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The offshore trust is implemented as a primary means of escaping the litigious society in the U.S and the U.S. court system in general.  However, knowledgeable persons in the U.S. are learning that offshore trusts may also be used as a means for investing in international markets without restriction.

Investment reasons for going offshore

Confidentiality.  Confidentiality or privacy (not secrecy), although desired, is not required for an offshore trust to succeed in preventing a creditor from reaching the assets.  Generally, the offshore trust and its details will be discovered in the event of a lawsuit.  The offshore trust may provide confidentiality as to: (a) the existence of the trust; (b) the terms and provisions of the trust; (c) the value and nature of the assets in trust; (d) the location of the assets of the trust; (e) the identity and activities of the trustee and protector; (f) the identity of the settlor and beneficiaries; (g) the nature, name, and role of any ancillary entities associated with the trust; and (h) financial statements, bank statements, and other books and records of the trust.
Rule against perpetuities.  In most states, the rule against perpetuities permits trusts to continue during the lifetime of beneficiaries living at the settlor's death, plus 21 years for beneficiaries born after the settlor's death.  Favorable trust laws either extend this rule (for anywhere from 80 to 150 years) or abolish the rule altogether.  These trust laws permit the continuation of trusts after the death of the settlor for the benefit of several generations of lineal descendants, with the advantage of avoiding substantial U.S. estate and generation-skipping transfer taxes.

Diversification of investments.  Many investments, such as eurobonds and foreign mutual funds, are closed to U.S. persons.  The offshore trust permits diversification of investments into international markets.  Use of an offshore trust to acquire eurobonds is particularly attractive in a volatile stock market or when fixed interest investments are low in the U.S.  Mutual funds of Swiss, Austrian and other banks are also useful for diversification into markets across the globe.

Modern portfolio theory.  Most state laws in the U. S. require trustees to invest under the "prudent person rule".  This rule obliges the trustee to make an individual asset evaluation to determine whether the asset will produce reasonable income and be safe with respect to the preservation of principal.  The "prudent investor rule", in contrast, requires the trustee to look at all of the assets rather than at each asset individually in order to determine an overall strategy. The aim of the prudent investor rule is the alignment of the portfolio's risk and return objectives with the trust's objectives, while considering all circumstances. 

While the prudent person rule focuses on preserving principal, the prudent investor rule focuses on increasing principal.  The prudent person rule does not permit delegation by the trustee to other parties, such as an investment manager, whereas the prudent investor rule permits delegation and the acceptance of responsibility for that delegation.

In general, the prudent person rule does not permit investing under the modern portfolio theory of investing.  Establishing an offshore trust allows the trustee to delegate responsibility under the prudent investor rule, and investments can be made under the modern portfolio theory of investing.

Reporting requirements.  The use of an offshore trust permits more economical and advantageous purchases of foreign securities, directly or through foreign mutual funds.  Foreign securities purchased by or on behalf of U.S. residents, either individually or through a mutual fund, must be reported under Regulation S to the Securities & Exchange Commission.  This reporting is extremely time-consuming and expensive for banks, brokerage firms, and financial institutions, whether located inside or outside the United States.  The offshore trust, which is treated as a foreign person for legal purposes, avoids the requirement to report the purchase of foreign securities by or on behalf of U.S. persons to the Securities & Exchange Commission.

Miscellaneous.  An offshore trust may be used in planning for the contingency of changing one's domicile and citizenship.  In addition, it is a mechanism for pre-planning in anticipation of currency control or restrictions on ownership of bullion.

Structuring the investment vehicle

How the Trustee Forms the IBC.  It is often advisable for the trustee to form an international business corporation ("IBC"), especially where foreign securities are to be acquired as trust assets, discussed below.  The trustee forms an IBC and holds the stock of the IBC as an asset of the trust.  The IBC is especially appropriate where the assets are managed by a financial institution located in a civil law jurisdiction that does not recognize trusts, such as Switzerland.

Avoiding Tax Problems of an IBC Owned by a Foreign Trust.  If offshore trust assets include stock of companies residing in foreign countries, such as England, for example, inheritance taxes (death taxes in the U.S.) may be due to England upon the death of the settlor.  If, however, an IBC is formed by the trustee to own the foreign securities, no inheritance taxes are due to England at the death of the settlor.

The potential adverse income tax consequences to the U.S. settlor of the foreign trust with an IBC (or to a U.S. person directly owning an IBC) are as follows:

i) capital losses in the IBC are not deductible until the IBC is liquidated;

ii) the IBC converts all capital gains into ordinary income (20% tax versus 39.6% tax);

iii) double taxation results from distributions of dividend income from U.S. sources (stock in U.S. companies) through the foreign trust to the U.S. beneficiary (or to a direct owner of the IBC);

iv) the basis of the stock does not step-up to its fair market value at the death of the U.S. shareholder of an IBC not engaged in a trade or business (i.e., it owns passive investment assets). Typically, if a U.S. taxpayer pays $100 for a share of stock which is worth $1,000 at death, the basis (cost) steps up to $1,000.  The basis does not step-up for stock in the IBC that holds passive investments.

