has control over these funds will encounter additional IRS reporting requirements. 

How to treat Australian superannuation contributions for your expat tax return?

The IRS treats these funds as grantor or employee benefit trusts, so they are not recognized qualified retirement plans, though they operate very similarly to a 401(k). 

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Living as an Expat in Australia

Moving to Australia but still having tax residency/citizenship status in another country (including the United States) can lead to questions about filing for both. Let’s look at the overall question below:

Do I Need to File 2 Income Tax Returns – Both US and Australia?

If you’re an American working or residing in Australia for some time (short or permanent), you should assume you have an income tax return obligation in both the U.S. and Australia. 

If you’re an American working in Australia, you may also have to file Australian taxes based on your residency and domicile status. Where Australian taxes are concerned, your domicile is generally where you have your permanent home, and your tax residency is where you spend most of your time. You can be a resident in more than one country, but you can only have one domicile.

How do U.S. Expat Taxes Work While You Live and Work in Australia?

Here is what American expatriates can expect from both U.S. and Australian tax laws about living and working in Australia:

Americans Who Are Self-Employed in Australia

It is required by Australia’s tax law to file a U.S. income tax return in the case that you have net earnings worth $400 or more from self-employment, regardless of age. You are required to pay self-employment tax onto your self-employment income, no matter if it can be excludable as foreign earned income in figuring your income tax. 

Does Australia tax foreign income?

The Australian income tax system taxes its residents based on their worldwide income (i.e., whether the income is earned within or outside Australia). 

Generally, non-resident individuals are only required to pay tax to the ATO on an Australian-sourced income. However, unlike the U.S., individuals that have become residents in Australia for a short time may be eligible for a temporary resident tax exemption on their foreign income and capital gains.

What is the Income Tax Rate in Australia Compared to the U.S.?

Current Australian income tax rates are relatively high compared to the U.S., which is 37%. Australian tax rates vary depending on your taxable income and between 0% – 45%, 

When is My Australian Income Tax Return Due?

Australia’s tax year starts on July 1 each year and ends the following year on June 30. The deadline to lodge (file) your taxes is October 31.

U.S. Taxes – What You Need to Know

If you earned over U.S. $12,550 (per individual) in 2021 (or $12,400 in 2020), have $400 of self-employment income, or only have a minimum of $5 of any income if you are married to (but happen to be filing separately) from a foreigner, it is a requirement to file Form 1040. While taxes owed are due on April 15, expats are able to get an automatic filing extension until the deadline of June 15, which can be extended further online on request until October 15.

If you have foreign assets valued at over U.S. $200,000 (per person, excluding your home if it is owned under your name), you must also file a Form 8938 to declare them.

If you had over U.S. $10,000 in one or multiple foreign bank accounts during the tax year at any time, it would be necessary for you to file FinCEN form 114, also known as an FBAR (Foreign Bank Account Report).

If you are paying any income tax in Australia, several IRS provisions allow you to avoid paying double tax onto the same income in the U.S. 

The two primary provisions are the Foreign Earned Income Exclusion, as it lets you exclude the first US$110,000 income earned from U.S. tax, and the Foreign Tax Credit. This gives you a U.S. tax credit to offset the tax you already have paid in Australia. 

The Foreign Tax Credit is a more beneficial option for American expats who find themselves paying more tax in Australia than they would in the U.S. They can carry any excess U.S. tax credits forward for any future use. No matter if you don’t owe any tax in the U.S., you will still have to file if your income exceeds the IRS minimum thresholds.

Does the U.S. Have a Tax Treaty with Australia?

Yes, the U.S.-Australia Income Tax Treaty was signed in late 1982 and later entered into force a year later in 1983

The U.S. – Australia Tax Treaty

However, the U.S. – Australia Tax Treaty doesn’t prevent U.S. expats living in Australia from having to file U.S. expat taxes. It contains provisions that can benefit some U.S. expats in Australia, such as students and individuals who will be given retirement income.

Most kinds of income are set out in the Treaty for U.S. expats so that they can avoid double taxation of their income arising in Australia. One way is to claim U.S. tax credits towards the same value as Australian taxes that have already been paid on their income by claiming the IRS Foreign Tax Credit.

If they have income arising in the U.S., U.S. expats in Australia can claim Australian tax credits against any U.S. income tax paid to the IRS when they file their Australian tax return.

The Treaty also covers any corporation taxation, stating that a company shall only be taxed in the country which it is registered under. An exception would be a ‘permanent establishment’ (an office, branch, factory, etc.) in another country. In that case, the permanent establishment’s profits shall be taxed within the country where it is located.

It’s also worth mentioning that the Treaty contains a clause that allows the two countries to share tax information; in other words, the IRS can see the Australian taxes U.S. expats currently residing in Australia are paying and vice versa. 

Australian banks also share their U.S. account holders’ contact and balance info with the U.S. Treasury.

To claim a provision in the Tax Treaty (besides claiming U.S. tax credits), expats should use IRS form 8833.

What are Australia’s Taxes Like for U.S. Expats?

For the 2022/2023 tax year, all Australian residents are expected to be taxed on all income over $18,200, regardless of where it’s earned. Also, non-residents are taxed on all Australian-sourced income, with some exceptions.

Australian Pension Plans

Superannuation is considered to be Australia’s version of a pension system, as superannuation is partly mandatory and voluntary. Excluding salary and wages, the government has minimums employers and employees must meet to fulfill superannuation requirements. The current rate is 9.5%, which will increase to 12% by 2025. 

Employee investments are both funded and vested. 

Superannuation funds can make filing U.S. expat taxes extra complicated. The IRS treats these funds as grantor or employee benefit trusts, so they are not considered to be qualified retirement plans; they also operate similarly to a 401(k). Anyone who has authority over these funds will encounter additional IRS reporting requirements. 

The U.S.-Australia Totalization Agreement

This agreement influences most tax payments and benefits under their respective social security systems due to it being designed to eliminate dual social security taxation. This situation occurs when a worker from one country relocates (digitally or in-person) to another country to work and is required to pay social security taxes to both countries (IRS and ATO) on the same earnings. It’s also good to fill gaps in benefit protection for all workers who have divided their careers between the United States and Australia.

What Tax Forms do Americans Living in Australia Have to File?

The most common forms to file as a U.S. expat include the following:

  • Foreign Bank and Financial Account Report (FBAR): it should not be considered a tax form and is not filed with the IRS. Instead, it is an informational form submitted to the U.S. Treasury Department. Any U.S. account holder (either person or entity) with a financial interest in or has signature power over one or more foreign financial accounts with more than $10,000 in aggregate value in a calendar year must file the FBAR annually with the Treasury Department.
  • Form 8938, Statement of Specified Foreign Financial Assets (FATCA Reporting): If you reside outside the U.S. and have a bank account or investment income account with a foreign financial institution, you will be required to include FATCA Form 8938 along with your U.S. federal income tax return if you meet certain monetary thresholds.
U.S. Tax Forms for Expats in Australia
    • FinCEN Form 114: Report of Foreign Bank and Financial Accounts (FBAR)
    • Form 1040: Individual Income Tax Return 
    • IRS Form 8938: Statement of Specified Foreign Financial Assets (FATCA) 
U.S. Tax Reporting Considerations

U.S. expats who possess accounts or other overseas assets can be subject to several specific filing requirements in the structure of informational forms. Some forms need to be submitted to the IRS as attachments onto the personal income tax return (Form 1040), while others can be submitted to other governmental departments. Failing to file any of the proceeding forms will result in severe civil penalties, such as a $10,000 per form per year. Additionally, criminal penalties, including fines and incarceration, may apply in certain extreme cases if the reporting delinquency is shown to be willful.

Australia Expat Income Taxes

There are a few standard expectations when paying taxes for Australian-sourced income, such as:

Who is Liable for Income Taxes in Australia? 

For the 2022/2023 tax year, all Australian residents are expected to be taxed on all income over $18,200, no matter where it’s earned. Non-residents are taxed on all Australian-sourced income, with some exceptions.

Who is an Australian Tax Resident

You can qualify as an Australian resident if you’re domiciled in Australia or spent more than half of the tax year without a permanent home residing elsewhere. Additionally, you also may be a resident if you happen to be an “eligible employee” of a superannuation fund.

Tax Year in Australia and Tax Filing and Payment Rules

Unlike in the U.S., the Australian tax year starts on July 1 and ends on June 30 of the following calendar year. The official deadline for filing an Australian income tax return is October 31, after the end of the country’s tax year. 

Extensions are available for taxpayers in certain situations for exceptional and unforeseen circumstances, such as those affected by natural disasters or even those who volunteered to aid victims of natural disasters. 

If you hire a registered tax agent before October 31, the filing deadline is automatically extended to June 5 of the following year. 

Expat Tax Withholding in Australia

When U.S. Expats start working as an employee in Australia, they pay income tax on payments received from their employers. The U.S. Expats’ employers deduct tax from your pay and send those amounts to us.

As an expat your employer withholds tax on your behalf from your salary or wages. Your employer will use your TFN declaration to work out how much taxes will be withheld from your pay.

Who Qualifies for a Resident of Australia?

If you’re domiciled in Australia, you qualify as a permanent resident of Australia or spent more than half of the tax year without a permanent home elsewhere. Additionally, permanent residents may be “eligible employees” of a superannuation fund.

What is the Implication of Being a Self-Employed American in Australia?

All U.S. expats are required to file a U.S. income tax return if your net earnings are $400 or more from self-employment, regardless of age. You must also pay self-employment tax onto your self-employment income, no matter if it is excludable as a foreign-earned income when calculating your income tax. Any net earnings from self-employment include the income earned in Australia and the United States.

What You Need to Know about Living and Working in Australia for Your U.S. Expat Tax Return

Along with standard expectations, some common dos and don’ts come with being an Australia-residing expatriate are:

Common Mistake

Of particular importance is that U.S. expats, more often than not, mistakenly assume that once they have moved abroad, any U.S. tax obligations will cease to exist.

So much so that, as a basic rule, all U.S. citizens, even those residing outside the United States, will be recognized as U.S. residents for tax purposes. Therefore, they are subject to U.S. tax reporting on their worldwide income and can be held towards tax liability if unable to report all current tax information. 

Australia Foreign Bank Account

Suppose you reside outside the U.S. and possess a bank account or investment account in a foreign financial institution. In that case, it is necessary to have FATCA Form 8938 included with your U.S. federal income tax return so you can meet certain monetary thresholds.

Additional Child Tax Credit for American Families in Australia

American expatriate families living in Australia should know the benefits they can receive from the Additional Child Tax Credit.

Australia is a country that has a higher income tax rate than the U.S., so Americans residing abroad in Australia can use the Foreign Tax Credit way instead of the Foreign Earned Income Exclusion. They can also then receive up to $1,400 per qualified child per year.

A qualifying child must be dependent on you, is under 17 years old, and has a valid Social Security Number.

We have met families who made up for lost years of tax filing through our Streamlined Procedure and were surprised to receive up to $3,000 of refunds every year when they claim the child tax credit.

What Tax Deductions are Available for Expats Living in Australia?

Because of the Treaty, most Americans residing in Australia already have an exemption from double taxation. However, the IRS can also provide several other beneficial tax credits and deductions for expats, such as: 

Most expats who apply these tax credits are able to erase their U.S. tax debt entirely.

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How to Deal with the Different Tax Year in Australia in Your U.S. taxes?

Filing your U.S. tax return is due on June 15 – the automatic, 2-month filing extension for expats. However, you may need to file for the October 15 deadline because Australia has a different tax year.

When you report income as a U.S. citizen in Australia, you cannot use the same tax year in Australia as in the U.S. Both countries have different tax years. Therefore, for filing a U.S. tax return as an expat, you’ll need to calculate your worldwide income according to the U.S. tax year. This tax year is January 1 – December 31.

Due to this, it is recommended to use monthly payslips so you know how much income you receive every month. That way, you can translate what you earned from the Australian tax year to the U.S. tax year.

You `must report your worldwide income and file a U.S. tax return by June 15 every year as an American living abroad in Australia. However, if you are waiting for your second Australia income statement, that may come after the U.S. expatriate filing deadline. 

Should I Take the FTC over the FEIE if I Live and Work in Australia?

While Australia’s top marginal rate is at 45%, the U.S. instead charges 37%. And the Australian maximum marginal tax rate starts much earlier. That way, you will be better off ignoring the FEIE but still claiming a full foreign tax credit. 

But exercise caution, as you can only claim a new FEIE if six full years have passed since you had last rejected an FEIE. The sole exception for this scenario is if you receive permission from the Internal Revenue Service in order to change back earlier. 

You may carry any qualifying unclaimed foreign tax credits for one year and then carry them forward for ten years. However, you can only claim these against other foreign income, so if you return to the States and still have excess foreign tax credits, you can’t use these against U.S.-sourced income.

Use the Foreign Tax Credit to Prevent Double Taxation

If you’d like to avoid double taxation, American expatriates in Australia can apply and use the Foreign Tax Credit. That way, whatever amount of taxes that is owed will be paid in Australia by you and can be applied to your U.S. tax return. That way, you will only have to pay taxes once. 

Filing Requirements and U.S. Tax Deadlines

Suppose you are a U.S. citizen or resident, and your tax home and your abode are outside either the United States and/or Puerto Rico upon the regular due date of your return. In that case, you will be automatically granted an extension for June 15 to file your return and pay any tax due. You do not have to file a particular form to receive this extension, and you must attach a statement to your tax return when you file it, showing that you are eligible for this automatic extension.

Qualified Dividends in Australia for your Foreign Corporation or Investment

Resident shareholders in foreign companies can receive credits on distributions. If you happen to own shares within an Australian company and receive a grossed-up dividend report of profits, the company has already paid any and all taxes on a portion of those dividends (as of this posting, the rate is 30%). Australian residents can also receive a rebate (also known as franking or imputation credit) on the tax that has been paid and distributed by that company. Depending on your Australian tax bracket, receiving the entire credit or a portion of the credit is possible.

Selling Your Home in Australia

You need to be aware of some tax implications if you are planning on selling your home in the U.S. or Australia as a U.S. citizen abroad.

As an expat in Australia, you have the ability to claim Section 121 Exclusion and exclude up to $250,000 of profit from U.S. taxation if you file taxes separately (e.g., if your spouse is a non-U.S. citizen). But if filing jointly with another U.S. citizen, you individually can exclude a U.S. $500,000 maximum.

As long as you are qualified under Section 121 Exclusion and its protocols and have lived in your primary house for either two out of five years or owned it for two out of five years, you have the ability to exclude up to $250,000 on your U.S. tax return.

If not, and if the profit when selling the house comes to an estimated $300,000, then $50,000 will be taxable by the IRS. You need to make sure all your tax documents are on a cost basis. The house purchase price includes the cost of renovations, home improvements, etc., so your profit number goes down. Unless you make a significant profit on your home, it is unlikely you will owe U.S. tax for selling your home.

U.S. Tax Benefits are Available to You

Now that we’ve covered the financial and legal aspects that come with being an Australian-residing expatriate, here are some benefits for you to consider:

Foreign Earned Income Exclusion

The Foreign Earned Income Exclusion permits you the ability to exclude your wages from your U.S. taxes. However, this option is only available to those who meet specific time-based residency requirements.

Foreign Housing Exclusion/Deduction

Along with the FEIE, you can also claim a foreign housing deduction or exclusion (applied through Form 2555) for any housing expenses, with the exception of the base housing amount. This exclusion applies to housing paid for with employer-provided amounts similar to a salary, while the deduction can apply to housing that is paid for through self-employment.

Your housing expenses are your reasonable expenses incurred, limited to 30% of your maximum FEIE. High-cost localities like Melbourne, Perth, or Sydney have a higher limit listed in the Instructions for Form 2555. Housing expenses do not include the cost of buying a property, making improvements, or incurring other expenses to increase its value. And your housing expenses can also be within your total foreign-earned income.

The base housing amount is usually 16% of your FEIE. 

Foreign Tax Credits

The Foreign Tax Credit permits you to claim a credit for any income taxes that have been paid to a non-domestic government.

Bilateral Agreements

There are two bilateral agreements to be aware of for future research and consideration. They are:

    • Double Tax Treaty – U.S./Aus
    • Social Security Totalization Agreements

Reach of U.S. Government

Because of FATCA and its Supporting International Agreements have made the U.S. Income Tax Reach more comprehensive than ever before.

FATCA, also recognized as the “Foreign Account Tax Compliance Act,” FATCA is a relatively new tax law enacted in 2010 as an addition to the HIRE Act. The objective behind FATCA since then has been to combat all offshore tax evasion by requiring U.S. citizens to report their holdings residing in foreign financial accounts and any foreign assets to the IRS annually. As part of FATCA’s implementation since the 2011 tax season, it is an IRS requirement that certain U.S. citizens must report (on Form 8938) the total value of any of their “foreign financial assets.”

Starting January 1, 2014, to further enforce FATCA reporting, foreign financial institutions (also known as “FFIs,” which include just about every investment house, foreign bank, and even some foreign insurance companies) must report all account balances held by U.S. citizen customers. To date, several large foreign banks have required that all U.S. citizens who have maintained accounts with them (the large foreign banks) to provide a Form W-9 (a form to declare their status as U.S. citizens) and to sign a confidentiality waiver agreement where they grant permission to the bank to provide the IRS all information about their account. There are cases where foreign banks have closed the accounts of U.S. expats who refuse to cooperate with the requirements.

This renewed effort by the U.S. government to combat offshore tax evasion through FATCA has led to a recent surge in tax compliance efforts by U.S. expats.

Recently, the IRS announced that the United States had signed a so-called competent authority arrangement (“CAA”) with Australia in furtherance of a previously signed intergovernmental agreement (“IGA”) with Australia. This agreement is designed to promote the implementation of the FATCA tax law requiring financial institutions (mainly banks and investment houses) outside the U.S. to report information on financial accounts held by their U.S. customers to the IRS.

Suppose you are a U.S. expatriate living in Australia. In that case, you must remain compliant with your continuing U.S. tax obligations and contact your local ATO for tax services and questions.

 

Our experts at Asena Family Office are available to help you understand your U.S. tax filing requirements and assist you with your U.S. tax compliance needs.

–Shaun Eastman

–Peter Harper

 

Multi-Member LLC

Posted on by Peter Harper

Multi-Member LLC

In our previous articles, we have discussed the single-member LLC and the advantages and disadvantages of owning and operating such an entity, not to mention its default tax treatment. Today, we will be discussing what it means to form and control a multi-member LLC (MMLLC), which is simply a limited liability company with more than one member. 

Understanding Multi-Member LLCs?

While there are similarities between a single-member LLC (SMLLC) and an MMLLC, there are also many differences. But before we elaborate on the details and differences between the two, it may be beneficial to talk more about the history of this entity type. 

History of Multi-Member LLC

Even though the first state to authorize the creation of the LLC was Wyoming in 1977, it was in 1996 that all 50 states in the U.S. had LLC statutes. Through Revenue Ruling 88-76, the IRS decided in 1988 that Wyoming LLCs were taxable as partnerships. And even today, this is the default tax treatment of an LLC with more than one member – a partnership. 

What is a Multi-Member LLC?

This type of LLC has two or more owners ( or members) that share control of the company. Unless electing S Corporation tax treatment, there can be an unlimited quantity of members within a multi member LLC. The LLC may also decide on how (and what percentage of) profits and losses shall be distributed among its members, customarily done through its operating agreement.

Who Can Form a Multi-Member LLC?

Members can be either individuals, corporations, or even other LLCs. 

How Multi-Member LLCs Work

Now that we have discussed a bit about the history of this entity type and what it is, it is time to explain how such entities work. 

Ownership

This LLC is comprised of two or more owners ( or members) that share control over the company. The LLC is its own legal entity that is separate from its owners. Unless it decides to elect for S Corporation tax treatment, there could be an unlimited number of members within an MMLLC. The LLC may decide on how (and what percentage of) profits and losses shall be distributed among its members.

Personal Asset Protection

An MMLLC offers asset protection for the owners’ personal assets because it is a separate legal structure. Indeed, the biggest reason why many people form an MMLLC is the limited liability that it offers its owners. Specifically, the owners’ personal assets cannot be appropriated to pay the debts of the LLC. Owners may, however, be held personally responsible within certain situations (such as when they “pierce the corporate veil”), and in this scenario, they would potentially incur personal liability. 

Profit Distribution to Owners

MMLLC owners are entitled to a distributive share of the profits in the entity, and typically, these profits are in proportion to the percentage interest each owner has in the company. Using this example, if one member owns 70 percent of a multi-member LLC and another member owns 30 percent, then the first person will be entitled to 70 percent of the company’s profits, and the second person will be entitled to 30 percent of the company’s profits. Since the LLC is a flexible entity structure, you can divide profits and losses by way of a particular allocation using something other than the percentage of membership interest. In this scenario, each member might be entitled to a percentage of profits that is different from their percentage of ownership in the business. However, again, this should be clearly stated. While an LLC is not required to distribute profits to its owners, the entity’s owners will still be on the hook for reporting their share of the LLC profits and then paying tax on these profits. 

Income Tax Treatment

The default tax treatment of an MMLLC is similar to that of an SMLLC in that it is a pass-through entity, with the profits being allocated to the owners and thus flowing through to their personal tax returns. How it is different is that instead of the income, expenses, and profits being reported on a Schedule C (as for an SMLLC), the income, expenses, and profits are reported on Form 1065 (partnership tax return), and each member of the LLC receives a Schedule K-1 (and must then report this information on their personal return) reporting their share of the LLC’s profit or loss. 

Federal Income Taxes and the Multi-Member LLC

A multi-member LLC’s default federal tax treatment is that of a partnership. And, just like a single-member LLC, an MMLLC does not pay taxes on its business profits. Instead, the owners (members) individually pay tax, which is based on their share of the profits, on their personal returns. As stated in the previous section, an MMLLC is required to file a Form 1065 (partnership return), and each member receives a K-1, on which they will see their profits or losses associated with the partnership. Finally, each member must then report the profits on Schedule E of their personal return Form 1040. In terms of taxes payable, members will need to pay not only federal taxes but also (Social Security and Medicare) on their share of the LLC’s earnings.

You may then decide that you like that an MMLLC is a pass-through entity but that you hate paying so much self-employment tax. In this scenario, the owners could file Form 2553 for the MMLLC to be taxed as an S Corporation, whereby the profits and losses are still passed through to members’ individual returns (filed via Schedule E of Form 1040). However, the difference here is that the owners must only pay a self-employment tax on their wages and salaries, not on their profit distributions. Typically, the owners would pay themselves a salary, and then whatever profit was left over would flow through to their personal returns. 

However, an MMLLC’s owners may decide to have the entity not be treated as a partnership. In this scenario, members can elect to have their business taxed as a C-Corp, so the entity will no longer be a pass-through entity. It will pay corporate tax on its profits (presently, the federal corporate tax rate is 21%). To do this, owners must file Form 8832 to change the default tax treatment of the entity. 

State Income Taxes and the Multi-Member LLC

This is where things can vary quite a bit. At the state level, tax laws can vary for LLCs. For instance, some states levy fees on LLCs, such as a minimum or franchise tax. Contrary to its name, a franchise tax is not assessed against a business operating as a franchise. A franchise tax is charged to LLCs, corporations, and partnerships into the form of a fee for the concession to form and conduct business in that state. 

Who Manages a Multi-Member LLC?

What is excellent about this entity structure is its flexibility. Members of an MMLLC get to decide how it is structured and who manages the entity. Some MMLLCs elect one or more members, or even a third party, to manage the business. This type of MMLLC is called a manager-managed MMLLC. On the other hand, if the LLC members are running the entity equally, the entity is called a member-managed MMLLC. 

Involvement

If two or more individuals are managing the company, then you should be able to demonstrate that each manager is involved with the company’s business decisions and operations. 

Formation

Multi-member LLC members can be individuals (whether they are Americans or not, and whether they live in the U.S. or not), corporations, or other LLCs. It is important to note that LLCs have organized on a state level, not the federal level.  

Compliance

MMLLCs are required to file Form 1065 (unless they elected to be taxed as an S Corporation, which requires a Form 1120-S filing, or a C Corporation, which requires a Form 1120 filing) as well as potentially a state return. 

Bankruptcy

When an individual declares bankruptcy, the court possesses the power to seize a large quantity of assets, including those related to the LLC. However, if the LLC is multi-member, the court cannot seize company assets without the unanimous agreement of other LLC members, as this would result in the court taking one person’s assets because of another’s misconduct.

Divorce

There are scenarios in which spouses own a multi-member LLC. Thus, couples often meet in court to divide their assets when a divorce occurs. It is good practice to stipulate how much of the company each member owns (or spouse, in this case). In this scenario, the court may rule that each spouse will retain the share stated in the operating agreement.

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Management Options

Again, one of the best things about an LLC is its flexibility. Thus, with an MMLLC, you can decide how the business is managed.

Member-Managed LLC vs. Manager-Managed LLC

As described previously, in a member-managed LLC, the members participate in running the business. As such, when making big decisions, such as entering into contracts or purchasing expensive equipment, the majority approval of all its members is necessary.  

In a manager-managed LLC, on the other hand, the members are able to agree on electing a manager, either one particular LLC member or members, or even a third party, to whom they grant authority to manage the business’ day-to-day decisions and operations. 

Basic Steps to Form a Multi Member LLC

While every entity is different, and you may take slightly different steps in forming an entity, the below are best practices and should be followed at a minimum. 

Choose a Business Name.

The new LLC name needs to be distinguishable from all other registered entities for tax purposes. You can start searching on the Secretary of State’s business search tool.

Apply for an EIN (Employer Identification Number).

As LLCs are pass-through entities, an application for a new EIN number needs to be obtained if the LLC will be multi-member or if the election is made by its members to be taxed as a corporation.

File Your LLC’s Articles of Organization.

While it may differ from state to state, this document needs to meet articles of organization, such as detailing the name and address of the LLC, the contact details and names of the owners, the application date, and a description of the new business.

Create an Operating Agreement.

This internal document needs to be drafted by members and will set out the rules for ownership and management of the newly formed LLC. It will detail what will happen if additional members are introduced to the LLC, if the LLC will be liquidated, or if members leave the LLC.

Apply for the Necessary Business Licenses and Permits.

Suppose the nature of the business requires the LLC to obtain business licenses or permits to operate. In that case, the relevant agencies need to be contacted to ensure that the licenses or permits are transferred from the sole proprietor to the newly formed LLC.

Open a Separate Bank Account for Your Business.

A bank account for any new business needs to be opened in the name of your LLC to ensure a clear separation between the LLC funds and the members’ personal funds. This also eases the management of assets and allows for more accurate recordkeeping.

Ongoing Compliance Obligations

As with any business entity, owning a multi-member LLC means that there are certain obligations that its members must adhere to. Some of those include renewing any licenses or permits (if required), paying state franchise fees, filing entity tax returns, updating the state the LLC is organized in if there are significant changes, filing an annual report, and so forth.

