Guam, an unincorporated territory of the United States, has enacted legislation refunding to Guam-based trusts all Guam taxes collected on extraterritorial income. Guam trusts are not subject to U.S. income taxation on foreign source income or most capital gains. United States individuals treat Guam trusts as domestic. Thus, transfers to Guam trusts (even of appreciated assets) are usually free of tax. U.S. beneficiaries pay tax only on distributions from the trust and then only to the extent of the trust's income relating to the year of distribution. From a U.S. citizen's standpoint, Guam-based trusts offer a nearly tax-free return. From the standpoint of a foreign entrepreneur, they provide a special opportunity to attract U.S. venture capital.
Introduction to Guam. Guam is the southernmost island in the Marianas archipelago, lying roughly 2400 kms south of Tokyo and 2000 km east of Manila. Its area is about 500 square kms. Guam is famous for the charm and hospitality of its native Chamorro culture and people. More than one million Japanese visit Guam's luxury hotels, restaurants and palm fringed beaches each year. Guam was acquired by the United States at the end of the Spanish American War. It elects its own legislature and, since 1970, has elected its own governor. The protections of the United States Constitution have been extended to Guam. Decisions of Guam courts may be appealed to the United States Court of Appeals for the Ninth Circuit in San Francisco. English is the language of law and commerce. U.S. currency is used. Guam is part of the domestic U.S. banking system. Calls to Guam are at domestic long-distance rates.
Taxation in Guam. Since the United States Internal Revenue Code (the "Code") treats the "United States" as including only the 50 States and the District of Columbia , Guam is generally treated as foreign for purposes of the United States income tax (the "USIT"). Congress has enacted a separate tax for Guam, known as the Guam Territorial income tax ("GTIT"). The content of the GTIT is essentially the same as the USIT with appropriate substitution of "Guam" for "United States." This has led to the GTIT being referred to as a "mirror code" (that is a mirror of the USIT).
GEDA. The Guam legislature established the Guam Economic Development Authority ("GEDA") more than thirty years ago with authority to issue "Qualifying Certificates" for rebates of the GTIT. This rebate authority has been upheld. In 1998 Guam extended GEDA's authority to permit rebate of the taxes paid by Guam-based trusts.
The Rebates. To be eligible for a rebate, a trust must apply for a Special Qualifying Certificate ("SPC") from <P.GEDA. Beneficial ownership and the total assets must be disclosed. The trust must agree to file an annual accounting with GEDA. For trusts with assets from one million to one hundred million dollars the filing fee and the subsequent annual fees are each $1,000. Above one hundred million dollars the fees are each $2,000. Copies of the trust instrument and the trustee's license to act as trustee in Guam are also required.
A Guam-based trust may be established by will or instrument for the purpose of protecting or conserving property. Guam must be the principal place of administration and for tax reasons primary jurisdiction should lie with Guam courts. A $10,000 deposit must be maintained with a Guam bank for the duration of the trust.
A Guam-based trust may not engage in a business or be a shareholder in a business for which a Guam business license is required.
The holder of an SPC is entitled to a rebate of 100% of all GTIT on "all its earnings from either inside or outside of Guam, including all income from investing its funds on Guam or elsewhere" for twenty years. Guam intends that the rebate itself not be taxable.
GTIT paid by Guam-based trusts is deposited in a special-purpose trust account maintained by an FDIC-insured bank with offices in Guam. One hundred and eighty days after filing its income tax return the trust is entitled to "the refund of the income tax."
Authority of Guam Legislature to Grant Rebates. The Treasury has informally questioned the authority of Guam to provide these rebates. Guam has informally relied on Ramsey. This case is perhaps most useful for the proposition that despite Code Section 61's inclusion of all income "from whatever source derived," the rebate is not included in gross income.
