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  __  _ _

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.
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
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
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-


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