A Brief Overview of the Judicial Reasoning That Has Thwarted Foreign Asset Protection Trusts

Hale Stewart, Tax Advisor

As I have documented previously, there are several cases where courts have ruled against the grantors of a foreign asset protection trust, thereby nullifying the asset protection benefit. In this post, I want to briefly sum up the judicial reasoning used by the courts to thwart these trusts.

Some offshore jurisdictions have amended their code to include provisions such as shortening the fraudulent transfer statute of limitations or not recognizing foreign judgments. Seeking to take advantage of these debtor-friendly rules, drafting attorneys typically add a choice of law provision to trust documents, stating that the haven’s rules will apply to their trust and its interpretation. This drafting tactic is supported by Scott on Trusts, which states that the grantors choice of law designations should generally be respected.

But as the Portnoy court observed, the Restatement of the Conflict of Laws allows courts to overturn a trust’s choice of law clause if, “…required by the policy of a state.” The court continued, “application of Jersey’s substantive law would offend strong New York and bankruptcy policies if it were applied,” followed by this intellectual coup de grace: New York would not “permit a debtor to shield from creditors all of his assets because ownership is technically held in a self-settled trust, where the settler beneficiary nonetheless retains control over the assets and may effectively direct disposition of those assets.”

The policy is clear: courts won’t allow debtors to run up large obligations, default, and then not provide creditors a legal avenue to be made whole. Not only is this ethically and politically unsavory, its economically inefficient and poor public policy. Courts will not allow themselves to be a party to a transaction that allows debtors to “have their cake and eat it too.”

Long ago, attorneys recommending foreign assets protection trusts (FAPT) realized that courts might hold grantors in contempt because they wouldn’t repatriate assets from a foreign jurisdiction. To theoretically thwart this possibility, drafters included a “duress clause” in trust indentures. When a “duress” event occurs (such as a judge forcing the grantor to repatriate assets), the grantor will either be stripped of all his trust benefits or the trustee will be allowed to deny the request.

The cases contain the following general fact pattern: the court threatens the grantor with contempt; the grantor asks the trustee for a distribution; the trustee uses the duress clause to deny the distribution; the grantor than tells the court, “I tried to comply but couldn’t.” But judges have read the relevant literature and are fully aware this is a case of artful drafting. Therefore, they impose a very high burden on the grantor when he creates the “impossible” situation.

The court in Affordable Media observed:

With foreign laws designed to frustrate the operation of domestic courts and foreign trustees acting in concert with domestic persons to thwart the United States courts, the domestic courts will have to be especially chary of accepting a defendant’s assertions that repatriation or other compliance with a court’s order concerning a foreign trust is impossible. Consequently, the burden on the defendant of proving impossibility as a defense to a contempt charge will be especially high.

In effect, the courts treat the grantors pre-planned failed compliance effort as kabuki theater. There is always a possibility that a grantor could overcome the court’s “especially high” bar.  But it seems doubtful. In effect, the courts treat the grantors pre-planned failed compliance effort as kabuki theater. There is always a possibility that a grantor could overcome the court’s “especially high” bar. But it seems doubtful.

In the final installment of this series on foreign asset protection trusts, I’ll look at if and when someone should use these structures.

Have a question? Contact Hale Stewart

Your comments are welcome!

Mr. Stewart has a masters in both domestic (US) and international taxation from the Thomas Jefferson School of Law where he graduated magna cum laude. Is currently working on his doctoral dissertation. He has written a book titled US Captive Insurance Law, which is the leading text in this area.

He forms and manages captive insurance companies and helps clients in international tax matters, US entity structuring, estate planning and asset protection.

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