The United States is one of very few countries in the world that taxes on a citizenship as well as a residency basis. Many tax practitioners may not be fully aware that they have US citizens in their client base – citizenship is often an irrelevant question when advising a client on the operation of Australian tax laws.
But far from being a silly question to ask a prospective client, it can be a very important one; there are many individuals who have always lived in Australia, possibly inheriting US citizenship from their parents, who have never realised that they are required to file US tax returns and pay US tax.
The situation may prove to be even worse where Australian structures have been established. Tax, asset protection and estate planning strategies that are effective for the Australian environment may create unintended outcomes for US citizens, potentially leading to double taxation and penalties.
Discretionary trusts
Discretionary trusts are commonly used in Australia to protect and generate passive wealth, and are sometimes even used as a vehicle to operate an active business. However, if a practitioner is unaware of a client’s US citizenship, this type of structure might end up being extremely detrimental to the client.
Similar to Australian rules relating to transferor trusts, the US applies the concept of a ‘grantor’ to a foreign (non-US) trust to which a US person has contributed. If a US citizen has provided any funding for the trust, in most cases they can be deemed a grantor in respect of the trust. The grantor will be considered to ‘own’ a portion of the trust, and will be effectively attributed any income generated from their share of the trust’s assets.
Where a high-income US citizen has provided substantial funding for a trust, the common strategy of distributing trust income to lower-income family members or a corporate beneficiary will become ineffective. While the lower marginal tax rates of other beneficiaries may apply in Australia to that income, it is taxable to the US person at their US marginal rate – which could be up to 43.4% at present levels.
Furthermore, where the Australian tax has been paid by another entity, it is unlikely any foreign tax credit is available to the US citizen in respect of that income, leaving real potential for double taxation to result.
Passive Foreign Investment Companies
Where a foreign (non-US) company generates 75% of its income from passive sources or at least half its assets are passively held, the company may be considered a Passive Foreign Investment Company (PFIC).
For US owners of these entities, substantial tax liabilities can be triggered unwittingly – the disposal of a PFIC may be subject to discounted CGT treatment in Australia at a maximum of 24.5%, but be taxed at marginal rates in the US. An additional tax representing an accumulated interest charge on the perceived ‘deferral’ could result in an effective tax rate in excess of 50%. Distributions from PFICs are also treated as ordinary income regardless of the actual components of the distribution, and losses are more difficult to utilise.
Unfortunately the scope of the PFIC rules are sufficiently broad as to catch Australian-based managed funds as well. This can often catch financial planners as well as accountants unaware.
An extremely thorough disclosure regime applies to US interests in foreign companies, making annual compliance a potentially costly exercise even where the structure does not give rise to US tax. For PFICs in particular, complex calculations are necessary to determine the tax and interest charges.
Superannuation
Superannuation is another area that is especially problematic in a planning sense. The tax concessions available to Australian superannuation accounts are largely ineffective for US citizens, as neither the US Code nor the Double Tax Treaty provide any relief from US tax on these assets.
There is a lot of uncertainty amongst US tax practitioners as to how superannuation should be treated, with views ranging from a grantor trust treatment as described above, meaning current taxation of earnings in accumulation phase, to an annuity style calculation upon starting a pension or taking a lump sum.
Either way, there is no US concession for superannuation that matches the Australian concessional treatment. Income generated from superannuation assets will be taxable at US marginal rates either as it arises or as it is paid out, and employer contributions to super will generally be considered wages and also be taxable at marginal rates. The low Australian tax rate means limited ability to apply foreign tax credits to offset any US tax applicable.
The implications of Australian structures for US citizens are potentially extremely complex, and a detailed understanding of the US system is necessary for tax practitioners to develop effective strategies for their clients.
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