Give Me Your Tired, Your Poor…and Your Tax Planners? Pre-Immigration Tax Planning for the Hong Kong Emigrant

By:
Alicea Castellanos, CPA
Published Date:
Sep 1, 2020

At the foot of the Statue of Liberty is an inscribed plaque with a poem about America being the land that welcomes the refugee. Film footage from the turn of the 20th century depicts ships overloaded with immigrants passing the statue and dreaming of a better tomorrow in the United States.

Fast forward to the present day. In our dramatically globalized world, you’ll find that immigrants hopeful for a better tomorrow will plan ahead to increase the likelihood of their dreams coming true—and those dreams require planning for taxes. In an increasingly connected society, where countries freely exchange information, it’s possible that a new start in another area of the globe could be stunted by a tax impact too burdensome to carry.

This is especially the case with many citizens of Hong Kong who are seeking a fresh start elsewhere.

Amid several recent protests decrying Chinese deteriorative encroachment upon Hong Kong democracy and citizens’ liberties, people are second guessing the region’s stability and are concerned for their own future and welfare. Many are considering emigration to countries like Canada, Australia, Taiwan, and the United States.

Background

Prior to 2019, two main events contributed to a flux of emigration from Hong Kong. The first occurred in 1997, when the United Kingdom handed over sovereignty of Hong Kong to China. The second happened in 2014 after the Umbrella Movement by Pro-Democrats, when a series of sit-in protests occurred between September and December that year and threatened Hong Kong’s political and economic stability.

In recent weeks, the Chinese government has been exerting greater controls over Hong Kong, causing widespread consternation. As a consequence, several companies in China are now looking to register with the Singapore stock exchange. With the current desire to emigrate from Hong Kong also comes the need for a preparation strategy to leave the country. This strategy includes planning for future taxes arising at the time of—and after—emigration in the country of destination.

The United States imposes income tax not only on its citizens but also on tax residents. This includes Green Card holders and individuals who satisfy a “substantial presence test” because they’re generally physically present in the United States for at least 122 days per year under a complicated rolling three-year average formula.

Under the 2017 tax act, the United States extended the reach of its taxation of U.S. income tax residents who own controlling interests of foreign businesses, such as a Hong Kong company operating in China. Especially for service businesses operating in China but also possibly for manufacturing businesses, the U.S. shareholders of the Hong Kong corporation would be subject to current “phantom income” from virtually all the active business income and passive investment income of the Hong Kong corporation, even if none of the earnings are distributed to shareholders. Moreover, even if the Hong Kong corporation has no profits, the U.S. shareholder could face very onerous U.S. tax information reporting about the Hong Kong corporation.

Planning Considerations

Prior to becoming a U.S. income resident, an immigrant from Hong Kong may want to consider achieving certain tax objectives. In doing so, they must keep in mind that Hong Kong and the United States don’t have an income tax treaty. Hong Kong imposes an income tax only on income earned in or from Hong Kong sources. No worldwide income tax applies to a Chinese domiciliary (household registration) or a resident of more than six years.

Entity planning

In developing a plan, one must consider entity planning, since there’s more favorable tax treatment in direct foreign investment by a Chinese company in the United States. Tax strategizing could also include the recognition of capital gains and a step-up in basis, the acceleration of income, deductible expense deferment, and transfers made to foreign trusts.

Consider this scenario: A Hong Kong citizen owns a portfolio of traded securities or owns a concentrated position in one stock, such as Amazon or AliBaba. These are highly appreciated stocks. If the shares are sold after becoming a resident, this person will have to pay capital gains taxes based on the U.S. rates schedule. A stock basis (amount paid for the stock acquisition) of $100,000 sold at fair market value for $1 million will realize a gain of $900,000! The simplest way to avoid this scenario is to sell off the shares before establishing residency.

In the same vein, business owners have the option of “selling” their businesses to themselves by making certain elections in the United States for the Hong Kong business, converting it from a corporation to a disregarded entity—which is essentially a nonrecognizable tax event. No U.S. taxes will be due upon the conversion. Upon the sale of the business after establishing residency, the taxes due will be based on the appreciation in value from the day it was “sold.” This technique is called stepping up basis.

For example, if a Hong Kong citizen plans to move to the United States in January 2021, and forms are filed with the IRS to have such person’s company treated as a partnership in December 2020, this triggers the sale to the person. The prerequisite is that the company should have a viable nexus to the United States. Since the person is not a U.S. resident yet, however, it isn’t a tax-recognizable event.

Assume the value of the business at this juncture is $900,000. In 2022, the business is sold for $1 million to a third party. Due to savvy pre-immigration tax planning, the tax due would be on the $100,000 of appreciation accruing from 2020 to 2022.

