Foreign Affairs 101: Tax and Estate Planning
Issues for U.S. Clients Who Own Foreign Property
By M. Read Moore*
* Licensed to practice law in Illinois and in California. Special thanks to John Duval of the McDermott Will & Emery LLP Chicago Library staff for his assistance in chasing down many obscure cases, statutes, and treaties, to Deb King for suffering through innumerable rewrites of this outline. This outline was prepared on November 14, 2005 and updated on March 3, 2006, on September 16, 2006, and on October 3, 2007. Portions of this outline were originally prepared for the University of Miami School of Law Philip E. Heckerling Institute on Estate Planning, reprinted here with permission from the University of Miami School of Law and Matthew Bender & Co., Inc. All rights reserved.
A. When a U.S. citizen or resident client owns property in a foreign country, that client will face a number of U.S. and foreign legal and tax issues, and these issues sometimes are complicated or simplified by treaties between the United States and the foreign country involved.
B. The most obvious situation is when a U.S. client owns real property in another country. Numerous complex issues, however, can also arise when the client owns intangible property with a connection to another country, such as shares in a foreign corporation or an interest in a foreign partnership. While these items of property may not raise too many foreign succession law issues, these items of property can raise complex federal income tax issues for clients. In all cases, U.S. federal estate tax issues will also be lurking.
C. This outline describes some of the basic ground rules that U.S. estate planning advisers should follow when U.S. citizen and resident clients own foreign property, with a focus on succession law issues, federal income tax issues, and federal estate tax issues.
II. Some Basic Things You Should Know About Foreign Succession Law and Tax Law
A. Not Every Country Works Like the United States
1. Apart from Louisiana, all U.S. states have the common law legal system, which originated in England centuries ago. Louisiana has a mixed system of common law and civil law, which it inherited from the French. Puerto Rico also has a civil law legal system. Some of the U.S. states that were part of Mexico retain an important feature of the civil law - community property.
2. The United States shares the common law system with other jurisdictions that inherited their legal system from England, including the Canadian provinces and territories (other than Quebec), the Australian states and territories, Ireland, and New Zealand. While the language of common law countries is usually English and the legal systems in these jurisdictions are similar, the differences in substantive law among the jurisdictions means that a U.S. lawyer cannot assume that the law in England, for example, is the same as the law of Illinois.
3. The other major legal system that you are likely to encounter when you have clients with foreign property is the civil law system.
a. The civil law system derives from Roman law and the Corpus Juris Civilis of the Emperor Justinian. Most of the civil law countries have taken the path of enacting codes of law that reflect general legal principles. A few jurisdictions, however, such as Scotland, have implemented the Roman tradition without a code.
b. Those civil law countries that rely on codes enacted by legislatures were generally inspired by the Napoleonic Code that France implemented following the French revolution. The laws in Spain, Italy, the Netherlands, Portugal, and many Latin American countries were heavily influenced by the Napoleonic Code. The Napoleonic Code also influenced the development of the German Civil Code, although the German Civil Code is more precise and technical than the Napoleonic Code. Japan has adopted the German Civil Code. Switzerland also developed its own Civil Code in the early 1900s, and the Swiss Code, along with the French and German Codes, influenced the Brazilian, Peruvian, and Mexican codes. See generally Tetley, "Mixed Jurisdictions: Common Law vs. Civil Law (Codified and Uncodified)" at 6-7 (1999) (available online at www.unidroit.org/english/publications/ review/articles/1999-3.htm).
c. The principal difference between a civil law system and a common law system is the role of courts. In a common law jurisdiction, judicial decisions are the principal source of law; statutes supplement the common law. Court decisions in common law jurisdictions have the force of law through the principle of stare decisis. On the other hand, in civil law countries the codes or the uncodified general principles of law are the principal source of the law. Court decisions that interpret the law do not have preferential effect. Although court decisions may be looked to by civil law lawyers as evidence of what the law is, the opinions of commentators sometimes are as important as court decisions in interpreting the law. See generally Hansman & Mattei, "The Functions of Trust Law: A Comparative Legal and Economic Analysis," 73 N.Y.U.L. Rev. 434, 439-442 (pointing out that "academic lawyers in the universities were the leading force in development of the law" and that "[t]he law itself was to be found not in a register of [civil] writs, but in the Justinian compilation....").
d. Civil law systems also differ considerably from common law legal systems in their substantive law, particularly in the area of succession law and property law, which is of great interest to estate planning advisers. The principal differences between the legal systems with respect to matters of succession law are discussed below. If you remember nothing else about a civil law system, however, remember that trusts are not a part of civil law legal systems.