What are the Benefits of a Multi-Member LLC?

There are numerous benefits to owning an MMLLC. One is limited liability, as an LLC is considered a separate entity from its members. Subsequently, members are not personally liable for the business’s debts and other legal liabilities (i.e., they have limited liability protection). Further, members of LLCs include the business profits in their individual returns because the LLC is classified as a pass-through entity. Additionally, members may be able to apply the 20% pass-through deduction to business profits.

What are the Drawbacks of a Multi-Member LLC?

At the same time, there can be a few drawbacks to having such an entity. Members of LLCs receive units in proportion to their contribution/LLC agreement, and these units are more challenging to transfer than stocks in a corporation. This difficulty in transferring ownership is one of the reasons that external investors/venture capitalists prefer investing in corporations over LLCs.

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Why Should I Have a Multi-Member Operating Agreement?

It could be argued that any entity should have one. Still, it becomes crucial for a multi-member LLC to have an LLC operating agreement, if for no other reason than to avoid ambiguity in the ownership and management structure, profit distribution, and even what happens when/if the company is liquidated or its members leave. 

What Should a Multi-Member Operating Agreement Include?

Certain sections are crucial to include. Those include the following:

Article I: Company Formation

This section deals with the formation of the company itself, and it should include information on the list of members and the company’s ownership structure. In addition, it should outline whether the members have equal or different amounts of ownership.

Article II: Capital Contributions

This section covers each member’s initial capital contribution in starting the LLC, whether the contribution is in cash or other assets that are contributed to the business. The total value of the contributions should be clearly listed. 

Article III: Profits, Losses, and Distributions

This section describes how profits and losses are allocated (whether they are ownership percentages or some special allocation) and whether the profit distributions are on an annual basis or more often. 

Article IV: Management

This section addresses managing the company (whether the firm is member-managed or manager-managed) and how each member will vote, with a transparent system of appointing managers and how individual members will be assigned other specific duties. 

Article V: Compensation

This section discusses the topic of compensation. For instance, if the LLC is to be taxed as a corporation, any members can receive a salary for the labor they have performed in the business, along with profit distributions. If the LLC is to be taxed as a partnership, members receive distributions on the basis of their ownership interest in the company.

Article VI: Bookkeeping

The agreement should be clear on whether and which LLC member/members can check the LLC’s books and records, such as financial documents and board meeting minutes.

Article VII: Transfers

This section discusses removing or adding new members to the LLC. Additionally, it states if and when members of the LLC can transfer their ownership in the company. Finally, this section should also clearly specify what happens in the event of death, bankruptcy, or divorce. It cannot be expressed enough on the importance of accounting for these types of scenarios, as, despite everyone’s best efforts, business and life are unpredictable, and in order to protect each member’s share and business interests, these situations and how to handle them should be stated in this document. 

Article VIII: Bank Account

This is something that gets overlooked often but is quite apparent. As stated previously, this is essential for any new business to ensure a clear separation between the LLC funds and the members’ personal funds. Additionally, this eases the management of assets and allows for more accurate recordkeeping.

Article IX: Dissolution

This section explains the circumstances if the LLC may be dissolved, and if so, the process of terminating the LLC should all the members vote to end it. 

How are Multi-Member LLCs and Their Owners Taxed?

What is the tax status for an MMLLC? A domestic LLC possessing at least two members is usually classified as a partnership for federal tax reasons unless it decides to file Form 8832 to be elected for treatment as a corporation. Each partner must pay taxes separately on the grounds of their operating agreement. Most agreements favor having the taxes corresponding to the membership interest. This means that each LLC member is required to pay taxes on their share of the LLC’s profits whether or not they receive their share of those profits. Unlike a corporation, even if a member or members have the need to leave profits in their LLC for any tax purposes, they can be liable for any income tax for their proportionate share of the LLC’s income. However, as discussed previously, the LLC that is classified as a partnership will be required to file Form 1065, U.S. Return of Partnership Income, with the IRS, as well as provide their members with a K-1 (a breakdown of each member’s profits and losses), and can be subjected to the same filing and reporting requirements as partnerships. Each state could use different tax regulations for an LLC, and the income derived by the LLC and be attributed towards a member or members can be taxed at the state level if it is sourced or derived from that state.

How Do I Pay Myself from a Multi-Member LLC?

You do not get paid a salary as the member/owner of an MMLLC. Instead, you pay yourself by withdrawing the profits made by the LLC as and when needed. This is also referred to as an owner’s draw.  

Single-Member vs. Multi-Member LLC

There are numerous differences between an SMLLC and an MMLLC. Some of those differences are discussed below.

LLC taxes

The default tax treatment of an SMLLC is that the owner must report the business’s profits and losses onto a Schedule C of IRS Form 1040 as personal income, and the small business itself does not report or pay taxes independently (nor does it file its own tax return). The LLC owner must also make payments onto self-employment taxes (Social Security and Medicare) on any and all taxable income coming from the business. 

An MMLLC, on the other hand, is required to file a return (Form 1065) and provide its members a Schedule K-1 form, which contains information the members will need to file their personal returns. Like with an SMLLC, business owners are subject to federal income tax, FICA taxes, and possibly even state income tax. 

Liability protections

Both SMLLCs and MMLLCs have liability protection by default. 

Multi-Member LLC vs. Partnership

Even though the default tax treatment for an MMLLC is for it to be taxed as a partnership, there remain differences between an MMLLC versus other entities that may also have more than one member.

Multi-Member LLC vs. LLP

While individuals can own MMLLCs, corporations, and other LLCs, a limited liability partnership (LLP) can only be owned by individuals. Further, in many states, an LLP can only be formed by certain professions, such as doctors and attorneys. On the other hand, multi-member LLCs can be created by and for nearly any profession. Finally, an LLP cannot change its tax classification, whereas MMLLCs can elect to be taxed as a partnership or corporation. 

Multi-Member LLC vs. LP

In a limited partnership (LP), general partners have unlimited liability and are personally liable for the business, whereas limited partners receive liability protection. In an MMLLC, all members have liability protection. Further, in an LP, only general partners can manage the business, whereas, in an MMLLC, all members can manage the business. 

Is it Better to be a Multi-Member LLC?

Generally speaking, it is more advantageous to be structured as an MMLLC than as an LLP or LP, for the reasons stated in the previous section. However, your needs (or the requirements set forth by your state for your industry/profession) may require you to go with something other than an MMLLC.

Which One is Right for Your Business?

This is a difficult question to answer within the confines of an article. You will have to consider your business’s unique goals, business structure, industry, and profit margin, among other things, to determine which entity type is best. However, this article hopefully elucidates many advantages of a multi-member LLC. 

Multi-Member LLC FAQ

Here are some quick additional facts about MMLLCs you should consider:

Does a Multi-Member LLC Need an EIN?

Yes, it does. The entity will need an EIN to do things such as file an income tax return. 

Can a Multi-Member LLC become a Single-Member LLC?

Yes, it can. The only official condition is the sale of the membership interest surronding the leaving member(s) towards the remaining member, as well as the filing of a new tax election form. 

How Do You Dissolve a Multi-Member LLC?

There are numerous steps you must take in order to ensure that your LLC is properly dissolved. Most MMLLCs will have to perform actions such as:

    • voting by members to dissolve the LLC;
    • filing a final return;
    • filing an Articles of Dissolution with the state the entity is doing business in;
    • settling any outstanding debts; and
    • distributing assets to LLC owners/members. 
For more advice on starting your own multi-member LLC, reserve a consultation with one of our advisors in our Contact Us section to the right.

Arin Vahanian

Peter Harper

International Estate Planning

Posted on by Peter Harper

A short time ago, we had touched on the common pitfalls and necessary strategies a high-ultra networth individual residing in the United States would need to know when starting or in the middle of the U.S. estate planning process. Continuing onto that, we will be expanding the topic on a global scale and all the rules on taxation, residency, and succession that come with it.

International Estate Planning

International estate planning (or IEP) is a set of strategies and tactics applied to the U.S. and foreign clients to obtain the following objectives:

The first and most important objective is maintaining control and ownership of all wealth and property that the client has acquired in life and will be given upon their death. To determine said ownership and control, there are a few key factors to consider, such as:

  • The true domicile of the client and their beneficiaries;
  • The nature of the ownership rights of the client, their beneficiaries, and any political entities within which the property resides;
  • The tax jurisdiction between states based on local and international tax treaties to ensure efficiency when considering transfer taxes;
  • Transfers of control and ownership through trusts, contracts, and probate.

Another crucial objective is to the ability to provide absolute financial security for the client and their descendants that will last for multiple generations. As cash flow is an important way to leverage the behavior of family members, it is imperative to project the cash flow from the current assets and estimate the costs of winding up the estate. Financial security should also be ensured when the client is unwilling or unable to remain competent, as this can result in property, investments, and other financial assets to either be seized, lose monetary value, or be lost due to mishandling.

When is International Estate Planning Triggered?

There are several ways for international estate planning to be triggered when a U.S./Foreign client (with assets in the U.S.) either:

  • Accumulates or transfers a significant amount of wealth during their lifetime;
  • Probates, owns, or divides a significant amount of property (it should be noted that due to ‘FATCA’ and other reporting requirements, any amount above $100,000.00 is now considered “significant”).

Reporting and Confidentiality

Financial security is not the only concern for IEP clients when it comes to efficient tax planning. The confidentiality of their personal tax and account information may rank higher on the list of importance, as international estate planning will require much financial accuracy and scrutiny in order to complete the process efficiently. 

Unfortunately, with the implementation of the OECS’s CRS framework and the U.S. FATCA legislation, reporting on the client’s financial and tax information is no longer optional. It is mandatory for all tax history and current finances to be present not only at the beginning of inheriting or purchasing an international estate but throughout the entire operation in the case of changes or situations that could arise. It is critical to know precisely the kind of information the client needs to disclose in the various jurisdictions and the consequences of non-compliance in order to avoid the latter.

Who Does International Estate Planning Affect?

There are two specific client groups that are most often affected by international estate planning within the U.S.:

  • Any U.S. citizen or non-resident aliens living in the U.S. who own assets or have family members residing outside of the USA;
  • Non-US resident individuals who own interest in property located within the U.S. 

These two groups of clients share having a connection, whether familial or business-related, to the U.S. For those looking into other countries, it is vital to research the laws, tax treaties, and such that their specific country requires for international estate planning. For example, some countries, such as Britain, may impose a global inheritance tax on beneficiaries for estates that meet or exceed a specific monetary value, while others, like Portugal, do not.

International Estate Planning: Five Key Issues to Consider

It is of utmost importance for global families (especially families with U.S. expats) to create an international estate plan which considers the succession, domicile, generation-skipping transfer, succession, and gift tax laws in each jurisdiction where distributions may occur and/or assets are held at the time of the client’s death.

The U.S. imposes gift and estate taxes based on citizenship and domicile, which is more common in other countries, making planning for the U.S. expat particularly complex. To avoid the negative implications and consequences when the multi-jurisdictional estate plan is drawn up, the five factors below need to be considered for U.S. expats, green card holders, and/or other U.S.-connected persons.

Review The Basics of U.S. Estate and Gift Tax Law

The U.S. government imposes income and estate/gift taxes primarily based on citizenship. The maximum rate at which federal estate and gift taxes may be levied is 40%. There are tax exemptions and credits that Treasury amends on an annual basis, which typically excludes many U.S. citizens – due to this, many U.S. citizens are not concerned with estate tax planning.

Non-resident aliens may face estate tax on U.S. situs property (including shares and real estate in companies established or expanded into the United States). If the country in which the non-resident alien resides has an estate tax treaty, the jurisdiction where they are resident may have favored gift tax and estate treatment. If there is no estate tax treaty, there may be a cap on the tax exemption on their U.S. situs assets.

For individuals with a joint asset can bypass probate, with married holders adding 50% in value to their asset in the instance that one passes away. For more information, please read our article on issues to consider with joint assets to consider when doing international estate planning.

Understand the Jurisdiction in which The Decedent and Assets Are Situated

The United States offers generous gift tax and estate exemptions for U.S. citizens. However, other countries may have lower thresholds. A simple domestic estate plan may not address the complex issues which may arise if the client has assets in multiple jurisdictions.

The most significant difference is that of inheritance tax rules versus estate tax rules. Inheritance tax is typically paid by the person receiving the asset, while the estate pays estate tax. 

Succession laws also differ globally as many civil law countries in Europe, South America, and Asia have restrictions on who may receive assets at death – this is called forced heirship. The E.U. Succession Regulation (EU650/2012) alleviated some aspects of forced heirship. However, individuals may not assume they can proceed assets to any individual they want when residing within a civil law country.

Pay Attention to Nationality, Residency, Domicile, and Situs Rules

If multi-jurisdictional assets are considered, residency, nationality, and domiciled issues must be closely considered and understood. 

The estate tax for U.S. immigrants is imposed based on domicile. For estate tax purposes, a person is domiciled in the U.S. if they live within the U.S. and have no present intention of leaving. A Green Card may be a key indicator of their choice to remain in the U.S. and establish a domicile.

Other countries have codified requirements of when someone is resident and/or domiciled. European countries focus on how many days have been spent in the country when determining when worldwide assets will be subject to their local tax law. Multiple countries may consider the individual a domiciliary and/or subject certain assets to estate and gift taxes. In this instance, the special tie-breaker clauses in the tax treaties would need to be considered to avoid double taxation and determine legal domicile.

How certain types of property will transfer is subject to situs rules. Situs refers to a property’s physical location for legal purposes. The general guidelines for assets typically forming part of situs assets for non-resident aliens include:

    • Real Property (Structures, Land, Fixtures, and renovations/improvements located in the U.S.);
    • Tangible Personal Property (property physically in the U.S., including physical currency);
    • Intangible Personal Property (depends on the nature and character of the investment);
    • Business Investment Funds (funds used in connection with a U.S. business or trade and then held in a brokerage or bank account – this includes the U.S. branches of foreign banks);
    • Personal Investment Funds (Checking/Saving accounts; qualified retirement plans; stock; bonds; life insurance, and annuities).

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Check Relevant U.S. Estate Tax Treaties

Bilateral estate and gift tax treaties provide clarity on international transfer taxes. The U.S. has signed estate/gift tax treaties with sixteen foreign countries, with each treaty altering the rules regarding the applications of the estate and gift taxes between the two countries.

The content and protections afforded in each treaty may be vastly different while also providing a framework to determine the situs of the property, the domicile of the decedents, and the application of the relevant tax credits in order to avoid double taxation.

The benefit of the tax treaties for non-U.S. citizens is to alleviate the estate tax on U.S. situs assets, thus saving money while still preserving the value of the estate.

Regularly Update an International Estate Plan

Reviewing and updating a draft in estate planning is vital when acquiring assets in different jurisdictions or moving across borders. Structuring an estate plan in a single country may create unforeseen and undesirable consequences when the estate is being executed in another country. Reviewing the domicile and residency of someone at the time of their death is crucial for the functionality of the estate plan.

Individuals can cement the fulfillment of their wishes after their passing by approaching legal counsel to adopt a Last Will and Testament, which meets the requirements of the United States and any other foreign country to facilitate the distribution of their estate.

Reviewing any trusts that the individual may have is as important as executing a professional international Will. When trustees and settlors of trusts move between jurisdictions, it is imperative to be examining the treatment of trusts in the new jurisdiction for new requirements that will call for financial redocumentation or applying for a form, service, or taxation status.

Some countries, such as the U.K. and New Zealand, may impose entry and exit tax on trust assets, while others (mostly European countries) do not recognize trusts due to their definition and structure of laws surrounding inheritance (common law vs. civic law).

However, it is possible for trusts to be moved internationally, though it would have to be done without the full knowledge of foreign financial and tax laws. In some cases, this can be done unknowingly by actions of a trustee or a settlor, and this may create unforeseen consequences. Trustees or settlors of trusts are advised to seek specialist tax advice before relocating to a new country to accommodate the changes in their international estate plan.

Cross Border Issues That Amplify The Complexity of Estate Tax Planning

As with any transglobal purchase, any expat looking to purchase property in another country must be aware of the following issues that appear often:

U.S. Estate Tax Basics

U.S. transfer taxes can be applied to a U.S. citizen no matter where they are residing, the location of gifts property, or if they have died. U.S. expats are entitled to benefit from income tax relief in the form of foreign-earned income exclusion since there is no such benefit where transfer taxes are concerned.

U.S. expats should expect The United States Treasury to impose estate tax upon their worldwide assets at the moment of their death. These assets will include proceeds from personal property, retirement assets, life insurance policies, real estate, and other assets. 

Treasury may also levy an estate tax on certain assets which may have been transferred to others within a specified period before the time of the individual passing or in the case where the decedent/beneficiary retains an interest in the property after the death of the cedent.

Changes to the recent estate tax law have increased the threshold for federal estate and gift tax lifetime exclusion to very high thresholds. During the 2022 financial year, the exclusions are as follows:

    • $12.06M personal lifetime exemption;
    • Interspousal transfers: transfers between spouses are unlimited (during the lifetime of the spouses or after death as long as the transfer happens to a citizen spouse);
    • The unused portion of the exemption from the first dying spouse’s estate can be carried over to the estate of the last surviving spouse. This will, therefore, increase the threshold for the last surviving spouse’s estate as long as an election is made on the first dying spouse’s estate tax return.

Should a U.S. citizen transfer any funds during their lifetime to a non-US citizen spouse, there may be a reduction in the U.S. citizen spouse’s estate; however, the annual marital gift allowance is reduced from unlimited to an amount of $164,000.00 in 2022.

A Brief Overview of Contrasting International Transfer Tax Regimes

U.S. laws surrounding estate tax can be found in numerous states, with each possessing either similar or different criteria to be met critical differences, especially regarding state taxation and population, such as New York to Illinois. However, these differences are insignificant compared to the rest of the world. Most U.S. states make use of English common law, while other countries may make use of civil law systems. And as of October 2020, less than half of all American states and territories had ratified the International Wills Treaty and adopted the Annex.

Current civil law has been modeled after Roman law, resulting in statutes being longer, more detailed, and with less discretion and interpretive power to the court. 

Common law has more concise constitutions and statutes which afford more discretion and interpretive power to the courts when laws are applied to particular facts and circumstances.

As a common law country, the U.S. allows individuals more control and discretion in terms of distributing their wealth to their heirs. This is done by drafting a legal Will that provides specific instructions for the bequeathing of their wealth using the probate system.

Trusts can be used as vehicles to bypass probate and to avoid/defer estate tax. The estate is typically taxed before the distribution of wealth is made to the heirs. If a valid Will is not in place, state intestacy laws will determine how the decedent’s property should be distributed.

Due to the fundamental differences in common and civil law countries, it is possible for the existing estate plan that the family may have in place to become outdated, ineffective, and perhaps very counter-productive. This is especially the case if the family relocates overseas. 

Concepts of Citizenship, Residency, and Domicile

Along with cross-border taxation and laws, another critical factor in any international estate planning process is how one’s residency, citizenship, or domicile. These concepts have crucial significance in determining the transfer taxes to which the individuals could be exposed.

Expats need to understand any requirements and definitions under the laws of the countries where they live, work, and own assets. The likelihood that the effectiveness of an existing estate plan may deteriorate is dependent on where the family relocates and how much their existing assets integrate into their new country of residence as well. The duration of how long they are in the new jurisdiction is also a component an individual must consider before starting the process.

U.S. tax residency is determined using two tests: The first is the substantial presence test which measures the number of days an individual physically spends in the country. The second is based on the individual’s permanent residency – i.e., as soon as the individual becomes a green card holder, they are deemed to be a U.S. tax resident. Let’s also distinguish that a U.S. citizen is always considered a resident for income tax purposes.

Transfer taxes, however, do not consider the individual’s tax residency. Instead, it will focus on the concept of domicile. Domicile is established by determining the jurisdiction in which an individual resides without the intention of leaving permanently at some time in the future. 

Should the individual meet the requirements to be regarded as a tax resident in the U.S. but does not have the intention to remain in the country permanently, a domicile has not been created. However, once domicile has been established in a country, the only way to sever it would be actually to move outside the country/emigrate. Immigrants may be able to obtain estate tax residency if a green card is obtained and they intend to remain in the U.S. permanently.

 

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Transfer Tax Situs Rules, Tax Treaties, And Foreign Tax Credits

Now that we have gone over general key information and issues to be aware of let’s dive into strategies, credits, and other rules surrounding global taxation for IEP.

Tax Planning Strategies: Cross-Border Pitfalls and Considerations

The transfer tax implications for expats and other non-US person’s property will depend on the following:

    • The character and nature of the assets;
    • The physical location of the assets;
    • Whether there is an estate tax treaty between the country of domicile/citizenship or residence and the U.S.;
    • Whether there are any tax credits available in the U.S. and the relevant jurisdiction should there be an overlapping of any taxes which need to be imposed.
Understanding The Role Of Situs In International Transfer Taxation

As discussed above, situs is the Latin word for “position” or “site.” In legal terminology, it refers to the property’s location.

Federal estate taxes are levied on the worldwide assets of U.S. citizens and residents. For non-residents, the situs rule is that any tangible asset physically located in the U.S. will become subjected to federal estate tax. The rules for intangible property and assets are more complicated. It is possible for an asset to be considered a non-situs asset for U.S. gift taxes but may be considered to be a situs asset for U.S. estate taxes.

The Interplay of Tax Treaties Are Foreign Tax Credits On Cross-Border Estates

The U.S. currently has estate and gift tax treaties with fifteen other jurisdictions. The tax treaties serve important roles when determining the transfer tax consequences of the assets which may form part of the cross-border estate. The treaty may provide a meaningful reduction in estate taxes employing mitigating discriminatory tax treatments and double taxation.

The treaty determines the country of the donor/decedent’s domicile and the country where the property is deemed to be located. Once this determination has been made, the treaty controls which countries can assess transfer taxes.

Some treaties relieve some of the burdens which may occur when a surviving spouse of the estate is non-resident upon the passing of a US-domiciled spouse. This is done by increasing the marital deduction for non-resident spouses. If both countries have claimed to levy estate taxes, a tax credit regime may be in place to at least reduce or eliminate double taxation.

When preparing the international estate plan for clients, the interplay between the relevant transfer tax regime and the relevant treaty. This is to ensure that the impact of domicile and citizenship is also considered in addition to not only the nature of the location and the property. The filer must also specify any benefit which has been claimed under the treaty in their actual tax filings. Otherwise, the presumed benefit may be lost. Unlike the tax treaties, the U.S. does not make any special claims to negate the treaty on the basis of the heir or decedent’s citizenship.

Tie-breaker clauses are key factors in these tax treaties. How the tie-breaker rules operate depends on whether the newer or older situs rules are followed in the estate tax treaties. 

The most recently ratified estate tax treaties follow the rules based on the domicile-based approach. The treaty rules prioritize determining the jurisdiction where the decedent is domiciled. The domiciliary country can tax any and all transfers of property within the estate, while the non-domiciliary country may only tax situs property. Foreign transfer tax credits will then be provided to the non-domiciliary country by the domiciliary country for taxes paid.

The older treaties follow the more elaborate character/nature rules discussed above for non-resident aliens owning U.S. situs assets. The foreign jurisdiction’s situs rules will apply to the portion of the U.S. person’s estate in the foreign country. These treaties are not uniform; some eliminate double taxation better than others. Generally, provision for primary and secondary credits may be applied to reduce any potential double taxation. The non-situs country will grant a primary credit against the tax imposed on the situs country. Secondary credits may be issued where the individual situs laws of the countries determine that the property has situs in both or even neither country. 

Where there is no tax treaty, there is an increase in the probability of double taxation. Foreign transfer tax credits may still be able to provide a form of relief from double tax taxation, and the availability of same in the U.S. will hinge on the following:

  • Is the property situated in a foreign country?
  • Is the property subject to estate/inheritance taxes?; and
  • Does the property form part of the gross estate of the decedent?

U.S. Internal Revenue Code §2014 elaborates on the credit for foreign death taxes. It should also be noted that the potential foreign tax credits could be unavailable by Presidential proclamation if the foreign country does not provide a reciprocal tax credit to U.S. citizens.

Can Non-US Citizens Inherit Property?

Noncitizens are able to inherit property just as citizens can. One common example of special rules can apply to spouses when one of them is a non-US citizen. When the spouse who is set to inherit property from the estate is a non-US citizen, the marital deduction is no longer unlimited, even if the spouse happens to be a permanent U.S. resident. The rationale is to ensure that a non-US citizen does not inherit a large sum of money tax-free and then return to their native land. On the other hand, if the non-US citizen spouse were to pass away first, the assets left to the U.S. citizen would qualify for the unlimited marital deduction.

Just as the marital deduction is not unlimited to a non-U.S. resident spouse, the special tax-free treatment of gifts given to spouses during their lifetime is also subject to a limit of $164,000 annually. The amount is indexed for inflation and is subject to change annually.

Can U.S. Trust Own Foreign Assets?

Yes, it is possible for a U.S. trust to own foreign assets. However, it should be noted that certain countries or jurisdictions do not recognize trusts, which can result in higher taxes when or obstacles when transferring foreign assets. A possible reason is that the country or jurisdiction utilizes a civil law system rather than a common law system, with the latter allowing clients to use trusts for inheritance.

Look into whether the country you wish to engage in international estate planning operates on either a civil law or a common law system before beginning the process. If not, consult with your client or advisor to determine possibilities for you to meet civil law regulations and additional tax laws with little to no room for complications.

What is an International Will?

An International Will is intended to take effect in more than one country or jurisdiction. It can also be referred to as an Offshore Will and specifically deals with assets located in a foreign country or jurisdiction, whether from family, friends, or business-related reasons. Should it be intended for the Will to deal with the individual’s worldwide assets, it may be referred to as a ‘Worldwide Will.’

How an International Will is produced and finalized depends on the country or jurisdiction it originates from, but in many cases, it requires to be handwritten and witnessed by at least two individuals. Most countries with a common law system are accepting of a Will from the United States and vice versa, as well as recognizing if the Will was executed in the United States and vice versa. And with any of these cases, a Will can be written in a language of the writer’s choosing.

Are Foreign Assets Subject to Estate Tax?

Citizens and permanent residents of the U.S. who are domiciled within the U.S. can be subjected to estate tax on their worldwide assets, including any foreign ones they have acquired at any point in time. Should there be a tax treaty with the jurisdiction where the assets are located, this needs to be considered when determining if foreign estate tax credits may be applicable. That way, you can either reduce incoming taxation or to avoid double taxation. Which solution, or another, that may apply to your case must be consulted with professional advisors before moving forward in order to avoid filing with inaccurate information and other legal consequences.

Our consultants can help you with your international estate planning case. Contact us to set up an appointment in the “Have a question?” section to the right.

