The purpose of this section is to provide a cursory view of foreign trusts and financial planning, the emphasis of which is asset protection from judgments. The basic taxation regime of a foreign trust can be reviewed in a previous writing, Income Taxation of Foreign Trusts and Beneficiaries, TaxConnections, November 25, 2013.
The focus here is the treatment by the United States taxing authority upon a foreign trust pertaining to the tax consequences subsequent to transfer. The points of relevance are the income tax treatment to the Settlor, beneficiary, and trust and the consequential use of the foreign trust to accomplish other objectives.
A hypothetical backdrop for illustration of principles would be in this factual setting. A United States Settlor establishes a foreign trust in an Offshore Financial Center and an independent trustee is designated in that declaration of trust. The Settlor relinquishes complete dominion and control over all assets transferred to the foreign trust. The terms of the trust estate are that it is irrevocable and the Settlor thus is prohibited to alter or amend the terms of the trust, beneficiaries, or trustee; an absolute release of dominion and control as interpreted in conformity with United States gift and estate provisions. The two beneficiaries are the children or issue of the Settlor. The independent trustee has the discretion to distribute the trust net income or accumulate it. Each beneficiary is granted a special power of appointment over his or her separate share interest of corpus upon death.
Section 679 Taxation of Settlor
A United States Settlor of an irrevocable foreign trust that has a United States beneficiary is deemed to be the owner of the foreign trust with respect to the application of United States income taxation. Subject to statutory exceptions, the Settlor is the taxable party regardless of whether the Settlor has released all dominion and control of the trust assets by an irrevocable transfer, the right to alter, amend, and modify the trust document. This is the income tax treatment of a United States Settlor by virtue of Section 679 of the Code. (1) Because the Settlor is deemed the owner of the trust assets, the transfer of appreciated assets to a foreign trust does not occasion a taxable event as contemplated by Section 684 of the Code. (2)
There are conditions that must be present when Section 679 is applicable to subject a Settlor to the income tax upon a foreign trust’s income. It first must be a foreign trust by definition. Secondly it shall be established that the trust has a United States beneficiary. The transferor of assets, the Settlor in this instance, must be a United States person. Lastly the transferor must have made either a direct or indirect transfer of property to the trust. (3)
Foreign trusts will be construed to have United States beneficiaries if income or corpus of the trust can be paid or accumulated during the taxable year or used for the benefit of a United States person. In furtherance of this rule, no part of the corpus or income can be deemed payable to or for the benefit of any United States person if the trust provisions provided that result upon termination during a taxable year. (4)
Because the Settlor is deemed to be the owner of the foreign trust, there is no United States gift tax because it is deemed to be an incomplete gift. There is also no United States federal estate tax if the Settlor becomes a decedent because United States federal estate tax provisions provide that the Settlor has not relinquished the assets. Therefore, it will be included in his or her gross estate for estate tax purposes. (5) It is deemed not relinquished by virtue of the Settlor being recognized as the owner of the income. Gift and estate tax consequences are beyond the scope of this writing.
The Purpose of Foreign Trusts
Even though a United States Settlor relinquishes his or her interest in assets to a foreign trust, the income generated is taxable to the Settlor. It does not facilitate an opportunity to establish an estate plan as it would in the domestic trust setting. The real question is the primary motivation of a United States Settlor desiring to use a foreign trust in light of the less-than-advantageous United States federal estate and income tax consequences.
But there are purposes that can be very important to a client. There are a multitude of objectives. Those purposes could be to protect assets from future creditors for those in high exposure professions and to prevent adverse marital claims by establishing trust instruments prior to marriage. Another purpose can be conceived in the context of estate planning opportunities where exceptions to Section 679 (6) provide opportunities to a Settlor that is a subsequent estate decedent.
Additionally purpose is sometimes motivated by the reality of an inability of a United States taxpayer to realistically reach a settlement with the Department of the Treasury of the United States regarding a tax liability. These purposes are not meant by any means to be inclusive and there are a multitude of objectives to be achieved. This writing is directed to judgment creditors and most specifically the treatment of tax judgments by other sovereigns.
