FOCUS ON INDIA: CURRENT U.S. TAX POLICY WILL CHASE AWAY THE BEST AND THE BRIGHTEST

Heavily entrenched in our tax system is the view that wealth accumulation by any citizen or resident is U.S. based. This view fails to take into account the growing trend that new wealth accumulation will occur at an increasingly rapid rate, not in the U.S., but in Asia.

Faced with U.S. tax burden and erroneous reporting rules on foreign income and wealth that some consider unjustified, many wealthy U.S. citizens and residents of Asian origin are considering doing what a decade ago would have been unthinkable – giving up their green cards or citizenships as a wealth preservation strategy.  Unless the current U.S. tax system is reexamined, the country is in danger of losing some of its best and brightest.

U.S. citizens and residents must report and pay tax on worldwide income.  In addition, tax rules require disclosures of foreign bank accounts and ownership in foreign entities.  This past year we’ve been advising many clients from India who are, in U.S. tax terms, “off the grid”.   These individuals obtained their green cards and U.S. citizenships, some at birth, and have been working and living outside the U.S. for many years.  The scale of the problem is hard to know although the net worth of these noncompliant citizens and residents is in the many billions of dollars.  Merely omitting required disclosures can result in significant civil penalties and possible criminal prosecution under U.S. tax law.  Many offenders living abroad are U.S. citizens and green card holders with Indian origin.  They are corporate executives running large companies that have paid their full amount of Indian taxes.  How will the U.S. deal with these noncompliant “taxpayers?”  The answer is not hard to find.

In December 2010, IRS Commissioner, Doug Shulman, stated that cleaning up abuses and mounting a greater attack on tax evasion is the order of the day.  International tax evasion is the number one offense on the IRS’s top ten areas of tax evasion schemes. Another more recent example is the Department of Justice action.  They issued a summons on the Hong Kong and Shanghai Banking Corporation of India (HSBC India) that requires the bank to turn over information on U.S. residents and citizens who may be using its accounts to evade tax.  Information provided to the Department of Justice indicates that there are approximately 9,000 US persons with accounts in Indian in just this one bank.  After its win with obtaining information from the Swiss banks, the Department of Justice is focusing attention on Singapore, India and Hong Kong.  China may be next.

Background

In the 1970s, 80s and 90s India imposed severe restrictions on travel and on investment outside the subcontinent.  Students from India entered the best American universities, graduated in large numbers with engineering degrees, found jobs, obtained green cards and ultimately obtained their U.S. citizenship.  These engineers, to become entrepreneurs, played a major role in Silicon Valley’s boom.  U.S. citizenship was itself a treasured goal:  it was the escape hatch from restrictions imposed by India on its citizens.  U.S. citizenship also provided an evergreen ticket to sponsor family in India to immigrate to the U.S.  All was fine in the Valley as these “super immigrants” prospered like no other group in American history.  India’s businesses started to flourish in part due to the Silicon Valley training with many returning to India with a green card or a U.S. passport in their pocket.

In 1999, India abolished many restrictions on inbound investment, and the economy rapidly expanded.  Simultaneously, the internet fueled a tech boom in India, turning sleepy cities like Bangalore and Pune into major tech centers.  This fueled huge appreciation in real estate values that accelerated wealth accumulation and turned local businessmen into billionaires in a very short time. Mumbai is now the home of some of the most valuable real estate on the planet.


Today, families in India have joined the global superrich.  The Forbes 400 list of the world’s richest men and women include a growing number of Indian entrepreneurs.  Industries and real estate empires are in the process of being passed to the next two generations - but hold on!  The old family wealth was now being passed down to the sons and daughters and grandchildren that are American citizens.  The engineers from Stanford, MIT, Harvard and Berkeley have been returning home with MBAs in hand to start their own businesses.  India does not impose gift or estate taxes, so estate planning typically followed family traditions without any concern for gift or estate taxes. However, a growing number of these new moguls are U.S. citizens and green card holders, and this new wealth is now trapped inside the U.S. estate tax system with apparently no ability to exit without severe tax costs.  Today, the U.S. gift and estate tax is 35% on amounts in excess of $5 million, as of December 2010.   The problem regarding noncompliance is primarily due to:

1.   All or most of the wealth is in India, not the U.S.

2.   Families and advisors living in India are unfamiliar with U.S. tax rules and have been poorly advised.

3.   To get things back on track, as many wish to do, the penalties due to nonreporting in past years is enough to humble Warren Buffett. 