Jean-dré Tombisa

Peter Harper

Peter Harper on US Tax – American Kleptocracy

Posted on by Peter Harper

Asena Advisors is proud to present an episode of US Tax, the podcast for Australian accountants with US clients. CEO Peter Harper dives with host Heide Robson into how the United States has become the most popular offshore haven with illicit finances.

Transcript:

Peter Harper: As far as how did a lot of these island nations and tax havens get into trouble, it had nothing to do with their tax rules. Their tax rules in of themselves were completely fine. It was the way that they managed those tax rules in conjunction with their secretive banking practices to effectively hide and laundered by.

[introductory music plays]

Narrator: You’re listening to US Tax; the podcast for Australian accountants with US clients.

Heide Robson: Welcome to Update 33 of US Tax. This is Heide Robson. So now we are back to publishing content that is unique to this podcast here, US Tax. So this podcast, this episode was not published previously somewhere else.

Heide Robson: When I was talking with Peter Harper of Asena Advisors during the last three updates, I asked him about a book. The book is called American Kleptocracy by Casey Mitchell. The full title is American Kleptocracy: How the US Created the World’s Greatest Money Laundering Scheme in History. Amazon quotes the book, “An explosive investigation into how the United States of America built one of the largest illicit offshore finance systems in the world.”

Heide Robson: So I wanted to get Peter’s input on this. And at the time I (had) asked Peter about this book, neither Peter nor I had read it. In fact, the question was unplanned. I didn’t know I was going to ask Peter this (because) my mind sometimes goes off on a tangent. So neither Peter nor I had read the book and we don’t really discuss the book. What had triggered my question to Peter was the blurb on the back of the book. I had read the blurb and let’s just quickly read the beginning of the blurb. It’s quite long, so let’s just read the first one and a half paragraphs and skip some bits to make it shorter.

[transitional music plays]

Narrator: “For years, one country has acted as the greatest offshore haven in the world, attracting hundreds of billions of dollars in illicit finance (that has been) tied directly to corrupt regimes, extremist networks, and the worst the world has to offer. And this one country is the United States of America. American Kleptocracy examines just how the United States’ implosion into a center of global offshoring took place. How states such as Delaware and Nevada perfected the art of the anonymous shell company.”

Heide Robson: So that’s part of the blurb. So this is what triggered my question to Pete, and bear in mind that Peter hadn’t read the blurb. And my question to Peter is, “Do LLCs just help to hide assets, or do they also help to avoid tax? And if the latter, how does that work? How can you avoid tax using an LLC? Is that what this is about?”

[transitional music plays]

Heide Robson: Before we start, please let me just quickly play you the legal disclaimer that Peter Harper has recorded for you.

Peter Harper: So we talk about those complex questions. I want to caution listeners that each case that may come before them will be unique, and it is vital that they consult with someone that has US expertise in order to handle delicate matters. These topics are not simplistic and need experience and proficiency to tackle. So please reach out to us to address any issues that your clients may bring up with the diligence they deserve.

[transitional music plays]

Heide Robson: Here’s Peter’s answer:

Peter Harper: If you’re a conspiracy theorist, which, in every conspiracy theory, there is some truth. But this is the reality of what happened: the US went out with fat (finger) error, and through all this stuff that happened in Switzerland with UBS, and then in Asia with HSBC, you know, the offshore stuff, and applied these very draconian empirical financial laws.

Peter Harper: The US has gone around and set up all these mutual disclosure regimes around extracting information and information sharing, all that type of stuff. But its states, in itself, are not actually bound by those jurisdictions. And then, you’re quite right, the structure of the LLC is kind of hiding in plain sight, right? Because if you’re generating non-US sourced income and you’re a non-US owner, it’s not subject to US taxation.

Heide Robson: So you basically have three buckets: in the first one, you have EFTP. In the second one, you have ECI. And then in the third bucket, you have income that is neither EFTP nor ECI, and this third bucket does not get taxed in the US if you are not a resident of the US. And so you are referring to this third bucket that is not taxed in the US if it flies through an LLC.

Peter Harper: Yeah, correct. So this is the thing: when you think about a US LLC, and this took me a while to wrap my head around, I spent a lot of time thinking through this. I’m like, “Oh, well, you know, there’s automatically got to be this notion or presumption of a US LLC having a US trade or business,” because my first exposure to an LLC and a lot of people is they go, “Ah, it’s a partnership.” And that is true. When you add multiple people together in a US LLC like it is in Australia, there is this presumption when you have a partnership in Australia that it is two people in business with a view of profit, right, that creates this nexus sort of business. In the US, that’s conceptually true, but it’s not guaranteed. In the context of a single-member LLC, categorically, it’s really straightforward; if you don’t have US-sourced income, so (like) you don’t have a US tradeable business with effectively connected income and you’re not generating US FDAP income, there’s no US tax.

Heide Robson: To just kind of guess what structure they are aiming at, it would be a single-member LLC that is then held by a multilayer structure of international shell companies in tax havens. So you would have a single-member LLC that is held by a tiered structure of companies in tax havens. Most likely then, also, with not even a registered shareholder, but just holding certificates, so that it’s very difficult to work out who is actually owning these assets in the LLC, correct?

Peter Harper: Yeah, correct. So what then happened when all these tax havens got hit through the last round, again, the money always looks around the world. And obviously getting bank accounts and all that type of stuff is very different, right? Because you’ve got to go through and deal with anti-monetary (laundering), or AML, policies and all that type of stuff. But just that process of having a legal structure where you’re not concerned about getting access to US banking. And this is where a lot of the European nations and other countries have since kind of paid the heavy price. (And what) really pushed back at America is America’s willingness and desire to regulate the rest of the world, but its unwillingness to let the rest of the world regulate it, right? And I think when you’re the biggest economic gorilla in the room, you get to push a different agenda. But that is absolutely the truth when it comes to wealth structuring that’s driven by confidentiality today.

Heide Robson: So we identified how it might be structured, but the question is what income could actually flow through it. Because I think the main income that is in this third bucket where it’s neither EFTP nor ECI is when you have product businesses selling products from outside the US into the US. Because then you don’t have a US trade or business, you don’t have an FDAP, hence you are in this third bucket.

Heide Robson: But I think as a vehicle for major tax avoidance, I can’t see how it works. Because, for example, if you set up an LLC that is then held by a multi-tiered structure in tax havens and multiple tax havens scattered across the globe. If you have passive income running through that LLC, you have FDAP, hence it’s taxable in the US. Unless, of course, you’re aiming at capital gains, yes. So it would be mainly capital gains then because they would be-

Peter Harper: FDAP has still got to be coming from a US source. Really where, I think, this has gone, right, it should be very, very clear. This is something I can see how it resulted like this, but we’re not in the business of helping this stuff happen is… I think it’s really (that) a lot of this is driven by folks that have got money that may not have paid (the) proper tax. That may have some issues around how it was derived. And so the only way this kind of works as being a tax haven, it’s a tax haven in the sense that you can have non-U.S. sourced income flow into a US structure and flow out of a US structure.

Peter Harper: What the US gives these clients is (that) they give a really high level of confidentiality that they probably used to have in places such as Switzerland and in Hong Kong that they don’t enjoy anymore. And that’s really it. Because if you think about tax havens, if you really think about most tax havens as they used to exist for many, many years, there’s been really strong anti-avoidance provisions that have existed in most major city nations across the world. But so the ability to maintain substantial amounts of capital in offshore tax havens without attribution, you know, it’s not impossible, but it’s been extremely limited over the course of the last 10 to 20 years. So then the people that are storing money there are just… They’re doing it by being dishonest as far as compliant with the rules.

Peter Harper: So I think why a lot of people are saying, you know, they go (and) say, “Is [the] US a tax haven?” They’re thinking about it in the context where they’re saying, “Okay, you’ve got an LLC, you’ve got a foreign owner, you’ve got income coming into an LLC that’s foreign-sourced (and) that’s flowing back out to a foreign owner. Therefore there’s no US taxation.” Now Americans sometimes jam up and say, you know, “Tax haven.” I’m like, “Okay, well, Australia has a whole bunch of rules. They like to take the conduit, foreign income rules. You got foreign-sourced income flowing through a foreign holding company back out to a foreign owner. There’s no Australian tax.”

Peter Harper: So this notion that it’s really a tax haven automatically on its own, I think, just by virtue of the fact you’ve got income flowing out and not being taxed, that’s a bit of a rich statement. I think what is a fair statement is it is that coupled with the rules that each of these states has implemented around confidentiality. And to me, that’s a bigger issue. The confidentiality (and) the rules they have around confidentiality are more of an issue than the tax rules in of themselves. And some of these rules are not too dissimilar from places like the Cook Islands.

Heide Robson: Yes. Now I’m with you, Peter, because I couldn’t see the tax avoidance, because when you have FDAP, for example, you have withholding tax. Yes, the capital gains would not be taxed in the US and hence would be taxed probably nowhere if the whole structure is held in a tax haven. But I agree with you. It’s really the privacy rules that are around these LLCs by the different states who establish these LLCs. That’s really where you can then hide assets; it’s more about hiding assets than avoiding tax, correct?

Peter Harper: Yeah, correct. And I think, really, if you actually survey a lot of the most recent (years), particularly over the last 30 years, as far as how did a lot of these island nations and tax havens get into trouble. It had nothing to do with their tax rules. Their tax rules in of themselves were completely fine. It was the way that they managed those tax rules in conjunction with their secretive banking practices to effectively hide and launder money, right? And I think the concern with America is, “Hey, guys! You guys went around with a sledgehammer and smashed up the whole offshore tax world.” Right, which is fair enough. You think that’s bad guys doing bad things, anti-money laundering basics. But then at the same time, you’re happy with some of your really more Republican-in-nature states to say that, “Come and put your cash over here or your assets over here and no one can know about it.” It was just one of those things, I think that you know, a lot of people, particularly in Europe, feel that it was a very sort of unfair thing.

[transitional music plays]

Heide Robson: Welcome back. So the criticism leveled at US LLCs is not about tax evasion, because when you have assets in the US that earn US-sourced income, usually for FDAP, you pay tax in the US. Not you, but the LLC which holds those assets pay tax in the US.

Heide Robson: So LLCs in this web of illicit finance are not about evading tax, but are about hiding assets. So if you are a dictator or an oligarch or a corrupt official or a money launderer or a drug or illegal weapons dealer, in short, if you have assets that you shouldn’t have, then US LLCs allow you to hide those assets. So your LLC will still be paying tax in the US, but folks back home can’t see where your assets are. So when you look at offshore tax havens, LLCs, and the lot, distinguish between tax evasion and the hiding of assets, tax evasion has become a lot harder with FATCA, the U.S. Foreign Account Tax Compliance Act, and the Common Reporting Standard, CIS, (which is) the equivalent to FATCA for non-U.S. countries. So tax evasion has become a lot harder with FATCA and CIS, but you can still hide assets. And one way to do that is a US LLC.

Heide Robson: So that’s all for today. The next episode will come out soon. We don’t have a set schedule or rhythm for US Tax. It just would get too much to publish each week on Tax Talks, as well as US Tax. Apologies. So we just publish US updates here as they come.

Heide Robson: Thank you for listening. Bye for now and see you in the next update.

[closing music plays]

 

Got more questions? Speak with one of our consultants at Asena Advisors.

Peter Harper

IRC 675

Posted on by Peter Harper

IRC 675

Following our previous articles on grantor trusts, we will cover the first of the three main IRCs: Section 675.

What is an IRC Section 675?

IRC 675 of the Internal Revenue Code, or IRC, involves, under treasury guidelines, the administrative powers of a foreign grantor trust. To be more precise, it states that the grantor of any foreign trust shall be treated as the owner of the foreign trust. This is only true if, under the instruments’ terms of the trust, that specific administrative control can be exercised primarily for the benefit of the grantor instead of the benefit of the beneficiaries. 

Additionally, suppose the owner of the foreign trust has the power to amend the administrative provisions of the trust instrument, which would result in him, her, or they becoming the trust owner. If that were to happen, the grantor would be treated as the owner of the trust. 

Now that we know the basic understanding of what IRC 675 is, let’s explain its various powers, such as what may cause a foreign trust to become a grantor trust, who the owner of a grantor trust is, and how to toggle grantor trust status. 

Sec. 675’s Administrative Powers

The administrative powers under IRC 675 include several different authorities related to administrative duties; notable examples to take note of include voting powers and directing the investment of trust funds, borrowing funds, and the ability to deal with trust income and funds for less than adequate consideration, as well as not having sufficient interest or security. 

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General Powers of Administration

When we refer to a general power of administration, this will commonly include the following: 

  • The power to vote or direct voting of a trust’s stock or other securities, where holdings belonging to the grantor or the trust are significantly essential from the viewpoint of voting control. 
  • The power to control the funds’ investment by directing or vetoing proposed any trust investment or reinvestment. Of course, this is only to the extent that the funds consist of corporation stocks or securities, in which the grantor and trust’s holdings are significant from a voting control viewpoint.
  • The power to reacquire the trust corpus, also known as the sum of money or trust property set aside to produce income of the trust for beneficiaries by substituting other property of an equivalent value. 

To summarize our three points above, the perspective through which we need to assess whether a grantor has these powers has to do with controlling funds and assets within a trust. 

Borrowing of the Trust Funds

Another power a grantor can possess is the ability to borrow trust funds. For example, we should consider a scenario where the owner can directly or indirectly borrow the corpus or trust’s income and wouldn’t be expected to completely repay any loan, including any interest, before the beginning of the taxable year.

Power to Deal for Less than Adequate and Full Consideration

This particular power is exercisable by the grantor in a nonfiduciary capacity without the approval or consent of another party. It enables the grantor to purchase, exchange, or otherwise deal with or dispose of the corpus or the trust’s income for less than adequate consideration in money or its monetary worth. Specifically, it could allow a grantor to remove assets from the trust for a small amount of deliberation, thus resulting in the grantor being able to terminate that trust completely. 

Power to Borrow Without Adequate Interest or Security

This power enables the grantor to borrow the corpus or income, directly or indirectly, without sufficient interest or adequate interest or security except where a trustee, if under a general lending power, is authorized to create loans for any person without regard to said adequate interest or security.

What Are The Grantor Trust Powers?

To summarize the definitions and examples above, here are the most common and vital powers a grantor can have over a trust and its process:

  • To change or add the beneficiaries of the trust. 
  • To borrow from the trust or a portion of the trust without adequate security. 
  • To use income from the trust in order to pay life insurance premiums.
  • To change the trust’s composition by substituting assets of equal value.

What Causes Grantor Trust Status?

Now that we know several types of powers a grantor can have, let’s look into what causes a trust to be considered a grantor trust. There are various criteria, but among the most relevant are the following:

  • IRC § 673(a): the grantor maintains a reversionary interest, meaning that the grantor holds a ‘reversionary interest’ in a trust greater than 5% of the trust principal or income.
  • IRC § 674: the grantor can control the ‘beneficial enjoyment’ of trust income or assets.
  • IRC § 675: the grantor maintains administrative control over the trust that can be exercised for his benefit rather than for the trust’s beneficiaries.
  • IRC § 676: the trust allows the grantor (or a nonadverse party) to revoke any part belonging to a trust and reclaim or take back the trust’s assets later. 
  • IRC § 677(a): if the trust distributes income to the grantor, the trust may be regarded as a grantor trust.
    • The grantor will also be treated as the trust’s owner if its income is, or in the owner’s direction, distributed to the owner or the grantor’s spouse. It will also accumulate for any future distribution to the grantor or the grantor’s spouse, or to be applied to payment of insurance policies on either the life of the grantor or the grantor’s spouse.

Additionally, it’s crucial to note that a grantor trust is considered a disregarded entity by the IRS for federal income tax purposes. This will mean that the grantor’s income tax return will include any taxable income or deduction earned by that trust. For the taxpayer’s convenience, the IRS will allow a grantor trust to employ the grantor’s Social Security number (SSN) rather than having a separate tax ID number (TIN).

Also, when discussing what causes grantor trust status, a vital topic to always consider is what grantor trusts’ advantages and disadvantages are. The primary benefit of estate planning is the potential to preserve wealth while minimizing taxes for one’s beneficiaries. That way, beneficiaries will have a lowered tax rate and better prioritization of any estate tax inclusion that may be available. However, a major concern is an assumption that the grantor, as a taxpayer, will have the funds to pay income tax obligations on trust assets and possible interest for the income of the trust during their lifetime. These implications for income tax purposes may cause a grantor to toggle grantor trust status so that the trust is no longer treated as a grantor trust (discussed later in this article). Further, the gift tax is also a concern, so the taxpayer must consider gift tax considerations and tax consequences when creating the trust. 

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Who Is Considered the Owner of a Grantor Trust?

The grantor, also known as the owner, settlor, or trustor, is typically the person who creates the trust and contributes property (such as real estate), other funds, or even trust instruments, such as life insurance, to that trust. The trust property and the owner’s funds become part of the trust corpus (in other words, the trust’s assets). 

Personal or familial trusts often have only one grantor, but can, along with business trusts, have two or more. For example, if more than one person had funded a grantor trust, each one will be treated as a grantor in proportion to the cash or property value they transferred to. 

Suppose a resident of a foreign country is treated as the owner of the trust under the grantor trust rules. In contrast, that specific trust has a domestic civilian or resident as a beneficiary. In that case, the beneficiary will be treated as the trust’s grantor to the extent that the beneficiary made gifts (directly or indirectly) to the foreign owner, irrespective of gift tax applying. 

Bear in mind that the grantor is the person who retains the power to control or direct the trust’s income or assets, and is allowed full discretionary protection as the grantor. It’s crucial to understand, especially when dealing with a foreign trust and the income tax consequences surrounding this instrument. Moreover, the owner can also be any person who creates a trust directly or indirectly and makes a gratuitous property transfer to a trust.

How Do I Toggle Grantor Trust Status?

One common question received when looking at IRC 675 is how to toggle a grantor trust status so that the trust will no longer be treated as a grantor trust.. 

Why would a grantor want to do this? Given that there are implications for income tax purposes of a foreign grantor trust, the grantor may deem it too burdensome to be liable for tax on the income attributable to the trust, year after year. Other common motives include keeping up with the tax rate that comes with their specific grantor trust, or for their own discretionary reasons. Therefore, to terminate the grantor trust status or toggle it off, the powers we explored above (which are often used to create the grantor trust status) must be released or terminated. 

How is this done? One possibility this can be accomplished is by transferring power to a specific trustee or a third party, such as a trust protector.

Similarly, to turn the grantor trust status back on after it has been released, the powers released previously must be brought back and given to the previous grantor. This can be done by amending the trust instrument. However, it’s important to remember that a grantor or trustee should never approach this toggling of status flippantly and that professional advice and assistance should be engaged when going down this path. 

New Responsibilities With Incorporation

If the grantor trust status terminates during the grantor’s lifetime, and the trust ceases to be a grantor trust, then the grantor is deemed to have transferred the assets to the trust at that time for federal income tax purposes. The question then becomes, does the grantor recognize a taxable transaction or a gain? Assume the trust has non-recourse liabilities to a third party secured by the trust’s assets. If that is true, the grantor will recognize the gain because the grantor will be deemed to have transferred the secured assets to the trust in exchange for a release of liability. In another scenario, the grantor may also recognize capital gain where the trust owes the debt to the grantor because the trust can be received the secured asset from the grantor in exchange for the promissory note to the grantor as of the date that the grantor trust status terminated. However, based on numerous court cases and tax law examples, there appears to be no gain recognized by either the trust or the grantor’s estate at the grantor’s death for income tax purposes. 

We will be discussing more on the responsibilities within incorporation in later articles, such as gift tax implications, estate tax inclusion, and creating an irrevocable trust, and where the trust deed is drafted to trigger a certain status intentionally (such as an IDGT, which is an irrevocable trust set up by the owner for this particular purpose).  

Speak with one of our consultants to see how IRC 675 can help your financial case.

Arin Vahanian

Peter Harper

#IndiaU.S.TaxSeries Ep. 1: What are Tax Treaties?

Posted on by Peter Harper

This refreshing entry of the #AsenaTaxBlog series on tax treaties focuses on the US and India tax treaty framework. The first blog presents a brief history that might interest my readers, who are curious to learn about the application of tax treaties and their interplay with domestic legislation to determine how beneficial provisions impact their cross-border tax planning needs. In doing so, there is a list of questions that you should discuss with your advisor to ensure your tax compliance is in order. 

Background

A tax treaty is an agreement or a convention between two countries. For instance, an income tax treaty is an agreement primarily concerning the taxation of income, prevention of double tax, and evasion. There can be various reasons for a country to negotiate and enter a tax treaty with another country.  

Post the First World War, the League of Nations began developing model tax conventions, which were taken over by the Organization for Economic Co-operation and Development (OECD) and later the United Nations. The United Nations was essential in establishing the United Nations Economic and Social Council (ECOSOC) to address the needs of the developing countries to formulate a model tax convention promulgating the manner to negotiate a tax treaty that is focused on addressing the sourcing country’s taxing. In 2003, the United Nations’ Department of Economic and Social Affairs published a revised edition of the Manual for the Negotiation of Bilateral Tax Treaties between Developed and Developing Countries. It noted that “the twin goals of a tax treaty are, firstly, to encourage economic growth by mitigating international double taxation and other barriers to cross-border trade and investment, and secondly, to improve tax administration in the two Contracting States by reducing opportunities for international tax evasion.”  

US Tax Treaty Framework

In the US Constitution’s Article II, Section 2, Clause 2 confers the President to make treaties and lays out how to enforce a treaty. The US has signed the Vienna Convention on the Law of Treaties (Vienna Convention) but considers many of its provisions concerning the application of international law to the law of treaties. 

The US has entered into income tax treaties with several foreign countries. The US concluded the first income tax treaty with China in 1932 to foster trade relations between the US and France. As more developing countries seek to achieve foreign investments, the bilateral income tax treaties could be a guidance tool for taxation of income, avoidance of double taxation, and evasion of taxes.  

The US has below types of treaties dealing with tax matters:

  1. Double tax avoidance income tax treaties;
  2. Estate and gift tax treaties; 
  3. Tax information exchange agreements (TEIAs); 
  4. Social security agreements or Totalization agreements; and 
  5. Multilateral Convention on Mutual Assistance in Tax Matters.

The list of countries with which the US has an income tax treaty is provided on the IRS’s official website. Countries included are Armenia, Australia, Austria, Azerbaijan, Bangladesh, Barbados, Belarus, Belgium, Bulgaria, Canada, China, Cyprus, Czech Republic, Denmark, Egypt, Estonia, Finland, France, Germany, Georgia, Greece, Hungary, Iceland, India, Indonesia, Ireland, Israel, Italy, Jamaica, Japan, Kazakhstan, Korea, Kyrgyzstan, Latvia, Lithuania, Luxembourg, Malta, Mexico, Moldova, Morocco, Netherlands, New Zealand, Norway, Pakistan, Philippines, Poland, Portugal, Romania, Russia, Slovak Republic, Slovenia, South Africa, Spain, Sri Lanka, Sweden, Switzerland, Tajikistan, Thailand, Trinidad, Tunisia, Turkey, Turkmenistan, Ukraine, Union of Soviet Socialist Republics (USSR), United Kingdom, United States Model, Uzbekistan, Venezuela, and Vietnam.

India Tax Treaty Framework

Article 253 of the Indian Constitution confers the Parliament of India to make treaties and lays out how to enforce a treaty. However, India is not an official signatory to the Vienna Convention. Still, how the courts (Ram Jethmalani v. Union of India (2011) 8 SCC 1 and various high courts in India) have acknowledged and embraced the customary international law provisions is a small step towards encouraging an integrated framework. 

India has below types of treaties dealing with tax matters:

  1. Double tax avoidance income tax treaties including comprehensive, limited bilateral, limited multilateral, and other agreements (DTAs);
  2. Tax information exchange agreements (TEIAs); 
  3. Social security agreements (SSAs); and 
  4. Multilateral Convention on Mutual Assistance in Tax Matters.

India has entered into 96 comprehensive and eight limited bilateral income tax treaties. These include Armenia, Australia, Austria, Bangladesh, Belarus, Belgium, Botswana, Brazil, Bulgaria, Canada, China, Cyprus, Czech Republic, Denmark, Egypt, Estonia, Ethiopia, Finland, France, Georgia, Germany, Greece, Hashemite Kingdom of Jordan, Hungary, Iceland, Indonesia, Ireland, Israel, Italy, Japan, Kazakhstan, Kenya, Korea, Kuwait, Kyrgyz Republic, Libya, Lithuania, Luxembourg, Malaysia, Malta, Mauritius, Mongolia, Montenegro, Morocco, Mozambique, Myanmar, Namibia, Nepal, Netherlands, New Zealand, Norway, Oman, Philippines, Poland, Portuguese Republic, Qatar, Romania, Russia, Saudi Arabia, Serbia, Singapore, Slovenia, South Africa, Spain, Sri Lanka, Sudan, Sweden, Swiss Confederation, Syrian Arab Republic, Tajikistan, Tanzania, Thailand, Trinidad and Tobago, Turkey, Turkmenistan, United Arab Emirates, UAR (Egypt), Uganda, United Kingdom, Ukraine, United Mexican States, United States of America, Uzbekistan, Vietnam, and Zambia. 

The Indian tax legislation prescribes the availability of tax treaty benefits subject to certain procedural compliance and poses a challenge for taxpayers. For example, a non-resident Indian (NRI) is required to obtain a Tax Residency Certificate (TRC) from the tax authorities of a country of which he/she/they are a resident, in addition to filling out a self-declaration form. 

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India-US Income Tax Treaty Framework

Forms of tax treaty agreements between India and the US: India and the US have only two bilateral tax agreements, namely:

  1. The Convention Between the Government of the United States of America and the Government of the Republic of India was made for the avoidance of double taxation and the prevention of fiscal evasion concerning taxes on income 1989, which came into effect on 1 January 1989 (India-US DTA), and the protocol and technical explanation to guide for that.  
  2. The Agreement between the Government of the Republic of India and the Government of the United States of America for improving the international tax compliance and to implement the Foreign Account Tax Compliance Act (FATCA). This agreement was entered on 9 July 2015 in terms of Article 28 relating to the exchange of information for tax purposes on an automatic basis and put into effect from the period beginning 1 January 2017.

There is no gift, inheritance, nor estate tax treaty between India and the US. Therefore, a taxpayer is required to be governed and comply with the domestic tax legislation of the country where the citizenship/residence/domicile is established at the time of the taxing event.