Legal judgments and their enforceability are significant legal risks. The ability to enforce and execute upon an obtained judgment is influenced by the status of an offshore center’s sovereign agreements with other nationals and international law. Consideration is directed to recognition and enforcement of foreign judgments. The two areas of importance are foreign judgments related to personal or commercial dealings and taxation or revenue judgments obtained by a foreign government. One objective is to illustrate it may be beneficial to a Settlor that judgments obtained against a defendant located in specific offshore centers are not enforceable or given recognition.
The due process concept, as discussed in jurisdiction, is a requisite to the recognition of a foreign judgment. It incorporates the principle no person will be deprived of liberty or property without due process of law. It is applicable at the United States federal and state levels. United States jurisprudence requires that judicial jurisdiction cannot violate this notion of reasonableness. Because there is no uniformity in international law, due process is a country-by-country determination. Understanding how the United States perceives these principles of due process and their subsequent application to international views is essential. There are significant planning opportunities resulting from this lack of international uniformity and the state-by-state issues arising from the United States federal system of law.
With this as a backdrop, the method to decipher recognition and enforcement of foreign judgments is the process of determining what is essential for a valid judgment. When it is established there is judicial jurisdiction, a competent court, and proper service of process, a prima facie essence exists for a recognizable judgment. If those elements are present in a domestic setting, a judgment is deemed to be recognized subject to enforcement.
There is a departure from a domestic setting in an international matter with each country having a procedure for enforcing judgments rendered in local or foreign courts. Each will have a process to enforce recognized judgments regardless of whether a country has a common law, civil law, or hybrid judicial system. A prima facie recognized judgment has a status of being res judicata or a preclusive effect, judgment which estoppes the same parties from bringing an action on the same claim before any court. The concept of the recognition of a foreign judgment goes to the issue of the preclusive effect of a judicial judgment and whether courts in an international forum will bestow recognition.
The other question arising upon the rendering of a recognized foreign judgment is the enforcement of it. Recognition and enforcement of foreign judgments can be subject to law provided by treaty, multi-national conventions, or bilateral agreements entered into between sovereigns. The United States has no treaty with any country, is not a party to any multi-lateral convention, or any bilateral treaty that addresses the recognition or enforcement of a foreign judgment. Understanding the reaches of this concept is the very heart of Financial Center planning with respect to core issues.
To enforce a foreign judgment in the United States, the interest of the United States in the enforcement of the particular foreign judgment is the controlling factor. Comity defines the basis upon which enforcement is determined, absent state law or the Uniform Foreign Money-Judgments Recognition Act of 1962. The general proposition is that, aside from comity, the United States common law holds foreign judgments as not enforceable. (7)
That is the crux of a sovereign refusing to recognize the judgment obtained by another sovereign. Before comity is to be extended, generally there is a requirement of reciprocity that is the principle that the courts of one jurisdiction will recognize a judgment from a second jurisdiction only if the courts of the second jurisdiction would recognize a judgment from the first jurisdiction’s court. (8) By virtue of the United States refusal to recognize foreign judgments, it establishes the comity necessary for a foreign sovereign to not only not recognize a judgment decree in the United States, but to find it unenforceable.
Recognition and Enforcement of Foreign Judgment
To facilitate an understanding of recognition and enforcement of judgments, the focus for purposes here is on United States concepts. Those concepts are then applied in considering an offshore situs. Rather than trying to avoid foreign judgments, there are also instances where the ability of a client to obtain and enforce judgments in the international market place is a primary consideration in the selection of a particular Offshore Financial Center. Importantly in this concept is an understanding that in the international community, a plaintiff obtains a judgment, but that judgment must first be one that is recognized by a jurisdiction where it is sought to be enforced and enforceable.
In the discussion of the recognition and enforceability of judgments, there is a presumption a judgment has been obtained. This transcends very intricate and complex litigation issues embodied in international civil litigation. Certain aspects of jurisdiction, service of process, obtaining of evidence abroad, and defenses special to international litigation are beyond the scope of this writing. Some related concepts are a material part of the discussion of judgments and enforcement. They are incorporated when appropriate.
The recognition of a foreign judgment by any court, be it domestic or international, must be rendered in a manner embracing notions of due process. There is not a body of international public or private law that provides a definitive analysis. Because of this, international financial transactions require formulation of an ad hoc approach regarding each international jurisdictional determination. Due process in the context of recognizing judgments is grounded in Articles V and XIV of the United States Constitution.
