DISCUSSION OF INVESTMENT, INCOME AND ESTATE TAX ISSUES ...



DISCUSSION OF INVESTMENT, INCOME AND ESTATE TAX ISSUES FACING MEXICAN CITIZENS WITH INVESTMENTS OUTSIDE OF MÉXICO

By Robert Atkins Walker

The investment issues:

           The investment management assets of certain Mexican citizens are being transferred from Merrill Lynch’s management to a new manager and are being invested in Fidelity accounts.  The new manager’s objectives are three fold: (1) maximize after-tax and after-fee return for these clients, (2) maintain client confidentiality, and in most cases (3) allow the clients control of their portfolios through  trusts (fideicomisos).  The new manager prefers non-México-domiciled trusts because of these objectives and has asked CITCO to establish offshore trusts.  For those clients needing trusts, the Fidelity accounts will be in these trusts, and the new manager will manage the asset allocation.  For the other clients, the Fidelity accounts will typically be held individually or as JTWROS.

 

            The new manager’s questions are:

1.  At what point is a Mexican citizen considered a US resident for tax purposes?

2.  What happens when the clients receive 1099s from Fidelity?

3.  What are the income tax effects of investments held in trust in México, offshore and the US?

4.  What are the estate tax effects of investments held in trust in México, offshore and the US?

 

1.  At what point is a Mexican citizen considered a US resident for tax purposes?

            If the Mexican citizen is neither a dual citizen of the US nor holds a green card, then the Substantial Presence Test applies.  A Mexican citizen meets the Substantial Presence Test if he is physically present in the US for 31 days during the current calendar year AND he is physically present in the US for 183 days or more in the current and prior two years with the days of physical presence counted as follows:  all the days in the current year, 1/3 of the days last year, and 1/6 of the days two years ago.

 

            Foreign Tax Home exception:  A Mexican citizen may establish his US nonresident status if he is in the US less than 183 days in the current year disregarding his time in the US in the prior two years.  He must establish that he has a closer connection to México than to the US during the current year as evidenced by factors such as where his permanent home is, where his financial accounts, church and cultural organizations are, where he votes, and where his driver’s license is issued.  To claim this exception he needs to file Form 8840 along with his US nonresident tax return.

 

            US-México Tax Treaty exception:  A Mexican citizen may establish his US nonresident status if he is in the US for 183 days or more in the current year by asserting that he is a nonresident under the provisions of Article 4 of the Treaty.  To claim this exception he needs to file Form 8833 along with his US nonresident tax return.  Nonresidence may be harder to assert if he’s in the US all year than for, say, 220 days.

 

            Days not included in physical presence:  Days spent in the US as a commuter from a residence in México, stays of less than 24 hours while in transit between other countries, days spent while unable to leave due to a medical condition arising after arrival, or days as an exempt individual (a foreign government-related individual, visitor under a specific academic visa, or athlete participating in a charitable event).  Days of physical presence would, however, include visits to obtain medical treatment for a condition existing prior to arrival.

 

2.  What happens when the clients receive 1099s from Fidelity?

            2a.  First step:  Before the end of the tax year, the new manager needs to take steps to reduce or eliminate the clients’ US income tax withholding on their Fidelity accounts.

            The important thing is what needs to be done before the end of the tax year to avoid Fidelity’s withholding US income taxes on investment income at a 30% rate.  For those clients having their investments held in Fidelity accounts individually or JTWROS, Form W-8BEN needs to filed with the withholding agent, i.e., Fidelity, to reduce or avoid this withholding.  If the assets are held in trust, the trust needs to file Form W-8IMY with Fidelity.  Also the clients may need to file Form W-8BEN with their trustee (CITCO). 

 

            Fidelity should be familiar with the reporting required.  CITCO or other companies offering foreign trust services should also be familiar with the alternatives with respect to the use of intermediaries and the ensuing requirements for Forms W-8BEN and W-8IMY.  The end result for the Mexican investors should be the same, regardless of where U.S. withholding is applied.  Please verify this with Fidelity and CITCO.  

 

            By filing these reduced-tax-withholding forms, the withholding tax rate will be reduced or eliminated depending on the type of income, thanks to the provisions of the US-México Tax Treaty.  Dividend withholding (including dividends on money market accounts and REITS) is reduced from 30% to 10%.  Interest withholding on OID, corporate bonds, US Treasuries, tax-exempt bonds, bank account interest including bank CDs is reduced to zero.  A reduced-tax-withholding form may also need to be filed to avoid withholding on proceeds from stock and bond sales.  The Treaty exempts capital gains from tax.  Please check with Fidelity on this.