Snapshot of the Articles covered under the India-US DTA

Broadly, the articles under the India-US DTA can be categorized as under:

Category

Article
Scope and Taxes Covered Article 1: General scope;

Article 2: Taxes covered;

Article 30: Entry into force;

Article 31: Termination
Definition Article 3: General definition;

Article 4: Residence;

Article 9: Associated enterprises
Individual Income  Article 6: Income from immovable property;

Article 10: Dividends;

Article 11: Interest;

Article 12: Royalties and fees for technical services;

Article 13: Gains; Article 15: Business personnel services;

Article 16: Dependent personnel services

Article 17: Director’s fees;

Article 18: Income earned by entertainers, and athletes;

Article 21: Payments received by students. and apprentices;

Article 22: Payments received by professors, teachers, and research scholars;

Article 23: Other income;

Article 29: Diplomatic agents, and consular officers
Business Income Article 5: Permanent establishment;

Article 7: Business profits;

Article 8:  Shipping and air transport;

Article 14: Permanent establishment tax
Pension Income Article 19: Remuneration and pensions in respect of government services;

Article 20: Private pensions, annuities, alimony, and child support
Other Provisions Article 24: Limitation on benefits;

Article 25: Relief from double taxation;

Article 26: Non-discrimination;

Article 27: Mutual agreement procedure;

Article 28: Exchange of information and administrative assistance

The interpretation of the articles covered under the India-US DTA needs deep analysis, and a cross-border tax advisor should be consulted to apply the tax treaty to the facts and circumstances of your situation.

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Key Questions to Discuss with Your Advisor Concerning the DTA While Tax Planning or Compliance: 

  1. Whether the DTA is effective or in force?
  2. What is the nature of the DTA in force – comprehensive or limited?
  3. Does the scope of the DTA cover me?
  4. What is the basis for determining my residential status under the DTA?  
  5. Does the “saving clause” under the DTA apply to me?
  6. What types of income are covered under the DTA?
  7. Does my business activity in a country establish a “permanent establishment” status?
  8. Do I have an option between applying the DTA and domestic tax legislation? 
  9. Is the application of the DTA more beneficial than domestic tax legislation? How do they interact? 
  10. What are the relevant provisions for the elimination of double taxation?
Our team of international tax specialists at Asena Advisor has in-depth knowledge of interpreting international tax treaties and ascertaining their applicability to your specific circumstances. Please contact Janpriya Rooprai, Head of the US-India Tax Desk, for more information.

Janpriya Rooprai

Peter Harper

Entity Classification Election

Posted on by Peter Harper

Entity Classification Election

Following our previous discussion about entity changes with check-the-box regulations, let’s go into another process that entrepreneurs and executives are likely to consider with the tax season fast approaching: the entity classification election.

What is the Purpose of Entity Classification Election?

The purpose of the entity classification election is to enable business entities to avoid the default tax classification applied by the IRS for federal income tax purposes. Business entities receive a default tax classification, which can result in paying for more federal taxes than necessary. If your entity is eligible to use the entity classification election form, you can change your tax election status and potentially lower your tax liability.

For example, a U.S. corporation can avoid double taxation by using the CTB regulations, and it also benefits foreign eligible entities by avoiding potential double taxation. For example, an entity in India could be classified and taxed differently in the U.S. than in India, such as a tax treaty or an income tax treaty. The CTB rules, therefore, provide the entity in India to elect its entity classification for U.S. tax purposes with that said tax treaty. 

The entity set up in India can also use the tax treaty, along with any treaty benefits included, to qualify for lower dividend withholding taxes if it elects to be taxed as a corporation in the U.S. 

A Parent company in the U.S. can also use the CTB rules to benefit from the tax treaty with India and avoid double taxation. 

What Is A Business Entity Classification?

A business entity is any entity that is recognized for federal tax purposes that is not correctly classified as a trust under Regulations section 301.7701-4 or otherwise subject to special treatment under the Code regarding the entity’s classification. A business entity is classified as either a C-Corporation, partnership, or disregarded entity for federal tax purposes. 

Here is how you can remember:

Association – For purposes of the CTB regulations, an association can be an eligible entity that’s taxable as a corporation by election or under the default rules for foreign eligible entities, as discussed below.

Business entity – A business entity is any entity recognized for federal tax purposes that is not accurately classified as a trust under Regulations section 301.7701-4. Or they are otherwise subject to special treatment under the Code regarding the entity’s classification. 

Corporation – For federal tax purposes, a corporation is any of the following: 

    • A business entity is organized under a federal or state statute or a federally recognized Indian tribe statute if that same statute describes or refers to the entity as incorporated or as a corporation, body corporate, or body politic. 
    • An association.
    • A business entity is organized under a state statute if the statute describes or refers to the entity as a joint-stock company or joint stock association. 
    • An insurance company. 
    • A state-chartered business entity that is conducting banking activities, if any of its deposits are insured under the Federal Deposit Insurance Act or a similar federal statute. 
    • A business entity that is wholly owned by a state or any political subdivision or is wholly owned by any entity described in Regulations section 1.892-2T, such as a foreign government.
    • A business entity that can be taxable as a corporation under a provision of the Code other than section 7701(a)(3). 
    • A foreign business entity as listed on page 7 of Form 8832. 
    • An entity is created or organized under tax laws of more than one jurisdiction (an example can be a business entity that has multiple charters) if the entity will be treated as a corporation with respect to any of the jurisdictions. For examples, see Regulations section 301.7701-2(b)(9).

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What is an Entity Classification Form?

This federal tax form allows certain businesses to select whether they want to be taxed as a corporation, partnership, or disregarded entity for future tax purposes and protected under tax law. 

What is IRS Form 8832?

You can use IRS form 8832 to choose to have:

      • A corporation with more than one owner is treated as a partnership for tax purposes.
      • A corporation with a single owner is treated as a ‘disregarded entity for tax purposes.
      • A partnership is treated as a corporation for tax purposes.
      • A ‘disregarded entity is treated as a corporation for tax purposes.

Which Businesses Can Use Form 8832?

Only businesses that are considered eligible entities can use Form 8832. The following are regarded as eligible entities:

      • Partnerships
      • Single-member LLCs
      • Multi-member LLCs; and
      • Certain types of foreign entities

Not every type of business can use Form 8832 to change their business’s tax classification. The following can be considered businesses eligible for filing Form 8832:

      • Partnerships
      • Single-member LLCs
      • Multi-member LLCs
      • Explicit types of foreign entities (Page 5, Form 8832)

The above entities can use Form 8832 to elect to be taxed as a C corporation, partnership, or sole proprietorship.

If you’re currently a limited liability company (LLC) taxed as a corporation, you can use Form 8832 to revert to a previous tax classification.

Eligible businesses that don’t fill out the form will be taxed based on their default tax status. If you are content with your current or default tax classification, do not fill out Form 8832.

Remember that your business can only change its tax classification once every five years.

Who is Not Eligible to File Form 8832?

Sole proprietors, domestic corporations, and foreign corporations are listed in IRS Regulations 301.7701-2(b)(8). 

How Do You Fill Out Form 8832?

Form 8832 is a straightforward form to fill out and only requires the entity’s name, address, and tax identification number, followed by making an election by checking the relevant box and the signature of the entity’s eligible owner, member, partner, or officer.

Before you begin filling out your form, you need to gather some information. Take a look at what to have handy for Form 8832:

      • Business name, address, and phone number
      • Employer Identification Number (EIN)
      • Owner’s name and Social Security number (if the business only has one owner)

There are two parts to the form: Election Information (Part I) and Late Election Relief (Part II). Part I asks a series of questions on your tax status election. Depending on your answers, you may be able to skip some lines.

Part II is for businesses seeking late election relief only. To be eligible for late election relief, all of the following must apply:

      • The IRS denied a previous Form 8832 filing because you didn’t file on time.
      • You haven’t filed your taxes because the deadline hasn’t yet passed, or you’ve filed your taxes on time.
      • You have reasonable cause for not filing your form on time.
      • It has been less than three years and 75 days from your requested effective date.

Is Form 8832 Complicated?

No. The required information you need to know is: 

        • The name of your business
        • The phone number and address of your business
        • The employer identification number (EIN)

Who Must File Form 8832?

Keep in mind that it is not a mandatory form at all. It provides eligible entities the option to change their default classification should they wish. 

What Information is Required?

        • The name of your business
        • The phone number and address of your business
        • The employer identification number (EIN)
        • Owner’s name and Social Security number if the business only has a single owner

Where Should It Be Filed?

        • The form can not be filed electronically. 
        • If you are living as either a resident or non-resident in the U.S., you will have to mail it to the appropriate IRS office in your state.
        • If you are a resident or non-resident in a foreign country, you will need to mail the form to the Department of the Treasury, Internal Revenue Services, Ogden, UT 84201-0023.

Where Do You Send the Form?

This will depend on the location your entity is residing in a domestic or foreign location:

        • If you live in the U.S., you’ll mail it to the appropriate IRS office in your state.
        • If you live in a foreign country as a resident or non-resident, you will need to mail the form to the Department of the Treasury, Internal Revenue Services, Ogden, UT 84201-0023.

Once your specific office receives your form, they will notify you immediately whether it has or hasn’t been accepted. A final determination notice of the election change will be sent to you within 60 days of the acceptance decision.

What’s the Form 8832 deadline?

Because Form 8832 is not mandatory, it doesn’t have a deadline per se. It can be filed at any point by an eligible entity. There are, however, specific but basic rules to take note of. When you file the form, you can include the date the change will take effect. 

Broadly, an election specifying an eligible entity’s classification will not take effect more than 75 days before the election is filed, nor can it take effect later than 12 months after the election is filed. However, an eligible entity may be able to apply for an exemption and receive a late election relief in certain circumstances.

How Long Does It Take to Prepare?

The IRS estimates that 17 minutes are required to prepare the form. However, this doesn’t take into account the time it will take to learn and understand the applicable tax law.

What Else Should I Know About Form 8832?

It is essential to know the difference between Form 8832 and Form 2553. Both forms allow certain businesses to request a new tax classification. However, the major difference is the type of tax classification you request.

Form 8832 authorizes businesses to request to be taxed as a corporation, partnership, or sole proprietorship, whereas Form 2553 is the form corporations and LLCs use to elect S-Corp tax status. 

The check-the-box regulations authorize entities to elect to change their U.S. tax classification, though a change in tax classification, no matter how achieved, has tax consequences. This applies to U.S. and International business owners.

Essentially there are three ways to accomplish a classification change:

        • An elective classification change by filing IRS Form 8832.
        • An automatic classification change, wherein an entity’s default classification changes as a result of a change in the number of owners.
        • An actual conversion, wherein an entity merges into, or liquidates and forms, an entity that has the desired classification.

Suppose a corporation elects to be classified as a partnership. In that case, it will be deemed to have distributed all its assets and liabilities to shareholders in liquidation. The shareholders are considered to contribute all the distributed assets and liabilities immediately after that to a newly formed partnership. An entity will be deemed to have liquidated under §331 or §332, and the deemed liquidation will be treated like it were an actual liquidation for tax purposes.  

An entity not regarded as eligible will first need to convert into an eligible entity before making the check-the-box election. 

Lastly, an actual conversion can be implemented.

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Why to Use Form 8832

Businesses receive a default tax classification, which can result in paying more business taxes than necessary. If you’re eligible to utilize the entity classification election form, you can change your tax election status and potentially lower your liability on a tax return, saving you money and building more tax credit.

Why Comply?

Even though this form is not mandatory, this will be an advantage for some taxpayers to decide whether their entity will be taxed as a partnership (one with multiple owners), as a corporation, or disregarded for tax purposes (single owner entity) and taxed like a proprietorship.

What is the Best Tax Classification for an LLC?

An ideal tax classification for a limited liability company (LLC) will depend on if you’d like your business profits should be taxed at your personal income tax or corporate tax rates. If you would rather use your personal tax rates instead, you can classify it as a disregarded entity or as a partnership. If not, you can classify it as a corporation instead.

An LLC can be taxed in several ways for the business and its owner to save on taxes. Below are ways how an LLC can be taxed, how your business can benefit from being taxed as an S corporation or as a corporation, and how you can elect this tax option:

An LLC can be considered as a disregarded entity, similar to the way sole proprietorships are treated, or can be taxed as a partnership if it has multiple members. Those are the most usual classification for LLCs, with each case having the profits ultimately taxed as a part of every member’s personal income.

It’s also possible for an LLC to be considered a corporation. If so, the entity will have to pay corporate taxes instead of passing profits through to each member’s personal income tax return.

To be taxed as a corporation, use the entity classification election or IRS Form 8832. The election for being taxed as a new entity will go into effect on the date entered on line 8 of Form 8832. However, the election cannot take effect over 75 days before the date the election is filed, nor will it take effect any later than 12 months after it is filed.

The form includes a consent statement that may be signed by all or one member on behalf of all other members. If one member does sign, there needs to be some record in a company membership meeting that all members have approved this specific election.

For single-member LLCs, you will need to provide the name(s) and owners’ Social Security number. The same will be applied for multi-member LLCs, but with an Employer ID Number instead of Social Security number. 

You can fill out an IRS Form 2553 in order to be taxed as an S corporation, also known as an election by a Small Business Corporation. To start a new tax classification for a year, you will need to file by March 15, which will be effective for the entire year. You must also include all necessary information about each shareholder: name and address, Social Security number, the date the owner’s tax year ends, shares that they owned, and a consent statement.

For any change to a corporation, you must note the following: when your election to corporate status goes into effect, the IRS will determine that any and all liabilities and assets from the previous business (whether it was a partnership or a sole proprietorship) will be added to the corporation in exchange for shares of the corporate stock.

By default, the IRS can tax a multi-member LLC as a partnership since LLCs don’t have a separate IRS tax category.

If you want to convert your LLC’s tax status from a partnership to a corporation while not changing the LLC’s legal form, you will only need to file an IRS Form 8832 (taxed as a C corporation) or an IRS Form 2553 (to be taxed as an S corporation). 

Note that once an LLC has elected to change its classification, it cannot elect again to change its classification for the 60 months after the election’s effective date. 

Any election for changing a partnership classification to a corporation shall be treated like the partnership provided all of its liabilities and assets to the corporation in exchange for stock. The partnership is then immediately liquidated by distributing the stock to its partners.

IRS Form 8832: Q&As

If you have any further questions about Form 8832 and if this is the best decision for your business, please feel free to contact us at Asena Advisor for a private consultation or check out the IRS’ entity classification election page, which will have a digital copy of the form. Click here to check the latter.

Speak with one of our consultants to learn more about how Entity Classification Election can help you.

Shaun Eastman

Peter Harper

Check-The-Box Regulations

Posted on by Peter Harper

Check-The-Box Regulations

Also known as the Regulations, the Check-The-Box regulations (CTB) is a classification process that allows an entity, if they so choose for U.S. tax purposes, to be recognized as a corporation or partnership. Entities that can be considered for CTB are those that have already been incorporated under federal or state law, associations, insurance companies, joint stock companies, state-owned entities, banks, publicly traded partnerships, and certain foreign entities.

When Did Check-The-Box Regulations Come Out?

The IRS declared in Notice 95-14 its intention to simplify the entity classification process. Final entity classification regulations under Internal Revenue Code 7701 and treasury regulations sections 301.7701-1 through 301.7701-3, also known as Check-the-Box or CTB regulations, went into effect on January 1, 1997, for all, whether they are domestic or foreign eligible entity. The regulations allow a qualified (or not automatically classified as a corporation) entity to be classified as a corporate (association) or a flow-through (partnership or an entity disregarded from its owner (DRE)) for U.S. income tax purposes if they wish so.

What Is A “Check-The-Box” Election (IRS Form 8832)?

A CTB election is an entity classification election for federal tax purposes made on Form 8832 – Entity Classification Election. The process can be relatively straightforward; you will need to select the appropriate box and the date that the election will become effective. 

What Is The Effect Of A Check The Box Election?

Regulations under a Check-The-Box election allow an eligible (i.e., not automatically classified as a corporation) entity to be classified as a corporation (association) or as a flow-through (a partnership or entity that is disregarded from its owner (DRE)) for U.S. federal tax purposes.

The CTB regulations permit U.S. investors to create limited liability partnerships (LLP) or companies to incorporate business entities in foreign countries, particularly civil law countries. That way, all members would enjoy limited liability, which would be treated as a corporation under foreign limited liability and could be treated as a partnership or disregarded entity under U.S. tax law. 

However, the entity cannot change its classification again for five years, with this limitation applying only to changes made by an election. Accordingly, a new eligible entity that elects from its default classification may change its classification by election at any time. 

The Benefits Of The US Check-The-Box Regulations

Now that we have defined what the CTB is, let’s go into more detail about the benefits that come with it:

Benefits Of Check-The-Box Regulations For Entities With Two Or More Members

In a domestic entity with two or more members, the default classification (if no CTB election is made) is that of a partnership. 

Some of the benefits of making a CTB election are:

    • A corporation, such as C Corporations, is considered a separate legal entity and continues in perpetuity. 
    • As a U.S. corporation, it can benefit from various Double Tax Treaties the U.S. has in force. 
Benefits Of Check-The-Box Regulations For Entities With One Member

The Default classification of a domestic entity with a single member is that it will be treated as a disregarded entity and, therefore, as a sole proprietorship. The same benefits will apply if an election is made to be taxed as a corporation.

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Considerations On Whether To Check-The-Box For Foreign Subsidiaries

Following the benefits of CTB, the following are factors to take into mind before making a final decision:

Deferral And Timing Of Income

Due to U.S. taxpayers being taxed on a worldwide basis, U.S. owners of a transparent foreign entity are not able to defer or time the amount of U.S. tax on their foreign income. U.S. tax is payable when the income is earned, regardless of whether they repatriate the cash. 

Making a CTB election for your foreign subsidiary to be classified as a corporation gives the U.S. shareholder more flexibility on whether and when they want to receive a dividend from the foreign subsidiary. U.S. tax is only payable once the cash is distributed to the U.S. owner. 

Rate Differential

Suppose you decide to treat a foreign eligible entity as transparent. In that case, the U.S. owner is considered to be earning the entity’s income directly and, therefore, taxable at the U.S. owner’s marginal rate, which could be as high as 37%.

If you make an election to treat the foreign subsidiary as a corporation and separate entity, the tax rate would be 21% in the U.S. 

There are various tax planning opportunities available.

Use Of Foreign Losses

A US taxpayer may prefer a transparent entity initially to realize the current tax savings that foreign losses can provide.

Foreign Tax Credit Regime

This regime prevents U.S. taxpayers from paying U.S. tax on income that a foreign jurisdiction already has taxed. 

U.S. citizens and domestic corporations may credit income taxes paid to foreign countries (subject to limitations). Generally, a U.S. person may only claim a credit for the foreign income tax if they paid. 

However, Section. 902 allows domestic corporations to claim a credit for taxes paid by underlying foreign corporations as if the U.S. taxpayer paid these taxes directly. U.S. shareholders will then claim this deemed-paid credit in the same year the undistributed income is taxed. 

Can An LLC Check-The-Box?

Yes, an LLC can apply CTB regulations. Limited Liability Companies have the advantage of the flexibility and limited liability for their owners. However, from a tax and accounting perspective, it will take on the complexity of the box it checks. An LLC can therefore make a CTB election.

New Check-The-Box Rules Simplify Entity Classification

The new regulations simplify entity classification. These new rules divide business entities into three groups:

  • Those automatically classified as corporations – such as insurance companies, banking organizations, state-owned companies, and specific listed organizations formed outside of the U.S.
  • Those that may elect to be classified as partnerships or corporations – include all other business entities with at least two members.
  • Those that may elect to be classified as corporations or be disregarded for tax purposes – entities that may elect to be classified as corporations or be disregarded, include all business entities not in the group automatically classified as corporations with only a single owner.

Classifying Business Entities Under The Check-The-Box Regulations

If you already have a business, whether an LLC or Corporation, here are some ways to determine if it falls under CTB regulations.

Determining If a Separate Entity Exists

U.S. Federal tax laws are applied to determine whether a separate entity (S.E.). Local law will not be the determining factor. 

If a business entity, for example, has more than a single member, and if participants were to carry on a trade, financial operation, business, or venture, followed by dividing the resulting profits, an S.E. is considered to exist (even if one is or isn’t considered to exist under an applicable state law). A mere expense-sharing collaboration or mere co-ownership of an asset, however, does not create an S.E.

Automatic Classification as Corporation

Below are the following entities that are automatically classified as corporations:

    • A business entity is arranged under federal or state statute (or under the statute of a federally recognized Indian tribe) if that said statute should describe or refer to the entity as incorporated or a corporation, body corporate, or body politic. 
    • An association as determined under Regs. Sec. 301.7701-3, where an unincorporated entity that elects to be taxed as a corporation.
    • A business entity is arranged under a state statute if that same statute describes or refers to the entity as a joint-stock association or company.
    • A business entity is taxable as an insurance company.
    • A state-chartered business entity that is conducting banking activities, if any of its deposits are insured under the Federal Deposit Insurance Act. It is also amended or a similar federal statute.
    • A business entity that is completely owned by a state or political subdivision. Also, a business entity is completely owned by a foreign government.
    • Any business entity that can be taxable as a corporation under a provision of the Code other than Sec. 7701(a)(3). For example, include a publicly traded partnership, real estate investment trust, tax-exempt entity, or regulated investment company.
    • A foreign entity designated explicitly as a corporation (see Regs. Sec. 301.7701-2(b)(8) for a list).
    • A business entity with multiple charters and is treated as a corporation in any one of the jurisdictions.
Classifying unincorporated domestic single-owner entities

A newly formed domestic single-owner entity that cannot be automatically classified as a corporation — including a single-member limited liability company or an LLP is, by default, classified as a disregarded.

Classifying unincorporated domestic multi-owner entities

A newly formed domestic entity that has two or more owners, which is an eligible entity, is classified by default rules as a partnership.

The IRS ruled in Rev. Rul. 2004-77 that if an eligible entity has two members under local law. Still, suppose one of the members is a disregarded entity owned by the other member. In that case, the eligible entity cannot be classified as a partnership and be taxed as a disregarded entity or also elect to be taxed as a corporation.

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Beware Of Tax Consequences Of Classification Changes

Taxpayers need to understand the tax treatment when an entity’s classification changes. If that entity changes its classification from a corporation to a partnership or a disregarded entity, the resulting tax consequence of that transaction will often be treated as a taxable liquidation.

Although it may be straightforward to file Form 8832 to change the classification of an entity, the tax exposure can be significant and immense.  

What Does It Mean When an LLC Checks The Box?

The IRS provides the following summary regarding the default rule:

  • A Limited Liability Company is an entity created by state statute.
  • Depending on elections made by Limited liability companies and the quantity of members, an LLC will be treated by the IRS as either a corporation, partnership, or a piece of the owner’s tax return (as a “disregarded entity”).
  • A domestic LLC that has, at minimum, two members is classified as a partnership for federal income tax purposes. That would apply unless the members decide to file Form 8832 and elects to be treated as a corporation.
  • For income tax purposes, limited liability companies that have a singular member will be treated as an entity that isn’t separate from its owner unless it files Form 8832 and affirmatively elects to be treated as a corporation. However, an LLC that only has a singular member is still considered a separate entity for employment tax and certain excise taxes.
For any more information on Check-The-Box regulations, contact Asena Advisors.

 

Shaun Eastman

Peter Harper

How to Avoid the Net Investment Income Tax

Posted on by Peter Harper

How to Avoid the Net Investment Income Tax

Ever since the net investment income tax, or NIIT, was introduced by the IRS, taxpayers have tried to understand this tax and at the same time try to avoid it. What follows is an introduction of what this tax entails, how it is triggered, the types of income that are and are not included, how to calculate it and, strategies for how to avoid or minimize it. 

What Is The Net Investment Income Tax?

This is a tax that is not widely understood by many people, but is a very important concept to learn about, especially if a large part of one’s income is derived from investments. 

Simply put, the NIIT is a 3.8 percent tax that is applied on certain investment income. For the purposes of calculating net investment income (NII), the IRS looks at income derived from investments (before any applicable taxes are applied) such as bonds, stocks, mutual funds, annuities, and loans (minus properly allocable expenses). 

The other way to think about this tax is that it is a surtax imposed on certain unearned income. The tax equals 3.8 percent of the lesser of the taxpayer’s NIIT, or the excess of the taxpayer’s modified gross income (MAGI) over a certain threshold (discussed later in this article). 

The tax applies to estates, trusts, families and individuals. However, certain income thresholds need to be met before the tax takes effect. 

When Did The Net Investment Income Tax Take Effect?

As is the case with all taxes, the main purpose for including NIIT as part of the Health Care and Education Reconciliation Act, was to raise revenue. In this case, this surtax was used to help pay for the Affordable Care Act. The official name of this tax is actually “Unearned Income Medicare Contribution Tax,” which would logically imply that it is used to fund Medicare. However, this is not the case. The surtax is effective for tax years beginning after December 31, 2012.

What Triggers Net Investment Income Tax?

In the case of individual taxpayers, section 1411(a)(1) of the tax code imposes a tax (in addition to any other tax imposed by subtitle A) for each taxable year equal to a tax rate of 3.8 percent of the lesser of the individual’s NII for that tax year, or the excess (if any) of the individual’s MAGI for that tax year, over the threshold amount. We will discuss the calculations behind this tax, later in this article.

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What Counts As Net Investment Income?

Net Investment Income Includes:

For the purposes of calculating this tax, net investment income includes short and long-term capital gains (as well as gains from the sale of investment real estate, and gains from the sale of interests in partnerships and S corporations to the extent the partner or shareholder was a passive owner), taxable interest income, rental and royalty income, qualified and non-qualified dividends, passive income from investments, business income from trading financial instruments or commodities, and taxable portion of non-qualified annuity payments (for example, Roth IRAs). 

It Doesn’t Include:

In general, NII does not include wages, unemployment income, operating business income from a non-passive activity, Social Security Benefits, alimony, tax-exempt interest, self-employment income, municipal bonds, Alaska Permanent Fund Dividends and distributions from certain qualified plans (those described in sections 401(a), 403(a), 403(b), 408, 408A or 457(b) of the tax code), such as qualified annuities.

What Is Exempt From NIIT?

The NIIT does not apply to any portion of a gain that is excluded from regular income tax. Therefore, gains from sale of a principal residence are excluded from the NIIT unless the gain exceeds the principal residence exclusion amount of $250,000 (for a single filer) or $500,000 (if filing jointly with your spouse).

In addition, non-resident aliens (NRAs), who are individuals that are neither U.S. citizens nor U.S. residents, are not subject to this tax. The U.S. Treasury regulations state that in the case of a U.S. citizen or resident who is married to a non-resident alien individual, the spouses will be treated as married filing separately for purposes of section 1411. The U.S. citizen or resident spouse will be subject to the threshold amount for a married taxpayer filing a separate return, and the non-resident alien spouse will not be subject to the NIIT.

Who’s Subject To The Net Investment Income Tax?

All individuals who file tax returns, except NRAs, are subject to NIIT if they have NII and MAGI over the aforementioned taxable income thresholds. 

Trusts and estates that have undistributed NII and an AGI greater than the highest tax bracket applicable will be subject to this tax. 

Is Your MAGI Greater Than The Threshold?

For the purposes of meeting the threshold to be subject to this tax, the MAGI amounts are:

  • Married filing jointly — $250,000
  • Married filing separately — $125,000
  • Single or head of household — $200,000 or
  • Qualifying widow(er) with a child — $250,000

How To Calculate The NIIT?