Acceleration of income

Another planning tool is the acceleration of income. It would be advisable to accomplish this before the move to the United States since the non-U.S. income earned by a nonresident alien (NRA) isn’t taxable in the United States.

The selling off of accounts receivable; accelerating stock options; making dividend payouts; and prepaying salaries, bonuses, commissions, and rents are all the means of disposition to accelerate income. Another available option is to trigger accumulated earnings and profits of the foreign corporation. For many immigrants, upon establishing residency, the corporation will bear the added classification of a controlled foreign corporation (CFC).

Subpart F income will be limited to the extent of accumulated earnings and profits and is taxable. (Subpart F income consists of various types of income. Earnings and profits of a CFC that have been included in the income of the U.S. shareholders aren’t taxed again when such earnings are actually distributed to the U.S. shareholders. These earnings are known as “previously taxed income” or “PTI.”)

But these earnings and profits can be stripped via a dividend distribution liquidating the CFC and incorporating a new entity with a check of the box to disregard the entity status.

Estate planning

In the author’s experience, the best estate planning strategy for an immigrating wealthy Hong Kong resident with substantial assets and children who are or will become U.S. persons is to establish an irrevocable U.S. domestic trust as a separate taxpayer.

Before becoming a U.S. tax resident and while still an NRA of the United States, the individual could make unlimited amounts of gifts of foreign property, including Hong Kong real estate and U.S. intangible property (U.S. stocks and bonds) to such irrevocable trust for the benefit of their U.S. children. The trust could be settled in a modern trust state where the trustee is directed on investments and distributions.

As long as the Hong Kong resident retains no proscribed powers over the trust that would cause inclusion in their U.S. taxable estate, none of the trust assets would be subject to U.S. estate tax. For children remaining in Asia and not immigrating to the United States, the Hong Kong resident could establish and fund a non-US irrevocable trust. As a result, none of those trust assets would be subject to U.S. estate tax.

While an immigrating Hong Kong individual could establish a non-US irrevocable trust prior to a move to the United States that prevent its assets from becoming subject to estate tax, it would be very difficult to prevent U.S. income tax of the immigrating Hong Kong on worldwide income of the trust.

U.S. tax law provides that if an individual establishes a foreign trust and then immigrates to the United States within 60 months of transferring property to the trust, such trust becomes a U.S. grantor trust with all worldwide income taxed to the former Hong Kong individual who created the trust. Moreover, following the death of the trust creator, if such foreign trust had U.S. beneficiaries, they could face onerous throwback tax and reporting.

Sometimes an immigrating Hong Kong individual will move forward with funding a non-U.S. irrevocable trust if they believe they will be U.S. tax residents for only a specified period of time before departing the United States. They might view the trust as a “drop-off trust.” Only unneeded assets should be contributed to the drop-off trust, and the trust creator should not receive distributions of trust property to meet lifestyle needs while in the United States.

In establishing the drop-off trust, a major objective is avoiding U.S. estate tax, either on U.S. assets as a nondomiciliary or on worldwide assets if they stay indefinitely in the United States and are deemed a U.S. domiciliary taxable on worldwide assets. To avoid current U.S. income tax on trust income and gain the only practical solution is to wrap the trust assets in a foreign private placement life insurance policy. Once inside the policy, there would be no current income tax on the inside build-up of the cash value in the policy owned by the drop-off trust, and through strategic funding the trustee could access the cash value on a tax-free basis.

For the Hong Kong resident who has no plans to immigrate to the United States but who has U.S.-based children, an optimal trust strategy is a foreign grantor dynasty trust coupled with a wholly owned BVI holding corporation (or portfolio investment company). Again, the trust might be settled in a modern U.S. state permitting a “directed” trust structure. The U.S. situs assets would be owned by the BVI holding corporation, which should effectively block U.S. estate tax.

During the lifetime of the Hong Kong resident he could revoke the trust, which would cause such trust to be classified during its first phase as a foreign grantor trust. All income and gain would be taxed to the Hong Kong individual. The trust is considered an NRA taxpayer, and the United States can tax only U.S. source income of the trust. Any distributions made to U.S. beneficiaries are not subject to tax but may have to be reported by the gift recipients.

The foreign grantor dynasty trust offers substantial nontax benefits during the life of the Hong Kong resident settlor: the retention of wealth for future generations, with discretionary income and principal payments (not available in most civil law countries), protection from foreign taxes, protection from creditors, protection from nationalization and political risks, and protection from spouse’s marital claims and children’s forced heirship claim (in most civil law countries). After the death of the Hong Kong resident settlor, the trust may also save U.S. estate and generation-skipping transfer (GST) taxes for future generations.

