July 8, 2020 – New York, United States
Give Me Your Tired, Your Poor, and Your Tax Planners?
Pre-Immigration Tax Planning for the Hong Kong Emigrant
At the foot of the Statue of Liberty is an inscribed plaque with a poem about America being the land that welcomes the refugee. Film footage from the turn of the 20th Century depicts ships overloaded with hopeful immigrants passing the statue dreaming of a better tomorrow after settling in the US. Fast forward to the present day and in a dramatically globalized world, you will find that immigrants hopeful for a better tomorrow will plan ahead to increase the likelihood of such dreams coming true. Those dreams require planning for taxes. In an ever-increasing connected society where countries freely exchange information, it is possible that a new start in another area on the globe could be stunted by a tax impact too burdensome to carry. This is especially the situation today as many citizens of Hong Kong are seeking a fresh start elsewhere.
Amid several recent protests decrying Chinese deteriorative encroachment upon Hong Kong democracy and citizens’ liberties, people are second guessing the region’s stability and are concerned for their own future and welfare. Many are considering emigration to countries like Canada, Australia, Taiwan, and the US.
Prior to 2019, there were two main events contributing to a flux of emigration from Hong Kong. The first main event occurred in 1997 when the United Kingdom handed over sovereignty of Hong Kong to China. The second happened in 2014 after the Umbrella Movement by Pro-Democrats when a series of sit-in protests occurred between September and December that year threatening Hong Kong’s political and economic stability. In recent weeks the Chinese government has been exerting greater controls over Hong Kong causing widespread consternation. As a consequence, a number of companies in China are now looking to register with the Singapore stock exchange. With the current desire to emigrate from Hong Kong also comes the need for a preparation strategy to leave the country. This strategy includes planning for future taxes arising at the time of, and after, the emigration in the country of destination.
The US imposes income tax not only on its citizens but also on tax residents, which includes Green Card holders and individuals who satisfy a “substantial presence test” because they are generally physically present in the US for at least 122 days a year under a complicated rolling three-year average formula. Under the 2017 tax act, the US extended the reach of its taxation of US income tax residents who own controlling interests of foreign businesses such as a Hong Kong company operating in China. Especially for service businesses operating in China but also possibly for manufacturing businesses, the US shareholders of the Hong Kong corporation would be subject to current “phantom income” from virtually all of the active business income and passive investment income of the Hong Kong corporation even if none of the earnings are distributed to shareholders. Moreover, even if the Hong Kong corporation has no profits, the US shareholder could face very onerous US tax information reporting about the Hong Kong corporation.
Prior to becoming a US income resident, an immigrant from Hong Kong may want to consider achieving certain tax objectives. In doing so, he/she must keep in mind that Hong Kong and the US do not have an income tax treaty. Hong Kong only imposes an income tax on income earned in or from Hong Kong sources. No worldwide income tax as applies to a Chinese domiciliary (household registration) or more than 6 year resident. Further, in developing a plan, you must consider entity planning since there is more favorable tax treatment in direct foreign investment by a Chinese company in the US. Tax strategizing could also include the recognition of capital gains and a step up in basis, the acceleration of income, deductible expense deferment, and transfers made to foreign trusts.
Consider the scenario wherein a Hong Kong citizen owns a portfolio of traded securities or owns a concentrated position in one stock such as Amazon or AliBaba. These are highly appreciated stocks. If the shares are sold after becoming a resident, this person will have to pay capital gains taxes based on the US rates schedule. A stock basis (amount paid for the stock acquisition) of $100,000 sold at fair market value for $1,000,000 will realize a gain of $900,000! The simplest way to avoid this scenario is to sell off the shares before establishing residency.
In the same vein, business owners have the option of “selling” their businesses to themselves by making certain elections in the US for the Hong Kong business, converting it from a corporation to a disregarded entity, which is essentially a non-recognizable tax event. No US taxes will be due upon the conversion. Upon the sale of the business after establishing residency, the taxes due will be based on the appreciation in value from the day it was “sold”. This technique is called stepping up basis.
For example, if a Hong Kong citizen plans to move to the US in January 2021, and forms are filed with the IRS to have such person’s company treated as a partnership in December 2020, this triggers the sale to the person. The prerequisite is that the company should have a viable nexus to the US. However, since the person is not a US resident yet, it is not a tax recognizable event. Assume the value of the business at this juncture is $900K and in 2022, the business is sold for a cool million dollars to a third party. Due to savvy pre-immigration tax planning, the tax due would be on the $100K of appreciation accruing from 2020 to 2022.