 

            In general, interest-related dividends and short-term capital gains dividends from a regulated investment company (mutual fund) are exempt from withholding per § 871(k).  However, this exemption does not apply to dividends paid or addressed to, or for the account of, persons in certain foreign countries identified by the IRS as having inadequate information exchange with the US per § 871(k)(1)(B)(iii).  Whether the IRS has made such a determination may be a significant factor in the choice of jurisdictions for the foreign trust.  I have not yet located a published list of countries so identified by the IRS perhaps because this provision is so recent having been added to the Code in late 2004.

Please check with Fidelity on this as well.

 

            2b.  What should the clients do once they’ve received their 1099s from Fidelity?

            They typically need to do nothing if the reduced-withholding-tax forms discussed in 2a above have been appropriately filed.  The 1099s will report their income from various investments, their sale proceeds from broker transactions, and the income tax withheld.  If not all of the US tax they owe was withheld from the clients’ US-source income or if too much tax was withheld, they will need to file Form 1040NR.

 

            2c.  Confidentiality concerns

            Form W-8BEN need not bear a US Taxpayer Identification Number if it is filed solely to claim treaty benefits with respect to income from marketable securities including dividends and interest from actively traded stocks and debt obligations, mutual fund dividends, and dividends, interest or royalties from publicly offered and SEC-registered unit investment trusts.  However, in order for the investors to obtain treaty benefits, the trust arrangement will have to be transparent to both US and Mexican tax authorities.

 

3a.  Tax effects if the investments are held in a Mexican trust 

            México recognizes domestic trusts (fideicomisos) as legal entities.  Nonbusiness trusts (e.g., investment portfolio trusts), however, are treated as fiscally transparent in the sense that Mexican tax law considers any income earned to be earned directly by the owners or grantors or the beneficiaries depending on the particular type of trust.  In other words, the tax law disregards nonbusiness trusts as entities.  This means that, if the investments were held in a Mexican trust, the clients’ trust income would be subject to Mexican individual income tax rates as follows.

 

            For the current tax year the individual income tax rate is 28% on income over $2.5 million pesos (about $230,000 U.S.), and there are tax brackets from 3% to 25% on income slices below that.  Thanks to the 2005 Mexican tax reform law (Ley de Ingresos 2005), the top rate will decline to 29% in 2006 and 28% in 2007, but the lower brackets will be phased out replacing them with a single 25% rate on income up to $2.5 million pesos.  There is a $76,000 peso standard deduction along with deductions for home mortgage interest, etc.  Thus Mexican individual income tax rates are lower than U.S. rates for high income individuals.

 

3b.  Tax effects if the investments are held in an offshore (CITCO) trust 

            What are the effects if the investments are in an offshore (CITCO) trust in a tax haven country?  Although Mexican law has blacklisted a number of tax haven countries, some of México’s trading partners (non-blacklisted countries) have adopted favorable tax rates.  Because México was reluctant to blacklist those trading partners as well, it passed a 2005 tax reform that attacks the issue from a different angle.  According to Articles 212 and 213 of the Ley de Ingresos 2005, income from a foreign jurisdiction that is taxed by that jurisdiction at a rate less than 75% of the rate that would have applied in México will be taxed by the Hacienda (Mexican tax authority) regardless of whether the Mexican owner receives distributions of the income.

 

            I do not know at this point whether the Hacienda will tax the income from the tax haven at 30% (assuming the Mexican citizen is in the top tax bracket) or at 22.5% (30% x 75%).  I think it’s likely that the 30% rate will apply and the citizen may take a foreign tax credit on his Mexican income tax return for any tax paid to the tax haven country.

 

            I have emailed several CPAs who are knowledgeable based on their published articles about the 2005 Mexican tax law reform asking them how the Hacienda will calculate the tax on income from tax haven countries under the new law.

 

            The new manager said that the Mexican income tax will be assessed on the difference between the trust value at the end of the year minus the value at the beginning of the year.  Therefore I also included in my email to the knowledgeable CPAs the following question:  Does the Hacienda compute the tax on the investment income in the tax haven or simply on the increase in value of the investment during the year?  For example, assume the investment is worth $1,000,000 pesos on Dec. 31, 2006 and $1,200,000 pesos on Dec. 31, 2007.  During the year the Mexican investor received $100,000 pesos in interest income from the investment.  Had the interest not been distributed, the investment would have been worth $1,300,000 pesos at Dec. 31, 2007.  Is the tax computed on only the $100,000 pesos of interest income, or is it computed on $300,000 pesos ($1.2 million minus $1 million, plus $100,000 of income distributed)?