Following the death of the Hong Kong resident, the trust enters its second phase and becomes irrevocable. It is generally preferable for the trust to become a U.S. domestic trust because of the U.S.-based beneficiaries, rather than continue as a foreign nongrantor trust. The trust document must be carefully reviewed to ensure that all trustees and trust protectors are U.S. persons during the second phase, removing any foreigner who had decision making power over the trust assets.

As a U.S. domestic trust as separate taxpayer, the trust’s worldwide income would be subject to U.S. income tax to the extent it’s accumulated by the trustee. If the trustee distributes trust income to U.S. beneficiaries, those beneficiaries will report the income on their personal tax returns. A key advantage in converting to a U.S. domestic trust as separate taxpayer is that there would be no throwback tax exposure and foreign trust reporting by the U.S. beneficiaries.

In addition, some planning strategies may be available to step-up the inside basis in the assets in the BVI trust following the death of the Hong Kong trust creator, though they’re complicated and, to some extent, a favorable outcome depending on when during the tax year the trust creator dies.

U.S. source income within the trust limits whatever tax advantages are available, as well as if the trust has U.S. beneficiaries or if the trust is still within the first five years of its creation. However, should the trust be classified intentionally as a grantor trust, the throwback regime is effectively avoided and the grantor is taxed on the income.

In planning for the estate upon the death of the grantor, the foreign grantor person needs to establish an underlying foreign corporation to serve as an estate tax blocker on U.S. situs assets owned by the individual. With U.S. heirs surviving, the trust should be converted to a U.S. domestic accumulation trust upon death to avoid the onerous throwback regime.

A foreign grantor trust is a very efficient means of planning ahead before coming to the United States. This is especially true if the immigrant is the owner of substantial assets in their native country. With such a trust, the income from the distribution is not taxable to the trust. A U.S. beneficiary in such an instance would have been taxed upon receipt of the underlying investment income.

Structuring the trust with a non-U.S. person as the settlor of a non-U.S. revocable trust for the benefit of family members is the ideal planning technique, specifically for the benefit of those who are emigrating from Hong Kong to the United States. Pursuant to U.S. trust tax law, the settlor in such an instance will be considered the owner of the trust assets. As such, any distributions to beneficiaries, including the U.S. persons, will not give rise to any U.S. tax liability for the beneficiaries. This will be the case even though the beneficiaries still have other reporting requirements here.

Implications

The immigrant experience at its core remains steadfast. Hong Kong citizens coming to build a new foundation in the United States are as optimistic and as hopeful about what the future holds for them as those coming on the ships passing the Statue of Liberty at the turn of the 20th century. The modern immigrants of today are living in a much more sophisticated world, being met with challenges wrought with complications unforeseen by predecessor generations.

Tax planning plays in important role in the immigrant experience of today. It can potentially reduce U.S. income and estate taxes significantly. As demonstrated, this planning plays out in a variety of ways, such as with the transfer of asset ownership into newly created legal entities, distributions from existing entities to obtain basis step up, and stripping out accumulated earnings and profits. There also exist various deferment options in addition to the acceleration of income and foreign trust funding.

Consideration is always given to the tax scheme of the immigrant’s home country, because a reduction in U.S. taxes wouldn’t make sense if the home country taxes are increased by the same amount. Via the coordination of these two taxing regimes, the immigrant reaps the greatest tax benefits. This can alleviate financial worry and allow for a smooth transition to a new culture and a new home.


Alicea Castellanos, CPA, is the CEO and Founder of Global Taxes LLC, a firm that provides personalized U.S. tax advisory and compliance services to high-net-worth families and their advisors. She has more than 17 years of experience in U.S. taxation of individuals from around the world. Prior to forming Global Taxes, she founded and oversaw operations at a boutique tax firm and worked at a prestigious global law firm and a CPA firm. In 2020, she was selected for the prestigious Forty Under 40 Award by the NYSSCPA for notable skills and visibly making a difference in the accounting profession. 

Alicea specializes in U.S. tax planning and compliance for non-U.S. families with global wealth and asset protection structures that include non-U.S. trusts, estates and foundations that have a U.S. connection, as well as foreign investment in U.S. real estate property.


Please note: This content is intended for informational purposes only and is not a replacement for professional accounting or tax preparatory services. Consult your own accounting, tax, and legal professionals for advice related to your individual situation.. Any names or situations have been made up for illustrative purposes — any similarities found in real life are purely coincidental. 

 
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