Information Reporting Arbitrage: The New American Way

In the United States, tax compliance exceeds 95 per cent when there is substantial information reporting but drops to as low as 45 per cent without it. This fact likely holds true for other countries as well. The Foreign Account Tax Compliance Act (FATCA) and the Common Reporting Standard (CRS), both seismic shifts in financial transparency, should have been the tools that governments needed to receive information on financial accounts held by trusts. And information should have led to compliance. Instead, because the United States is not a party to CRS — it obtains the information it needs through FATCA — we have seen foreign (i.e., non-US) persons move trust structures to the United States in an attempt to skirt information reporting to their home countries.

Exploiting the differences in information reporting rules — referred to herein as “information reporting arbitrage” — was again brought to the limelight by the International Consortium of Investigative Journalists (ICIJ) in the Pandora Papers. This time, instead of shining the light on trusts formed in “traditional” tax havens, the findings focus on US trusts. This article describes the legitimate reasons why trusts are formed in (or migrated to) the United States and illustrates the asymmetries that permit information reporting arbitrage by establishing US trust structures.

Trust Structures

Trusts are an increasingly common vehicle used in wealth planning for high net worth individuals and families. At their most basic, trusts are an arrangement where one person (the settlor) transfers assets to a second person (the trustee). The trustee holds and manages those assets in accordance with a trust agreement, for the benefit of a third person (the beneficiary). Under US law, if the settlor retains enough control over the disposition of the assets, he or she is treated as the “owner” of the trust (or portion thereof), and the income, deductions, and credits attributable to the assets the settlor is treated as owning are included in computing his or her tax. This regime, which also applies to trusts settled by non-US persons, albeit under more restrictive circumstances, creates myriad tax planning opportunities.

Trusts are used for many reasons, ranging from tax and estate planning to asset protection to simply helping younger generations learn the ropes of financial decision-making. Trusts also afford a degree of privacy for the settlor, allowing assets to be owned and managed by an entity separate from the settlor. While privacy can create the potential for abuse, it must (and should) be balanced against the safety it provides to individuals and families from countries where kidnapping and ransoms are an unfortunate reality of obtaining wealth.

Trusts are creatures of law. Because of this, certain jurisdictions, both domestic and foreign, have become popular for specific types of trusts. One such type is the dynasty trust — a trust that lasts for a long period of time, even, in some cases, perpetually. These trusts are used to hold wealth for successive generations and may last as long as is permitted by the rule against perpetuities in any given jurisdiction. A settlor will use a dynasty trust when he or she wants the trust to hold assets for longer than two or three generations, which is how long a trust in a jurisdiction governed by the common law rule against perpetuities typically lasts.[i]  By using a dynasty trust, a settlor may be able to achieve extended relief from federal and state transfer taxes while also creating long term incentives for certain types of behaviour from the beneficiaries of the trust. Additionally, if the settlor establishes the dynasty trust in certain jurisdictions, the trust may be able to avoid state income tax.

Some of the most well-known jurisdictions for establishing dynasty trusts include South Dakota, Nevada, and Alaska — jurisdictions accounting for nearly half of the trusts that appear in the Pandora Papers’ data. Alaska and South Dakota have eliminated the rule against perpetuities entirely, making them popular destinations for trusts meant to last in perpetuity.[ii]  Nevada, though it has not eliminated the rule against perpetuities, does allow for longer-term trusts than under the common law, permitting a time frame of 365 years from the date the trust is established.[iii]  Additionally, all three states do not impose trust income taxes, giving them an edge over other states that have done away with the rule against perpetuities.[iv]  Therefore, settlors with the flexibility to do so often look to these jurisdictions to establish long-term trusts meant to hold wealth for generations in a tax-efficient manner.  But dynasty trusts are not limited to US persons. Because US law classifies a trust (even one organised under state law) as a foreign trust if US persons do not control all substantial trust decisions, what appears to foreign countries to be a US trust can in fact be a foreign trust that is not subject to US tax, creating more tax planning opportunities for the well-informed.

Information Arbitrage

Though legitimate reasons exist for foreign persons to establish US trusts, recent information from the Pandora Papers suggests South Dakota trusts are being used to hide funds. This is, no doubt, a result of the United States’ rules for classifying trusts and it not participating in CRS.

FATCA was enacted in 2010 to combat US persons’ use of foreign entities and accounts to hide assets and evade taxes. The implementing regulations were finalised in January 2013 and the bank reporting regime became effective in 2014.[v]  FATCA requires foreign entities to classify themselves as “Foreign Financial Institutions” (FFIs) or “Nonfinancial Foreign Entities (NFFEs)”. FFIs are required to report their US account-holders to the IRS and NFFEs are required to report their “substantial US owners”. If an entity fails to comply with its FATCA obligations, it is subject to 30 per cent withholding on all its US source income — a sharp contrast to the “qualified intermediary” regime.