4. Countries with a predominantly Islamic population are likely to follow the general traditions of Sharia law, the jurisprudence of which is based on the Koran and other important Islamic religious sources. There is considerable variety among the Islamic countries with respect to their substantive rules, making it hard to generalize about those rules. In general, however, the Sharia legal system shares more in common with civil law countries than with common law countries, particularly with respect to matters of succession law.
5. The legal systems in a number of jurisdictions have elements of both civil law and common law, including Scotland, South Africa, Quebec, Puerto Rico, the Philippines, and Louisiana.
B. Succession Law Is Not The Same In The Rest Of The World
1. A fundamental feature of any legal system is rules related to property ownership, and an important subset of these rules are the rules related to transfers and inheritance of property on death. This outline refers to these laws as "succession laws."
2. Common law jurisdictions generally allow an individual to give his or her property to whomever he or she wishes in the form that he or she wishes, including in trust. Spousal elective share laws and community property laws sometimes limit an individual's ability to freely dispose of all his or her property; these laws vary widely from jurisdiction to jurisdiction. State statutes in the United States generally allow after-born children to take their intestate share of a decedent's estate under pretermitted heir statutes.
3. Civil law countries, on the other hand, traditionally limit an individual's testamentary freedom through community property laws and forced heirship laws.
a. Many civil law countries follow a default system of community property for property acquired by a couple while married, which limits one spouse's ability to disinherit the other spouse. Lawyers in the United States should be familiar with the general principles of Spanish and French community property law given the influence of those laws on the U.S. community property states. Other civil law jurisdictions have different systems that tend to have similar results. German law, for example, has three kinds of marital property regimes. The default marital property regime is Zugewinngemeinschaft or "community of surplus." This regime is not a classic community property regime the way that U.S. lawyers understand community property. The other regimes are community property (Gutergemeinschaft) and separate property (Gutertrennung). If a couple who was married in Germany wanted one of the optional regimes to apply during their marriage they would have had to have a notary draw up a fairly simple agreement to that effect.
b. Civil law countries' "forced heirship" laws also limit an individual's ability to freely dispose of his or her separate property and his or her share of community property.
(i) Forced heirship laws either in actuality or in effect require a decedent to leave some proportion of his or her assets to his or her children at his or her death. Forced heirship laws also may give a surviving spouse a share of a decedent's estate in addition to the share to which a spouse may be entitled under the country's marital property laws.
(ii) For example, Italian forced heirship laws apply to a decedent's one-half share of community property and the decedent's separate property. If there is a surviving spouse and one child, the spouse's "compulsory share" or riserva a favore dei legittimari is one-third of the subject property; the child's compulsory share is also one-third of the subject property. If there is a surviving spouse and more than one child, the spouse's compulsory share is one-fourth. If there is no spouse and one child, the child's compulsory is one-half of the subject property. If there is more than one child, the children's collective compulsory share is two-thirds of the property. Children of deceased children succeed to the rights of their deceased parents.
(iii) German forced heirship laws take a slightly different approach than the Italian forced heirship laws. Germany's forced heirship laws give a disinherited heir a monetary claim against the persons who received the decedent's estate. Thus, a German individual can dispose of his or her estate as he wishes but the persons to whom he or she leaves his or her property may face a monetary claim from the disinherited children and the decedent's surviving spouse. The amount of a disinherited heir's claim (Pflichtteil) is equal to one-half of the value of the share that the heir would have received had the decedent died intestate. The intestate shares of descendants and a spouse vary under German law. Germany includes gifts made within 10 years of death in the pool of assets used to determine the value of a forced heirship claim.
(iv) Swiss law similarly treats forced heirship claims as monetary claims against the individuals or entities who receive a decedent's property. Like the laws in many other civil law countries, Swiss law pulls gifts within five years of death back into the estate for purposes of computing the basis on which a forced heirship claim could be made. Swiss law also pulls back a gift made more than five years before death if the purpose of the gift was to avoid forced heirship laws.