Governmental Revenue Judgments
A final and important comment of legal risk and foreign trusts is with respect to the recognition and enforcement of foreign penal judgments. There exists in the United States the often-referenced revenue rule. As a general proposition, judgments obtained from a foreign sovereign are to be recognized by courts of the United States when general principles of comity apply. There are two frequently stated exceptions to comity. These exceptions occur when a judgment is based upon either the tax or penal laws of a foreign sovereign. The taxation exception is the revenue rule. (9)
The United States has sought at this point to refuse enforcing foreign revenue judgments. This position continues to be based on the notion that in the United States the political branches of the government have entered into two tax treaties with the Canadian government. These treaties are extensive and deal with a number of questions arising from instances of individuals, corporations, residents, or citizens of one country owning property or doing business in the other country. A section of the treaty agreement provides for an exchange of information between the two countries for the purpose of preventing international tax evasion.
This portion of each treaty has addressed enforcement powers as an exchange of information. Even though the political branches of Canada and the United States could have abolished the revenue rule between themselves at the time the treaty was agreed to, they did not. If this rule is to be changed, the judiciary recognized it is a more proper function of the policy-making branches of the United States government to accomplish such a change. (10)
To further bolster this universal rule that United States courts will not enforce foreign tax judgments, the Uniform Foreign Money-Judgment Recognition Act specifically excludes any judgment for tax revenues. (11) The case of Her Majesty the Queen In Right Of The Province of British Columbia v. Gilbertson (12) was a Federal District court case which was obliged to apply the law of the forum state, Oregon. The significance of this is that Oregon was one of the several states to have adopted the Uniform Foreign Money-Judgment Recognition Act of 1962.
With respect to the revenue rule, those sister countries not having a reciprocity doctrine may provide some safe haven from United States tax collection of assessments. The reasoning is that if the United States chooses not to enforce tax judgments of a sister country, then a sister country adhering to a doctrine of reciprocity may find the necessary rationale to deny enforcement of a United States tax judgment in its sovereign. (13)
This use of foreign trusts has been presented in this writing without the anticipation of circumventing creditors and the niceties of the Uniform Fraudulent Transfer Act (14) or the Uniform Fraudulent Conveyance Act. (15) The thrust of those statutes is to distinguish transfers of property with the intent to defraud past or present creditors. This writing does not contemplate an intent to defraud, but rather well grounded financial planning.
In answer to these strong statutory provisions, offshore trust facilities have been accommodating. They have crafted their trust laws to meet this demand of those circumstances. The two most notable are the trust ordinances of the Cook Islands and Nevis, W.I. of recent. It is beyond the scope of the writing, but those statues are designed to defeat the fraudulent transfer statutes. (16)
The recent flurry of emphasis upon the reporting of foreign accounts in the international banking sector culminated from the great melt down of the international monetary system commencing in 2008. It brought to light what all central bankers have known, that International Financial Centers are deeply involved with banking law that requires no insurance, reserve requirements, and basically the environment of minimal regulation. In that crisis the looming question for years of who was a lender of last resort came to the forefront. The complexities of the unregulated foreign exchange interbank market and sovereign mercantilism will continue. It has since the beginning of international banking. (17)
Banking with confidential accounts has been attacked on the basis of loss of tax revenues. But in fact the movement of capital offshore that has been occasioned by asset protection dwarfs any loss of revenue to a sovereign. It has been estimated that in 1994 at least one to five trillion dollars has been held and funded in asset protection trusts offshore rather than in the United States. (18) International Financial Centers around the globe are competing for this capital to flow to their benefit just as a market economy and free trade is designed to work. Taxpayers are availing themselves of these opportunities to safe guard their hard assets from judicial regimes that pose a clear and present danger to their financial well being. This writing is meant to emphasize that these foreign trusts can be established without a connotation of alluding some unjust or irrational judgment, but rather sensible long term financial planning.
