Relocating to the US? Beware the grantor trust rules

Much of the commentary as to the impact of Australia’s tax regime on the startup world relates to our employee share scheme rules, which should get a whole lot easier from July 1, 2015.

However, an even bigger problem can arise for founders that hold their shares through a family trust and relocate to the US.

The common scenario

Conventional wisdom dictates that founders should structure their shareholdings through a family trust. From an Australian tax perspective, there are a number of advantages to using family trusts, including asset protection and income splitting (though be wary of the ATO’s views regarding ‘reimbursement agreements’, that is, resolving to distribute to low tax rate beneficiaries but having the actual benefit flow through to higher rate beneficiaries).

Where founders relocate to the US, which is often the case in order to take advantage of a much larger consumer market and far deeper capital pools, it is critical they obtain pre-departure advice from an Australian tax perspective covering:

1.         the impact (if any) of triggering Australia’s ‘exit tax’; and

2.         the impact (if any) of a change of individual tax residency on any controlled entities, that is:

(a)        Australian companies;

(b)        Australian trusts; and

(c)        Australian self-managed superannuation funds.

However, equally important is obtaining US pre-arrival advice before relocating to the US, especially where the Australian founder has an Australian trust as the US grantor trust rules may operate to treat them as a ‘grantor’ and therefore, deem them to hold the assets of the trust personally for US tax purposes.

US grantor trust issues

I am by no means an expert on the operation of the US grantor trust rules and I cannot stress enough the importance of specific, expert advice when founders are relocating to the US. However, broadly, a grantor includes any person to the extent that they either create a trust, or directly or indirectly make a gratuitous transfer to the trust.

There are two main ways to fall within the US grantor trust rules:

1. Actual grantor trust

An Australian trust will be a grantor trust from a US perspective if the grantor retains the right, exercisable either alone or with the consent of another person who is a related or subordinate party who is subservient to the grantor, to revoke the trust.

2. Deemed grantor trust

Even if the Australian trust falls outside the actual grantor trust rules, the trust will be deemed to be a grantor trust if the relevant grantor individual directly or indirectly made a transfer to the trust within five years of becoming a US resident.

If this applies, the US legislation deems the grant to have been made on the date that the individual becomes US resident triggering the US grantor trust rules.

Why are the grantor trust rules a problem?

If the US grantor trust rules apply, the grantor will be taken to own all, or a portion, of the assets of the Australian trust and therefore, from a US tax perspective, will be taxed on the income and capital gains derived from those assets regardless of where those amounts are actually distributed, for example, if the trustee resolved to distribute income/gains to an Australian beneficiary:

1.         the Australian beneficiary would be taxed in Australia in the ordinary course;

2.         the US resident grantor will be taxed on the same income or gains in the US; and

3.         as they are separate taxpayers, no foreign tax credit would be allowed to either.

Can this be fixed by simply making actual distributions to the grantor?

The answer is “yes”, but at a (tax) cost when it comes to CGT.

Although making actual distributions to the grantor facilitates the use of foreign tax credits so as to avoid double taxation, since 2012 non-residents have been ineligible for the 50% CGT discount. In relation to non-resident beneficiaries of Australian trusts, an Australian sourced capital gain will be taxed:

1.         in the hands of the trustee in Australia at a reduced discount rate (based on the proportion of the holding period the beneficiary was resident versus non-resident); and

2.         in the US under the US grantor trust rules (albeit with a foreign tax credit for the Australian tax paid by the trustee on the grantor beneficiary’s behalf).

Therefore, although there is no double taxation, the longer a beneficiary is non-resident of Australian over the holding period, the higher the effective tax rate on a capital gain. For example, if a beneficiary was Australian-resident for half the ownership period and US resident for the other half, the discount percentage is reduced to 25%, proportionately increasing the effective tax rate as follows:

* MTR = Marginal Tax Rate

Conclusion

It is clear that pre-departure/pre-arrival planning in both jurisdictions prior to relocating is absolutely critical. The US grantor trust rules require careful pre-departure planning and even then, the deeming rules are a sleeper that can catch many un-suspecting ex-pat founders.

Pre-departure planning will enable founders to avoid any nasty surprises and at the very least, understand from the outset what the true tax impact of relocating to the US will be.

David Kenney is a corporate services and tax partner of Hall Chadwick Chartered Accountants.

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