4. What are the implications of forced heirship laws for estate planning?
a. Forced heirship and community property laws leave very little of an estate for an individual to dispose of. As a result, individuals who live in civil law countries tend not to use wills to the same extent as individuals who live in common law countries do. When individuals in civil law countries use wills, those wills are often not as extensive or complicated as wills used in common law countries. Part of the reason for this is the absence of trusts as part of the law in most civil law countries.
b. Estate and inheritance tax systems in civil law countries often complement the country's forced heirship laws. Thus, gifts to close relatives, which forced heirship law requires, are taxed at a lower rate than gifts to more remote relatives. In some civil law countries, a gift or bequest to a trust is treated as a gift to an unrelated person that attracts inheritance tax at the highest rate.
c. While not necessarily tied to forced heirship laws, you should be aware that notaries, rather than lawyers, often draft wills and related documents in civil law countries. A notary in a civil law country is not like a notary public in a common law country. Rather, the civil law notary is a legal professional who drafts legal documents such as conveyancing, contracts, and wills. By contrast, a notary public in the United States simply has the power to take oaths from witnesses and acknowledge legal documents.
C. Trusts Are Not Used Everywhere In The World
1. The trust is among the most useful and flexible devices in the U.S. estate planner's play book. Trusts, however, are not found everywhere in the world. Believe it or not, much of the world manages to do estate planning without trusts. See Langbein, "The Contractarian Basis of the Law of Trusts," 105 Yale L.J. 625, 669 ("[W]hen we ask how the Europeans function without the trust, we find that they achieve mostly by means of contract what Anglo-American systems do through trust."). Thus, it is important to understand that when you start thinking about a client's foreign property, you may not be able to use a trust.
2. Trusts are generally seen as a creation of English court of chancery, which later merged with the law courts in England. As England exported its law to other countries during its days of imperialism, many of those countries picked up the common law of trusts as part of the common. Trusts are now an established part of common law legal systems, including in many tax havens which have an English legal heritage.
3. Codes in civil law countries, on the other hand, do not normally contain trust laws. Civil law countries do have certain kinds of entities and relationships that resemble trusts, but these entities and relationships lack the bifurcation of ownership that is one of the essential elements of a trust. Some civil law countries such as Japan and South Africa do have trusts by statute, but they are isolated examples. Interestingly, at least one scholar's research suggests that the trusts do in fact have roots in the civil law. Lupoi, "The Civil Law Trust," 32 Vand. J. Transnat'l L. 967, 973 ("ample evidence exists that testamentary secret trusts were well known in Europe in the sixteenth and seventeenth century"). The French Revolution, however, ended the development of trust law in France and, therefore, throughout Europe and Latin America, given the influence of the Napoleonic Code on the law in those other jurisdictions.
4. Some civil law countries are signatories to the Hague Convention on the Law Applicable to Trusts and Their Recognition. This outline discusses the convention in more detail below. A country's accession or ratification of the convention, however, does not mean that the country adopts trust law as part of its domestic law. Rather, the convention simply requires a signatory to recognize a trust and certain features of a trust if the trust is valid under the law of a jurisdiction the domestic law of which provides for trusts.
5. Some civil law countries do recognize trusts as part of their domestic law. Colombia and Liechtenstein, for example, recognize and enforce trusts as part of their domestic law. Italy is also developing a domestic law of trusts based partly on the Hague Convention on the Law Applicable to Trusts and Their Recognition. See Lupoi, supra, at 985-988.
6. Civil law countries also have legal arrangements that achieve results similar to the result of a trust, though they are not identical to trusts. See generally Christensen, "Foreign Trusts and Alternative Vehicles," 12-16 (published by ALI-ABA in its International Trust and Estate Planning Course of Study Materials, August 2005).
a. For example, a usufruct (usufruit) is a right to use property for a period of time, which can be measured by a life or by a term of years. The holder of the usufructuary interest has the right to the income from the property and the use of the property. Another person, the remainderman, in English legal terminology, has a "naked interest" or "nue propriete." The principal difference between the usufruct and the trust is that there is no trustee.
b. Switzerland and Liechtenstein provide by statute for a foundation or "stiftung," which has some features similar to a trust, such as a person holding property for the benefit of another. Germany and Austria recognize foundations for charitable purposes. The uses of foundations, however, are more limited than the use of trusts in common law legal systems. Christensen, supra, at 13.