**********Footnotes 1. Section 679 IRC of 1986. 2. Section 684 IRC of 1986. 3. Treas. Reg. Section 1.679 of the IRC of 1986. 4. Id. at note 3. 5. Section 2511 IRC of 1986 and as thereafter amended. (Gift Tax); see Section 2031 IRC of 1986 and as thereafter amended. 6. Supra note 1. 7. Hilton v. Guyot, 159 U. S. 113 (1895), 16 S. Ct. 139, 40 L.Ed 95 (1895), Note that reciprocity is not a requirement in comity.; see Somporex. LTD v. Philadelphia Chewing Gum Corp., 318 F. Supp. 161 (E. D. Pa. 1970). Also note that a foreign judgment is not required by public international law to be enforced by comity if it violates public policy; see, Ackerman v. Levine, 788 F. 2d 830 (2nd Cir. 1986). The principles of comity were stated in Hilton v. Guyot, to wit: “…where there has been opportunity for a fair trial abroad before a court of competent jurisdiction, conducting the trial upon regular proceedings, after due citation or voluntary appearance of the defendant, and under a system of jurisprudence likely to secure an impartial administration of justice between the citizens of its own country and those of other countries, and there is nothing to show either prejudice in the court or in the system of laws under which it was sitting, or fraud in procuring the judgment, or any other special reason why the comity of this nation should not allow it full effect, the merits of the case should not, in an action brought in this country upon the judgment, be tried afresh, as on a new trial or an appeal, upon the mere assertion of the party that the judgment was erroneous in law or in fact.” 8. Id at note 7. 9. Her Majesty The Queen In Right of The Province of British Columbia v. Gilbertson, 597 F. 2d. 1161 (9th Cir. 1979). 10. Id. at note 9. Also see Johansson v. United States, 336 F. 2d. 809 (5th Cir. 1964). 11. Section 1.(2) of The Uniform Foreign Money-Judgments Recognition Act of 1962. 12. 597 F. 2d. 1151 (9th Cir. 1979). 13. See, 5/International Comity, Introduction, pages 14-18, Born and Westin, International Civil Litigation in the United States, 1991, Kluwer Law and Taxation Publishers, Peventer, The Netherlands. 14. UNIF. Fraudulent Transfer Act, 7A-2 U.L.A. 266 (1999). 15. UNIF. Fraudulent Conveyance Act, 7A-2 U.L.A. 2 (1918). 16. See Nevis International Exempt Trust Ordinance of 1994 (as amended) (NIETO) and Cook Islands International Trusts Act of 1984. As to Cook Islands International Trusts Act of 1984, see Sec. 13 (C) wherein it is provided that even if a judgment creditor may not reach a Settlor’s interest even if Settlor has retained a right to revoke the trust. Under this statute even if a creditor is able to prove that a Settlor intended to defraud a creditor by transferring assets to trust, the creditor is not able to reach the assets unless it is proven that the Settlor was insolvent at the time the creditor’s claim arose, see Section 13 (B). Even if a creditor was able to prove that a conveyance or transfer was fraudulent the Cook Island statute imposes a very limited statute of limitations on creditor claims. And most importantly, the statute provides that no Cook Islands court will recognize or enforce a foreign judgment against a Cook Islands trust, or Settlor, or Trustee or beneficiary of the trust if the judgment is based upon application of a law inconsistent with the statute, see Section 13 (D). That provision is a most emphatic stipulation of the Cook Islands position regarding the concept of comity of international private law as to any judgment. Note that the Nevis International Exempt Trust Ordinance has a similar favor, requiring a posting of bond of twenty-five thousand dollars to be permitted to make such an assertion such as a conveyance or transfer being fraudulent, but also establishes that a creditor must show it to be beyond a reasonable doubt, that the trust was established or a transfer made with a principal intent to defraud, plus a second threshold to be proved beyond a reasonable doubt is that the trust’s establishment or funding left the Settlor insolvent or without property, by which that creditor’s claim, if successful could have been satisfied; see Creditor Protection Art. 14.2.4, Sec. 24.1 NIETO. 17. The Rise and Fall of International Banks, Institute of International Bankers, Washington, D.C. April, 14, 1988, by David C. Cates, President Cates Consulting Analysts, Inc., New York City, New York. 18. See, Debra Baker, Island Castaway, A.B.A.J., Oct. 1998.; also see David D. Beazer, The Mystique of of ‘Going Offshore’ UTAH BJ., Dec. 1996.
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