The Organic Act of Guam provides a firmer foundation. Congress has conferred on the Guam legislature the power to enact laws on "all rightful subjects of legislation not inconsistent" with U.S. law. This language was copied from the Virgin Islands Organic Act. The United States Court of Appeals for the Third Circuit construed such language to mean, "in common with the legislatures of the several states it [the United States Virgin Islands legislature] has the widest latitude in selecting the subjects of taxation and in granting exemptions." The power to spend, which is at issue here, is a historic power of legislatures. Further, the only effect of Guam's actions is to limit its tax collection so as to exclude extraterritorial income, a principle recently endorsed by the United States Congress.
Since the GTIT is federal law, Guam has no power to alter it. The critical issue is whether the Guam rebate alters federal tax law.
It is useful to distinguish income from the 50 States and District of Columbia ("U.S. Source"), income from territories ("Territorial Source") and income from outside any of these areas ("Foreign Source"). The power of territories to rebate income tax on territorial source income is not in doubt. Conversely, any territorial rebate on U.S. source income would erode the core U.S. tax base. However, since the U.S. taxes such income, and the mirror codes provide a tax credit for such taxes against territorial income tax the issue almost never arises.
The most interesting issue is the power of the territories to rebate the tax on foreign source income. The Commonwealth of the Northern Mariana Islands ("CNMI") is denied this power under Section 602 of the Covenant, but this was negotiated, suggesting that in the absence of such an agreement the CNMI would have the power . In 1960 Congress added Code Section 934(a) providing that the Virgin Islands Territorial income tax "shall not be reduced or remitted in any way" except as provided in Code Section 934. Currently the United States Virgin Islands ("VI") is given limited authority to rebate tax on foreign source income. The inference is that absent the prohibition, the VI would have been able to rebate tax on foreign source income . Similarly Code Section 7654(e) grants the Treasury authority to prescribe regulations "prohibiting the rebate of taxes covered over which are allocable to United States source income." Such regulations would not be necessary unless the territories had such authority. Note also that the only authorized prohibitions relate to U.S. source income.
In light of the foregoing, Guam's obligation to honor SPCs and Treasury's failure to date to publicly attack the rebate legislation, it seems unlikely that a SQC issued prior to a change in law or treasury position would be challenged.
United States Income Taxation of Guam-Based Trusts. A trust is not a "United States person" unless "a court within the United States is able to exercise primary supervision over the administration of the trust." For this purpose the United States does not include Guam. Hence the Guam-based trust here contemplated is not a United States person. Therefore, absent specific statutory language to the contrary, a Guam-based trust is classified as a foreign trust for United States income tax purposes. Therefore unless the grantor trust rules (discussed below) apply, a Guam-based trust is taxed as a nonresident alien individual who is not present in the United States at any time.
The trusts contemplated here would not engage in business in the United States directly or indirectly. Therefore the trust is only taxable on certain U.S. source income. Most interest income from United States sources is not taxed No foreign source income is taxed, and since the trust is not deemed present in the United States at any time, most capital gains (as from sale of U.S. stocks, and bonds) are not taxed. Note however that gain on the sale of U.S. real property and U.S. real property interests is subject to U.S. tax .
United States Income Taxation of U.S. Citizens and Individual Residents who are Grantors or Beneficiaries of Guam-Based Trusts. The system so far described is no better than (in some ways perhaps, not so good as) that of a dozen or more offshore jurisdictions. The critical component for Guam is Code Section 935. Section 935 applies to a citizen or individual resident in the United States who has income derived from Guam for the applicable taxable year. Under Section 935(c)(1), for such an individual:
for purposes of so much of this title (other than this section and section 7654) as relates to the taxes imposed by this chapter, the United States shall be treated as including Guam,
In computing the income tax liability of such persons, the United States includes Guam and therefore a Guam-based trust is a United States person and a domestic trust. Thus the special rules applicable to foreign trusts do not apply to grantors or beneficiaries of Guam trusts.
Subject to the grantor trust rules (discussed below) the grantor has no income tax consequence arising from the transfer, holding, sale or distribution of assets to or by a domestic trust. The beneficiary is taxed on distributable net income. By arranging the operation of the trust it may be possible to reduce or eliminate tax on the beneficiary.