The U.S. system is unique in its global scope and penalty regime for nondisclosure of sometimes remote and hard-to-find information.  It is by far the most aggressive tax system on the globe when it comes to the reporting of investments outside the U.S.  Many of these wealthy Indians, having resettled back in India, are now being advised about the U.S. expatriation rules.

Procedures exist that allow U.S. citizens to expatriate which has the effect of terminating their ongoing U.S. tax filings.   However, Section 877A of the Internal Revenue Code imposes a “small” catch.   If you’ve held a green card for more than seven of the last 15 years, and if your global wealth exceeds $2 million or your average U.S. taxes for the past five years exceeded $125,000, then the U.S. imposes an exit tax.  Expatriation has the effect of selling one’s assets at their current fair market value, and with the resulting tax.  Giving up citizenship is an emotional issue for some, due to the effort expended in obtaining U.S. citizenship in the first place, as well as ties to family now entrenched in the U.S.  However, many individuals are choosing to give up their U.S. status for purely tax reasons. 

On a recent trip to India, I visited several law firms and financial institutions and consulted with families where the exit taxes were so large that the sums would cripple the individuals’ financial wellbeing and their related family enterprises.   Consider, for example, that contributing assets to a non-US trust could result in a penalty of 25% of the value of the assets if not disclosed on one’s income tax return.  Or consider the potential penalty of 50% of the highest account balance in one’s foreign bank accounts or foreign brokerage accounts merely due to nondisclosure each year on Treasury Form TDF 90-22.1.

Savvy financial institutions and international tax advisors are busy mapping out strategies.  For many wealthy Indians, negotiating these rules is like driving in the streets of Mumbai – you can’t survive merely by following the rules in the motor vehicle code.   In order to properly expatriate and properly exit the U.S. tax system, a person needs to submit five years of properly filed U.S. returns and provide the IRS with complete disclosures on IRS Form 8854.  Since India may one day impose gift and estate taxes, holding U.S. citizenship may still be a good hedge if the tax system in India is radically changed.  However, given the fact that the current government is mostly composed of the upper tier of the high net worth families in India, there’s little likelihood of any major change in this area for some years to come. 

In February, the IRS announced an amnesty program whereby individuals can voluntarily file past returns with the correct tax and discloses. By doing so, potential criminal charges are waived and the 50% penalty on undisclosed foreign accounts will be reduced to 25% for accounts in excess of $75,000.  For example, if one has an undisclosed foreign account of $1 million, even if the additional income and additional tax is minor, the penalty for not filing the annual Treasury Form TDF 90-22.1 is $250,000.  The scope and amount of the penalties are confiscatory and appear unfair to many, since the wealth was generated outside the U.S. and in many instances has already been taxed in India.  In general, even well intentioned people will not comply with laws that on their face appear to be unfair. 

Like it or not, U.S. citizenship has lost much of its luster.  Wealth and talent are mobile and can reside in almost any country.  In the February 6^th issue of the Financial Times, the leading article highlighted changes in U.K. immigration law being implemented specifically to attract the global high net worth person to take on UK residency.  Tax laws in the U.K. are also being liberalized to attract this wealth and talent based on the assumption that capital will follow the individual’s residence.  Other countries are considering similar rules.  Today, high net worth entrepreneurs can move in an out of countries with increasing ease because they are seen by most countries as bringing capital, jobs, and opportunities to the local economy.

 The SolutionCongress might not like to the bitter pill of liberalizing the expatriation rules for a group of high net worth individuals that appear on the surface to be tax evaders.  It will take some reflection and forward thinking to solve the problem in a way that is beneficial to both foreign residents and to the U.S. Treasury. The U.S. Tax Code can stick with assumptions that are no longer valid, or Congress needs to reconsider how to keep all of its citizens and residents within the system.  Otherwise, vast amounts of wealth will stay outside the U.S. - undeclared and untouchable by U.S. tax policy.  Major sources of income taxes will go uncollected and the best and the brightest will bypass the U.S. as a friendly place to call home.