The tax itself is computed on Form 8960 of one’s U.S. tax return. Individual filers report and pay the tax on Form 1040, while trusts and estates report and pay this tax on Form 1041. 

For purposes of calculating NII, modified adjusted gross income is a household’s AGI, with certain deductions and tax-exempt interest payments, such as contributions from individual retirement accounts (IRAs), included again. The relevant deductions for purposes of AGI are listed on Schedules 1, 2, and 3 of Form 1040. If your MAGI is higher than the thresholds for your filing status, you will need to pay NIIT.

The next step is to calculate your NII based on the included income stated above. Before you can calculate your NII, however, you first need to ascertain what your gross investment income is. This is the amount prior to considering any eligible deductions (which are discussed later in this article). 

Once you arrive at the gross investment income, it will be reduced by deductions allowed against the income tax which are properly allocable to those items of gross income or net gain to arrive at the NII. 

Finally, the amount that will be subject to NIIT at a rate of 3.8 percent will therefore vary as follows: 

  • If your NII is higher than the amount by which MAGI surpasses the threshold, the tax applies to your MAGI
  • If your NII is lower than the amount by which MAGI surpasses the threshold, the tax applies to your NII

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Will I Have To Pay Both The 3.8% Net Investment Income Tax And The Additional .9% Medicare Tax?

You may be subject to both taxes, but not on the same type of income, as these two taxes apply to different types of income. The 0.9 percent additional Medicare tax applies to individuals’ wages, compensation, and self-employment income over certain thresholds, but it does not apply to income items included in NII.

Can Tax Credits Reduce My NIIT Liability?

Indeed, any tax credit that is allowed to offset a tax liability imposed by subtitle A of the tax code may be used to offset the NII. However, if the tax credit is only allowed to be offset against tax imposed by Chapter 1 of the tax code, such as regular income tax, that credit may not reduce the NIIT. For instance, foreign tax credits may not be used to reduce NIIT exposure in the U.S., as they are only allowed to offset a tax liability on regular income tax. Further, foreign tax credits are only allowed against taxes imposed by IRC Chapter 1. 

Strategies To Avoid Or Reduce The Tax

There are various strategies and planning opportunities to either reduce your NII or reduce your MAGI, which will result in reduced taxable income. No blanket strategy or planning tool exists, and due to the complex nature of the NIIT, it is advisable to consult professionals such as your tax advisor or CPA on possible mitigation. The IRS will not be lenient if these regulations are willfully avoided. This is why it is so important to get advice from a tax advisor who has experience dealing with these sorts of matters.

Tips For Managing Your Investments

As stated previously, no blanket strategy or planning tool exists, due to the complex nature of this tax. However, if you do have investment income and if you think you will be subject to this tax, there may be deductions available for you to take advantage of.

Some examples of deductions which may be properly allocable to gross investment income include brokerage fees, investment advisory fees, tax preparation fees, fiduciary expenses (which only apply to estates and trusts), interest expense, investment advisory fees, expenses incurred in relation to royalty and rental income, and state and local income taxes. 

If the deductions are not properly allocable to gross investment income, then they will not be allowed. For instance, brokerage fees that are not properly allocable will not be allowed as a deduction. The instructions to Form 8960 provide examples of deductions that are not deductible for NII purposes; for example, deductions for contributions to IRAs or other qualified plans. 

Additionally, special rules apply for traders of financial instruments and commodities regarding the deduction of expenses in relation to self-employment income.

 

If you have further questions or want to begin the process, reach out to one of our Asena consultants.

Arin Vahanian

Peter Harper

US-AU DTA: Article 18 – Pensions, Annuities, Alimony and Child Support

Posted on by Peter Harper

Background

The background of this week’s blog is a bit different from the previous ones due to the unique nature of the topic. This week we will be looking at Article 18 of the DTA – Pensions, Annuities, Alimony, and Child Support, which affects a much broader demographic than other articles. The background focuses more on the global economy and financial markets, but there is a reason for this.

Most people start saving for their retirement when they earn their first salary. Contributions are made monthly (either by yourself or on your behalf) towards a Pension Fund (IRA, 401k, super, etc.) and are invested in various classes of assets. We diversify investments to reduce risk and maximize continuous growth, and it gives people a sense of comfort and security to invest in their future via a Pension Fund. 

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In recent months, the world has contended with the emergence of the Omicron variant, central bank policy tightening, and persistent inflation. And most recently, Russia’s invasion of Ukraine has ignited a geopolitical crisis that is shaking global financial markets to their core.

As tensions continue to mount in Eastern Europe, the concern about what is to come has led to some people impulsively cashing out their retirement portfolios or reviewing them. 

I’ve always been a great admirer of Warren Buffet and his quotes on investments. 

So just to lay the foundation for this week’s blog, I thought I would share two relevant quotes about the current economic climate.

“The most important quality for an investor is temperament, not intellect.” 

“Uncertainty actually is the friend of the buyer of long-term values.”

Humans are, by nature, irrational beings and are often tempted to make trades when they think the market is working against them, whereas in contrast, it is the well-tempered investor that learns not to watch the market. This person ultimately ends up reaping the most rewards over the long term. 

Their investment philosophy is that you don’t need to have an extremely high I.Q. to build more wealth, but rather that you should be more disciplined with your reaction toward the market’s irrationality. 

Now to link the background with the rest of the blog to follow, if you are a U.S. resident with an Australian pension or vice versa, prior to considering whether to cash out your pension or not, make sure you take a step back and instead make sure you understand the potential adverse tax implications of having an international pension fund. 

Introduction

The purpose of the Australian treaty is to prevent double taxation and fiscal evasion.

Because the U.S. does not tax contributions or accumulated earnings, and Australia does not tax the distribution of benefits, a U.S. resident could perceivably relocate from the U.S. to Australia and never pay income tax on contributions, accumulated earnings, or the payment of pension benefits that accrued while the employee worked in the U.S. To prevent this issue, the two countries formed a double taxation agreement.

Interpreting Article 18 of The DTA – Pensions, Annuities, Alimony, and Child Support

Article 18 addresses the taxation of cross-border pensions and annuities. Subject to Article 19, pensions and other similar remuneration paid to an individual who is a resident of one Contracting State in connection with past employment shall be taxable only in that State. 

Article 18(4) 

defines the term’ pensions and other similar remuneration, as used in this Article, to mean ‘periodic payments made by reason of retirement or death, in consideration for services rendered, or by way of compensation paid after retirement for injuries received in connection with past employment.’ 

Article 18(5) 

defines the term ‘annuities,’ as used in this Article, to mean ‘stated sums paid periodically at stated times during life, or during a specified or ascertainable number of years, under an obligation to make the payments in return for adequate and full consideration (other than services rendered or to be rendered).’ 

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Article 18 is critical to any U.S. person who is a beneficiary of an Australian Superannuation Fund for the following reasons:

  • The U.S. has taxing authority over vested Australian superannuation benefits pursuant to Article 18 of the DTA; and
  • In the absence of a specific Article dealing with contributions and the annual income derived by pension schemes (as exist in the U.K. treaty), the U.S. retains the right under Article 1 of the DTA to tax contributions and accumulated earnings under its domestic tax laws.

In terms of the IRC, most foreign retirement plans are not considered “qualified plans” under Section 401(a), which means the plans generally do not qualify for tax-deferral treatment. 

For a pension plan to be tax-exempt, the plan must satisfy the requirements contained in § 401 Internal Revenue Code 1986 (IRC). Section 401(a) IRC specifically provides that, for a pension plan to be a “qualified plan” (and therefore exempt from tax under § 501 IRC), it must be organized in the U.S. Accordingly, this means that no Australian superannuation plan (whether retail or self-managed) can be a “qualified plan.” (Read our Whitepaper on Taxation of Foreign Pensions for more details)

There are essentially three phases of U.S. tax treatment that need to be looked at when dealing with the taxation of an Australian superannuation plan. I will provide a brief summary of the three phases for this blog, but please review our Whitepaper for more information.

Phase 1 – Contributions 

Suppose contributions are made to an Australian superannuation fund after an Australian citizen becomes a U.S. person (or a U.S. citizen becomes an Australian resident). In that case, the contributions will be taxable in the U.S. under § 402(b)(1) IRC. 

Phase 2 – Earnings Derived Within A Superannuation Plan After An Australian Citizen Becomes A U.S. Person

Subchapter J contains the general rules concerning estates, trusts, beneficiaries and decedents, specifically the grantor trust rules. While it is critical that an individual assessment of the circumstances of every taxpayer be undertaken, most superannuation plans (or portions thereof) in Australia could be classified as grantor trusts for U.S. tax purposes. 

Phase 3 – Distribution of benefits 

In our opinion, there are two possible ways in which accrued Australian superannuation benefits (contributions and earnings) may be taxed in the U.S.

The first is that Australian superannuation benefits of a U.S. person will be taxable upon such a person attaining 60 years of age (the Australian retirement age). The taxpayer will first be liable for tax in Australia, but receive foreign tax credits in the U.S. (creditable only against U.S. federal income tax) for the Australian tax paid (which will be nil if the account is in the benefits phase). In the event of any shortfall, they will pay further federal, state, and city income tax (where applicable).

The second view (the alternate view) concerns highly compensated employees (HCE) and the application of § 402(b)(4) IRC. If an employee is a highly compensated U.S. person who is also a member of a foreign pension plan (i.e., an Australian superannuation plan), technically, on a literal reading of § 410(b)(3)(C) IRC, there is a high likelihood that the foreign pension plan will fail the minimum coverage tests because contributions made in favor of non-resident aliens with no US-source income are not included for the purposes of determining whether the coverage tests have been satisfied.

Conclusion

Both Australia and the U.S. recognize the need for their citizens to be able to self-fund their retirement and the importance of having a globally mobile workforce. This is evident when looking at the concessional tax treatment for individuals who maximize superannuation and pension contributions, and the current impact government-supported pension plans have on federal and state budgets.

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The inadequacies in the DTA arise because it approaches Australian superannuation and U.S. pensions as though they are only taxed at one point, which is on distribution.

Unfortunately, unless Article 18 is amended, the adverse tax implications of U.S. migration on a taxpayer’s superannuation benefits may become a determining factor in whether an executive migrates between Australia and the U.S.

So, the current global economic turmoil might be the perfect opportunity to focus on reviewing the tax exposure of your pension fund instead of considering cashing it out.

 

Our team of International Tax specialists at Asena Advisors will be able to assist you with these complex tax rules that could apply to your pension fund. In times of adversity, you need proper guidance to your specific needs, and our Multi-Family Office will help you find opportunities in uncertain times. 

Shaun Eastman

Peter Harper

US-AU DTA: Article 17 – Entertainers

Posted on by Peter Harper


INTRODUCTION

In this week’s blog we will be discussing Article 17 of the US/Australia DTA which relates to entertainers and how they are taxed from an international perspective. 

In general, Article 17, provides that if a resident of one country derives income in the other country as an entertainer or sports person, some of the income earned may be protected from tax in that other country, but usually not to the same degree as other individuals who are not entertainers or sports person.

What distinguishes entertainers and sportspersons from other individuals who receive income from employment is that by the nature of their work, some entertainers and sportspersons may have the opportunity to earn a large amount of income in a very short period of time.

INTERPRETING ARTICLE 17 OF THE DTA – ENTERTAINERS

Article 17 states that income derived by visiting entertainers and sportspersons from their personal activities as such will be taxed in the country in which the activities are exercised, irrespective of the duration of the visit. 

However, where the gross receipts derived by the entertainer from those activities, including expenses reimbursed to the entertainer or borne on the entertainer’s behalf, do not exceed $10,000 or its equivalent in Australian dollars in the year of income, the income will be subject to tax in accordance with Article 14 or Article 15, which deals with independent or dependent personal services, as the case may be.

It should be noted that income derived by producers, directors, technicians and others who are not artists or athletes is taxable in accordance with Article 14 or 15, accordingly. The commentary to the OECD Model Convention indicates that the word “entertainer” extends to activities which involve a political, social, religious or charitable nature, provided entertainment is present. 

It does however not extend to a visiting conference speaker or to administrative or support staff. The commentary acknowledges that there may be some uncertainty about whether some persons are entertainers or not, in which case it will be necessary to consider the person’s overall activities.

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Article 17(2) is a safeguarding provision to ensure that income in respect of personal activities exercised by an entertainer, whether received by the entertainer or by another person, is taxed in the country in which the entertainer performs. This is irrespective of whether or not that other person has a “permanent establishment” or “fixed base” in that country. 

If it is however established that neither the entertainer nor any person related to him/her participates in any profits of that other person in any manner, the relevant income accruing to that other person shall be taxed in accordance with the provisions of Article 7, 14 or 15, dealing respectively with business profits and income from independent or dependent services, as the case may be.

A legislative instrument has removed the PAYG withholding requirement in relation to entertainers and sportspersons who are US residents when working in Australia. This only applies where the payments relate to entertainment or sports activities carried on in Australia and where the combined payments do not exceed $10,000 or its equivalent in Australian dollars in the year of income.. 

This legislative instrument applies from 3 April 2014 until 1 October 2024.

A US entertainer who fulfils the contractual obligations of a US employer by performing in Australia, for a salary paid by the employer, is considered to derive “income from personal activities”, within Article 17 of the US/Aus DTA. This is irrespective of the fact whether or not the entertainer is at arm’s length from the US employer. Where the entertainer is paid an annual salary, an apportionment will be necessary to determine the amount applicable to the period of time spent in Australia.

Where the contract for the personal services of a US entertainer in Australia is made between a US resident and an Australian resident, and Article 17(2) of the DTA applies, both the US resident and the entertainer may be taxable in Australia. 

The US resident will be liable to tax under Article 17(2) on the taxable income derived by it, and the entertainer may be taxed under Article 17(1) on remuneration derived from the US resident in respect of the personal activities in Australia.

CONCLUSION 

For any person interested in tax planning, Article 17 could be a good motivator to start exercising to ensure this Article applies to you. However, that is easier said than done. 

Our team of International Tax specialists at Asena Advisors, will be able to assist you with your international tax planning needs to ensure that Article 17 is adhered to by entertainers. Lastly, we will never say no to an autograph.

Our team of International Tax specialists at Asena Advisors, will be able to assist you with submitting the relevant forms in the US and Australia to get access to these relief measures.  

Shaun Eastman

Peter Harper

US-AU DTA: Article 16 – Limitation of Benefits

Posted on by Peter Harper


INTRODUCTION

In this week’s blog we will be discussing the technical Limitation of Benefits (LoB) Article (Article 16) of the US/Australia DTA.

Article 16 states that, in addition to being a resident of the US or Australia, taxpayers need to satisfy the requirements of Article 16 to obtain the benefits of the DTA. 

In particular, the benefits of the DTA are only available if the resident is:

  1. A qualified person (Article 16(2));
  2. Actively engaged in a trade or business (Article 16(3)); or
  3. Entitled to treaty relief because the IRS or ATO makes a determination (Article 16(5)).

The purpose of these restrictions is to prevent residents of third countries from using interposed companies or other entities resident in either Australia or the US to access treaty benefits, also commonly referred to as treaty shopping. 

Treaty shopping is the use by residents of third countries of legal entities established in either the US or Australia with a principal purpose of obtaining the benefits of the US/Australia DTA. 

INTERPRETING ARTICLE 16 OF THE DTA – LIMITATION OF BENEFITS

Article 16(1) stipulates that except as otherwise provided in Article 16 only residents of the US or Australia for the purposes of the DTA that are qualified persons are entitled to the benefits otherwise available under the DTA. 

The benefits otherwise available under the DTA to residents are all limitations on source-based taxation under Article 6 through 15 and Article 17 through 21, the treaty-based relief from double taxation provided by Article 22 (Relief from Double Taxation), and the protection afforded to residents of a Contracting State under Article 23 (Non-discrimination). 

The limitation in Article 16 does however not apply where a person is not required to be a resident in order to enjoy the benefits of the DTA. For example, Article 26 (Diplomatic and Consular Privileges) applies to diplomatic and consular privileges regardless of residence.

Article 16(2) lists the eight categories of resident that will constitute a qualified person for a taxable year and thus will be entitled to all benefits of the DTA provided that they otherwise satisfy the requirements for a particular benefit. It is therefore important to note that the tests must be satisfied for each year that benefits under the DTA are sought.

Article 16(2)(a) – Individuals 

Article 16(2)(a) states that individual residents of a Contracting State will be a qualified person and hence entitled to rely on the DTA. 

However, the definition of US resident in Article 4(1)(b)(ii) excludes citizens who are also a resident of another country with which Australia has a DTA.  In addition, an individual that receives income as a nominee on behalf of a third country resident, may be denied the benefits of the DTA due to the beneficial ownership requirement in Article 10 for example, despite meeting the requirement in Article 16(2)(a).

Article 16(2)(b) – Governmental bodies

Article 16(2)(b) states that the Contracting State, any political subdivision or local authority of the state, or any agency or instrumentality of the state will be a qualified person and hence entitled to rely on the DTA. 

Article 16(2)(c)(i) – Publicly traded companies

Article 16(2)(c)(i) states that a resident company will be a qualified person in the following circumstances:

  • Its principal class of shares is listed on a US or Australian stock exchange; and
  • Those shares are regularly traded on one or more recognized stock exchanges.

Article 16(2)(c)(ii) – Subsidiary companies

Article 16(2)(c)(ii) states that a resident company will be a qualified person if:

  • At least 50% of the aggregate vote and value of its shares are owned directly or indirectly by five or fewer companies that are qualified persons due to Article 16(2)(c)(i); and
  • In the case of indirect ownership, each intermediate shareholder is a resident of either the US or Australia.

Article 16(2)(d) – Other listed entities

Article 16(2)(d) states that certain publicly traded entities (other than companies) and entities beneficially owned by certain publicly traded entities or companies may be qualified persons and hence entitled to rely on the DTA. 

Article 16(2)(d)(i) – Publicly traded entities

 Article 16(2)(d)(i) states that a resident entity that is not an individual or a company is a qualified person if:

  • The principal class of units is listed or admitted to dealings on US or Australian stock exchange; and
  • These units are regularly traded on one or more recognized stock exchanges.

Article 16(2)(d)(ii) – Other Entities

Article 16(2)(d)(ii) states that a resident entity that is not an individual or a company will be a qualified person if at least 50% of the beneficial interests in the entity are owned directly or indirectly by five or fewer companies that are a qualified person due to Article 16(2)(c)(i) or publicly owned entities that satisfy the requirements of Article 16(2)(d)(i).

Article 16(2)(e) – Tax exempt organizations

Article 16(2)(e) states that a resident religious, charitable, educational, scientific or other similar organizations is a qualified person if:

  • It is organized under the laws of the US or Australia; and
  • Was exclusively established and maintained for a religious, charitable, educational, scientific or other similar purpose.

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Article 16(2)(f) – Pension funds

Article 16(2)(f) states that a pension fund is a qualified person if:

  • It is organized under the laws of either the US or Australia;
  • Established and maintained to provide pensions or similar benefits to employed or self-employed persons pursuant to a plan; and
  • More than 50% of the beneficiaries, members or participants are individuals resident in either the US or Australia.

Article 16(2)(g) – Unlisted entities

Article 16(2)(g) states that a person other than an individual that is a resident of either the US or Australia is a qualified person and hence entitled to rely on the DTA if both an ownership and base erosion test are satisfied. 

However, one or more of the following categories of qualified persons must principally own the unlisted entity directly or indirectly:

  • Individuals who are residents in the US or Australia (Article 16(2)(a));
  • Government bodies of the US or Australia (Article 16(2)(b); and
  • Entities resident in either the US or Australia that satisfy public listing and trading requirements in Article 16(2)(c)(i) and Article 16(2)(d)(i)).

Ownership test — companies

Article 16(2)(g)(i) requires that 50% or more of the aggregate voting power and value of the company must be owned directly or indirectly on at least half the days of the company’s taxable year by certain qualified persons.

Ownership test — trusts/partnerships

Article 16(2)(g)(i) requires that 50% or more of the beneficial interests of entities other than companies must be owned directly or indirectly on at least half the days of the entity’s taxable year by certain qualified persons.

Base erosion test

Article 16(2)(g)(ii) disqualifies a person that satisfies the requirement in Article 16(2)(g)(i) if 50% or more of the unlisted entity’s gross income for the taxable year is paid or accrued (directly or indirectly) to a person or persons who are not residents of either Contracting State in the form of payments deductible for tax purposes in the payer’s state of residence. 

Article 16(2)(h) – Headquarters companies

Article 16(2)(h) states that a resident of the US or Australia that is a recognized headquarters company (RHC) for a multinational corporate group (MCG) is a qualified person and hence entitled to rely on the DTA.

A RHC is a US or Australian resident company where:

  • It has a substantial involvement in the supervision and administration of companies forming the MCG.
  • The MCG being supervised is engaged in an active business in at least five countries and each company generates at least 10% of the gross income of the MCG. 
  • The gross income from any single country where a MCG member carries on business activities must be less than 50% of the gross income of the MCG.
  • No more than 25% of the gross income of the RHC can be derived from the other Contracting State.
  • The supervision and administrative activities for the MCG are carried out by the RHC independently of any other person.
  • Generally applicable taxation rules apply in its country of residence.
  • Income derived in the other Contracting State is attributable to the active business activities carried on by MCG members in that state.

Article 16(2)(h)(i) – Supervision and Administration

Article 16(2)(h)(i) requires that to be a RHC, the company must provide in its state of residence a substantial portion of the overall supervision and administration of the MCG. 

Article 16(2)(h)(ii) – Active business

Article 16(2)(h)(ii) requires that the MCG supervised by the headquarters company must consist of corporations that are residents in, and engaged in active trades or businesses in, at least five countries. In addition the business activities carried on in each of the five countries (or groupings of countries) must generate at least 10% of the gross income of the MCG

Article 16(2)(h)(iii) – Single country income limitation

Article 16(2)(h)(iii) requires that the business activities carried on in any one country other than the headquarters company’s state of residence must generate less than 50% of the gross income of the MCG. If the gross income requirement under this clause is not met for a taxable year, the taxpayer may satisfy this requirement by averaging the ratios for the four years preceding the taxable year.

Article 16(2)(h)(iv) – Gross income limitation

Article 16(2)(h)(iv) requires that no more than 25% of the headquarters company’s gross income may be derived from the other Contracting State. 

Article 16(2)(h)(v) – Independent supervision of MCG

Article 16(2)(h)(v) requires that the headquarters company have and exercise independent discretionary authority to carry out the supervision and administration functions for the MCG. 

Article 16(2)(h)(vi) – Taxation rules

Article 16(2)(h)(vi) requires that the headquarters company be subject to the generally applicable income taxation rules in its country of residence.

Article 16(2)(h)(vii) – Income derived from the other Contracting State

Article 16(2)(h)(vii) requires that the income derived in the other Contracting State be derived in connection with or be incidental to the active business activities referred to in Article 16(2)(h)(ii).

Article 16(3) states that a resident of a Contracting State that is not a qualified person under Article 16(2) is a qualified person for certain items of income that are connected to an active trade or business conducted in the other Contracting State.

In broad terms, the benefits of the DTA will be available if the person resident in the US or Australia:

  • Is engaged in the active conduct of a trade or business in their state of residence;
  • The income derived in the other Contracting State is derived in connection with or incidental to the trade or business conducted in their state of residence; and
  • The trade or business activity in the person’s state of residence is substantial in relation to the activity in the state of source of an item of income.

Article 16(3)(a) firstly requires that a resident of the US or Australia must be engaged in the active conduct of a trade or business in their state of residence. However, a business of making or managing investments for the resident’s own personal account is not regarded as an active trade or business unless these activities are banking, insurance or securities activities carried on by a bank, insurance company or a registered, licensed or authorised securities dealer. 

Secondly, the income derived in the other Contracting State must be derived in connection with or incidental to the trade or business conducted in the state of residence.

Article 16(3)(b) states that where a person or an associate carries on a trade or business in the other Contracting State which gives to an item of income the trade or business carried on in the state of residence must be substantial in relation to the activity in the state of source of the income. 

The substantiality requirement is intended to prevent a narrow case of treaty shopping abuses in which a company attempts to qualify for benefits by engaging in de minimis connected business activities in the treaty country in which it is resident. 

The substantiality requirement only applies to income from related parties. 

Article 16(3)(c) states that where a person is engaged in the active conduct of a trade of business then the following will be deemed to be part of that activity:

  • Partnership activities provided the person is a partner, and
  • Activities of connected persons.

There are three circumstances in which a person will be connected to another person are, firstly, if either person possesses at least 50% of the:

  • Beneficial interest of the other;
  • Aggregate vote and value of a company’s shares; or
  • Beneficial equity interests of the company.

Secondly, if another person possesses directly or indirectly, at least 50% of the:

  • Beneficial interest;
  • Aggregate vote and value of a company’s shares; or
  • Beneficial equity interest in the company in each person.

Thirdly, a person is connected to another person if the relevant facts and circumstances indicate that:

  • One has control of the other; or
  • Both are under the control of the same person or persons.

The above rule is of particular importance to holding companies since they will generally not be able to satisfy Article 16(3)(a) due to the fact that they are managing investments for their own account.

Article 16(4) is an anti-avoidance provision and denies the benefits of the DTA where a company has issued shares that entitle the holders to a portion of the income from the other state that is larger than the portion of such income that holders would otherwise receive.

Article 16(5) states that the competent authorities of the US and Australia can grant the benefits of the DTA to a resident of the relevant Contracting State if they are not a qualified person in accordance with Article 16(2). However, to exercise this discretion the IRS or ATO has to determine that the establishment, acquisition or maintenance of such a person and the conduct of its operations did not have the principal purpose of obtaining the benefits of the DTA.

Article 16(6) defines the term “recognized stock exchange” as:

  1. The NASDAQ System owned by the National Association of Securities Dealers and any stock exchange registered with the Securities and Exchange Commission as a national securities exchange for purposes of the Securities Exchange Act of 1934
  2. The Australian Stock Exchange and any other Australian stock exchange recognized as such under Australian law, and
  3. Any other stock exchange agreed upon by the competent authorities of the Contracting States.

Article 16(7) lastly states that nothing in Article 16 restricts, in any manner, the ability of the Contracting States to enact and enforce the anti-avoidance provisions in their domestic tax laws.

CONCLUSION 

The Limitation on benefits clause is drafted with the intention of avoiding treaty shopping.

When planning an international structure it is therefore crucial to ensure compliance with Article 16. Failure to plan properly could result in a loss of valuable benefits and can render the structure ineffective. 

To achieve optimal results, immediate business concerns of the client should be carefully balanced with the long-term goals to ensure the establishment of activities in the most favorable environment. 

Our team of International Tax specialists at Asena Advisors, will be able to assist you with your international tax planning and ensure that Article 16 is adhered to.