 

3c.  Tax effects if the investments are held in a US trust (one that is a domestic trust under US tax law).

            What are the effects if the investments are in a US trust that is a domestic trust under US tax law?

 

            First it must be determined if the trust qualifies as a domestic trust.  To do so, it must pass both the court test and the control test.  In brief, a trust automatically meets the court test if the trust is registered with a US court.  The fact that a trust document specifies that Mexican law will govern the trust does not necessarily mean that the trust will fail the court test as long as it gives a US court primary jurisdiction over enforcing that law.  The trust will pass the control test if one or more US persons have the authority, by vote or otherwise, to make all substantial decisions of the trust with no other person having veto power except for the grantor.

 

            If the trust passes these tests, it is subject to US income tax.  The US-México Tax Treaty, however, will reduce or eliminate the tax on all the income that flows through to the clients (the beneficiaries).

 

            In the case of a simple trust (one that requires all the income like interest and dividends to pass through to the beneficiaries), the only problem is capital gain income.  Normally capital gains and losses are treated under the Uniform Principal and Income Act as principal.  As such, they are not distributed to the beneficiaries and are taxed in the trust.  Because the trust is a US-taxable trust, the trust will have to pay tax on the capital gains even though capital gains are normally exempt from tax for Mexican nonresident aliens.  To avoid this tax treatment, the trust instrument must specify that capital gains and losses are classified as income and are distributable to the beneficiaries.

 

            In the case of a complex trust (one that does not require all the income to pass through to the beneficiaries), the trust will have to pay US tax on any undistributed income.  Therefore all the income must be distributed to avoid tax at the trust level.  To avoid tax on capital gain income, the complex trust instrument must specify that capital gains and losses are classified as income, and it must distribute that income to the beneficiaries.  A complex trust has 65 days after the end of the tax year to make the distributions if the trustee makes a § 663(b) election to treat any amount paid or credited to a beneficiary within 65 days following the close of the tax year, i.e, through March 6 (March 5 in a leap year), as a distribution in the prior year.  This is an irrevocable election.

 

            3d.  Foreign (Mexican or offshore) trust tax effects if a Mexican client becomes a US resident or citizen.

            If a Mexican client plans to become a US resident or citizen at some point in the future, he needs to understand and plan for the impact of US tax law with respect to pre-immigration foreign trusts – both grantor and irrevocable foreign trusts.

 

      a.  If there is any likelihood that any beneficiary of a foreign trust is, or may become, a US citizen or resident, the new manager may wish to consider whether the trust is drawn in consideration of § 672(f), which limits the applicability of the grantor trust rules of §§ 671-678.  In general, a US beneficiary will be subject to US income tax on any distributions from a foreign trust, unless the trust is revocable solely by the grantor (or a subservient party), and then only during the grantor’s lifetime.  For further information, refer to the examples in Treas. Reg. § 1.672(f)-3.

      b.  Any nonresident alien who transfers property to a non-US trust, and who may establish US residency at some time in the future, may wish to consider the provisions of § 679(a)(4).  Any portion of a foreign trust attributable to transfers by such a person within five years before establishing residence (including undistributed income attributable to such transfers) is treated as having been transferred on the residency starting date.  § 679 then operates to treat such portion of the trust as a grantor trust if the trust has a US beneficiary—and there is a strong presumption of a US beneficiary set forth in § 679(c).  In such a case, the income is currently taxable to the grantor, whether or not distributed.  The five-year timeframe, then, is an important tax planning consideration.  After five years have elapsed from a transfer to a trust that is (and has been for five years) otherwise a nongrantor trust under US rules, the transferor may immigrate to the US and trust income will be subject to US income tax only as it is distributed to U.S. beneficiaries.   See examples in Treas. Reg. § 1.679-5, Pre-immigration trusts.

So if, for example, a Mexican investor considers immigration to the US possible at some time in the future, it is probably best that transfers to a foreign trust be made irrevocable—so as to start the five-year clock running as soon as possible—either at the trust’s inception or by subsequent.  In contrast, if the investor desires that trust income be distributed during his lifetime to any US beneficiaries, he should consider retaining the power to revest the transferred property.