Congress needs to heed the prophetic words from one of Bob Dylan’s songs in the ‘60s:

Come Senators, Congressmen, please heed the call

Don’t stand in the doorway, don’t block up the hall

For he that gets hurt will be he who has stalled

There’s a battle outside and it is ragin’

It’ll soon shake your windows and rattle your walls

Oh, the times they are a-changin’.

DOJ Seeks John Doe Summons for Data on HSBC India Accounts of U.S. Residents

Year-End Tax Planning and 2011 Tax Rate Changes

Historical perspective: It’s always interesting to look back at tax rates when we are in the middle of a Congressional battle over preserving current rates or reverting to higher rates. Here are the top tax rates dating back to 1913 when the U.S. adopted an income tax.

Top Income Tax %

Year	Top % Rate		Year	Top % Rate
1913– 1915	7		1946-1951	91
1916	15		1952-1960	92
1917	67		1961-1964	77
1918	77		1965-1980	70
1919-1921	73		1981-1986	50
1922-1923	58		1987	35
1924	46		1988-1990	28
1925- 1931	25		1991- 1992	31
1932-1935	63		1993 - 2000	39.6
1936–1940	79		2001	39.1
1941	81		2002	38.6
1942	88		2003-2010	35
1944-1945	94		2011	39.5 (projected)

(1) Tax Foundation - see full rate tables at

http://www.taxfoundation.org/files/fed_individual_rate_history-june2010.pdf

For 2011, Federal tax rates will most likely increase as the tax cuts enacted in 2001 and 2003 under the Bush Administration will expire. There is, however, a political see-saw between now and the end of the year so it's still a guessing game. The worsening of the employment picture and economic news in general provides leverage for the critics of the tax increase and with mid term elections coming up in November, it’s possible that the scheduled increases will be delayed.

At this point, the momentum appears to be with the Obama Administration. New business incentives were proposed this week. That should buffer complaints that higher rates will be a drag on the economy. Tax cuts for the middle class with incomes below $200,000 for individuals or $250,000 for a married couple will also help the Obama Administration sell the higher rates on "the wealthy".

The following changes will likely occur for 2011:

Ordinary Income

·   35% bracket  will increase to 39.6%

·   33% bracket  will increase to 36%

·   28% bracket will increase to 31%

·   25% bracket will increase to 28%

·   10% and 15% will condense to 15%

·   The top tax rate on dividends will increase from

    15% to 39.6%

Capital Gains

·   Tax rate will increase from 15% to 20% (1)

Estate and Gift

                                                  2009                   2010                      2011
Top estate tax rate (2)       45%                     -0-                        55%
Exemption                       $3.5 mil.           Unlimited                $1 mil.

      Notes
(1) Rates apply to capital gain on assets held for more than one year.  Ordinary income tax rates apply to assets held for one year or less.

(2) For 2010, there is no estate tax unless Congress enacts a retroactive tax. The Bush tax cuts increased the exemption to $3.5 million in 2009, but for 2010, the estate tax went to zero. The assumption was that Congress would enact new legislation by the end of 2009. It didn’t, so the zero rate is currently in effect until 2011 when the old rates in effect prior to 2001 are re-established.

SUGGESTED ACTIONS

Corporate Bonuses

Taxpayers should plan now for a higher rate structure. Corporations will need to consider whether 2011 bonuses should be accelerated to the current year to lessen the impact on high income earning employees.

Reconsider C Corporation vs. Pass - Through Entities for Conducting Business

For owners of closely held companies, this may be the time to evaluate the benefits of using a C corporation vs. an S corporation, or a partnership or LLC for all or part of one’s business. The first $100,000 of taxable income in a C corporation results in a federal tax of $22,500 compared to $39,600 in 2011. The top personal tax rate is even higher than 40% if one considers the various phase outs on personal returns and possible self employment taxes added on.

Dividend Policy

The tax rates on qualified dividends and capital gains were “harmonized” under the Bush changes. Since 2003, the top tax rate on both dividends and long term capital gains is 15%. With respect to increasing the tax rate on dividends, the Obama Administration may need to consider several factors.