Some practitioners recommend that the trustee of the offshore trust form a foreign limited liability company instead of an IBC in order to avoid these four income tax disadvantages.  Foreign inheritance taxes are avoided only through a foreign corporation formed outside the jurisdiction(s) where the companies in which the securities are purchased reside.  Thus, use of the limited liability company is only a partial answer.

Generally, U.S. persons are allowed to "check-the-box" (under Treasury Regulations) on IRS form 8865 to treat an entity (foreign or domestic) for tax purposes as either a corporation or a partnership (or a disregarded entity in the case of a one person limited liability company). However, the U.S. Regulations list entities formed under corporate laws of stated jurisdictions as corporations for tax purposes.  This means that if an IBC is formed under the laws of any one of these particular jurisdictions, the IBC will be treated as a corporation for U.S. tax purposes, with no election available under the "check-the-box" Treasury Regulations. 

The IBC should be formed in a foreign jurisdiction which is not treated under U.S. Regulations as a corporation for tax purposes.  In this way, an IBC can be formed for legal purposes, but IRS Form 8865 can be filed to treat this organization as a partnership or a disregarded entity for tax purposes.  A "disregarded entity" is a flow-through entity for tax purposes, meaning the owner, not the entity, is taxed.  This results in treating the entity as a corporation for asset protection purposes and as a flow-through entity for tax purposes.  With a legal (not tax) operating IBC, inheritance taxes of a foreign country are avoided.  However, for tax purposes, the IBC is treated as a disregarded entity, thereby avoiding the negative income tax aspects of an IBC as stated above.

Some of the jurisdictions which are not on the list of U.S. Treasury Regulations include Bermuda, Cayman Islands, Isle of Man, Jersey, Nevis, St. Vincent and the Grenadines, The Bahamas, and Turks and Caicos.

Relationship between trustee, investment manager and custodian

Memorandum of wishes.  Assets (cash, stocks, bonds) transferred to the trustee of an offshore trust are invested in accordance with the provisions of the trust instrument or as directed by the trustee.  A non-binding memorandum of wishes, often used by a settlor in conjunction with establishing an offshore trust, may also provide guidance to the trustee regarding the investing of trust assets. 

The settlor's memorandum of wishes may set forth the desired allocation of assets between stocks, bonds, mutual funds or other assets.  It may provide the maximum percentage of assets that may be placed in securities, including a range of percentages between the U.S. market and all other markets.  The memorandum of wishes may also request one or more investment managers to manage the trust assets; request one or more independent foreign custodians to hold the trust assets; and state the overall goals of investing the assets, such as the desire for current income or long-term capital appreciation.

Contracts.  The trustee and the investment manager should enter into a written contract.  The written contract may include the general or specific goals for investments of the trust assets and the general or specific methods of allocating trust assets in stocks, bonds and other investments.  In some instances, the custodian may be separate from the investment manager.  It is also recommended that a written contract be entered into between the trustee and the custodian.  In addition, some agreement or understanding between the investment manager and the custodian must exist.  The custodian must possess the required technology to make the "trades" as instructed by the investment manager and further, to transfer income or principal to the trustee, when required, to be distributed to trust beneficiaries.

If the investment advisor and the custodian are the same person, attention should be given to potential conflicts of interest.  These conflicts of interest may include investment advisors using their own company, trading and settlement service charges, and other fees. 

If the custodian is independent of the investment manager, the investment manager should be knowledgeable regarding the custodian's trading and settlement service charges, and other fees.

Treating the IBC as a Nominee.  Whether an IBC is treated as a corporation or a limited liability company (disregarded entity) for income tax purposes, filing requirements with respect to the ownership of the entity apply.  These filing requirements may be avoided if the IBC is treated merely as a nominee.  The IBC may be treated as a nominee only if the contract between the trustee and the IBC on the operations of the IBC satisfies the requirements of the 1988 case of U.S. v. Bollinger.  The IBC must have no legal function or significance other than to act as nominee and agent for the trustee, and perform no service other than holding trust assets, which are to be administered and invested only as the trustee directs.

However, if these conditions are met and the IBC is treated as a nominee, investing the trust assets in foreign securities may cause the foreign country to argue that upon the death of the settlor there was no longer any real significance to the IBC.  If the foreign country's argument is successful, the trustee of the offshore trust will be treated as the direct owner of the foreign securities, resulting in the liability for inheritance taxes to that foreign country.
 

Richard Duke is a lawyer and principal of the Duke Law Firm, P.C. based in Birmingham, Alabama.  He received a J.D. from Cumberland School of Law, Samford University in 1973 and an LL.M. in Taxation from the University of Miami in 1974.  His practice areas are international taxation, estate planning, and asset protection.  Mr. Duke is an adjunct professor of law teaching international tax and asset protection, and is co-author of “Offshore Tax Strategies”. [Copyright 1999 O.F.C. Publications Inc.  This article was published in the May/June 1999 issue of Offshore Finance U.S.A. magazine]

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