To minimise the burden of implementing FATCA and to facilitate coordination with local law restrictions on the reporting of information, the United States has entered into numerous intergovernmental agreements (IGA). Each IGA is based on one of two models, known as “Model 1” and “Model 2”. Under a Model 1 agreement, the FFI reports information on its US account-holders to its home government, which then send the information to the IRS. Under a Model 2 agreement, the FFI registers with the IRS and reports the information directly.

There is, however, definitional asymmetry in the IGAs. The United States requires FFIs to report accounts held by US persons or a non-US entity with one or more controlling persons that is a specified US person. But the United States will report information to an IGA partner only on (i) a depository account held by an individual resident in the IGA partner to which more than US$10 of interest is paid; or (ii) any other financial account held by an individual or an entity resident in the IGA partner country, with respect to which US source income subject to reporting under Chapter 3 of the Internal Revenue Code is paid or credited. The ease by which non-US persons can establish non-reportable accounts in the US is glaring. 

CRS piggy-backed on FATCA to provide for the automatic exchange of financial information for other countries. Over 100 countries have committed to its implementation and information exchange has commenced between most. Like FATCA, CRS classifies entities as “Financial Institutions” and “Non-Financial Entities”. While there are many similarities between the two regimes, differences exist, especially when it comes to trusts. As a result, information reporting arbitrage exists when trust structures move to the United States.

The OECD has tried to combat CRS abuse by publishing the “Model Mandatory Disclosure Rules for CRS Avoidance Arrangements and Opaque Offshore Structures” which allows for the exchange of information on structures engaged in information reporting arbitrage. The rules rely, to a large degree, on “hallmarks” of a CRS avoidance arrangement to identify such structures. These hallmarks include, in relevant part, (i) any arrangement where it is reasonable to conclude that it has, is designed to have, or marketed as having, the effect of circumventing CRS Legislation; and (ii) the transfer of a financial account, or the money or assets therein, to a jurisdiction that does not exchange information with the jurisdiction(s) of tax residence of the “Reportable Taxpayer”. The commentary to the rules states, “An arrangement does not have the effect of circumventing CRS Legislation if the Financial Account(s) information is exchanged under a FATCA Model 1A Intergovernmental Agreement with the jurisdiction(s) of tax residence of the Reportable Taxpayer”. Thus, while Model 1A FATCA reporting provides a safe harbor as to the first “hallmark,” it appears this caveat does not apply to make the United States a jurisdiction that exchanges information for purposes of the latter one.

There are at least two shortcomings with these rules. First, they put the reporting onus on the “Intermediary” — i.e., any person responsible for the design or marketing of a CRS Avoidance Arrangement or Opaque Offshore Structure, and any person providing assistance or advice with respect to the design, marketing, implementation, or organisation of such arrangement or structure where such person could “reasonably be expected to know” that such arrangement or structure is a CRS Avoidance Arrangement or an Opaque Offshore Structure. Notwithstanding this rule, however, the various iterations of the ICIJ leaks show that “gatekeepers” are a large source of what appears to be multiple CRS avoidance strategies. Second, if all arrangements and structures established in or migrating to the United States are reportable, what good is such an over-inclusive rule? Presumably the rules are intended to provide taxing authorities with better leads on tax avoidance structures. If US trust structures formed for legitimate purposes (and properly reported in the residence country) are included in the reporting, resources would be unnecessarily wasted on compliant structures, possibly allowing abusive structures to go scrutinised (tax authorities cannot audit everyone, after all).

Conclusion

There are legitimate reasons for using trusts (including South Dakota trusts) in a family’s tax planning. It thus seems that information reporting arbitrage should share the same fate as tax arbitrage — it should work where avoiding reporting is not the sole or predominant motivation. We are still in the early stages of a world in which countries are more open to collecting and sharing information on taxpayers. As beneficial ownership registers become the norm, it seems likely that using structures to hide assets and evade tax will become more difficult. But, as the leaks reported by the ICIJ show, there is big money in helping the ultra-wealthy (and criminals) hide assets, and the cat-and-mouse game is bound to continue.

 

Footnotes:

[i] The common law rule against perpetuities, while complicated, can be generally described as saying that any interest in a trust must vest or fail to vest within a life in being at the time the interest is created plus 21 years. If the interest does not so vest, the trust is invalid.

[ii] Other states that have eliminated the rule against perpetuities include Arkansas, Delaware, the District of Columbia, Hawaii, Idaho, Illinois, Kentucky, Maine, Maryland, Minnesota, Missouri, Nebraska, New Hampshire, New Jersey, North Carolina, Ohio, Oklahoma, Pennsylvania, Rhode Island, Virginia, and Wisconsin.

[iii] Other states that have taken the approach of permitting longer-term trusts include Alabama (360 years), Arizona (500 years), Colorado (1,000 years), Florida (360 years), Georgia (360 years), Mississippi (360 years), Tennessee (360 years), Utah (1,000 years), Washington (150 years), and Wyoming (1,000 years).

[iv] Florida, New Hampshire, Texas, Washington, and Wyoming also do not impose trust income taxes.

[v] FATCA also imposed additional information reporting requirements on individual U.S. taxpayer to report their interests in certain specified foreign financial assets.  This regime took effect in 2011.