Most economists and tax strategists agree that keeping the rates on dividends and capital gains the same allows companies to better manage their dividend policy. If the tax on dividends increases by almost 25%, companies may focus more on stock buy-backs or redemptions as a preferred strategy for shareholders, subject to rules related to a reduction in ownership to qualify for capital gains treatment.

Qualified dividends eligible for the 15% rate include dividends received from foreign companies incorporated in countries where an income tax treaty exists. Investors may rethink whether owning equities in either US or foreign companies for their dividend yield, is a good strategy if the tax rates increase to 39.6%.

For companies contemplating paying a dividend in Q1 of 2011, particularly with closely held companies, the different tax rates would in most cases favor accelerating dividend payments into the current year.

For both US and foreign hedge funds where there are substantial holdings by US investors, the fund managers should encourage investee companies to accelerate dividends into the current year. This strategy also applies to funds with foreign equities that pay qualified dividends. S corporations and other closely held pass through entities with ownership in US and foreign equities are well advised to do the same.


OTHER CONSIDERATIONS

Impact on real estate strategies

Economics aside, how should one factor in the potential tax increases noted above?

• For pending sales, the seller should attempt to close the sale prior to the end of this year.
• Old rates may continue if the sale is concluded, or a contract is executed prior to the effective date of the new rates. If the current 15% rates are "grandfathered", installment payments received in future years on sales made in 2010 may qualify for the lower rates.

Economic Policy

A Bloomberg commentator brought things into perspective for middle America with the following analysis this week:

• There are over 300,000 Americans earning over $1 million per year in the US
• For the $1 million earner, higher rates will result in an increased tax of approximately $45,000, equal to the cost of a BMW Roadster convertible

Will higher tax rates really hurt the U.S. economy? We recently had the following internal debate in the firm:

·        People over the $1 million earnings threshold might not decrease their

      spending due to higher tax rates

·        The additional money raised by higher taxes can be used to reduce

      the national debt

·        If our debt decreases, our currency will be stronger

·        If our currency is stronger, we’re less vulnerable to inflation

·        Keeping inflation in check helps everyone in the economy, so spending

      will not decline

·        If the general spending and investment level is maintained, businesses

      will have time to recover which translates into jobs which is the key

      determinant for a healthy economy

However,

·        The Administration may not use the additional revenue to pay down the

      national debt

·        The 99% of Americans earning less than $1 million may alter their

      spending habits which could drive down spending and create more

      deflation

Our final conclusion: Based on Bloomberg, you may wish to "short" your BMW stock!

Best Regards,

Brian Rowbotham

COMING SOON:

TAX PLANNING STRATEGIES FOR INVESTMENT FUND MANAGERS

The Offshore Investment Conference - Shanghai 2010

Harriet Leung and Brian Rowbotham were speakers at the annual Offshore Investment Conference in Shanghai, June 9th and 10th.

Their presentation was about International Tax Planning for Asian Families.
The speakers and attendees for this year's conference came from around the globe to discuss cross border business opportunities being generated by the red hot economy in China. The following comments summarize insights into the Chinese economy from the Investment Conference, from the Shanghai World Expo which was held concurrently, and from several clients and advisors in Shanghai.

1. The Shanghai economy is booming.

The Chinese government invested U.S.$4 billion in Expo alone, and an additional U.S.$58 billion in infrastructure projects in and around the city, including significant upgrades in rail transportation.

Huge amounts of capital have been invested in security. In every Metro station, riders must send their bags through airport like x-ray machines. The government wants to insure that the City is free of any incidents while Expo is in process.

Among the local businessmen, there is a lot of pride in the economic success achieved in Shanghai in such a short time period, along with an attitude of optimism. It's a bit like the dot com period in Silicon Valley in the late 1990s. Due to inflation concerns particularly in the real estate area, there is a degree of reserve about the economy overheating. There is a constant "bubble" or "no bubble" debate in the press, both locally and internationally.

2. China is gearing up for global leadership, reflected in their seriousness about education.

While in Shanghai, the President, Hu Jin Tao unveiled the government's plan to be a center of global innovation. Billions of dollars are being invested in the local universities and think tank centers.