Another planning tool is the acceleration of income. It would be advisable to accomplish this before the move to the United States since the non-US income earned by a non-resident alien is not taxable in the US. The selling off of accounts receivable, accelerating stock options, making dividend payouts, prepaying salaries, bonuses, commissions, and rents are all the means of disposition to accelerate income. Another available option is to trigger accumulated earnings and profits of the foreign corporation. For many immigrants, upon establishing residency, the corporation will bear the added classification of a CFC, controlled foreign corporation. Subpart F income will be limited to the extent of accumulated earnings and profits and is taxable. But these earnings and profits can be stripped via a dividend distribution liquidating the CFC and incorporating a new entity with a check of the box to disregard the entity status.
In the author’s experience the best estate planning strategy for an immigrating wealthy Hong Kong resident with substantial assets and children who are or will become US persons, is for the individual to establish an irrevocable US domestic trust as a separate taxpayer. Before becoming a US tax resident and while still a non-resident alien (NRA) of the US, the individual could make unlimited amounts of gifts of foreign property including Hong Kong real estate and US intangible property (US stocks and bonds) to such irrevocable trust for the benefit of his US children. The trust could be settled in a modern trust state where the trustee is directed on investments and distributions. So long as the Hong Kong resident retains no proscribed powers over the trust which would cause inclusion in his US taxable estate, none of the trust assets would be subject to US estate tax. For children remaining in Asia and not immigrating to the US, the Hong Kong resident could establish and fund a non-US irrevocable trust with the result that none of those trust assets would be subject to US estate tax.
While an immigrating Hong Kong individual could establish a non-US irrevocable trust prior to a move to the US that prevent its assets from becoming subject to estate tax, it would be very difficult to prevent US income tax of the immigrating Hong Kong on worldwide income of the trust. The US tax law provides that if an individual establishes a foreign trust and then immigrates to the US within 60 months of transferring property to the trust, such trust becomes a US grantor trust with all worldwide income taxed to the former Hong Kong individual who created the trust. Moreover, following the death of the trust creator if such foreign trust had US beneficiaries they could face onerous throwback tax and reporting.
Sometimes an immigrating Hong Kong individual will move forward with funding a non-US irrevocable trust if they believe they will only be US tax residents for a specified period of time before departing the US They might view the trust as a “drop-off trust”. Only unneeded assets should be contributed to the “drop-off trust” and the trust creator should not receive distributions of trust property to meet lifestyle needs while in the US In establishing the “drop-off trust” a major objective is avoiding US estate tax, either on US assets as a non-domiciliary or on worldwide assets if they stay indefinitely in the US and are deemed a US domiciliary taxable on worldwide assets. To avoid current US income tax on trust income and gain the only practical solution is to wrap the trust assets in a foreign private placement life insurance policy. Once inside the policy, there would be no current income tax on the inside build-up of the cash value in the policy owned by the “drop-off trust” and through strategic funding the trustee could access the cash value on a tax-free basis.
For the Hong Kong resident who has no plans to immigrate to the US but who has US based children, an optimal trust strategy is a foreign grantor dynasty trust coupled with a wholly-owned BVI holding corporation (or portfolio investment company). Again the trust might be settled in a modern US state permitting a “directed” trust structure. The US situs assets would be owned by the BVI holding corporation which should effectively block US estate tax. During the lifetime of the Hong Kong resident he could revoke the trust, which would cause such trust to be classified during its first phase as a foreign grantor trust. All income and gain would be taxed to the Hong Kong individual. The trust is considered a NRA taxpayer and the US can only tax any US source income of the trust. Any distributions made to US beneficiaries are not subject to tax but may have to be reported by the gift recipients.
The foreign grantor dynasty trust offers substantial non-tax benefits during the life of the Hong Kong resident settlor: the retention of wealth for future generations, with discretionary income and principal payments (not available in most civil law countries), protection from foreign taxes, protection from creditors, protection from nationalization and political risks, and protection from spouse’s marital claims and children’s forced heirship claim (in most civil law countries). After the death of the Hong Kong resident settlor, the trust may also save US estate and GST taxes for future generations.