State income tax depends on applicable state law. However states starting with federal gross income, adjusted gross income or taxable income in computing state taxable income will probably mirror the federal results for Guam-based trusts.
Illustrative Examples.
(1) "P" a U.S. citizen transfers a block of appreciated stock to a Guam-based trust created for the benefit of "C" his child June 1, 2001. On November 1, 2002 the trustee sells the stock on the New York Stock exchange, and invests the proceeds in foreign bonds. The trustee pays tax on the gain to Guam on April 15, 2003, receiving a refund on October 15, 2003. The refund is also invested in foreign bonds. On January 2, 2004 the bonds are liquidated without gain and the entire proceeds are distributed to C. Neither P nor C incurs U.S. income tax (though P will incur gift tax). All Guam taxes paid are refunded after six months.
(2) On reflection, P decides it unwise to provide C with such a large distribution at one time. The trustee decides to invest not in bonds but in foreign securities that pay little or no dividend. In 2004 the trustee, acting without direction from P distributes some cash to C and his child "GC". The trust was planned after considering generation skipping transfer tax consequences. The trust continues for many years. In a few years the trustee liquidates appreciated securities. No distributions are made in those years or the immediately following year (when the rebate is paid). Distributions are made in other years. The beneficiaries are taxed only to the extent of dividends received by the trustee in the year the trustee makes a distribution.
The Opportunity for Foreign Entrepreneurs. Dividends from United States securities are taxed in the United States. While gain on the sale of U.S. securities is not taxed in the United States, many trustees will prefer to minimize their contacts with the United States, as by avoiding transactions on U.S. exchanges. This creates a dilemma. Securities registered in the United States will mainly be issued by U.S. persons or traded on U.S. exchanges. Securities registered on foreign markets, or not registered generally may not be lawfully offered or exchanged in Guam. Thus a private offering of foreign securities has special appeal to the trustee of a Guam-based trust.
In addition, a foreign entrepreneur might consider suggesting a Guam-based trust to U.S. venture capitalists (individuals) as method of obtaining their return almost free of income taxation.
Respecting the Trust. Under general U.S. tax principles, the Internal Revenue Service may recharacterize the proposed arrangement if its true economic effect is different from its nominal legal structure. These possibilities will be grouped under (1) step transaction doctrine (2) disregard of entity (3) reclassification of entity and (4) grantor trust rules. They do not involve special territorial tax issues.
Step-Transaction. The substance rather than the form of a transaction will control. Shams will be ignored. Where appropriate, steps in an integrated transaction will be viewed as a whole and intermediate stages will be disregarded. For example if O enters into a binding contract to sell a capital asset and, prior to the sale, transfers the asset to a Guam trust, O will be treated as the seller and taxed on the income, even though legally the trust received the proceeds. While time alone does not eliminate such problems, a reasonable amount of time is required between what would otherwise be steps to avoid single transaction characterization.
Disregard of Entity. The IRS is attacking "abusive trusts". The program seems to be fully occupied with disallowing deductions for which there is little or no factual basis. Of more significance here is the Aiken Industries doctrine. A United States debtor did not withhold taxes on payments to a Honduran corporation based on a tax treaty. However the funds eventually came to rest in a related Bahamian corporation. The United States has no tax treaty with the Bahamas. The IRS asked the tax court to disregard the Honduran corporation to impose withholding tax on the payment. The Court declined to disregard any entity, but found for the IRS on the basis the Honduran corporation did not "receive" the money.
Uncertainty about the scope of this decision may have been put to rest in Northern Indiana Public Service Co. v Commissioner, 115 F.3d 506 (7th Cir. 1997). "Transactions involving a foreign corporation are to be disregarded for lack of meaningful economic activity if the corporation is merely transitory, engaging in absolutely no business activity for profit in other words it is a mere skeleton'." This must be translated for trusts, which, as next discussed, should not be engaged in business activity. However if the trust can avoid being a mere skeleton' it should be respected under current interpretation of the law.
