Jamie left her lawyer’s office with a great sense of relief. She’d just signed a new trust deed, created after months of planning with counsel. She felt that her beneficiaries would be protected now. But, when she tried to open an account using her new structure, the financial institution told her she couldn’t invest as she’d intended. Jamie’s expectations were frustrated as a result of incomplete and uncoordinated advice.
These unintended client results stem from mirror blind spots among advisors—private client lawyers who aren’t aware of the issues and securities lawyers who’ve never been asked to focus on the private client world. The takeaway? Private client lawyers who serve global families need to find ways to bridge the information gap among tax, trust and securities laws.
Many practitioners know much about international estate planning, trusts and the tax regimes affecting our ever-mobile clients, but we’re often unprepared when it comes to the mechanics of investing for these families or the securities rules, policies and investment vehicle distribution agreements that touch our well-crafted structures. True, your clients should talk to their financial advisors about investments—that isn’t the lawyers’ role—but the structures advisors create can generate unanticipated and unfavorable results when our cross-border clients seek to deploy their liquidity.
The U.S. securities laws impact the estate-planning world in countless ways—sales of partnership interests, pre-sale and pre-initial public offering considerations, grantor retained annuity trusts holding public company shares subject to insider trading rules—just to name a few. There are many reasons why private client lawyers and securities lawyers should team up. As attorneys become aware of common investment issues affecting international families, we hope such awareness will support a more collaborative approach among a client’s many professional advisors.
The best place to start is with some examples, so let’s turn to Ida and her family.
A Tale of Two Sisters
Ida left New York and returned to Israel to be with her sister, Julie, but she speaks to her trusted U.S. banker regularly. Recently, her banker started offering her non-U.S. funds because Ida lives outside of the United States. Ida may live in Israel now, but she’s a U.S. citizen, and she still pays U.S. taxes. These non-U.S. funds caused a mess on her tax return last year, and she wants to go back to U.S. products. What’s the problem?
Unlike her sister, Julie never moved to the United States, holds no U.S. passport and has always been an Israeli citizen. She thinks Ida’s banker does a great job, and she diversified her wealth in part by opening an investment account in New York with him. Julie gave her daughter, Rebecca, a power of attorney over her U.S.-custodied investment management account. Rebecca is a student in New York and can meet the banker in person. But suddenly, the banker wants to invest in U.S. products, and the change will trigger tax for Julie in Israel. What’s the problem?
The Ground Rules
Before it gets more complicated, we should lay out the ground rules. Cross-border tax advisors know that U.S. residency (and worldwide tax) can be triggered in various ways—holding U.S. citizenship, holding a U.S. Green Card or meeting the substantial presence test due to the number of days spent in the United States.1 As a U.S. citizen, Ida is a U.S. taxpayer. Her sister, Julie, isn’t tax resident in the United States. And, it’s possible that Rebecca may not be a U.S. taxpayer if she’s living in the United States as a foreign student through an F visa —but more facts are needed to determine Rebecca’s U.S. tax residency status.
What many advisors may not know is that Congress didn’t consult the Internal Revenue Code when it defined “residency” under the Securities Act of 1933 (the Act). Put a tax lawyer and a securities lawyer in the room together to discuss the term “residency,” and not only do you have the beginning of a really good party, but also you could recreate the famous Abbott & Costello “Who’s on First” skit. Unfortunately, the scope of this article doesn’t permit us to delve into the intricacies of how the Act defines “residency,” but here are the key takeaways:
A U.S. person includes (but isn’t limited to):
• A natural person resident in the United States
• A partnership or corporation organized under U.S. law
• An estate of which any executor/administrator is a U.S. person
• A trust in which any trustee is a U.S. person
• A non-discretionary account (other than a trust or estate) held by a fiduciary for the benefit of a U.S. person
• A discretionary account (other than a trust or estate) held by a fiduciary resident in the United States
A foreign person includes (but isn’t limited to):
• A discretionary account (other than a trust or estate) held for the benefit of a non-U.S. person by a dealer, or other professional fiduciary, organized in the United States
• An estate of which a professional U.S. fiduciary acts as executor/administrator, but sole or shared investment discretion is held by a non-U.S. person executor/administrator
• A trust of which any professional fiduciary acting as trustee is a U.S. person, if a trustee isn’t a U.S. person, has sole or shared investment discretion with respect to the trust assets and no beneficiary of the trust (and no settlor of a revocable trust) is a U.S. person
Why do these tax and securities law definitional differences matter? Because the structures we create for global families may be well designed to fit perfectly under the tax regime as “foreign” or “domestic,” but often, the mismatch of the tax and securities rules prevents clients from investing through their structures as originally intended.