Following the death of the Hong Kong resident the trust enters its second phase and becomes irrevocable. It is generally preferable for the trust to become an US domestic trust because of the US-based beneficiaries, rather than continue as a foreign non-grantor trust. The trust document must be carefully reviewed to ensure that all trustees and trust protectors are US persons during the second phase, removing any foreigner who had decision making power over the trust assets. As a US domestic trust as separate taxpayer, the trust’s worldwide income would be subject to US income tax to the extent it is accumulated by the trustee. If the trustee distributes trust income to US beneficiaries, those beneficiaries will report the income on their personal tax returns. A key advantage in converting to a US domestic trust as separate taxpayer is that there would be no throwback tax exposure and foreign trust reporting by the US beneficiaries. In addition, there are some planning strategies that may be available to step-up the inside basis in the assets in the BVI trust following the death of the Hong Kong trust creator, although they are complicated and to some extent a favorable outcome on when during the tax year the trust creator dies.
US source income within the trust limits whatever tax advantages are available as well as if the trust has US beneficiaries or if the trust is still within the first five years of its creation. However, should the trust be classified intentionally as a grantor trust, the throwback regime is effectively avoided and the grantor is taxed on the income. In planning for the estate upon the death of the grantor, the foreign grantor person needs to establish an underlying foreign corporation to serve as an estate tax blocker on US situs assets owned by the individual. With US heirs surviving, the trust should be converted to a US domestic accumulation trust upon death to avoid the onerous throwback regime.
A foreign grantor trust is a very efficient means of planning ahead before coming to the US. This is especially true if the immigrant is the owner of substantial assets in his/her native country. With such a trust, the income from the distribution is not taxable to the trust. A US beneficiary in such an instance would have been taxed upon receipt of the underlying investment income. Structuring the trust with a non-US person as the settlor of a non-US revocable trust for the benefit of family members is the ideal planning technique, specifically for the benefit of those who are emigrating from Hong Kong to the US. Pursuant to US trust tax law, the settlor in such an instance will be considered the owner of the trust assets. As such, any distributions to beneficiaries, including the US persons, will not give rise to any US tax liability for the beneficiaries. This will be the case even though the beneficiaries still have other reporting requirements here.
The immigrant experience at its core remains steadfast. Hong Kong citizens coming to build a new foundation in the US are as optimistic and as hopeful about what the future holds for them as those coming on the ships passing the Statue of Liberty at the turn of the twentieth century. The modern immigrants of today are living in a much more sophisticated world, being met with challenges wrought with complications unforeseen by predecessor generations. Tax planning plays in important role in the immigrant experience of today in that it can potentially reduce US income and estate taxes significantly. As demonstrated, this planning plays out in a variety of ways such as with the transfer of asset ownership into newly created legal entities, distributions from existing entities to obtain basis step up, and stripping out accumulated earnings and profits. There also exist various deferment options in addition to the acceleration of income and foreign trust funding. Consideration is always given to the tax scheme of the immigrant’s home country because a reduction in US taxes would not otherwise make sense if the home country taxes are increased by the same amount. Via the coordination of these two taxing regimes, the immigrant reaps the greatest tax benefits, which alleviates financial worry and allows for a smooth transition to a new culture and a new home.
About the Author
Alicea Castellanos is the CEO and Founder of Global Taxes LLC. Alicea provides personalized U.S. tax advisory and compliance services to high net worth families and their advisors. Alicea has more than 17 years of experience. Prior to forming Global Taxes, Alicea founded and oversaw operations at a boutique tax firm, worked at a prestigious global law firm and CPA firm. Alicea specializes in U.S. tax planning and compliance for non-U.S. families with global wealth and asset protection structures which include non-U.S. trusts, estates and foundations that have a U.S. connection.
Alicea also specializes in foreign investment in U.S. real estate property, and other U.S. assets, pre-immigration tax planning, U.S. expatriation matters, U.S. persons in receipt of foreign gifts and inheritances, foreign accounts and assets compliance, offshore voluntary disclosures/tax amnesties, FATCA registration, and foreign companies wanting to do business in the U.S. Alicea is fluent in Spanish and has a working knowledge of Portuguese.
Alicea is an active member of the Society of Trusts & Estates Practitioners (STEP), the New York City Bar, the New York State Society of Certified Public Accountants (NYSSCPAs), the American Institute of Certified Public Accountants (AICPA) and the International Fiscal Association (IFA). She is the New York/Northeast Regional Representative of the Women of IFA Network (WIN). Distinctly, in 2020, Alicea was awarded with a prestigious NYSSCPA Forty Under 40 Award. She was selected as someone that has notable skills and is visibly making a difference in the accounting profession.
Please note: This content is intended for informational purposes only and is not a replacement for professional accounting or tax preparatory services. Consult your own accounting, tax, and legal professionals for advice related to your individual situation. Any copy or reproduction of our presentation is expressly prohibited. Any names or situations have been made up for illustrative purposes — any similarities found in real life are purely coincidental.