      In addition, any foreign investor contemplating immigration to the US or funding a trust for the benefit of US persons must also consider the rules with respect to controlled foreign corporations, foreign personal holding companies, passive foreign investment companies, and controlled foreign partnerships.  Please let me know if one of the clients might be in this situation.

4.  What is the US estate tax impact of investments held in trust or otherwise by Mexican citizens who are US nonresident aliens?

 

            a.  First, I’ve listed below the assets owned by a nonresident alien that are includable or excludable from his gross estate for US estate tax purposes

 

            Assets owned by a nonresident alien that are situated in the US (that have US situs) and are subject to the US estate tax

            The following is a list of property owned by a nonresident alien that would be treated as having US situs and would be included in his gross estate for US estate tax purposes.

            1.  US real estate

            2.  US tangible personal property (e.g., currency, jewelry, furniture, vehicles, etc.)

            3.  Stock in a US corporation including shares in a US-based mutual fund

            4.  US partnership interest

            5.  Trust interest to the extent of the beneficiary’s share in the US-situs assets owned by the trust.  The situs of assets held in trust is determined by the same rules as assets held directly as discussed in paragraph b(3) below.  For example, bank deposits and portfolio debt obligations held by a trust do not have US situs.

            6.  US-situs assets that are part of §§ 2035-2038 transfers, i.e., transfers within 3 years of death, transfers with a retained life estate, transfers taking effect at death, and revocable transfers such as transfers to a revocable (living) trust

            7.  Debt obligations that are effectively connected with a US business of the decedent

            8.  Nonbank deposits, e.g., money market accounts in brokerage firms.

 

            Assets owned by a nonresident alien that DO NOT have US situs and are NOT subject to the US estate tax

            The following is a list of property owned by a nonresident alien that would not be treated as having US situs and would be not included in his gross estate for US estate tax purposes.

            1.  Foreign real estate

            2.  Foreign tangible property

            3.  Life insurance, except life insurance issued by a US insurer on the life of someone other than the decedent

            4.  Domestic (US) bank deposits

            5.  Deposits in foreign branches of domestic banks

            6.  Deposits in domestic branches of foreign banks

            7.  Debt obligations that yield portfolio interest (e.g., corporate bonds issued by US or foreign corporations, US treasuries, tax-exempt (muni) bonds, and loans to US or non-US citizens)

            8.  Debt obligations of foreign persons or countries

            9.  Interest-bearing amounts held by insurance companies

            10.  Stock in foreign corporations (as long as the corporate formalities are observed)

            11.  Foreign partnership interests (Note:  If the partnership owns US-situs assets, the partnership interest is still exempt if three relatively simple conditions are met.)

 

            b.  What is the US estate tax impact of holding assets in different forms?

 

                        (1).  Assets held in individual name

            All the situs rules above apply to such assets in determining whether they are includable in the nonresident’s gross estate.

 

                        (2).  Assets held as JTWROS or as Tenant in the Entirety where the only owners are the two spouses.  This type of ownership is referred to as a Qualified Joint Interest in the US tax code.

            Although all the situs rules above apply to such assets in determining whether they are includable in the nonresident’s gross estate, the normal rule under § 2040(b) of excluding one-half of the value from the decedent’s estate doesn’t apply when the surviving spouse is a nonresident alien per § 2056(d)(1).  Instead, the estate is required to substantiate the surviving spouse’s contribution to the ownership of the property to determine the excludable portion of US-situs assets.

 

                        (3).  Assets held in trust

            Holding assets in trust (whether a US or foreign trust) will not avoid the US estate tax on assets that have US situs.  The situs of beneficial interests in trusts is determined by reference to the underlying assets.  For example, if a trust (whether a US or foreign trust) has assets consisting of Fidelity mutual fund shares, the nonresident alien’s beneficial interest is includable in the decedent’s US gross estate for estate tax purposes because the mutual fund shares, if held directly by the decedent, would have had a US situs.  (Commissioner v. Nevius, 76 F.2d 109 (2d Cir., 1935), cert. denied, 298 U.S. 591 (1935), and Rev. Rul. 55-163, 1955-1 C.B. 674.)

 

                        (4).  Assets held by a foreign corporation – A GOOD SOLUTION!

            A good way for nonresident aliens to avoid US estate tax is to put their US-situs assets into a foreign corporation because a nonresident alien’s stock in a foreign corporation is exempt from the US estate tax.  Although this works for US real estate too, the real estate will not get a step up in basis at the date of death because it is held in the corporation and is not included in the estate.  Therefore it will be subject to capital gains tax at the time of sale.

 

            Another way is to own foreign mutual funds.  Even if the foreign mutual funds own stock in US corporations, the mutual fund shares are foreign stock and as such are exempt from US estate tax.

 

            c.  Other US estate tax considerations

                        (1).  Estate tax credit exemption equivalent:  Currently for US citizens and residents the credit exempts the equivalent of $1.5 million of taxable estate from the estate tax (increasing to $2 million in 2006).  For nonresident aliens the exemption equivalent is only $60,000, and it is not scheduled to increase through 2009.  In 2010 the estate tax ceases and will be replaced, in effect, by the capital gains tax on inherited assets.  But the estate tax will return in 2011 with an exemption equivalent of $1 million for US citizens and residents but still only $60,000 for nonresident aliens.

 

            For nonresident aliens of countries having an Estate and Gift Tax Treaty with the US, the treaties typically apportion the $1.5 million exemption equivalent based on the proportion of US-situs assets to total assets.  Unfortunately México and the US do not have such a treaty, although the US treasury has recently encouraged ratification of one.

                        (2).  Marital deduction:  There is no marital deduction for a nonresident’s US-situs assets passing to a nonresident spouse unless the assets pass to a Qualified Domestic Trust (QDT).   To be a QDT, in short, the trust must have a US trustee and that trustee must have the right to withhold tax on any distribution of principal.

 

            Note:  A marital deduction is allowed if the nonresident’s property passes to a spouse who is a US citizen or resident.

                        (3).  Community property:  Mexican citizens may be married in México under either of two regimes – separate property or community property.  Without digging into case law, I’m reasonably certain in the instance of nonresident aliens that the US tax law follows the regime under which the couple was married in their foreign country.  Therefore, only half of the US-situs assets of a Mexican citizen married under the community property regime in México would be includable in his US gross estate.

 

            d.  Gift tax considerations

            Although there is no gift tax exemption credit available to nonresident aliens (in contrast to the $60,000 estate tax exemption credit equivalent), the $11,000 annual gift exclusion (increasing to $12,000 in 2006) is available.  The gift splitting election, however, is not available if either spouse is a nonresident alien.

 

            A nonresident may NOT take advantage of the marital deduction for spousal gifts even if the gifts are to a Qualified Domestic Trust.  But § 2523(i) allows a $110,000 annual gift exclusion (increasing to $120,000 in 2006) for spousal gifts by a US citizen or resident to a nonresident spouse or it would appear by a nonresident alien to a nonresident alien spouse.

 

            e.  Generation Skipping Transfer Tax (GST tax) considerations 

            For a nonresident alien, the GST tax only applies to gifts or bequests of US-situs assets to a “skip person” (i.e., a descendant at least two generations removed from the donor or decedent).  Such transfers fall into three categories: (1) a direct skip (e.g., a direct gift to a grandson), (2) a taxable distribution of principal (corpus) to a skip person from a trust set up by transferor, or (3) a termination of a trust power or interest of the transferor’s child thus causing the assignment of the power or interest to the grandchild (skip person).

 

            There is currently a $1.5 million GST tax exemption (increasing to $2 million in 2006), which, put simply, is prorated by the portion of US-situs assets to total assets transferred.  Because there is no gift tax exemption credit available to nonresident aliens (in contrast to the $60,000 estate tax exemption credit equivalent), generation-skipping transfers of US-situs assets in excess of the $11,000 annual gift exclusion will be subject to gift tax.

 

            Bequeathing property to a skip person is not much better from a tax standpoint than by gift since the estate tax exemption credit equivalent for a nonresident alien is only $60,000.

 

            Nonetheless, a nonresident alien may give or bequeath any amount of non-US-situs property without any gift, estate, or GST tax consequence.

 

            f.  Mexican taxation of estates, inheritances and gifts.

            México does not have either an estate tax or an inheritance tax.  (Ley del Impuesto Sobre la Renta, Articulo 77o, XXIII.)  For real estate in particular, there are some transfer costs such as registration and closing costs.

            There is a gift tax, but it is quite limited.  It only applies to gifts of real estate to persons other than spouses or direct family members.  The gift tax is paid by the recipient, not the donor.  (Ley del Impuesto Sobre la Renta, Articulo 77o, XXIV.)

 

            Final note regarding Mexican taxation of its citizens:

            Mexican citizens are taxed on their worldwide income similar in effect to US tax law which taxes US citizens on their worldwide income.  (Ley del Impuesto Sobre la Renta, Articulo 1o, I.)

 

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