It is not uncommon for affluent families from certain countries to maintain offshore structures to hold a portion, and often times a significant portion, of their wealth. The reasons for holding assets outside of their country of residence are many, and such assets are frequently held in foreign corporations.
As such families grow over time, some family members may relocate to and become tax resident in other countries, such as the US. The family may continue to financially support a family member who has relocated to the US (the “US Donee”) − for instance, to maintain a certain lifestyle, to support business and investment activities or to attend school − and the support may flow from one of the family’s foreign corporations directly into the US Donee’s bank account.
While the family may view such support as a familial obligation and the US Donee may treat it as a gift of support, subject to specific exceptions, US tax law permits the Internal Revenue Service (IRS) to treat such gift of support received from a foreign corporation as income to the US Donee on which the US Donee must pay US federal income tax.
The application of that rule, commonly referred to as the “Purported Gift Rule,” can be an unwelcome surprise to the foreign family and to the US Donee. Foreign families that support their US tax resident relatives with funds and property from their foreign corporations should consider alternative methods for providing such support.
THE PURPORTED GIFT RULE
In the case of any transfer directly or indirectly from a partnership or foreign corporation which the US Donee treats as a gift (or bequest), the IRS may recharacterize such transfer in certain circumstances. Accordingly, and subject to specific exceptions, US taxpayers (i.e., US Donees) are generally required to include in their US taxable income the value of any “purported gifts” that are transferred to them directly or indirectly from a foreign partnership or foreign corporation. A US Donee reports a “purported gift” received from a foreign corporation as if the “purported gift” was a distribution from the foreign corporation.
A “purported gift” is generally defined as any transfer of property (including cash) by a partnership or foreign corporation, other than a transfer for fair market value, to a person who is not a partner in the partnership or a shareholder of the foreign corporation (or to a person who is a partner in the partnership or a shareholder of a foreign corporation, if the amount transferred is inconsistent with the partner's interest in the partnership or the shareholder's interest in the corporation, as the case may be). A transfer will not be treated as a purported gift if the US Donee can demonstrate to the satisfaction of the IRS that the US Donee is not related to a partner or shareholder of the transferor or does not have another relationship with a partner or shareholder of the transferor that establishes a reasonable basis for concluding that the transferor would make a gratuitous transfer to the US Donee.
The following example is adapted from Treasury Regulations:
FC is a corporation organized under the laws of the British Virgin Islands (BVI) that is wholly owned by A, a nonresident alien who is resident in Country C. FC makes a gratuitous transfer of property directly to A's daughter, B, who is a US permanent resident (i.e., Green Card holder). B generally must treat the transfer as a dividend from FC to the extent of FC's earnings and profits and as an amount received in excess of basis thereafter.
Although the purported gift rule can have certain unintended and adverse US tax consequences, there are exceptions to the rule.
Exceptions to the Purported Gift Rule
The Treasury Regulations provide specific exceptions to the purported gift rule that, if applicable, do not require a US Donee to treat the purported gift as US taxable income. The purported gift rule does not apply where:
- To the extent that the US Donee can demonstrate to the satisfaction of the IRS that either:
- A US citizen or resident alien individual who directly or indirectly holds an interest in the partnership or foreign corporation treated and reported the purported gift for US federal income tax purposes as a distribution to such individual and a subsequent gift to the US Donee, or
- A nonresident alien individual who directly or indirectly holds an interest in the partnership or foreign corporation treated and reported the purported gift for purposes of the tax laws of the nonresident alien individual's country of residence as a distribution to such individual and a subsequent gift to the US Donee, and the US Donee timely reported the gift on IRS Form 3520, if applicable.
There are a couple of notable observations to be made about the second prong of the exception as it relates to nonresident alien individuals. First, some jurisdictions do not tax deemed dividends and therefore, reporting of such dividends is not required (or is simply not possible). Second, some jurisdictions do not require their residents to report gifts. As a result, some US Donees may find it problematic to prove to the satisfaction of the IRS that the exception has been satisfied.
- A purported gift from a domestic partnership is received if the US Donee can demonstrate to the satisfaction of the IRS that all beneficial owners of the partnership are US citizens or residents or domestic corporations.
- To the extent that a US Donee that is a corporation can establish that the purported gift was treated for US tax purposes as a contribution to the capital of the US Donee.
- Either (i) the US Donee is a charitable organization as defined under the US Internal Revenue Code or (ii) the transferor is a tax-exempt entity as determined by the IRS and the transferor made the transfer pursuant to an exempt purpose for which the transferor was created or organized.
In addition, the purported gift rule does not apply if, during the taxable year of the US Donee, the aggregate amount of purported gifts that is transferred to such US Donee directly or indirectly from all partnerships or foreign corporations that are related does not exceed $10,000.
Application of the Passive Foreign Investment Company Rules
In addition to the already adverse US tax consequences that may result to a US Donee upon receipt of a purported gift, further adverse consequences may result from purported gifts received from foreign corporations characterized as passive foreign investment companies (PFICs) for US federal income tax purposes.
Collectively, the PFIC rules are an anti-deferral regime intended to prevent US taxpayers from deferring tax on income generated in certain foreign corporations (i.e., PFICs). If a foreign corporation that makes a purported gift is a PFIC, the US Donee of such gift must apply the PFIC rules when calculating their US income tax liability. A PFIC is generally defined as a foreign corporation where either:
- 75 percent or more of the gross income of such corporation for the taxable year is passive income, or
- the average percentage of assets held by such corporation during the taxable year which produce passive income or which are held for the production of passive income is at least 50 percent.
For purposes of the PFIC rules, cash is considered to be a passive asset. PFICs are often undesirable because of a penal interest charge, based on the holding period of the PFIC stock, that is levied on certain gains and distributions from PFICs. For purposes of the purported gift rules, a US Donee is not considered to have any basis in the foreign corporation that makes the purported gift. As a result, the potential US tax exposure of the US Donee may be further augmented.
Many foreign family corporations only hold cash, securities, insurance and other passive investments, rather than operating businesses or significant shareholdings of operating businesses. As a result, such foreign corporations are likely to be characterized as PFICs, and a US Donee receiving a purported gift from such a corporation must apply the PFIC rules when computing their US taxable income.
CONSIDER ALTERNATIVE STRUCTURES
In spite of ever-increasing information exchange between countries, many affluent families located in certain jurisdictions around the world continue to maintain family holding and investment structures outside of their country of residence. Families that wish to support relatives who become US tax residents with funds and property held in foreign structures must be mindful that such gratuitous transfers can result in a significant US tax burden for their US tax resident family members. Families that wish to support US tax resident family members via assets from foreign corporations and partnerships should consider alternative structures and funding mechanisms so as not to create a significant US income tax liability for family members who receive such transfers.