Our team of International Tax specialists at Asena Advisors, will be able to assist you with submitting the relevant forms in the US and Australia to get access to these relief measures.  

Shaun Eastman

Peter Harper

US-AU DTA: Article 15 – Dependent Personal Services

Posted on by Peter Harper

INTRODUCTION

In this week’s blog we will be discussing the tax implication of rendering dependent personal services as stipulated in Article 15 of the US/Australia DTA. 

The main purpose of Article 15 is to ensure that income derived by an individual who is a resident of the US or Australia as an employee or director in the other country is taxed appropriately.

In terms of Article 15 the source state will have taxing rights on such income if the individual is present in that state for a certain period of time. 

INTERPRETING ARTICLE 15 OF THE DTA – DEPENDENT PERSONAL SERVICES

Article 15(1) sets out the basis upon which the remuneration derived by employees and directors should be taxed. Pensions, annuities, and remuneration of government employees are covered by Article 18 and 19 of the DTA and therefore not covered in terms of Article 15.

Generally, other salaries, wages, directors’ fees, etc derived by a resident of one country from an employment exercise or services performed as a director of a company in the other country will be taxed in that other country. 

Article 15(2) includes an exemption from tax in the country being visited where the visits are only for a limited period. The conditions for exemption are:

  1. That the visit or visits not exceed, in the aggregate, 183 days in the year of income of the country visited;
  2. That the remuneration is paid by, or on behalf of, an employer or company who is not a resident of the country being visited, and
  3. That the remuneration is not deductible in determining taxable profits of a permanent establishment, fixed base or a trade or business which the employer or company has in the country being visited.

Where these conditions are met, the remuneration derived in the source state will be taxed only in the country of residence.

Article 15(3) stipulates that income derived from employment aboard a ship or aircraft operated in international traffic is to be taxed in the country of residence of the operator. The US Treasury however explained that under US law, the US taxes such income of a non-resident alien only to the extent it is derived from US sources (i.e. in US territorial waters). This paragraph does not confer an exclusive taxing right. 

Article 15(3) does not confer an exclusive taxing right and both countries retain the right to tax their residents and citizens under Art 1(3) of the DTA (Personal scope).

Remuneration derived by US residents from employment in Australia may in terms of Article 15 of the DTA, be taxable in the US rather than Australia if the remuneration is paid in respect of a visit not exceeding 183 days in the year by an employer who is not resident in Australia and has no permanent establishment in Australia.

Asena Advisors is the only multi-disciplinary (Accounting and Legal) international CPA firm in the United States that specializes in U.S. -Australia taxation.
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COVID RELIEF

Both the US and Australia implemented certain relief measures for individuals who inadvertently spent more than 183 days in the source due to the Covid pandemic. 

US Covid Relief Measures

Days that you were unable to leave the US either because of a medical condition that arose while were in the US or where you were unable to leave the US due to COVID-19 travel disruptions, you may be eligible to exclude up to 60 consecutive days in the US during a certain period.

Australia Covid Relief Measures

The ATO recognized that the Covid pandemic has created a special set of circumstances that need to be taken into account when evaluating the source of the employment income earned by a foreign resident who usually works overseas but instead performed that same foreign employment in Australia. If the remote working arrangement is short term (3 months or less), the income from that employment will not have an Australian source. However, for working arrangements longer than 3 months, an individual’s personal circumstances need to be examined to ascertain if the employment is connected to Australia. Employment income (ie salary or wages) is likely to be determined as having an Australian source if:

    • The terms and conditions of the employment contract change;
    • The nature of the job changes;
    • Work is performed for an Australian entity affiliated with the overseas employer;
    • The economic impact or result of the work shifts to Australia;
    • The employing entity is in Australia;
    • Work is performed with Australian clients;
    • The performance of the work depends on the individual being physically present in Australia to complete it;
    • Australia becomes the individual’s permanent place of work;
    • The individual’s intention towards Australia changes.

Income earned from paid leave (such as annual or holiday leave) while in Australia temporarily does not need to be declared in Australia. 

CONCLUSION 

Individuals should therefore make sure that they do not unnecessarily file tax returns in the source state if their stay was extended due to Covid related measures.  

Our team of International Tax specialists at Asena Advisors, will be able to assist you with submitting the relevant forms in the US and Australia to get access to these relief measures.  

Shaun Eastman

Peter Harper

US-AU DTA: Article 14 – Independent Personal Services

Posted on by Peter Harper

INTRODUCTION

In this week’s blog we will be discussing the tax implication of rendering Independent Personal Services as stipulated in Article 14 of the US/Australia DTA. Article 14 is luckily far less complex than our previous blogs. 

The main purpose of Article 14 is to ensure that income derived by an individual who is a resident of the US or Australia from the performance of personal services in an independent capacity in the other country is taxed appropriately.

INTERPRETING ARTICLE 14 OF THE DTA – INDEPENDENT PERSONAL SERVICES

In terms of US domestic legislation, income earned by a non-resident individual for personal services rendered in the US which are of an independent nature is taxed at a flat rate of 30%.

Income derived by an individual who is a resident of either the US or Australia for rendering independent personal services in the other country will be taxed in that other country in which the services are performed if:

Article 14(a) – the recipient is present in that country for a period or periods aggregating more than 183 days in the year of income (or taxable year) of the country visited, or

Article 14(b) – that person has a ‘fixed base’ regularly available in that country for the purpose of performing their activities, and the income is attributable to activities exercised from that base.

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Only the country of residence can tax this income if neither of the 2 tests above are met. The US Treasury Department noted that its understanding of the term fixed base is similar to the term permanent establishment.

Independent personal services include all personal services performed by an individual for their own account which includes any services performed as a partner in a partnership. This however does not include services performed as a director of a company which will be covered by Article 15 of the DTA – Dependent personal services.

Lastly, it is important to note that these personal services include all independent activities and are not limited to specific professions. 

CONCLUSION 

The interpretation by courts of Article 14 post COVID will be quite interesting as the way we conduct business has shifted significantly and could perhaps see an amendment to this article in the new future. 

Our team of International Tax specialists at Asena Advisors, will be able to guide you on how to interpret and apply Article 14 to your specific circumstances.

Shaun Eastman

Peter Harper

US-AU DTA: Article 13 – Alienation of Property

Posted on by Peter Harper

INTRODUCTION

When it comes to the alienation of property, it is usually standard practice to give the taxing rights to the state which, under the DTA, is entitled to tax both the property and income derived from it. 

Article 13 provides rules for the taxation of certain gains derived by a resident of a Contracting State. In general, the Article makes provision for the following: 

  1. gains from the alienation of real property may be taxed where the real property is located;
  2. gains derived from the alienation of ships or aircraft or related property may be taxed only by the State of which the enterprise is a resident, except to the extent that the enterprise has been allowed depreciation of the property in computing taxable income in the other State; and
  3. gains from the alienation of property referred to in paragraph 4 (c) of Article 12 (Royalties) are taxable under Article 12. 

Gains with respect to any other property are covered by Article 21 (Income Not Expressly Mentioned), which provides that gains effectively connected with a permanent establishment are taxable where the permanent establishment is located, in accordance with Article 7 (Business Profits), and that other gains may be taxed by both the State of source of the gain and the State of residence of the owner. Double taxation is avoided under the provisions of Article 22 (Relief from Double Taxation).

INTERPRETING ARTICLE 13 OF THE DTA – ALIENATION OF PROPERTY 

Article 13(1) states that income or gains derived by a resident of one country from the alienation of real property in the other country may be taxed in that other country.

For example, if a US resident derived income or gains from the disposal of real property located in Australia, that income or gain may be taxed in Australia.

The meaning of the phrase ‘income or gains’ was clarified by the Protocol. Article 2(1)(b) (Taxes Covered) was amended to include a specific reference to Australian capital gains tax to ensure that capital gains are within the scope of the DTA. 

Article 13(2) defines the term ‘real property’.

For purposes of the US, Article 13(2)(a) provides that the term ‘real property situated in the other Contracting State’ includes a ‘United States real property interest and real property referred to in Article 6 which is situated in the United States’. 

Accordingly, the US retains its full taxing rights under its domestic law.

For purposes of Australia Art 13(2)(b) provides that real property includes the following:

  1. real property referred to in Article 6;
  2. shares or comparable interests in a company, the assets of which consist of wholly or principally of real property situated in Australia, and
  3. an interest in a partnership, trust or estate of a deceased individual, the assets of which consist wholly or principally of real property situated in Australia.

Article 6 includes within the definition of real property a leasehold interest in land and rights to exploit or to explore for natural resources.

Shares or comparable interests in a company, the assets of which consist wholly or principally of real property, and an interest in a partnership, trust or deceased estate are also deemed to be real property in terms of Article 13(2)(b)(ii) and 13(2)(b)(iii).

Article 13(3) states that income or gains arising from the alienation of property (other than real property covered by Article 13(1)) forming part of the business assets of a permanent establishment of an enterprise or pertaining to a fixed base used for performing independent personal services may be taxed in that other state. 

This article also applies where the permanent establishment itself (alone or with the whole enterprise) or the fixed base is alienated and corresponds to the rules for the taxation of business profits and income from independent services in Article 7 and Article 14 respectively. 

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Article 13(4) makes provision for exclusive taxing rights of income and capital gains by the residence country from the alienation of ships, aircraft or containers operated or used in international traffic. It is also important to note, that this applies even if the income is attributable to a permanent establishment maintained by the enterprise in the other Contracting State.

Article 13(5) applies to the taxation of deemed disposals when ceasing your tax residency in a contracting state. This is also referred to as an exit tax. This article states that where an individual, has a deemed disposal event in their residence state due to ceasing residency, they can elect to be treated for the purposes of the taxation laws of the other state as having alienated and re -acquired the property for an amount equal to its fair market value at that time.

This rule has two significant consequences –

  • Firstly, if the individual is subject to tax in the other Contracting State on the gain from the deemed sale of the asset a foreign tax credit for tax on the deemed sale will be available pursuant to Article 22.
  • Secondly, the deemed sale and repurchase will result in the individual resident in the other Contracting State having a “stepped up” cost base equal to the fair market value of the property.

Article 13(6) states that where a resident of one state elects to defer taxation on income or gains relating to property that would otherwise be taxed in that state (upon ceasing to be a resident) only the state where they subsequently become a resident can tax the deferred gain. 

Article 13(7) makes provision for any other capital gains not covered by Article 13. These capital gains are to be taxed in accordance with the domestic laws of each country.

Article 13(8) lastly clarifies the taxation of real property which consists of shares in a company or interests in a partnership, estate or trust as referred to in Article 13(2)(b) is deemed to be situated in Australia.

CONCLUSION 

There have been numerous disputes regarding the application of this Article and reference to case law is extremely important. Especially in relation to limited partnerships and or indirect ownership through a chain of companies of Australian real property.

Make sure you understand how Article 13 can impact your potential liquidity event when planning to dispose of your business.  

We strongly recommend seeking professional advice when it comes to this Article and our team of International Tax specialists at Asena Advisors, will guide you on how to approach and interpret Article 13. 

We strongly recommend seeking professional advice when it comes to Article 12. As always, our team of International Tax specialists at Asena Advisors will guide you on how to approach and interpret Article 12. 

Shaun Eastman

Peter Harper

US-AU DTA: Article 12 – Royalties

Posted on by Peter Harper

INTRODUCTION

This week we will be taking a closer look at how royalties are dealt with in terms of the US/AUS DTA.  

Royalties earned outside of your resident state are generally taxed by the source state on a withholding basis. Under domestic law, a state can require a person to withhold tax on making a payment to another person. 

Royalties that are effectively connected with a permanent establishment are taxed either in terms of Article 7 which deals with business profits or Article 14 which deals with Independent Personal Services. 

The US/AUS DTA Protocol amended the treatment of royalties to:

  1. reduce the general rate of source country tax on royalties from 10% to 5%;
  2. exclude from the scope of Article12(4) payments for the use of industrial, commercial, or scientific equipment, and
  3. extend the royalties definition to cover additional types of broadcasting media (Article 12(4)(a)(iii)).

INTERPRETING ARTICLE 12 OF THE DTA – ROYALTIES

The purpose of Article 12 is to limit the tax that the source country may impose on royalty payments to beneficial owners in the other country to 5%, however, this limit only applies if the payments are at arm’s length. 

Article 12(1) states that royalties may be taxed in the country of residence of the beneficial owner even though derived from sources in the other Contracting State. This confirms Article 1(3) of the DTA that preserves the right of each country to tax its residents.

Article 12(2) stipulates those royalties may also be taxed by the source country but limits the tax to 5% of the gross amount of the royalties. 

Article 12, however, does not apply to natural resource royalties, which are taxable in the country of source in terms of  Article 6 of the DTA.

Article 12(3) sets out the exclusions and that the reduced withholding tax rate does not apply in the following cases:

    1. the beneficial owner has a permanent establishment in the source country;
    2. or performs personal services in an independent capacity through a fixed base in the source country, and the property giving rise to the royalties is effectively connected with the permanent establishment or fixed base. 

In that event, the royalties will either be taxed as business profits (Article 7) or income from the performance of independent personal services (Article 14).

Article 12(4) is important as it defines the word royalties for purposes of the treaty. The definition of royalty in Art 12(4) comprises of the following three components:

Component 1 – Intellectual property 

Article 12(4)(a) includes payments or credits of any kind to the extent that they are considered for the use or right to use any:

  (i) copyright, patent, design or model, plan, secret formula or process, trademark or other like property or right

  (ii) motion picture films, or

  (iii) films or audio or videotapes or disks, or any other means of image or sound reproduction or transmission for use in connection with television, radio, or other broadcasting.

Due to the technological advances made since the DTA was signed, the protocol was amended to reflect these advances more accurately. 

For example, due to the Protocol, Article 12(4)(a)(iii) will apply to a payment made by an Australian broadcaster to a US company for the right to transmit a live feed of an entertainment program through satellite or the Internet. 

However, on the other hand, Article 12(4)(a)(iii) will not apply to payments made by a retail customer who has subscribed to a satellite television service provided by a US company.

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Component 2 – Scientific, technical, industrial, or commercial knowledge or information

Article 12(4)(b)(i) states that royalties include payments or credits for scientific, technical, industrial, or commercial knowledge or information (“know-how”) owned by any person. 

The specific reference to knowledge or information owned is meant to indicate that the term royalties imply a property right as distinguished from personal services.

This is a very important distinction to understand, so let’s use an example – 

An IT specialist who prepares or designs a website for a customer will be considered to perform personal services and the remuneration received will be taxable in terms of either Article 14 (Independent personal services) or Article 15 (Dependent personal services). 

However, should the IT specialist supply a pre-existing design to a customer, this will be considered the furnishing of knowledge (know-how) or information and taxed in terms of Article 12? 

Article 12(4)(b)(ii) provides that consideration for any assistance of an ancillary and subsidiary nature that enables the application or enjoyment of know-how is also a royalty payment. However, if the service is supplied in connection with the sale of property, Article 12 will not apply. 

Article 12(4)(b)(iii) contains a special rule to deal with the situation of a disguised lease of a property right of the type covered Article 12(4)(b). 

Component 3 – Disposition of property that is contingent

Article 12(4)(c) provides that, to the extent that income from the disposition of any property or right described in this paragraph is contingent on the productivity or use or further disposition of such property or right, it is a royalty.

Article 12(5) applies where there is a special relationship between the payer of the royalties and the person beneficially entitled to the royalties or between both of them and some other person. 

Where this requirement is satisfied, the 5% limitation will only apply to the extent that the royalties do not exceed the amount that might be expected to be agreed upon by independent persons acting at arm’s length. The excess amount will therefore be taxable according to the law of each contracting state but subject to any other provisions of the DTA. 

The term special relationship is significantly wider than the term associated enterprise contained in Article 9 and should be read in conjunction with Article 12(5). 

Article 12(6) lastly provides special source rules for royalties. In general, a royalty is considered to have its source in a country if paid by the Government, or a resident of that country, or by a company that under domestic law is a resident of that country. 

The US Treasury Department explained that a royalty paid by a dual resident company may be eligible for the reduced rate provided in Article 12(2), although a royalty beneficially owned by such a company is not.

CONCLUSION 

It is important to take note that a mere accounting entry may be sufficient to attract royalty withholding tax as the definition refers to payments or credits.

To determine whether a payment is a royalty subject to Article 12 or a payment for services within the scope of Article 7, will depend on the purpose of the payment and circumstances of the arrangement been the parties. 

The interpretation of Article 12 is going to take center stage in the near future. Due to the pandemic, numerous people across the world started new business ventures based on models that enable them to generate global income while rendering services remotely. The DTA and Protocol were drafted long before anyone knew the pandemic so neither the US nor Australia took this into consideration when the DTA bilateral instrument was agreed upon. 

Make sure you understand how Article 12 can impact your new start-up, as you do not want to have non-compliance issues, penalties, or additional tax just due to not understanding Article 12. 

We strongly recommend seeking professional advice when it comes to Article 12. As always, our team of International Tax specialists at Asena Advisors will guide you on how to approach and interpret Article 12. 

Shaun Eastman

Peter Harper

US-AU DTA: Article 11 – Interest

Posted on by Peter Harper

INTRODUCTION

This week we will be taking a closer look at how interest is dealt with in terms of the US/AUS DTA.

Interest earned outside of your resident state is generally taxed by the source state on a withholding basis. Under domestic law a state can require a person to withhold tax on making a payment to another person.

An overly simplified example of how Article 11 (Interest) applies in practice is if a US tax resident earns interest income from Australia. The US has the right to tax the interest earned from sources in Australia. This right is however not exclusive. If Australia also wants to also tax the interest income, it is limited to the amount of tax it can levy in terms of Article 11.

Article 11 of the DTA (Interest) has a dual purpose:

– Firstly, to limit the tax imposed by the source state where the interest arises; and

– Secondly prevents the treaty benefits available where there is an excessive payment of interest arising from a “special relationship”.

INTERPRETING ARTICLE 11 OF THE DTA – INTEREST

Article 11 generally limits the withholding tax that the source country may impose on interest payments to beneficial owners in the other country to 10%.

Article 11(1) states that interest from sources in one of the contracting states to which a resident of the other is beneficially entitled may be taxed in that other country. Hence there is no exclusive right.

A person will be beneficially entitled to interest for purposes of Article 11 if they are the beneficial owner of the interest.

Article 11(2) provides that the source state (country where the interest arises) may also tax the interest that the resident of the other state is beneficially entitled subject to a maximum rate of 10%.

Currently the US has a non-treaty interest withholding tax rate of 30% and Australia has a general interest withholding tax rate of 10%.

Article 11(3) however provides an exemption for interest paid to government bodies and financial institutions subject to the restrictions in Article 11(4).

Article 11(3)(a) states that interest derived by a Contracting State or a political or administrative subdivision or a local authority of the Contracting State is only subject to tax in the State of residence. This exemption extends to interest received by any other body exercising governmental functions.

Article 11(3)(b) states further that interest derived by financial institutions that are unrelated to and dealing wholly independently of the payer are only taxed in the State of residence.

An example of the type of financial institutions that will qualify for the exemption in Art 11(3)(b) are investment banks, brokers, and commercial finance companies

A financial institution will be “unrelated and dealing wholly independently” of the payer of the interest if the financial institution and payer are not treated as Associated Enterprises as stipulated in Article 9.

Article 11(4) operates as a restrictive provision on the exemption provided in Article 11(3).

Article 11(4)(a) stipulates that the exemption in Article 11(3)(b) will not apply, and the interest derived will be taxed at 10% of the gross amount if it arises from back-to-back loans or an arrangement that is economically equivalent.

Article 11(4)(b) preserves the application of the domestic tax law of each State regarding anti-avoidance provisions. Nothing in Article 11 limits the ability of the US to enforce existing anti-avoidance provisions.

Similarly, Australia reserves the right to apply its general anti-avoidance rules where there is a conflict with the provisions of a tax treaty and Article 11(4)(b) extends this power to any anti-avoidance rule.

Article 11(4)(b) further does not limit the ability of Australia or the US to adopt new anti-avoidance provisions.

Article 11(5) defines “interest” to mean interest from:

(a) government securities, bonds, debentures, and any form of indebtedness, and

(b) income subject to the same taxation treatment as income from money lent according to the law of the Contracting State in which the income arises.

However, income dealt with in Article 10 (Dividends) and penalty charges for late payment are not treated as interest.

The exclusion of income dealt with by the Dividends Article, clarifies that Article 10 takes precedence over Article 11 in cases where both Articles can apply.

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Article 11(6) simply states that tax is not payable under Article 11 where the interest income of the person beneficially entitled to it is subject to tax under Article 7 (Business Profits) or Article 14 (Independent Personal Services).

Article 11(7) defines the source of interest, which is a necessary pre-requisite for the Contracting State withholding tax under Article 11(2).

Generally, interest is deemed to arise and hence has its source in the Contracting State where the payer is a resident.

Unfortunately, it is not always that simple or straightforward. For example, if a person paying the interest has a permanent establishment in connection with which the interest is attributable, the interest is deemed to arise in that Contracting State if borne by that permanent establishment. This is irrespective of the fact whether or not the payer of the interest is a resident of one of the contracting states.

Article 11(8) states that, in cases involving special relationships between persons, Article 11 applies only to that portion of the total interest payments between those persons that would have been made absent such special relationships. Any excess amount of interest paid remains taxable according to the laws of the US and Australia, respectively, with due regard to the other provisions of the Convention.

Article 11(9) contains two anti-abuse exceptions to the treatment of interest in paragraphs (1), (2), (3) and (4)

Article 11(9)(a) states that interest paid by a resident of one of the Contracting States to a resident of the other Contracting State that is determined by reference to the profits of the issuer, or an associated enterprise may be taxed at a rate not exceeding 15%.

Article 11(9)(b) states that interest paid on ownership interests in securitization entities may be taxed in accordance with the domestic law, but only to the extent that the interest paid exceeds the normal rate of return on publicly traded debt instruments with a similar risk profile.

This article is specifically included to preserve the US taxation of real estate mortgage investment conduits (REMICs). A REMIC is a US entity that holds a fixed pool of real estate loans and issues debt securities with serial maturities and differing rates of return backed by those loans.

The purpose of Article 11(9)(b) is to permit the US to charge purchasers of REIMIC investments the domestic US tax on residual interests in REMICs.

Article 11(10) is only regarded to be relevant to US withholding tax. It states that where interest incurred by a company resident in one of the Contracting States is deductible in connection with a permanent establishment (Article 5), due to Article 6 (Real property) or Article 13 (Alienation of property) in the other Contracting State and that interest exceeds the interest actually paid, the amount of the excess interest deducted will be deemed to be interest arising in that other Contracting State to which a resident of the first-mentioned Contracting State is beneficially entitled.

Example:

An Australian company carries on business in the US via a permanent establishment (Branch). For US purposes this relates to branch profit tax. The branch incurs interest that is deductible in determining its US profits. However, the interest incurred by the branch is more than the amount of interest actually paid by the branch. Article 11(10) gives the US the right to tax the amount of interest not paid.

CONCLUSION

We would recommend seeking professional advice when it comes to Article 11. As always, our team of International Tax specialists at Asena Advisors, will guide you on how to approach and interpret Article 11.

Our team of International Tax specialists at Asena Advisors, advise numerous clients and corporations on their international structuring and how to make sure it is done in the most tax effective way. 

Shaun Eastman

Peter Harper

US-AU DTA: Article 10 – Dividends

Posted on by Peter Harper

INTRODUCTION

For purposes of this week’s blog, it will be beneficial just to recap on the purpose of a DTA. The major purpose of DTA is to mitigate international double taxation through tax reduction or exemptions on certain types of income derived by residents of one treaty country from sources within the other treaty country. Due to the fact that DTAs often modify US and foreign tax consequences substantially, the relevant DTA must be considered in order to fully analyze the income tax consequences of any outbound or inbound transaction.

Article 10 of the US/Australia DTA is a great example of this. 

This week we will be looking at the tax implications of declaring a dividend in the context of Article 10 of the US/Australia DTA.

INTERPRETING ARTICLE 10 OF THE DTA – DIVIDENDS

Dividends are distributions made by a company of something of value to a shareholder. Both the US and Australia levy withholding tax when a dividend is paid to a foreign shareholder. 

Under US domestic tax law, a foreign person is generally subject to 30% US tax on the gross amount of certain US-source income. All persons (‘withholding agents’) making US-source fixed, determinable, annual, or periodical (FDAP) payments to foreign persons generally must report and withhold 30% of the gross US-source FDAP payments, such as dividends.

Under Australian domestic tax law, dividends paid to an Australian non-resident recipient is subject to a flat withholding tax to the extent they are unfranked and are otherwise not assessed in Australia.

Article 10 however limits the tax that the source country may impose on these dividends payable to beneficial owners’ resident in the other country.

Article 10(1) preserves the right of a shareholder’s country of residence to tax dividends arising in the other country by permitting Australia or the US to tax its residents on dividends paid to them by a company that is resident in the other Contracting State.

Article 10(2) allows the Contacting State of the company to tax dividends to which a resident of the other Contracting State is entitled subject to the limitations in Article 10(2) and 10(3). 

Important to note is that Article 10(2) also requires that if either the US or Australia significantly modifies their laws regarding taxation of corporations or dividends they must consult with each other to determine any appropriate amendment to Article 10(2).

Article 10(2)(a) stipulates that where the shareholder who is beneficially entitled to the dividend is a company resident in the other Contracting State and directly owns shares representing at least 10% of the voting power of the company paying the dividend then the withholding tax rate is limited to 5% of the gross dividend.

The term ‘beneficially entitled’ is not defined in the DTA and therefore the domestic law of the country imposing the tax should be considered. 

The term ‘voting power‘ is also not defined but must be determined to ascertain if the 10% shareholding test is satisfied. 

The US Department of Treasury’s technical explanation of the Protocol that replaced Art 10 of the Convention states the following:

“Shares are considered to be voting shares if they provide the power to elect, appoint or replace any person vested with the powers ordinarily exercised by the board of directors of a US corporation.”

In Australia voting power is considered to refer to the voting power on all types of shares and not only in relation to the power to replace members of the board of directors. 

In determining the voting power for the purposes of Article 10(2) only shares that are held ‘directly’ by the beneficial shareholder can be taken into account. 

Accordingly, indirect interests are not to be taken into account. However, the US Department of Treasury’s technical explanation of the Protocol when discussing Article 10(2) states the following:

“Companies holding shares through fiscally transparent entities such as partnerships are considered for purposes of this paragraph to hold their proportionate interest in the shares held by the intermediate entity. As a result, companies holding shares through such entities may be able to claim the benefits of sub-paragraph (a) under certain circumstances. The lower rate of withholding tax applies when the company’s proportionate share of the shares held by the intermediate entity meets the 10 percent threshold. Whether this ownership threshold is satisfied may be difficult to determine and often will require an analysis of the partnership or trust agreement.”