Reclassifying the Entity. With the advent of the "check the box rules " the only involuntary reclassification of a trust is to a partnership. However that is sufficient to subject the grantor/partner to full U.S. income taxation on the income of the trust/partnership. The IRS takes the position that to be classified as a trust the trustees must take title to property solely "for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate court." The courts are bit more generous.
Grantor Trust Rules. If the grantor retains any of several powers (as a reversion, the power to revoke or the power to change beneficial interest) the income of the trust will be taxed to him. Since the grantor will pay USIT, the benefits of the SQC may be lost. Trusts that comply with the grantor trust rules will be less vulnerable to attack on other substance over form issues.
Unfortunately, this involves a completed gift, resulting in gift tax liability (or reduction in the lifetime exemption) . However in an appropriate estate-planning situation this has already been anticipated. The proposed reduction or elimination of estate taxes will make Guam-based trusts more attractive. Assuming the asset transferred appreciates at a reasonable rate, lifetime gifts, even if they accelerate transfer tax, increase the after tax wealth passing to the next generation.
Many clients simply object to giving up control as required to avoid grantor trust treatment. This led to interest in the Electing Small Business Trust ("ESBT").
Electing Small Business Trusts. At one time it was proposed that assets be placed in an "S" corporation. This is usually a flow-through entity and an S corporation that has never been a "C" corporation need not worry about restrictions on passive income . The Guam-based trust becomes the shareholder of the S corporation. A trust that has only individuals for beneficiaries and in which no interest was acquired by purchase can elect to be an ESBT and therefore may be a shareholder in an S corporation. An ESBT is taxed on its income at the maximum trust rate.
It was argued that an ESBT would not be taxed as a grantor trust. However under regulations proposed December 28, 2000 if an ESBT is a grantor trust, the grantor will be taxed . Thus it is necessary to comply with the grantor trust rules to take advantage of Guam-based trust rebates.
The Project that Failed. The originators of Guam-based trusts planned to put U.S. businesses and other assets into a U.S. S corporation, establish a Guam-based trust, treat the trust as domestic to the U.S. by subjecting it to jurisdiction of U.S. courts, but rely on Section 935 to pay taxes to Guam but not the United States. Since the entity would be an ESBT, the plan was to avoid both the grantor trust rules and the gift tax. This rebate reached not just U.S. source dividends and second tier income, but active business income. In theory every worker or investor could be bundled into an S corporation, resulting in a de facto repeal of the U.S income tax. A Treasury attack was certain.
The first blow was Notice 2000-61, 2000-49 I.R.B. 1, holding that Section 935 does not apply to trusts. This subjected the trustee to U.S. tax on the U.S. S corporation's income . Since a Guam fiduciary is treated as a non-resident alien individual and Section 935 is applicable to individuals resident in Guam, it logically follows that a Guam fiduciary has no residence. Further, in 1981 Guam issued two rulings holding that Section 935 does apply to fiduciaries for GTIT purposes. Guam has "has the same administrative and enforcement powers" with regard to the GTIT as Treasury has with respect to the United State income tax . In the two decades since Congress has passed well over 100 laws amending the Internal Revenue Code without giving any intention of wishing to alter this result. Under the "legislative reenactment doctrine," Guam is bound to apply Section 935 to trusts. Comity and Koster would suggest that Treasury should follow Guam's lead. Currently however, one rule is applied for GTIT purposes and the opposite is applied for US income tax purposes.
Treasury's second blow was determining the grantor trust rules overrule the ESBT tax regime. Prior to USPL 105-34 the Small Business Job Protection Act of 1996 grantor trusts were already able to hold S Corporation shares. Congress dealt with those trusts that were not already eligible to be shareholders of an S corporation. The proposed regulations are consistent with Congressional intent.
In light of the ESBT regulations, it may be that Notice 2000-61 will be ignored or withdrawn.
In any event neither Treasury attack has any effect on the viability of the proposal made here. The ESBT proposal was a frontal attack on U.S. taxing authority since it involved rebating taxes on U.S. source active income. The proposal made in this paper is a marginal step towards a U.S. income tax system that limits the tax on extraterritorial income, a direction approved by Congress last fall.