The Act provides certain protections to U.S. resident consumers of investment products. Securities laws generally don’t regulate the product that’s sold, but rather the disclosures around the product, with the goal of giving investors in the United States enough information to make informed decisions. Investment advisors subject to the Act are prohibited from providing unregistered investment products unless an exception from registration exists.
Increased Complexities
Let’s go back to Ida. Although she’s a U.S. citizen, she isn’t a resident investor under the Act. Her banker can no longer sell her U.S. products even though the account lists her as a U.S. resident taxpayer. The non-U.S. funds he recommends are passive foreign investment companies (PFICs) but for a U.S. resident taxpayer, these funds may create a burdensome and tax-inefficient investment result. One solution may be to use direct equity investments and bonds, but Ida isn’t happy about losing access to the fund platform. Not a great client result.
Julie has the opposite problem. She isn’t a U.S. resident taxpayer, and she wants to have non-U.S. funds, but the decision maker on her account, Rebecca, may be considered a U.S. resident for securities law purposes. The investment manager can’t sell to a U.S. resident the non-U.S. funds. Rebecca could argue that her status as a student is transitory, and she shouldn’t be viewed as “resident” under the Act, but many financial institutions may not be able to accommodate that characterization.
Ida and her sister illustrate the increasing complexities of managing liquidity for global families. Ida’s case is a textbook problem faced by Americans abroad. But, there are many other versions of this story, each more complicated than the next.
For example, for succession purposes, a U.S. lawyer creates an irrevocable directed Delaware trust with a U.S. bank trustee for a Saudi family. The family office is located in Geneva and is named as the investment advisor in the trust deed, with full powers over the assets held in the trust. Counsel tells the client that the trust isn’t resident in the United States for income tax purposes even though there’s a U.S. trustee and the structure is governed by Delaware law. Having a non-U.S. investment advisor means that at least one of the trust’s substantive decisions is controlled by a non-U.S. person, so the trust fails the “control test”2 and is characterized as a nonresident for U.S. tax purposes.
For securities law purposes, at first glance, the Act would tell us that the trust is a U.S. resident investor because it has a U.S. trustee, meaning that the clients potentially lose access to unregistered funds. But, the Act further defines a trust as a “foreign” investor if a trustee who isn’t a U.S. person has sole or shared investment responsibility, and no beneficiary is a U.S. person. Is the role of investment advisor under the trust document a fiduciary position, such that the non-U.S. family office may be characterized as a co-trustee? If so, then the rules say the trust is both a nonresident for U.S. income tax purposes and a nonresident investor for securities law purposes, the client’s preferred result.
Law Mismatch
Change the facts slightly, and give the trust a Saudi protector, but the investment advisor is the trusted first born son who resides permanently in California. Now you’ve created a mismatch between tax and securities laws that may prevent your clients from achieving their desired investment goals.
When managing liquidity, many non-U.S. clients use an underlying holding company (a private investment company (PIC)). If the PIC holds the U.S.-based investment account, is the identity and status of the trust’s investment advisor relevant for investor characterization under securities law? Probably not. A non-U.S. PIC would be considered foreign under the Act and foreign for tax purposes, helping us realign the tax and securities laws.
But, if that account is held by a U.S. limited liability company (LLC) disregarded to the non-U.S. taxpayer, then the same mismatch concerns arise. The same could apply when a director of the foreign PIC with power over investments is a U.S. resident individual.
Building off the PIC example, a French husband and wife are moving to the United States. They own their financial assets in a société à responsabilité limitée (SARL), which they can’t terminate quickly for French tax reasons. Their attorney advised them to make a check-the-box election to preclude controlled foreign corporation status of the company once they’re U.S. taxpayers. As a result of that election, the SARL is treated as a partnership for U.S. tax purposes because it’s owned 50/50 by husband and wife. The partnership files a W-8 IMY (Certificate of Foreign Intermediary, Foreign Flow-Through Entity, or Certain U.S. Branches for U.S. Tax Withholding and Reporting) with the financial institution, and the spouses file W-9s (Request for Taxpayer Identification Number) once they trigger U.S. residency. Despite the tax planning, they still have problems because the U.S. investment management account is owned by a foreign investor (the SARL) for securities law purposes: The check-the-box election for tax purposes isn’t relevant under the Act. The result is a limited investment portfolio for the husband and wife.
An Italian family owns a non-U.S. company through which it holds the family’s investments. The shareholders are the three daughters, two of whom live in Italy and one in New York. The U.S. resident daughter treats the company as a partnership for tax purposes. The father, living in Milan, is the director of the company and has sole trading power. In this case, the securities law and tax law are a match—both are foreign. But, for our U.S. shareholder, the underlying investments of the company may create a tax-inefficient investment if they’re PFICs. Sometimes there’s no perfect answer, and the analysis centers on choosing the lesser evil.
Regulation S
Earlier in this article, we mentioned that financial advisors subject to the Act are prohibited from providing unregistered investment products unless an exception from registration exists. One important exemption to understand and apply when working with global families is Regulation S.3 The purpose of the Act is to protect consumers in the United States, but the U.S. financial industry must also be able to compete in a global world. Regulation S recognizes that the Act can’t extend to transactions that occur exclusively outside of the United States, and it provides a safe harbor when transactions (offers and sales) of unregistered securities occur outside of the United States. Regulation S doesn’t shield the issuer from compliance with any other securities regulations, but it does permit avoidance of the onerous and expensive SEC registration process, and it allows financial advisors to market securities outside of the United States (assuming the investments qualify under all local securities laws).
When global families have U.S. persons in control of their investment decisions (remember the trusted son living in California?) they may be shut out of the Regulation S exemption under the Act, because the marketing of the non-U.S. security is to a U.S. investor. But, Regulation S isn’t simple, and there’s always an exception to the exception. Under Rule 902 of Regulation S, a discretionary account held for the benefit of a non-U.S. person by a professional fiduciary incorporated or resident in the United States isn’t a U.S. person. What’s a “professional fiduciary?” The most commonly encountered professional fiduciaries are single family offices (SFOs), registered investment advisors (RIAs), domestic banks and insurance companies, but this isn’t an exhaustive list.
What about Julie and her daughter Rebecca? Does the power of attorney establish a fiduciary relationship that qualifies Rebecca as a fiduciary, triggering the exception? Does it matter if Julie is really directing the investments, and Rebecca is simply the messenger? It’s unlikely that a standard bank power of attorney over investments is sufficient to qualify as a professional fiduciary, but if Rebecca established an RIA, then Regulation S would apply, and non-U.S. products would be available to be bought and sold in Julie’s account.
An interesting carve-out for Regulation S is the SFO professional fiduciary exception. To qualify, an SFO must: (1) be a separate legal entity serving only one family, (2) be owned and controlled by the family, and (3) not advertise itself to the public as an investment advisor. Families that wish to fit into the SFO exception need to show that their company is operating as a legitimate SFO, and generally the rule wasn’t intended to cover the family’s PIC or holding company. In some cases, there are competing interests because it’s often more tax advantaged in the United States to act as a multi-family office instead of an SFO. Often, a non-U.S. family with accounts held by individuals or vehicles that are non-U.S. for tax purposes are serviced by a U.S.-based SFO. These clients can be sold non-U.S. products because the SFO exception applies.
Acceptable Client
Lastly, over and above the tension in the rules arising from tax law and securities law, there’s the further complication of what an investment fund deems as an acceptable client and what the distribution agreement stipulates when that fund is marketed. For example, a European mutual fund may say in its prospectus that it won’t accept a U.S. investor as that term is defined under U.S. security laws, so if a U.S. LLC disregarded to a nonresident taxpayer attempts to make a placement, it will be rejected. Similarly, the fund’s distribution agreement may preclude distribution to a U.S. taxpayer, even one who for securities law purposes is deemed to be a non-U.S. investor.
Involve the Investment Professional
Addressing succession planning, tax and trust law is complicated and sometimes overwhelming for our clients. From the advisor’s standpoint, adding yet more complexity to the conversation may not be beneficial to the main goal of creating a structure or providing a solution to the client’s estate-planning concerns. However, while nothing’s perfect, it’s important not to view the situation from one lens: The result will be a hefty legal bill for only a partial resolution, or you may have created one problem while solving another. Involving the investment professional in your planning conversations at an appropriate juncture is an ideal way to raise this issue . . . or make sure to befriend that securities lawyer! At a minimum, your cross-border family client will be better served by an estate-planning attorney who’s aware of this issue and can direct the client to have an active conversation with his investment professional.
— J.P. Morgan, its affiliates and employees do not provide tax, legal or accounting advice. The tax-related material contained herein has been prepared for informational purposes only, and is not intended to provide, and should not be relied on, for tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any financial transaction.
Endnotes
1. See Internal Revenue Code Section 7701.
2. Treasury Regulations Section 301.7701-7.
3. 17 C.F.R. 230.901 through 230.904 encompass the Regulation S rules under the Securities Act of 1933.