The voting power test in Article 10 is therefore likely to be applied differently in the US and Australia unless the reference to “beneficially entitled” is interpreted to override the requirement that the payee company holds the shares “directly”.

Article 10(2)(b) limits the withholding tax rate on dividends derived by a resident from shares held in a company resident in the other Contracting State to 15%. Accordingly, this rate will apply to individuals, trusts, partnerships and companies that cannot rely on Article 10(2)(a) or the exemption in Art 10(3) discussed below.

Article 10(3) is quite often misinterpreted. This Article stipulates that a shareholder company resident in the US or Australia is exempt from withholding tax on dividends if it owns 80% or more or the voting power of the company paying the dividends for a 12-month period ending on the date the dividend is declared. However, the exemption is subject to the shareholder company being:

  (a) a qualified person as defined in Article 16(2)(c), or

  (b) entitled to benefits under the Limitation of Benefits Article.

In contrast to Article 10(2), voting power for the purposes of Article 10(3) is limited to shares that are held “directly” by the beneficial shareholder and therefore excludes indirect ownership through corporate chains. 

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The shareholder company will be a “qualified person” if:

1. its principal class of shares is listed on a recognized stock exchange and is regularly traded on one or more stock exchanges. A recognized stock exchange is a recognized stock exchange under Australian or US law and any stock exchange agreed by the ATO and IRS as explained in Article 16(6), or

2. at least 50% of the vote and value of the shares in the shareholder company must be owned directly or indirectly by five or fewer companies that are listed on a recognized stock exchange as defined in Article 16(6). Importantly in addition, where the shares in the shareholder company are held indirectly, each intermediate owner must be a resident of either Australia or the US.

Where a shareholder company is not a qualified person the exemption from withholding tax may still be available provided that the ATO or IRS makes a determination under Article 16(5). 

Article 10(4) provides that dividends paid by a Regulated Investment Company (RIC) or Real Estate Investment Trust (REIT) are not eligible for the 5% maximum rate of withholding tax in Art 10(2)(a) or the exemption from withholding tax in Art 10(3). Accordingly, the 15% withholding rate will generally apply to these entities.

Article 10(5) excludes from the general source country withholding tax limitations under Art 10(2), (3) and (4) dividends paid with respect to holdings that form part of the business property of a permanent establishment as defined in Article 5 or fixed base situated in the source country. 

Article 10(6) defines “dividends” to mean income from shares and amounts subject to the same taxation treatment as income from shares under the laws of the country where the company making the distribution is a resident.

In Australia the rules for defining what constitutes equity in a company and what constitutes debt are set out in ITAA97 Div 974 of the ITAA 1997 that apply from 1 July 2001. 

In the case of the US, the term dividends include amounts treated as a dividend under US law upon the sale or redemption of shares or upon a transfer of shares in a reorganisation. Further, a distribution from a US publicly traded partnership, which is taxed as a corporation under US law, is a dividend for purposes of Article 10. However, a distribution by a US LLC is not a dividend for purposes of Article 10 if it is not taxable as a corporation under US law.

Article 10(7) states that where a company which is resident for example in the US and derives profits or income from Australia, Australia is not permitted to tax dividends paid by the company unless either:

1. the person beneficially entitled to the dividends is a resident in Australia; or

2. the shares in respect of which the dividends are paid is effectively connected with a permanent establishment in Australia.

Therefore, Article 10(7) overrides section 44(1)(b) of the ITAA 1936 which permits Australia to tax dividends paid to non-residents to the extent of profits derived from sources within Australia. 

Similarly, it overrides the ability of the US to impose taxes under Code s 871 and Code s 882(a) on dividends paid by foreign corporations that have a US source under Code s 861(a)(2)(B).

Article 10(7) also provides that the Contracting States cannot impose tax on a company’s undistributed profits even if the dividends are wholly or partly paid out of profits in the relevant Contracting State unless Article 10(8) applies.

However, Article 10(7) does not restrict a State’s right to tax its resident shareholders on undistributed earnings of a corporation resident in the other State. The authority of the US to impose the foreign personal holding company tax, the taxes on subpart F income and on an increase in earnings invested in US property, and the tax on income of a passive foreign investment company that is a qualified electing fund is in no way restricted by this provision.

Article 10(8) permits Australia and the US to impose a branch profits tax on a company that is a resident in the other State. This tax is in addition to other taxes permitted by the Convention.

Currently, Australia does not impose a branch profits tax. However, if Australia were to impose such a tax, the base of such a tax would be limited to an amount analogous to the US dividend equivalent amount.

Article 10(9) lastly provides that the branch profits tax permitted by Article 10(8) shall not be imposed at a rate of withholding tax exceeding the maximum direct investment dividend rate of withholding tax of 5% in Article 10(2)(a).

CONCLUSION 

As you can see, Article 10 of the DTA is comprehensive and one should be cautious when applying it to a specific situation. 

Our team of International Tax specialists at Asena Advisors, advise numerous clients and corporations on their international structuring and how to make sure it is done in the most tax effective way. 

Shaun Eastman

Peter Harper

US-AU DTA: Article 9 – Associate Enterprises

Posted on by Peter Harper

BACKGROUND

This week, we will have a closer look at Article 9 of the US/AUS DTA. Article 9 of the DTA incorporates into the treaty the US and Australian arm’s-length principles reflected in the transfer pricing provisions of the Internal Revenue Code Section 482 and in Australia the transfer pricing provisions in ITAA 1997 Division 815.

An arm’s-length transaction is a transaction between independent parties. For the purposes of this blog, a simple example will help in understanding the basic concept of what an arm’s-length transaction is and when transfer pricing provisions will apply to a specific transaction. 

Example: USCO A and B are both US companies and co-shareholders of AusCo, a company in Australia. The directors of both USCO A and B are John and Jane who are married.  Further, each owns 50% of the stock in AusCo. USCO A is considering selling its 50% stake in AusCo and determined that the market related value of the 50% stake is $10m. However, after further consideration and the adverse tax implications on disposal, John and Jane decided that USCO A should rather sell its 50% stake to USCO B. John and Jane decided that it will sell the 50% stake for $100, to avoid the tax implications and streamline their current structure. 

IMPLICATIONS

If USCO A sold the 50% stake for $10million to USCO B it would have been sold at arm’s-length as this is the market related price. 

USCO A however sold it to USCO B for $100. They would not have sold the same stake to an independent party for $100. Hence the transaction is not at arm’s length and a transfer pricing adjustment needs to be made.  

INTRODUCTION

Article 9 provides that when enterprises which are related engaged in a transaction and the enterprises engage in a transaction on terms that are not arm’s length, the Contracting States may make appropriate adjustments to the taxable income and tax liability of such related enterprises to reflect what the income and tax of these enterprises with respect to the transaction would have been had there been an arm’s-length relationship between them. 

INTERPRETING ARTICLE 9 OF THE DTA – ASSOCIATED ENTERPRISES 

Article 9 provides that, where related persons engage in transactions which are not at arm’s length, the Contracting States may make appropriate adjustments to their taxable income and tax liability.

It should be noted that it is generally accepted that Article 9 is intended to be permissive. It allows contracting states to apply the transfer pricing rules that form part of their tax legislation. It is generally considered that; Article 9 does not create a stand-alone right for countries to make transfer pricing adjustments that go beyond what is authorized by their own domestic rules. This is mainly because the basic purpose of a DTA is to relieve double taxation and it would go way beyond this purpose if a DTA imposed harsher tax treatment on a particular transaction between country A and country B than would have applied if the same transaction had taken place between country A and another country,

Article 9(1) sets out the general rule for this Article and when it will be applicable. Where an enterprise of one Contracting State (US) and an enterprise of the other Contracting State (Australia) are related through management, control, or capital and their commercial or financial relations differ from those which would prevail between independent enterprises, the profits of the enterprises may be adjusted to reflect the profits which would have accrued if the two enterprises had been independent. 

Where a reallocation of profits is affected under this paragraph, in such a manner that the profits of an enterprise of one country are adjusted upwards, a form of double taxation would arise if the profits so reallocated continued to be subject to tax in the hands of an associated enterprise in the other country.

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Article 9(2) states that where one of the Contracting States has increased the profits of an enterprise of that State to reflect the amount that would have accrued to the enterprise had it been independent of an enterprise in the other Contracting State, the second State shall make an appropriate adjustment, decreasing the amount of tax which it has imposed on those profits. 

In determining such adjustments, due regard is to be had to the other provisions of the DTA and the competent authorities of the two States (IRS and ATO) shall consult each other if necessary, in implementing this provision.

Article 9(3) states that each Contracting State may apply its internal law in determining liability for its tax. For example, although Articles 9(1) and 2 refer to allocations of profits and taxes, it is understood that such terms also include the components of the tax base and of the tax liability, such as income, deductions, credits, and allowances. 

The US will apply its rules and procedures under section 482 of the IRC and Australia on the other hand will apply the transfer pricing provisions in ITAA 1997 Division 815.  It is important that such determinations must be consistent in each case with the principles of arm’s length transactions.

CONCLUSION 

This Article is a great example of how the domestic transfer pricing provisions of the US and Australia are applied on international transactions. 

At Asena Advisors, we have years of experience in dealing with transfer pricing issues and how to ensure that both domestic transfer pricing provisions and the DTA’s transfer pricing provisions are applied correctly.

Shaun Eastman

Peter Harper

US-AU DTA: Article 8 – Shipping and Air Transport

Posted on by Peter Harper

INTRODUCTION

This week, we will be discussing an Article in the US/AUS DTA which is generally not as relevant to individuals as other Articles in the DTA, but still important to understand. Especially regarding the interrelationship with other Articles in the DTA and how one article can override another in the DTA. 

Article 8 of the DTA governs the taxation of profits of an enterprise of a contracting state from the operation of ships or aircraft in ‘international traffic’, meaning any transport by a ship or aircraft, except when such transport is solely between places in a contracting state. In simple terms, this article does not apply to an enterprise who solely renders services within the US or Australia and provides primary taxing rights to the Country of Residence. 

In this week’s blog we will therefore have a look at Article 8 of the US/AUS DTA and how it interplays with Article 7 of the DTA. 

INTERPRETING ARTICLE 8 OF THE DTA – SHIPPING AND AIR TRANSPORT 

In our previous blog – Article 7- Business Profits , we explained that where profits include items of income dealt with separately in other articles of the DTA, then the provisions of those Articles shall not be affected by the provisions of Article 7. 

Article 8 is such an article, as it deals with profits of an enterprise from the operation of ships or aircraft in international traffic. If Article 8 applies to the profits of an enterprise, it will therefore override the provisions of Article 7.

Article 8(1) stipulates that the profits derived by a resident of one of the Contracting States from the operation in international traffic of ships or aircraft are taxable only in that Contracting State. In addition, this treatment extends to certain items of rental income that are closely related to the operation of ships and aircraft in international traffic.

Article 1(3)(d) of the DTA defines international traffic as any transport by a ship or aircraft, except where such transport is solely between places within a Contacting State.  

In particular, the following is subject to the above treatment:

– Profits from the rental of ships or aircraft on a full time basis (for example with crewmembers) operated in international traffic if the resident either operates ships or aircraft in international traffic or regularly leases ships or aircraft on a full basis. Such income is exempt from tax in the other Contracting State.

– Profits from the lease of ships or aircraft on a bare boat basis (meaning without crewmembers) when the income is ‘merely incidental’ to the operation of ships or aircraft in international traffic by the lessor.

Whether profits from the lease of ships or aircraft on a bare boat basis are merely incidental to operation in international traffic, the operative effect of this phrase is to restrict the application of Article 8 to those bareboat leases where:

– The primary activity of the lessor is the operation of ships or aircraft in international traffic, and

– The lessor’s bareboat leasing activity only makes a minor contribution to, and is so closely related to, this primary activity that it does not amount to a separate business or source of income for the lessor.

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Article 8(2) stipulates that profits of an enterprise of a Contracting State from the use, maintenance or rental of containers (including equipment for their transport) that are used for the transport of goods in international traffic are exempt from tax in the other Contracting State. This applies regardless of whether the recipient of the income is engaged in the operation of ships or aircraft in international traffic. 

Article 8(3) stipulates that Article 8(1) and 8(2) apply to profits derived though participation in a pool service or other profit sharing arrangement entered into by carriers in shipping and air transport in the interest of international cooperation. As an example, airlines from the US and Australia may agree to share profits relating to the transport of passengers between the two countries. They each will fly the same number of flights per week and share the revenues from that route equally, regardless of the number of passengers that each airline transports. Article 8(3) further makes it clear that all of the income arising from the pool service or other profit sharing arrangement and not just the income derived directly by that carrier is taxable in the Contracting State of residence.

Article 8(4) states that the carriage of passengers, livestock, mail, merchandise or goods taken on board in a Contracting State for discharge in that State is not from an operation in international traffic of ships or aircraft and may therefore be taxed in that State (source state). This relates to profits from the transport of goods or passengers picked up and discharged within the same Contracting State and therefore does not fall within the definition of international traffic and may be taxed by that State at source. However, for the Contracting State to impose such tax at source it is considered that the requirements of Article 7 would need to be satisfied.

This can be simplified with the following two examples:

Example 1 – Company A, a US shipping company contracts to carry goods from Australia to a city in the US. Part of the contract includes the transport of the goods by road from its point of origin in Australia to another point in Australia.  The income earned by the US shipping company from the overland leg of the journey would still be taxable only in the US. 

Example 2 – Company B is a US airline company which carries passengers from New York to Hobart, with an intervening stop in Perth. The Perth to Hobart leg of the trip would be treated as international transport of passengers with respect to those passengers and would still only be taxable in the US.

INTERRELATIONSHIP WITH ARTICLE 7 (BUSINESS PROFITS)

Profits from the lease of ships or aircraft that are not covered by the Shipping and Air Transport Article will fall within the scope of Article 7. 

Examples of profits that would fall within Article 7 include the following:

– Full basis leases of ships or aircraft that are not operated in international traffic by the lessee or where the lessor only operates ships or aircraft between places in the source country and does not regularly lease ships or aircraft on a full-time basis; and 

– Bare boat leases not incidental to the lessor’s international transport operations.

More importantly the source country’s taxation is only permitted under the Business Profits Article to the extent the profits are effectively connected with a permanent establishment in that country.

CONCLUSION 

This is a great example of how a specific article in the DTA can override the provisions of Article 7.

At Asena Advisors, our team of International Tax specialists, are able to assist you with applying this article correctly and establishing whether the profits are taxable in terms of Article 7 or Article 8 of the DTA. 

Shaun Eastman

Peter Harper

US-AU DTA: Article 7 – Business Profits

Posted on by Peter Harper

INTRODUCTION

Covid has changed the way business is done globally. Two of the most common changes are 

– Remote working (Employee sitting in Australia could be working for an employer in the US); and

– The increase in e-commerce businesses and being able to grow and expand these businesses globally without actually leaving the house. 

That being said, have you ever as an employer considered what the potential tax implications could be for the company by having employees working remotely?  

And does your e-commerce business create a permanent establishment in another country perhaps? 

Make sure you have taken proper steps to mitigate any unnecessary tax implications due to the ‘new norm’.

Article 7 is one of the more complex and technical articles in the DTA as it has various components to consider. However, I will try and provide a brief summary of its interpretation.

The first overriding principle of double taxation treaties is that a company resident in one country will not be taxed on its business income in the other State unless it carries on that business in the other country through a Permanent Establishment (PE) situated in that country.

The second principle is that the taxation right of the State where the PE is situated does not extend to income that is not attributable to the PE. The interpretation of these principles has differed from country to country. Some countries have pursued a principle of general force of attraction, which means that all income such as other business profits, dividends, interest and royalties arising from sources in their territory was fully taxable in that country if the beneficiary had a PE there, even though such income was clearly not attributable to that PE. 

In this week’s blog we will have a look at Article 7 of the US/AUS DTA and highlight some key aspects. 

INTERPRETING ARTICLE 7 OF THE DTA – BUSINESS PROFITS

Article 7 sets out the limits of the source state’s taxing rights in relation to business profits. If an enterprise resident in a contracting state has a Permanent Establishment (PE) in the other state through which it carries on business it can be taxable in that other state, as well as the state of residence. The tax is limited in the source state to no more than the profits attributable to the PE. 

Article 7(1) states the basic principle which is that the profits of an Australian enterprise may be taxed in the US only if it carries on business in the US through a permanent establishment and vice versa. In the case of an Australian enterprise, the US can only tax the profits of the enterprise to the extent that they are attributable to the permanent establishment.

It should be noted that dual-resident corporations are excluded from the term “enterprise of one of the Contracting States” by reason of the definition of an Australian or a US corporation contained in Article 3(1)(g) and the definition of residence contained in Article 4.  Such dual-resident corporations are treated as a resident of neither country for convention purposes, and therefor denied the benefit of this article and other provisions in the convention. 

The phrase ‘business profits of an enterprise’ is critical to the operation of Article 7.

The term ‘profits’ is not defined in the agreement and the question arises as to whether it includes profits which are ordinarily regarded as capital in nature or which are not derived from the carrying on of a business.

Article 3(2) of the DTA provides that, unless the context otherwise requires, a reference to profits of a business is a reference to the taxable income of the business. As capital gains are included in taxable income, the section arguably supports the view that Article 7 applies to capital gains. 

The 2006 U.S. Model Treaty Technical Explanation attempts to define business profits more generally in Article 7(1), providing that business profits are ‘income derived from any trade or business’.

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Article 7(2), which is subject to Article 7(3), provides that the profits to be attributed to a permanent establishment are those, which it might be expected to make if it were an independent enterprise engaged in similar activities under similar conditions. The profits must reflect arm’s length prices. For example, the profits of a branch must be calculated as if it were a separate entity distinct from its head office and on the basis that the branch was dealing wholly independently with its head office.

The practical application of Article 7(2) is not as straightforward as it seems. Quite often, a functional analysis needs to be done to ensure that arm’s length principles are applied properly. This includes the proper characterization of the transaction and the commercial risks undertaken by the enterprise.

Article 7(3) states that expenses that are reasonably connected with the profits of the permanent establishment and would have been deductible if the permanent establishment were an independent entity are deductible. Further, these expenses are deductible whether incurred in the Contracting State in which the permanent establishment is situated or elsewhere including executive and general administrative expenses.

Article 7(4) states that no profits are to be attributed to a permanent establishment by reason of mere purchase by that permanent establishment of goods or merchandise for that enterprise. 

Article 7(5) states that unless there is a good and sufficient reason to the contrary, the same method of determining the business profits attributable to a permanent establishment shall be used each year.

Article 7(6) states that where business profits include items of income dealt with in other articles of the Convention the provisions of those other articles override the provisions of this Article. 

Categories of income not specifically included in the definition of business profits are subject to the “overlap” rule of Article 7(6), which provides that a treaty article that governs a specific category of income (for example, the article pertaining to interest or dividends) takes precedence over the business profits article. If the item of income is attributable to a permanent establishment, it may ultimately be taxed under the business profits article anyway, because many of the treaty articles addressing specific categories of income (such as dividends and interest) provide that if the income is attributable to a permanent establishment, it is subject to taxation under the business profits article. 

Article 7(7) allows the ATO and IRS to apply any of its domestic laws to determine a person’s tax liability where the information required to make an appropriate attribution of profits to a permanent establishment is inadequate. 

Article 7(8) provides that nothing in Article 7 prevents each country from applying its domestic law to tax insurance business income provided that such law remains the same (or is modified in only minor respects) since the date the Convention was signed. or will tax the net income of a US trade or business. 

Article 7(9) applies where a fiscally transparent entity, such as a trust, has a permanent establishment in a Contracting State and a resident of the other Contracting State is beneficially entitled to a share of the business profits (beneficial owner).

Where the above requirement is satisfied then the beneficial owner is treated as carrying on a business through the permanent establishment in the Contracting State and therefore its share of the business profits of the fiscally transparent entity are taxable due to Article 7(1). 

For example, if a trust with a US beneficiary carries on a business in Australia through its trustee, and that trustee’s actions rise to the level of a permanent establishment then the US beneficiary will be treated as having a permanent establishment in Australia. This has the consequence that the profits of the trust attributable to the US beneficiary will be treated as business profits subject to Australian tax.

Article 7(9) was introduced at the request of Australia because the trustees of a trust, as the legal owner of the trust property, might be regarded as the only person having a permanent establishment.

CONCLUSION 

This article is probably one of the more difficult articles to comprehend in the DTA. For purposes of this blog, it’s important to know that a source country can’t attribute any business profits in terms of Article 7 if there is no permanent establishment in that source country. 

Our diverse team of International Tax specialists at Asena Advisors, will be able to assist you with applying this article correctly and how to accurately attribute profits to a permanent establishment. 

Shaun Eastman

Peter Harper

US-AU DTA: Article 6 – Income from Real Property

Posted on by Peter Harper

INTRODUCTION

Almost everyone dreams of one day owning their own holiday home, which they can use switch off and relax. For those dreamers with aspirations, it usually materializes through hard work and dedication. 

In practice, we often have client who are US residents with real properties situated in Australia or Australian residents with real properties situated in the US. The purpose of investing in foreign real property will not always be the same. 

However, in terms of Article 6 of the US/Australia DTA (Income from Real Property) the tax treatment will be the same. Article 6 is in reality a sourcing provision, which means that the country where the real property is situated, will have the primary taxing rights. This aligns with both Australia and US domestic law, where income from real property is treated as being sourced where the real property is located. 

In this week’s blog we will be looking at the tax implications in the context of Article 6 of the US/Australia DTA when earning income from real property situated in the other jurisdiction. 

INTERPRETING ARTICLE 6 OF THE DTA – INCOME FROM REAL PROPERTY

Article 6 of the DTA states the following: 

Income from Real Property 

(1) Income from real property may be taxed by the Contracting State in which such real property is situated.

(2) For the purposes of this Convention:

 (i) a leasehold interest in land, whether or not improved, shall be regarded as real property situated where the land to which the interest relates is situated; and 

(ii) rights to exploit or to explore for natural resources shall be regarded as real property situated where the natural resources are situated or sought.

The US and Australia taxes their residents on a worldwide basis and hence the reason why Article 6 is heavily relied upon by US and Australian residents with foreign rental properties. 

In the context of Article 6, it is important to understand what constitutes real property, also referred to as immovable property, in other treaties. 

The definition of real property is determined under the law of the country in which the property in question is located. Regardless of source country law, however, the concept of real property includes the following elements:  

  1. Property accessory to real property (immovable property);
  2. Livestock and equipment used in agriculture and forestry;
  3. Rights to which the provisions of general law respecting landed property apply;
  4. Usufruct of real property (immovable property); and
  5. Rights to variable or fixed payments as consideration for the working of, or the right to work, mineral deposits, sources, and other natural resources.

Ships and aircraft, however, are not regarded as real property (immovable property). 

When relying on a specific provision in a DTA to determine the allocation of the taxing rights between the two countries, one of the most important distinctions to understand is the following – 

  1. ‘income that may be taxed by a contracting state’ and;
  2. ‘income shall only be taxable by a contracting state’.

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Article 6(1) uses the wording may be taxed and therefore does not confer an exclusive right of taxation on the State where the property is located. It simply provides that the situs State (the country where the property is situated) has the primary right to tax such income, regardless of whether the income is derived through a permanent establishment in that State or not. The country where the income producing real property is situated, is obliged to allow a resident of the other country to elect to compute that income on a net basis as if the income were business profits attributable to a permanent establishment in the source country. This is permitted in terms of IRC §871(d) and §882(d) as well in the absence of any treaty provision. 

Article 6(2) incorporates the rule that a leasehold interest in land and rights to exploit or explore for natural resources constitute real property situated where the land or resources, respectively, are situated. Except for those cases, the definition of real property is governed by the internal law of the country where the property is situated.

CONCLUSION 

Even though Article 6 is quite straight forward, there are various other domestic nuances to take into account when calculating your foreign rental income for either US or Australian tax purposes.  

Our team of International Tax specialists at Asena Advisors, will be able to assist you with applying Article 6 correctly and how to implement same in your US or Australian tax returns.

Shaun Eastman

Peter Harper

US-AU DTA: Article 5 – Permanent Establishment

Posted on by Peter Harper

GENERAL BACKGROUND

In the unprecedented COVID-19 environment the temporary displacement of employees has given rise to many concerns from employers that it may unintentionally be creating ‘permanent establishment’ issues for them in foreign jurisdictions. This is especially relevant where employees are working through the pandemic in a different country to where they ordinarily work.

Due to COVID-19, it is common for employees of US employers to be temporarily working in Australia when they would ordinarily work in the US and vice versa. 

Tax authorities around the world are also targeting in particular ‘artificial PE avoidance’ by multinationals on foreign-sourced income.

This blog will highlight some of the key permanent establishment issues facing US and Australian taxpayers with an emphasis on Article 5 of the US/Australia DTA. 

INTRODUCTION

The fundamental rationale behind the PE concept is to allow, within certain limits, the taxation of non-resident enterprises in respect of their activities in the source jurisdiction.

Understanding the rules relating to permanent establishments (PEs) has two steps to it. 

  1. The first step is to understand when a PE exists, and 
  2. The second step is to look at how profits are attributed to that PE.

Broadly speaking, an overseas resident has a substantive presence in a state if he meets the

threshold of having a PE. At the same time, if that person is carrying on business through the PE then tax may be due in the state in which the PE is established as well as in the state of residence.

Therefore, on its own, without a business activity through it, a PE may not of itself

give rise to a tax liability.

In its simplest form a PE exists where a company is resident in one country (referred to as the head office) but also has a business conducted from a fixed base in another country (the branch). The income attributable to the other fixed base usually attracts a tax liability in the second country. 

In its more complex form of deemed PE, it is a tax “fiction” enabling tax authorities to impose corporate taxes on the deemed branch. A third type of PE is again a tax “fiction” where there is a deemed branch providing services.

INTERPRETING ARTICLE 5 OF THE DTA – PERMANENT ESTABLISHMENT

Under the US/Australia PE provision, the business profits of a resident of one treaty country are exempt from taxation by the other treaty country unless those profits are attributable to a permanent establishment located within the host country.

Article 7 of the US/Aus DTA (which will be discussed in detail in the following weeks) states that profits are taxable only in the Contracting State where the enterprise is situated “unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein,” in which case the other Contracting State may tax the business profits “but only so much of them as [are] attributable to the permanent establishment.” 

TYPES OF PERMANENT ESTABLISHMENTS

There are a few common types of permanent establishment to be aware of based on traditional approaches, although these are being modified as more business is conducted virtually over digital mediums.

Fixed Place of Business Permanent Establishment

The historical and easiest test of ‘permanent establishment’ is having a fixed place of business and can include:

    • A branch
    • An office
    • A factory
    • A workshop
    • A mine, or gas/oil well
Sales Agents

Employees that work as sales agents and have the authority to conclude contracts in the name of an enterprise may also be sufficient to create PE.  The determining requirement is that the authority must be exercised habitually, rather than once or twice.  Also, the majority of the negotiation, drafting and signing of contracts must have occurred in the host country.