Education is being seen as the key to the country's future. During our stay, the papers were full of the anxiety and anticipation for the 10 million students sitting for the national exams to qualify for the top Universities. The pressure is even more intense due to the "one child" policy where parents see their own well being based on the ability of their only child to perform well in their studies.

It was unusual to see such focus on entrance exams. You don't see Americans get this excited unless it's Super Bowl week. The testing centers were all on high security alerts, metal detectors were in place to prevent cheating devices and the internet was being screened for sales of various software and hardware devices that facilitate cheating. In areas where new construction was in progress, activities would shut down so the noise factor wouldn't interfere with students in testing centers. Last year there were riots, and troops had to be brought into several testing centers to keep the parents from causing problems. The testing period passed this year without incident.

3. Doing business in China is not without its political side.

Our conference was held in the Pudong Shangri La Hotel for three days. On day two, Iran's President Mahmoud Ahmadinejad and his entourage arrived from Tehran. China has emerged in recent years as Iran's main trading partner. Its policy with respect to Iran is to push the diplomatic process rather than imposing sanctions over Tehran's nuclear program. While the Chinese voted to impose sanctions on Iran in the UN Council, both sides need each other, so the practical side of policy prevails. To Westerners, it looks somewhat duplicitous to sanction Iran and then welcome its leader, but to the Asian businessman, the practical side of politics is the approach. In China, Western attitudes in the political arena can at times seem self-righteous.

4. Hong Kong still plays a major role in Shanghai and China.

The financial infrastructure and experience of professionals in Hong Kong are still among the best in the world, giving Hong Kong the capacity to take on the fast paced growth in financial transactions. However, it would be a mistake to underestimate the desire and capability of Shanghai in particular to gain market share as their economy grows.

While Shanghai is gearing up to be a major financial center like New York, much of the financial strategy and planning is still overseen or managed by financial institutions, consultants and trust companies based in Hong Kong.

Chinese investors are still burdened by government regulations and exchange control so it's very typical to see businesses in China either affiliated with, or owned by companies that are headquartered in Hong Kong. When China based businesses expand beyond their borders, it's typically easier for such companies to move capital to the U.S. or Europe or other parts of Asia through a Hong Kong parent or affiliate company, for legal, tax and exchange control reasons. For now, Hong Kong and Shanghai are like business partners although they both compete when it comes to attracting new businesses from abroad.

5. Opportunities for U.S. business expansion are excellent for those who are careful.

The demand for U.S. products and the desire to invest into the U.S. market, and in particular, into U.S. real estate is immense. There is tremendous liquidity in China but due to exchange controls, it's challenging for locals to do a lot of investing outside China without approval from the Central Bank which is controlled by the government. For local businesses, expanding overseas is encouraged and moving capital outside of China is allowed, but for the pure investor, it's hard to do.

Exchange control constraints force much of the investible capital to go into the local stock markets, which aren't overwhelmingly popular, and into the local real estate market which continues to heat up. The government operates like the Federal Reserve in the U.S. but its financial powers are much broader. For second homes, the cash down requirement was recently increased from 40-50%, and for a time, third home purchases were not allowed in an effort to slow down the cost of real estate which is quickly pricing out most middle class people.

The government is currently implementing a number of programs to assist local companies with acquisitions in the U.S. The scale of these programs and the capital being committed is vast when compared to most economies around the world. While all this is good, we'll likely see a "controlled increase" with inbound investments into the U.S. as opposed to a flood, so the American businessman must be very patient.

Doing deals and negotiating terms are complex. Shanghainese are famous for being bargain hunters and this culture plays directly into day to day business. Caveat emptor or buyer beware is an absolute necessity to survive. Due diligence takes much more time and effort than in the U.S., but is an absolute essential ingredient to any undertaking.

International Tax & Estate Planning

Event hosted by Reed Smith LLP for San Francisco Bar Association and California Society of Certified Public Accountants members.
Brian Rowbotham spoke on International Tax and Richard Kinyon of Morrison Foerster on Estate Planning Implications. July 2010

International Tax

Estate Planning