7. The lack of trust law in civil law countries, even in ones that have adopted the Hague Convention on the Law Applicable to Trusts and Their Recognition, has several implications for U.S. estate planning advisers.
a. The trust is not necessarily part of the estate planner's tool box for property in a civil law country, though, as discussed below, to some degree this turns on the country's choice of law rules.
b. Even if a civil law country's choice of law rules appear to permit the use of a trust to hold property in that country, there may be practical difficulties in doing so. For example, it may be difficult to register land in the name of a trust in a country that does not recognize trusts and the distinction between legal and equitable ownership.
c. If a client has property in a civil law country that he or she wants to pass to a trust, it may be advisable to hold the property through an intermediate entity, such as a corporation or other company, and have a trust in the United States or a tax haven own the shares or interests in the company.
d. Depending on the country's choice of law rules, a gift to a trust may give rise to claims by the donor's family members under forced heirship laws.
e. Because civil law countries do not have trusts, the tax treatment of trusts is often uncertain or rather onerous. As noted above, some countries treat gifts to trusts as gifts to unrelated persons, which triggers an inheritance tax at a higher rate. The income tax treatment of a trust in a civil law country can also be uncertain if the trust has income with a source in that country, such as rental income. A country may also want to ignore a trust for purposes of its wealth tax and treat the trust beneficiaries as if they own the trust property outright.
8. Even if your client has property in a common law jurisdiction, the trust law and related tax laws in that jurisdiction are likely to differ somewhat from trust law commonly found in the United States, making it trickier to use trusts in those jurisdictions.
a. There are many differences between the English common and statutory law of trusts and the common and statutory trust law of the U.S. states. For example, England follows the common law rule against perpetuities but provides that a trust with a term of 80 years or less will not violate the rule. Contrast this provision with the lack of a rule against perpetuities in many of the U.S. states or the 90-year rule under the Uniform Statutory Rule Against Perpetuities. Another difference is that it is much easier for the beneficiaries and trustees to vary an irrevocable trust under English law than it is under U.S. law.
b. The other common law countries usually follow the English common law of trusts and give English court decisions much more weight than U.S. decisions, if they even consider those decisions. Thus, much of the common law of trusts and statutory law of trusts in British Commonwealth jurisdictions has more in common with English law than U.S. law. The Canadian provinces, however, tend to follow U.S. developments a little more closely than other common law jurisdictions. For example, the Canadian version of the prudent investor rule was inspired in part by the U.S. prudent investor rule. See Uniform Law Conference of Canada Report, "Investment by Trustees: The Prudent Investor Rule Revisited" (1996) (available online at www.law.ualberta.ca/alri/ulc/96pro/e96n.htm). Furthermore, and with the internet and the ease of obtaining court decisions, there seems to be a greater incidence of courts and legislatures looking to U.S. court decisions and legislation with respect to trust related issues. Despite this apparent trend, you should not assume that the laws of another common law jurisdiction are the same as they are in the United States
c. As discussed below in connection with U.K. inheritance tax treatment of gifts to trusts, the common law countries also may treat trusts considerably differently than the United States under those countries' wealth transfer tax laws.
d. The common law countries can also vary considerably in the way that their income taxes apply to trusts. In Canada, for example, the transfer of appreciated property to a trust, revocable or irrevocable is generally treated as a disposition of that property for Canadian federal capital gains tax purposes. There are certain exceptions to this deemed disposition rule for individuals over age 65 who transfer appreciated property to "alter ego" and "joint partner" trusts. Canada also deems a trust to have disposed of its property every 21 years for federal income tax purposes, which has an effect not unlike the U.S. federal generation skipping transfer tax.
D. Taxation of Wealth Transfers Varies Considerably Among Countries
1. Because a client has foreign property, you might assume that you will have a foreign gift tax or estate tax issue because of that property. While you may be right in your basic assumption, you should not assume that another country taxes transfers of wealth in a manner similar to the United States federal gift, estate, and generation-skipping tax.
