By Eli Akhavan
The Tax Cuts and Jobs Act of 2017 (P.L. 115-97, December 2, 2017, the “Tax Act”) introduced the most comprehensive reform to the Internal Revenue Code of 1986 since its enactment. The Tax Act not only affects U.S. citizens and residents but also significantly impacts non-U.S. persons that have a U.S. connection. Particularly, high net-worth Chinese individuals that either reside in the U.S. or have U.S. investments should have their business and investment structures reviewed to ensure tax efficiencies.
Planning for high net worth Chinese nationals involves a three-pronged approach:
Income Tax Planning
Estate and Gift Tax Planning
Asset Protection Planning
The following article highlights the Tax Act’s implications for Chinese high net worth individuals that are either not considered U.S. tax residents for income tax purposes and are investing in the United States or are tax residents of the United States and are investing outside the United States.
Chinese high net-worth individuals with business interests or family in the United States are affected by the Tax Act with respect to both “inbound investments” (investments made into the United States by non-resident non-citizen Chinese individuals) and “outbound investments” (investments made by individuals or their family members who are considered tax residents of the U.S.).
The threshold question in evaluating the appropriate planning is to evaluate whether an individual is a “resident” for income tax purposes. Generally, a Chinese individual is considered a U.S. income tax resident if he or she is either:
a U.S. citizen;
a U.S. greencard holder (unless an exemption is being claimed under the U.S.-China income tax treaty); or
present in the United States for a certain number of days.
Residency planning and determination is the fundamental step prior to implementing a tax plan. Since the rules are somewhat complex, consulting an advisor in advance of residency planning is strongly recommended.
The two most significant provisions of the Tax Act that affect Chinese investment in the United States are the reduced corporate tax rate and interest deductibility limitations. There is a lower corporate tax rate of 21%, which may make the corporate entity more appealing for businesses that generate significant income that do not intend to distribute the income. While there are generally two layers of tax with respect to corporate structures (i.e., tax on corporate income and tax on shareholder when a dividend is distributed), if a non-U.S. entity invests in an income-generating business, it can realize the gains through a non-taxable liquidation (unless the investment is in U.S. real property).
The Tax Act also limits a U.S. taxpayer’s deduction for net business interest expense to 30% of the taxpayer’s adjusted taxable income for the year. The interest deduction limitations may make capitalizing a U.S. entity through debt less attractive. Nonetheless, debt financing may be a viable option since the repayment of debt principal is generally non-taxable to the debtholder.
The interest expense and net operating losses limitations may provide further reasons to use trust structures since trusts aren’t as affected by these limitations as corporations are.
Finally, the Tax Act allows for 100% bonus depreciation for certain property placed in service between September 27, 2017 and January 1, 2023. Depending on the business, this may encourage Chinese investors to buy the assets of a target company rather than stock of the company.
Pursuant to the Tax Act, members of Chinese families who are U.S. income tax residents have to report and pay taxes on their worldwide income. Under prior rules, there were minimal U.S. income tax obligations on active business income sourced outside the U.S. within a non-U.S. corporation. Here are some highlights of the new rules:
A “GILTI” tax applies to non-U.S. source income at a rate which is essentially a minimum income tax on a U.S. shareholder of a controlled foreign corporation (“CFC”) where the business is not primarily based on tangible assets.
U.S. corporations are now incentivized to domesticate their intangible assets that are used abroad, with an effective tax rate of 13.125%
The definition of a “U.S. Shareholder” for purposes of a controlled foreign corporation has been broadened to include U.S. shareholders who own 10% of vote OR value. The prior rules required 10% vote only.
Generally, U.S. shareholders of controlled foreign corporations will have to include the CFC’s GILTI in their current income. The GILTI computation is somewhat complex but the takeaway is that the U.S. shareholder is subject to increased taxes. U.S. shareholders who are corporations are entitled to foreign tax credits and a new deduction. These rules incentivize the use of U.S. corporations.
U.S. members of Chinese families also have to file Form 5471 with respect to ownership of foreign corporations and attribution rules among family members with respect to stock ownership apply. This means that minimal transfers to U.S. entities or family members should be avoided and trust structures should be carefully looked at to avoid additional reporting and filing obligations. For example, if the child of a Chinese national becomes a tax resident of the U.S., then through the “attribution” rules, he or she may be subject to additional taxation and reporting requirement. It may be worth considering a trust structure to avoid this reporting requirement.
The definition of a U.S. tax resident for estate and gift tax purposes is different than the definition of a U.S. tax resident for income tax purposes. Generally, an individual is considered a resident of the United States for estate and gift tax purposes if the individuals is “domiciled” in the United States. “Domicile” in the United States means living in the United States with no present intention of leaving.
The Tax Act doubled the transfer exemption amount from $5 million to $10 million (as indexed for inflation) with an estate and gift tax rate of 40%. However, the estate tax exemption amount for non-residents and non-citizens remains $60,000 for U.S. situs property that they own. For example, if a Chinese individual who is not considered to be a resident of the United States for estate and gift tax purposes dies owning a condominium apartment in New York valued at $1,000,000, his estate will owe a federal estate tax of $376,000 (i.e., $1,000,000 - $60,000 exemption = $940,000 x 40% estate tax rate = $376,000).
However, if the real estate ownership is structured properly, the estate tax can be avoided entirely. Structures that can achieve significant tax savings include both foreign and U.S. trusts. The design of the structure will depend on whether the property is rental property or non-rental property, expected holding period and whether there are U.S. resident beneficiaries.
Additionally, Chinese individuals who are not considered tax residents for estate and gift tax purposes may wish to make gifts to their children who may reside in the United States. If the gifts are considered gifts of “U.S. situs” assets, gift tax planning must be considered to avoid gift taxes. Gifts of a U.S. situs assets to a non-spouse is limited to $15,000 per year and gifts to a non-citizen spouse are limited to $152,000 per year. Structuring the gifts appropriately so that they are not considered “U.S. situs” assets will help reduce or eliminate the gift tax.
Chinese nationals should ensure that their assets and investments in the United States are held in asset protection structures to help shield assets from domestic and foreign creditors, including family members, business creditors, and general tort creditors. A major component of asset protection planning is the use of trusts that are sitused in the United States or abroad (e.g., Cook Island or Nevis).
Chinese nationals who have U.S. financial and business interests or have U.S. beneficiaries (e.g., spouse or children who are residents of the United States) should strongly consider the use of trusts in their business structures. Trusts can:
Protect assets from creditors;
Allow beneficiaries to inherit assets without needing a will; and
Provide estate and gift tax savings.
It is important that trusts be incorporated as part of the overall investment strategy in parallel with the tax planning.
U.S. tax planning for high net worth Chinese individuals is a complex and sophisticated undertaking. A variety of factors such as the nature of investment, residency and existence of U.S. beneficiaries will dictate the design and operations of proper tax planning.
Should you have any questions or desire further insight, feel free to contact one of the members of our Tax Department: