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12 Int'l Bus. Law. 394 (1984)
Avoiding Withholding Tax through Use of A Clifford Trust

handle is hein.journals/ibl12 and id is 396 raw text is: 394 Tax __ _ _ AVOIDING WITHHOLDING TAX THROUGH USE OF A CLIFFORD TRUST WILLIAM E KRISEL Mr Krisel Associate Professor of Law, New York Law School. A nonresident alien investor is subject to United States income tax at a flat rate of 30% on dividends and interest paid by domestic corpora- tions. This article will discuss a domestic trust structure which can enable a foreign owner of portfolio investments in United States secur- ities to eliminate entirely the 30% withholding tax liability in connec- tion with dividend and interest in- come earned on his investment. A. TAXATION OF FOREIGN INVESTORS Income earned by a nonresident alien individual or corporation on in- vestments in United States secur- ities will be treated for income tax purposes as not 'effectively connected with the conduct of a trade or business within the United States' as long as such foreign investor does not effect or direct securities transactions from an office or other fixed place of busi- ness in the United States.1 Such 'not effectively connected income' will be subject to withholding tax on a gross basis with reference to the type of income which is earned. For exam- ple, dividend and interest income paid by domestic corporations is sub- ject to withholding tax at a statutory rate of 30%.2 By contrast, interest paid by a domestic bank or savings and loan association3 and original issue discount on treasury bills with maturities of less than six months are not subject to withholding tax.4 Similarly, long and short term gains realised on the sale of capital assets other than real property are also not subject to any United States income tax unless the foreign investor has been present in the United States for more than 183 days during the year in which the gain is realised.5 Be- cause a nonresident alien is taxable on 'not effectively connected income' on a gross basis, he is not entitled to the benefit of any offsetting deduc- tion for expenses incurred in connec- tion with the receipt of such income.6 1. Tax Consequences of Foreign Investment During the 1970's The statutory 30% withholding tax on dividends and interest paid by domestic corporations has historical- ly been viewed by foreign investors as a mere nuisance without signifi- cant financial impact. This view has prevailed for three reasons. First the United States-British Virgin Islands Income Tax Treaty permitted a nonresident alien'to own his portfolio of United States securities through a British Virgin Islands corporation and to pay withholding tax on di- vidends and interest paid to the cor- poration at the reduced treaty rate of 15. Second, 'growth stocks' attractive to a nonresident alien investor not subject to capital gains tax often paid dividends representing only a small percentage of the purchase price of the stock. Third, high interest rates on bank deposits and treasury bills and the attractiveness of United States real estate as an investment induced many foreign investors to diversify their portfolios of United States investment properties to in- clude assets other than stocks and bonds. Thus, the typical nonresident alien investor in United States prop- erty during the 1970's generally owned a diversified portfolio includ- ing treasury bills, bank deposits, real estate and securities. As the domes- tic securities often yielded a low rate of annual return and dividends so paid to a British Virgin Islands cor- poration were taxed under the treaty at a rate of only 15%, the typical foreign investor's annual withhold- ing tax liability was often inconse- quential when viewed as a percen- tage of the total value of his invest- ment in United States property. 2. Tax Consequences of Foreign Investment During the 1980's While the withholding tax may only have been a minor nuisance to the foreign investor of the 1970's, important changes in both the tax laws and the American investment climate have made the withholding tax a more significant concern to the nonresident alien investor of the 1980's. First, in view of the recent rise in the values of American securities, the decline in interest rates paid on certificates of deposit and treasury bills, and the imposition of capital gains tax on the sale of real estate, foreign investors are generally in- creasing the proportion of their port- folio invested in United States stocks and bonds and thereby exposing more of their United States source income to the reach of the 30% with- holding tax. Second, dividend and in- terest yields on many United States securities are relatively high; for ex- ample, it is not uncommon for a port- folio of stocks to yield an average of 5% in taxable dividends and a port- folio of long term bonds to yield an average of 11% in taxable interest. Third, the reduced rates of withhold- ing tax traditionally available to the nonresident alien investor who own- ed his portfolio investments through a British Virgin Islands corporation are no longer applicable.7 Thus, while a typical foreign in- vestor's United States withholding tax liability was relatively insignifi- cant during the 1970's the three changes affecting investment deci- sions discussed above should make the foreign investor more sensitive during the 1980's to the financial im- pact of the 30% withholding tax and more interested in finding legal tech- INTERNATIONAL BUSINESS LAWYER October 1984

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