Service Permanent Establishment

The areas of service PE are expanding in scope and can include situations such as providing technical or managerial services in the country.  

PRACTICAL EXAMPLES OF PERMANENT ESTABLISHMENT

Building and Construction Projects

Since building and construction projects are not “permanent” for the company, the test for PE becomes more time-based.  The time period applicable to the US/Aus DTA is a site which exists for at least 9 months may trigger PE.

Services and Consulting Projects

The analysis for services PE will revolve around the non-physical elements of permanent establishment, since there may be no office or branch in the country.

TYPES OF AGENCY PERMANENT ESTABLISHMENT

If a company uses sales agents inside a country, this type of activity may trigger permanent establishment if the agents are concluding contracts on behalf of the company.  This qualifies for the ‘revenue creation’ element of PE, and those contracts would be subject to corporate tax if the activity is habitual and ongoing.

Digital Sales and e-Commerce

An emerging area of PE is that of revenue created through the digital economy. This is extremely prevalent, especially with online platforms being used to sell goods or services worldwide. 

WHAT IS THE TAX RISK RELATED TO CREATING A PE?

When embarking on global expansion, one of the core considerations is corporate taxation on foreign sourced revenue.  While a company will typically be taxed on profits in its home country, there may be additional taxes owed in other countries of business activity.  This could affect the net profitability of entering a new country and should be part of an overall planning analysis.

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HOW WILL A PE BE TAXED?

If sufficient presence is created in a foreign country, but a multinational, this could make it liable for local corporate taxes or value-added tax (VAT).  This law basically reflects the rights of countries to tax businesses that are generating revenue through local operations, even if they maintain their principal headquarters in the home country.

The reason this becomes important for planning purposes is that a company could be subject to ‘double taxation’ on profits, since the home country could tax those amounts as well.  

The IRS will impose corporate tax on foreign companies that meet the PE criteria.  To avoid any penalties or back payments, a company should file IRS Form 8833 as a proactive claim on any treaty benefits with the US.

CONCLUSION 

To assist in managing PE issues from a US and Australian income tax perspective, taxpayers should ensure they action the following:

  • Carefully monitor and keep track of the geographical working location of employees during the COVID-19 pandemic;
  • Understand what constitutes a PE and a deemed PE;
  • Seek tax advice if due to COVID-19 you have employees temporarily exercising their employment in another country;
  • Seek tax advice if your business tax model has changed due to COVID-19 and could potentially place you at risk of creating a PE; and
  • monitor and carefully consider official guidance in respect of “permanent establishment” issues (ie. from the ATO, IRS, OECD and other relevant foreign authorities);

The global pandemic has changed the way businesses conduct business. It has also created opportunities for new businesses to conduct business exclusively on online platforms, without physically being present in the country the services are provided or goods are sold. 

Our team of International Tax specialists at Asena Advisor, have an in-depth knowledge of how to interpret international tax treaties and how to ensure you mitigate any potential PE risks associated with your business. 

Shaun Eastman

Peter Harper

US-AU DTA: Article 4 – Residence

Posted on by Peter Harper

GENERAL BACKGROUND

In this week’s blog, we will be discussing Article 4 of the DTA (Residence), with a specific focus on its applicability to individuals.

A person’s residence for treaty purposes is a key consideration when applying the DTA. Not only because this allows a person to claim certain treaty benefits, but also because the treaty will allocate taxing rights to the state of residence or the state of source. It is therefore vital to know where a person is resident for such purposes. 

INTRODUCTION

Article 4 contains ‘residency tie-breakers’ to determine residence for both individuals and companies.

When the domestic law of the US and Australia result in claimed residency by both countries, the taxpayer must apply the treaty’s residency tie-breaker provisions. The reason it is important is because residency determines the taxation of many important types of income, such as dividends, interest, royalties, capital gain, pension distributions, retirement pay, annuities, and alimony.

It should be noted that these tiebreakers, for companies and individuals, apply for the purposes of the treaty and so determine a sole state as the place of residence for treaty purposes only. A person does not cease to be resident of either state for domestic law purposes unless the domestic law specifically states this. 

For instance, in South Africa, the definition of ‘resident’ in Article 1 of the Income Tax Act No. 58 of 1962 includes a provision whereby the definition of ‘residence’ contained in any DTA between South Africa and another country overrides the domestic definition of a resident. So, this is an example whereby a person will cease its residency should they be regarded as an exclusive resident of another contracting states. Herewith an extract of the provision – 

‘But does not include any person who is deemed to be exclusively a resident of another country for purposes of the application of any agreement entered into between the governments of the Republic and that other country for the avoidance of double taxation.’

This however does not apply to Article 4 of the DTA between the US and Australia. One should therefore be careful when applying Article 4 and what limitations apply to the specific DTA’s definition of residence. 

INTERPRETING ARTICLE 4 OF THE DTA – RESIDENCE

The country of residence generally gets the most exclusive taxing rights. When an individual is determined to be a tax resident under the domestic law of two countries that have an income tax treaty with one another, there are a set of factors that ‘break the tie’. When interpreting the specific terms as set out below, one should look at the domestic interpretation of the US/Australia respectively and at the OECD commentary on Article 4 of the Model Tax Convention.

The country of residency for purposes of the DTA is determined by applying the following tie-breaker clauses in the US-Australia DTA.

Tie-breaker 1: 

Permanent home – first, the country in which the individual maintains a permanent home. If the individual has a permanent home in only one of the Contracting States, the individual will be treated as a resident of that State for treaty purposes.

The IRS states that a permanent home is one that is retained for permanent and continuous use and is not a place retained for a short duration. An individual has a permanent home in the US if he or she purchased a home in the United States, intended to reside in that home for an indefinite time, and did reside in that home. Individuals may also have a permanent home where:

    1. a room/apartment is continuously available to them, 
    2. their personal property (e.g., automobiles, personal belongings) is stored at a dwelling, and 
    3. they conduct business (e.g., maintaining an office, registering a telephone), including using such addresses for insurance and a driver’s license.

The OECD describes a permanent home to be a home that the:

‘Individual has arranged to have the dwelling available to him at all times continuously and not occasionally’. 

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Tie-breaker 2: 

Habitual abode – second, if the individual’s permanent home cannot be determined, then the state in which he has a habitual abode. 

The IRS states the following in this regard:

“An individual’s habitual abode is located in the Contracting State in which the individual has a greater presence during a calendar year. Although the length of time is not specified, the comparison must cover sufficient length of time and take into account the intervals at which the stays take place for it to be possible to determine where residence is habitual. For example, an individual who is present in the United States more frequently and at longer intervals than in the other Contracting State during a calendar year likely has a habitual abode in the United States. Determine whether the individual has a habitual abode in the United States by calculating how much time the individual spent in in the United States in a tax year…” 

The OECD explains that a habitual abode refers to the frequency, duration and regularity of stays that are part of the settled routine of an individual’s life and is therefore more than transient. 

There is no specific commentary on the Australian interpretation of the words habitual abode in the context of the Treaty, only the words habitual place of abode in the context of the statutory definition of resident in section 6 ITAA 1936. However, the Courts consider the Commentary on the OECD Model Tax Convention as authoritative guidance on the interpretation of Tax Treaties.  

Tie-breaker 3: 

Closer connections – third, if the individual has a habitual abode in both countries or in neither, then the country in which the individual has closer economic or personal relations, with regard being given to the country of citizenship. 

The IRS considers the following factors in this regard:

Personal relations:

    1. Family location – Includes parents and siblings, and where the individual spent his or her childhood. 
    2. Recent relocation – Whether the family moved from their permanent home to join the individual, or the individual relocated to a second state (for example, as a result of marriage). 

Community relations: 

Determine where the individual has his or her:

    1. health insurance, 
    2. medical and dental professionals, 
    3. driver’s license/motor vehicle registration, 
    4. health club membership, 
    5. political and cultural activities, and 
    6. ownership of bank accounts. 

Economic relations: 

Determine where the individual:

    1. keeps his or her investments or conducts business, 
    2. incorporated his or her business, and retains professional advisors (e.g., attorneys, agents, and The center of vital interests can shift, when an individual retains ties in one State but establishes ties in a second State, and all surrounding facts and circumstances must be considered in determining the individual’s center of vital interests. For example, the IRS states that evidence that an individual has executed contracts relating to his or her business in the second State may indicate that the center of vital interests is in the second State. 

CONCLUSION

It is of utmost importance to ensure that you understand how to apply the tie-breaker provisions set out in Article 4(2) of the US/Australia DTA. Secondly, it is important to note that by being regarded as a resident in terms of the DTA, does not automatically cease your tax residency. Especially if you are a US citizen living in Australia. It should only be applied for purposes of the treaty and allocating the taxing rights accordingly. 

Our team of International Tax specialists at Asena Advisor, have an in-depth knowledge of how to interpret international tax treaties and how to correctly apply the tie-breaker provisions.

Shaun Eastman

Peter Harper

US-AU DTA: Article 3 – General Definitions

Posted on by Peter Harper

GENERAL BACKGROUND

Last week we discussed the taxes covered by the DTA as set out in Article 2. In this week’s blog, we will be discussing Article 3 of the DTA – General Definitions; it is important to understand the application of the defined terms in the DTA and its interpretation by either US or Australian courts. I am not going to explain every definition set out in Article 3, but rather focus on certain specific terms and their interpretation.

INTRODUCTION

Article 3 provides general definitions and rules of interpretation applicable throughout the DTA. Certain other terms are defined in other articles of the DTA. For example, the term “resident” is defined in Article 4 (Residence), the term “permanent establishment” is defined in Article 5 (Permanent Establishment), and the term “royalties” is defined in Article 12 (Royalties).

INTERPRETING ARTICLE 3 OF THE DTA – GENERAL DEFINITIONS

Article 3 of the DTA can be broken down into two parts. Paragraph 1 defines some principal terms used throughout the DTA and Paragraph 2 makes provision for terms not defined in the DTA and how they should be interpreted.

Paragraph 1

The definitions of the terms ‘person’, “company”, “enterprise of a Contracting State”, and “international traffic” are similar to the definitions in the U.S. Model. The “competent authority” for the United States is the Secretary of the Treasury or his delegate and for Australia the Commissioner of Taxation or his authorized representative. The terms “United States” and “Australia” are defined to include the continental shelf areas of the two countries for exploration and exploitation of their natural resources. Definitions are provided for the terms “Contracting State,” “State,” “United States tax,” ”Australian tax,” and “resident of one of the Contracting States.”

The definitions of a ‘United States corporation’ and an ‘Australian corporation’ in terms of the DTA are of importance. The DTA specifically excludes from these definitions, corporations under the laws of the Contracting States are residents of both States. A corporation created and organized under the laws of a state of the United States is considered by the United States to be a United States corporation; but such a corporation could also be considered by Australia to be an Australian corporation if it is managed and controlled in Australia or if it does business there and its voting power is controlled by Australian resident shareholders. If such a situation does arise, the dual resident corporation is not considered a resident of either country for purposes of the Treaty and is therefore not entitled to benefits granted by either State under the Treaty to residents of the other State.

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Paragraph 2

Paragraph 2 provides that terms not defined in the Convention shall have the meaning which they have under the laws of the Contracting State concerning the taxes to which the Convention applies unless the context of the Convention requires a different interpretation.

Under the terms of Article 24 (Mutual Agreement Procedure), the competent authorities may agree on a common definition of an otherwise undefined term. The term “context” includes the purpose and background of the provision in which the term appears. An agreement by the competent authorities for the meaning of a term used in the Convention would supersede conflicting meanings in the domestic laws of the Contracting States. Difficulties arise when international rules of interpretation are applied to a DTA which may differ from a state’s domestic fiscal interpretation. Such a conflict might arise because on an international level the courts would look to the Vienna Convention (for example, the interpretation of matters such as non-defined terms in Article 3(2), multi-lingual versions of the treaty, aids to interpretation such as external materials, etc.), which would then need to be compared with the domestic approach to statutory fiscal interpretation. The domestic approach may differ, for example, the domestic law may require a more literal approach; the natural vs the specific meaning of words in the statute, the use of the OECD commentary; the application of Article 3(2) of the treaty for non-defined terms (and possible conflict between the contracting states as to such definitions); domestic case law precedent etc.

A further issue that should be highlighted is the timing of the enactment of a treaty and the subsequent domestic law of a contracting state which may be applicable under Article 3(2).

The question is whether the “static approach” or the “ambulatory approach” to interpretation should be taken. The static approach means the term has the meaning given under domestic law at the time the treaty was entered into – which may be different from the meaning at the time the term is being applied (due to changes in domestic law, for example). The ambulatory approach means the term has the meaning which it has under the contracting state’s domestic law as that is amended from time to time. So the interpretation of the term can be at a later date from the entering into of the treaty.

These two approaches may give rise to the conflict concerning undefined terms within a treaty, however, it should be noted that the ambulatory approach is generally seen as the more common method of interpretation of undefined terms. (This approach was used in the US case of Kappus v Commissioner, 337 F. 3d 1053 (DC Cir. 2003)). In addition, the OECD commentary itself supports the ambulatory approach to interpretation.

CONCLUSION

Due to the different approaches taken to the rules of interpretation for treaties or conventions and the approaches applied to the interpretation of domestic fiscal legislation, Article 3 (2) could be seen as leading to an apparent dichotomy.

It is therefore recommended to make sure that your international structure does not fall within terms not defined in the DTA as this could lead to an expensive exercise to resolve.

Our team of International Tax specialists at Asena Advisor has an in-depth knowledge of how to interpret international tax treaties and ensure that your international structure is not open to ambiguity.

Shaun Eastman

Peter Harper

US-AU DTA: Article 2 – Taxes Covered

Posted on by Peter Harper

GENERAL BACKGROUND

Last week we discussed the scope and limitations of the DTA as set out in Article 1.

In this week’s blog, we will be discussing Article 2 of the DTA – Taxes Covered.

This DTA is for the avoidance of double taxation and the prevention of fiscal evasion concerning taxes on income.

It, therefore, does not include taxes that fall outside the scope of Article 2. For examples Gift and Estate, Taxes are covered in the Gift Tax and Estate Tax Treaty respectively.

INTRODUCTION

Article 2 is intended to make the terminology and nomenclature relating to the taxes covered by the DTA more acceptable and precise, to ensure identification of the US and Australian taxes are covered by this convention. Further to widen as much as possible the field of application of the DTA by including as far as possible and in harmony with the domestic laws of the US and Australia imposed and to avoid the necessity of concluding a new DTA whenever the domestic laws of either the US or Australia are modified.

Shaun the only point I would add is that to the extent that a DTA is silent then that item is taxed under domestic law.  DTAs are not all-encompassing in that regard.  Otherwise, it is good.

INTERPRETING ARTICLE 2 OF THE DTA – TAXES COVERED

Article 2 of the DTA states the following –

(1) The existing taxes to which this Convention shall apply are:

(a) in the United States: the Federal income taxes imposed by the Internal Revenue Code; and

(b) in Australia:

(i) the Australian income tax, including a tax on capital gains; and

(ii) the resource rent tax in respect of offshore projects relating to exploration for or exploitation of petroleum resources, imposed under the federal law of Australia.”.

(2) This Convention shall also apply to any identical or substantially similar taxes which are imposed by either Contracting State after the date of signature of this Convention in addition to, or in place of, the existing taxes. At the end of each calendar year, the competent authority of each Contracting State shall notify the competent authority of the other Contracting State of any substantial changes which have been made during that year in the laws of his State relating to the taxes to which this Convention applies or in the official interpretation of those laws or of this Convention.

We are the only multi-disciplinary international CPA firm in the United States that specializes in U.S.– Australia taxation.
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Paragraph 1

US Taxes Covered –

Sub-paragraph (1)(a) of Article 2 provide that all U.S. income taxes are covered taxes for purposes of the Convention. Thus, the accumulated earnings tax and the personal holding company tax are also covered taxes because they are income taxes, and they are not otherwise excluded from coverage. Under the Code, these taxes will not apply to most foreign corporations because of either a statutory exclusion or the corporation’s failure to meet a statutory requirement.

The DTA excludes social security taxes and excise taxes, such as those imposed on private foundations and foreign insurers, from the taxes covered by the Convention.

Australian Taxes Covered –

Sub-paragraph (1)(b) of Article 2 provides that the covered taxes are the Australian income tax, including a tax on capital gains, and the resource rent tax in respect of offshore projects relating to exploration for or exploitation of petroleum resources (“RRT”), imposed under the federal law of Australia.

The specific reference to the Australian capital gains tax makes it clear that U.S. taxpayers receive a foreign tax credit for Australian capital gains taxes paid.

Concerning the RRT being covered Australian taxes mean that the provisions of the DTA, including Article 5 (Permanent Establishment), Article 7 (Business Profits), and Article 27 (Miscellaneous), generally will apply to the RRT.

However, the effect of the Protocol’s modification to Article 22 (Relief from Double Taxation) is that even though the RRT is a covered tax, the United States is not required by the Convention to grant a U.S. foreign tax credit for RRT paid to Australia. Whether the RRT is creditable therefore is determined under U.S. domestic law.

Paragraph 2

Under paragraph 2, the DTA will apply to any taxes that are identical, or substantially similar, to those enumerated in paragraph 1, and which are imposed in addition to, or place of, the existing taxes after the date of signature of the Convention. The paragraph also provides that the competent authorities agree to notify each other at the end of each calendar year of substantial changes in their income tax laws or the official interpretation of those laws or the Convention.

CONCLUSION

Ensure that you understand the taxes that are covered by this DTA. First and foremost, you need to identify the type of income generated before relying on the DTA.

It is important to note, that to the extent that a DTA is silent on a specific type of tax, that item is taxed under domestic law.  DTAs are not all-encompassing in that regard. 

The DTA only applies to US Federal Income Taxes, which implies that it does not extend to State taxes. You will therefore not be able to claim treaty relief for state taxes paid in the US.

Furthermore, Estate and Gift Taxes are covered in separate treaties and do not fall within the ambit of this DTA.

It will be interesting to see how the US and Australia interpret the taxation of Cryptocurrencies in terms of the DTA. Even though there is sufficient coverage currently we might see some amendments soon.

Our team of International Tax specialists at Asena Advisor has an in-depth knowledge of how to interpret international tax treaties and how to ascertain their applicability to your specific circumstances.

Shaun Eastman

Peter Harper

US-AU DTA: Article 1 – Personal Scope

Posted on by Peter Harper

GENERAL BACKGROUND

In this series, we will be discussing the Convention Between the Government of the United States of America and the Government of Australia for the Avoidance of Double Taxation and Fiscal Evasion concerning Taxes on Income 1982 and the 2001 protocol (DTA). 

These series aim to make sure the reader has a comprehensive understanding of the DTA and how to interpret and apply it correctly. 

The only way to get a comprehensive understanding of the DTA is to make sure you understand every article on its own. 

If the reader is anything like my wife, you will probably question the above statement and see it as a way of me dragging it out. Especially considering that the DTA only consists of 29 Articles in a 27-page document. How complicated can it be?

Well just to give you some perspective, the US bases all its DTAs on the US Model Tax Treaty. This model is used as a foundation and guideline on how to draft specific DTAs with various countries. The US Model Tax Treaty also has a Technical Explanation to understand how to interpret and apply a DTA. The technical explanation is 92 pages long. 

Most countries in the world (excluding the US) follow the Organization of Economic Co-operation and Development’s (OECD) Model Tax Convention which consists of 32 Articles. The commentary on the OECD’s Model Tax Convention is 658 pages. 

I would therefore recommend not taking international tax advice from my wife or any advisor who summarizes the DTA in one or two pages. It’s not that simple. 

In this week’s blog, we will discuss Article 1 of the DTA – Personal Scope

INTRODUCTION

The main reason why countries across the world implement DTAs is to avoid the imposition of comparable taxes in two or more countries on the same taxpayer in respect of the same subject matter and for identical periods. The harmful effects of double taxation on the exchange of goods and services and movements of capital, technology, and persons are so well known that it is scarcely necessary to stress the importance of removing the obstacles that double taxation presents to the development of economic relations between countries.

DTAs, therefore, help to clarify, standardize, and confirm the fiscal situation of taxpayers who are engaged in commercial, industrial, financial, or any other activities in other countries through the application by all countries of common solutions to identical cases of double taxation. 

The US and Australia tax their residents on a worldwide basis and non-residents on a source basis. So, these tax systems will seek to levy taxation where there is a source of income in a state/country (state is the term used for the country, either the US or Australia) and/or a person who is a resident in a country. Both source and residence are referred to as ‘connecting factors’ in the world of public international tax. This is where the DTA comes into play, to ascertain whether the US or Australia has taxing rights on a specific type of income.

INTERPRETING ARTICLE 1 OF THE DTA – PERSONAL SCOPE

Article 1 of the DTA states the following – 

Except as otherwise provided in this Convention, this Convention shall apply to persons who are residents of one or both of the Contracting States.

This Convention shall not restrict in any manner any exclusion, exemption, deduction, rebate, credit, or other allowance accorded from time to time: 

by the laws of either Contracting State; or 

by any other agreement between the Contracting States.

Notwithstanding any provision of this Convention, except paragraph (4) of this Article, a Contracting State may tax its residents (as determined under Article 4 (Residence)) and individuals electing under its domestic law to be taxed as residents of that state, and because of citizenship may tax its citizens, as if this Convention had not entered into force. For this purpose, the term “citizen” shall, for United States source income according to United States law relating to United States tax, include a former citizen or long-term resident whose loss of such status had as one of its principal purposes the avoidance of tax, but only for a period of 10 years following such loss.

The provisions of paragraph (3) shall not affect: 

the benefits conferred by a Contracting State under paragraph (2) of Article 9 (Associated Enterprises), paragraph (2) or (6) of Article 18 (Pensions, Annuities, Alimony and Child Support), Article 22 (Relief from Double Taxation), 23 (Non-Discrimination), 24 (Mutual Agreement Procedure) or paragraph (1) of Article 27 (Miscellaneous); or 

the benefits conferred by a Contracting State under Article 19 (Governmental Remuneration), 20 (Students) or 26 (Diplomatic and Consular Privileges) upon individuals who are neither citizens of, nor have immigrant status in, that State (in the case of benefits conferred by the United States), or who are not ordinarily resident in that State (in the case of benefits conferred by Australia).

Paragraph 1

This paragraph sets out the scope of DTA’s application. It applies to residents of the US and/or Australia. However, the scope is extended in certain articles of the DTA and can also apply to residents of third countries, for example, Article 10 (Dividends), Article 11 (Interest), and Article 25 (Exchange of Information). A resident is defined in Article 4 of the DTA. 

Paragraph 2

This paragraph goes on further to state that the DTA may not increase tax above the liability that would result under either the US or Australian domestic legislation or any other agreement between the US and Australia. It also provides taxpayers with the option to rather apply domestic law instead of the DTA, if the domestic law provides the more favorable treatment. A taxpayer, however, may not make inconsistent choices between the rules of the Internal Revenue Code and the DTA rules.

Asena Advisors is the only multi-disciplinary (Accounting and Legal) international CPA firm in the United States that specializes in U.S. -Australia taxation.
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Paragraph 3

This paragraph is probably one of the most important provisions of the DTA as it lays the foundation of taxing rights for the rest of the DTA. It provides the US with broader powers than what is usually provided to other countries in DTAs. This is due to the US being one of the only countries in the world (the other country is Eritrea) to continue to tax individuals who are US citizens on a worldwide basis irrespective of where they live in the world. 

It contains a ‘saving clause’ which stipulates that the US and Australia reserve the right to tax its residents as if the DTA had not come into effect.  The US and Australia also reserve the right to tax their citizens, individuals electing under their respective domestic laws to be taxed as residents, and in the case of the US, former citizens whose loss of citizenship had as one of its main purposes the avoidance of tax. This reservation was extended in the 2001 protocol to include not only former citizens but also former long-term residents of the US. This was to ensure that the DTA is consistent with US law, more specifically Section 877 of the Internal Revenue Code. 

Section 877(c) provides certain exceptions to these presumptions of tax avoidance. The US defines ‘long-term resident’ as an individual (other than a US citizen) who is a lawful permanent resident of the United States in at least 8 of the prior 15 taxable years. An individual is not treated as a lawful permanent resident for any taxable year if such individual is treated as a resident of a foreign country under the provisions of a tax treaty between the United States and the foreign country and the individual does not waive the benefits of such treaty applicable to residents of the foreign country.

The major thing to note here is that even though the right to tax its citizens is reserved for Australia as well, Australia does not tax individuals based on citizenship. Whereas in the case of the US, individuals are taxed based on citizenship. 

Paragraph 4

This paragraph sets out the limitations of the saving clause and where other provisions of the DTA will override the savings clause. The saving clause does not override the benefits provided under paragraph 2 of Article 9 (Associated Enterprises), relating to correlative adjustments of tax liability, or the benefits of paragraphs 2 or 6 of Article 18 (Pensions, Annuities, Alimony and Child Support), relating to social security payments, alimony and child support. 

Social security payments and similar public pensions paid by Australia and alimony, child support, and similar maintenance payments arising in Australia are taxable only by Australia even though the recipient may be a resident of the US. Similarly, social security payments by Australia to a citizen of the US, wherever resident, are taxable only in Australia. 

The benefits provided in Articles 22 (Relief from Double Taxation), 23 (non-Discrimination), and 24 (Mutual Agreement Procedure), and the source rules of paragraph 1 of Article 27 (Miscellaneous) are also available to residents and citizens of the Contracting States, notwithstanding the saving clause.

THE IMPORTANCE OF READING COMPREHENSION 

Although most people can read, the act of reading and the act of comprehending what you read are two very different things.

Reading comprehension is the ability to process text, understand its meaning, and integrate with what the reader already knows. 

Lawyers generally know the importance of reading comprehension. At law school, students are taught how to interpret legislation. So, this is not a gift or talent, lawyers are born with, but rather a skill set you can develop that will be extremely beneficial when looking at the DTA. 

The reason why it is extremely important to understand the DTA and more specifically Article 1 of the DTA, is so that you understand if the DTA even applies to you. We’ve assisted numerous clients who either misinterpreted the application of the DTA or whose advisor misinterpreted the application. 

The key questions you should consider to ensure the correct application of the DTA is – 

  1. What is the scope of the DTA and do I fall within that scope to use the DTA?
  2. Am I a resident of Australia or the US for purposes of the DTA?
  3. What are the benefits available to me in the DTA?
  4. What is the limitation of benefits in the DTA?
  5. What is the interplay between US/Australia domestic legislation and the DTA?
Our team of International Tax specialists at Asena Advisor has an in-depth knowledge of how to interpret international tax treaties and how to ascertain their applicability to your specific circumstances. 

Shaun Eastman

Peter Harper