2. Some countries have no wealth transfer taxes, such as Australia, Canada, Sweden, Israel, Mexico, and China. These countries, however, may have other kinds of taxes or tax policies that affect gifts and inheritances of property. Canada, for example, deems the death of a person to be a disposition of appreciated property for income tax purposes. Australia, on the other hand, permits deferral of capital gains through a carry over basis scheme.
3. Some countries have estate taxes but not gift taxes. Although the United Kingdom has an inheritance tax, the inheritance tax does not apply to gifts made more than seven years before the decedent's date of death. If the donor dies during the seven-year period after he or she makes a gift, however, some or all of the gift may be subject to inheritance tax. Despite the lack of a gift tax, a U.K. donor's gift to a trust may attract an immediate inheritance tax and may not be a "potentially exempt transfer." In this way the United Kingdom in fact has a gift tax, but only on gifts to discretionary trusts. The "gift tax" applies to amounts exceeding £ 300,000 (about $ 600,000) (the "nil rate band"). The £ 300,000 nil rate band is in effect until April 6, 2008, when it will increase to £ 312,000 ( £ 325,000 on April 6, 2009). The tax rate will initially be 20% on a transfer to a trust but could increase to 40% if the settlor dies within seven years of making the transfer. In addition to the immediate inheritance tax charge, the trust will be subject to a charge every 10 years - the "ten-yearly charge" of up to 6%. A charge may also apply on large distributions from the trust. Under certain circumstances a U.K. resident donor can create a lifetime "accumulation and maintenance" trust for children and grandchildren who are under age 18 without triggering an immediate inheritance tax charge. The trust must distribute its assets to the beneficiary when he or she reaches age 18 or convert to an interest in possession trust at that time to avoid becoming a tax-disfavored discretionary trust.
4. New Zealand has a gift tax but not an estate tax. If Congress lets the U.S. federal estate tax disappear in 2010 while retaining the gift tax, the United States will join New Zealand in this small club.
5. Civil law countries usually have "inheritance" taxes.
a. The civil law countries with wealth transfer taxes have either true inheritance tax systems or, as in some states of the United States, estate taxes that superficially resemble inheritance taxes.
b. A true inheritance tax is based on the citizenship or residency of the recipient of the transferred property; the donor's citizenship is irrelevant. Thus, in countries with a true inheritance tax, a resident or citizen beneficiary is taxed on all property he or she receives, regardless of its location and regardless of the donor's citizenship. Spain and Japan take this approach. Germany also takes this approach, though it also bases its taxation on a decedent's residency in Germany or a decedent's ownership of property in Germany.
c. Other civil law countries call their death taxes "inheritance taxes" because the rates and amounts of tax depend on the class of beneficiary receiving property. These countries, however, impose the tax based on the citizenship or residency of the decedent or on the location of the property, not of the recipient. To this extent, the tax is on transfers made by the decedent. A beneficiary is not taxed on the receipt of property from a nonresident or noncitizen decedent located in another country, except for property located in the taxing country. Countries that follow this approach include Belgium, Greece, Norway, and Germany. These taxes closely resemble U.S. state inheritance taxes.
d. In civil law countries an inheritance tax often complements the countries' community property and forced heirship laws; the more remote the beneficiary, the higher the tax rate. German gift and inheritance tax law, for example, bases its gift tax and inheritance tax rates on the relationship of the donor to the donee. A descendant is a Class I beneficiary; the top marginal rate for gifts or bequests to such a beneficiary is 30% (above [euro] 25,565,000 (about $ 36 million)). The general view in Germany is that trust is a Class III beneficiary regardless of the identity of the trust beneficiaries. The top marginal rate on a gift or bequest to a Class III beneficiary is 50% (above [euro] 25,565,000). Thus, a gift by a German resident to a trust for U.S. beneficiaries can trigger considerable German gift taxes.
E. The collective impact of all these differences between U.S. tax law and foreign tax law and succession law suggests one thing: strongly consider using foreign lawyers and tax advisers to help you when your clients have foreign property. Imagine a foreign lawyer trying to figure out how to dispose of property in one of the U.S. states, including attempting to understand the federal, state, and local tax consequences of the disposition. Do you want to try the same thing in a foreign country? You will sleep better if you seek foreign advice in one form or another during the estate planning process.