How is the relationship between a trust and a tax treaty assessed in the absence of any direction from any source? The answer is to establish the basics of trust law and the relationships that exist within a trust and how these may themselves be affected by the existence of a tax treaty. There are ostensibly three relationships that may exist and they are as follows:
1. between trustee and beneficiary
2. between beneficiary and trust asset/source
3. between trust asset/source and trustee
There may be a fourth, that between the Settlor and trust assets/Source where anti-avoidance legislation imputes income or gains to the Settlor, but this is outside the scope of this article.
The above three principal relationships are therefore the fundamental components to a trust. In some cases all three components may be in the same jurisdiction; however more often than not the three components will be situated or resident if you like, in three separate jurisdictions. Thus, the trustees will often be resident in say Jersey, whilst the beneficiaries may be resident in the US, UK France and Germany and the trust assets, which give rise to the source of the trust income, may be situated in any number of jurisdictions and comprise of many different types of investment such as real estate, shares, bank deposits and so on.
Given the multi-jurisdictional nature of the trust relationship it may well be that a tax treaty exists between all three component states. However, this is unlikely in the majority of cases and indeed this is not a vital ingredient to the successful use of a trust, and of tax treaties in international tax planning. For the trust to be a useful tool the practitioner will seek a tax treaty between the trustee and the jurisdiction in which the trust asset/source of income is located since it will be the trustee which will be legally and perhaps beneficially entitled to the trust income and/or gains. In other words a trust may be a viable tax planning tool as opposed to say, a standard offshore company where there is no treaty between the source and the beneficiary; to this end the trust may be interposed to take advantage of a tax treaty thus offering protection to gains, income and profits in general.
Can a Trust Benefit from Double Tax Treaties?
The traditional uses of a trust are as holding vehicle as opposed to being an active undertaking. Trusts are more likely to be used in situations where family wealth is an issue for the preservation of that wealth for future generations. In more recent times the asset protection trust has evolved out of our now litigious society and is a method of protecting assets from vexatious creditors and the like. Certainly the trust, especially the offshore trust has come in for some negative press but in all these instances the existence of double tax treaties is not a pre-requisite, and in some cases may even be detrimental to the cause.
Assuming therefore, that a situation arises whereby a practitioner believes a trust may be used to receive income or gains, what steps should be taken to ensure that the treaty will in fact apply to the trust? Certainty, in any business transaction is the most important aspect and this applies equally to tax planning.
For a trust to be of any use in the treaty context, the relationship between the source of income and the trustee is of paramount importance. For a tax treaty to apply residence is a key factor, thus the first factor to establish is whether the trust falls within the Personal Scope of the treaty which, if based on the 1977 Model, will be Article 1. Article 1 states that the treaty will apply to persons who are residents of one or both of the Contracting States. The questions, which must therefore be asked, are:
a) is the trust a person and;
b) is it a resident of one of the contacting States?
Both questions pose their own difficulties but may be answered by careful examination, again, of the basic principles.
As far as the trustees of the trust are concerned they may be either individuals or a trust company, in either case the trustees will ordinarily be resident in the jurisdiction from where the day to day management of the trust takes place. This is a pre-requisite and should not be overlooked. So, is the trust a person? Philip Baker, in his lecture delivered to an ITPA meeting 3 succinctly came to the conclusion that since Article 3(1)(a) of the 1977 Model defines a “person” as including “an individual, a company and any other body of persons”, and despite the fact that a trust is not expressly defined it could nonetheless be pigeon-holed as a body of persons. Even if a different conclusion could be reached the trustees would either be individuals or companies and thus fall within the definition provided for by Article (3)(1), and thus entitled to treaty benefits.
Is the trust a resident of the contracting State? This again is defined in Article 4 as “any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, place of management or any other criterion of a similar nature”. The fact that the trustees manage the trust from the jurisdiction in which they are resident is helpful in that establishing trust or trustee residence in the jurisdiction for treaty purposes is not too difficult. Thus, we can safely say that regardless of the fact that the 1977 Model and the Commentaries are by no means conclusive, together with the lack of academic treatise on the subject, that trusts should be able to benefit from double tax treaties.
Much has been written about the interaction between domestic law and double tax treaties and whether the latter is capable of overriding the former and so on. It is not within the scope of this article to discuss this particular subject. However, we must deal with the practical problem we keep coming back to and that is whether a treaty will apply. The first place to look is at the individual treaty and the Articles whose benefit are being sought. If this does not prove conclusive proof, in other words if the treaty makes no mention of trusts and whether it will extend to trusts, does the domestic law of the relevant country recognise the trust concept? If indeed domestic law does acknowledge the trust concept or the country in question, whilst not being a common law jurisdiction and thus not familiar with the laws of equity, is a signatory to the Hague Convention on the recognition of Trusts (such as Italy), this is a good indication that the treaty will be applicable.
Beneficial Trust Jurisdictions for Treaty Planning
Having now identified what characteristics must be present the next step is to identify which jurisdictions lend themselves to trusts in the treaty context. Because the characteristics are well defined and narrow in nature, so too are the numbers of possible locations for what we may refer to as a tax treaty trust. Certainly Jersey, Guernsey and the Isle of Man are not suitable for the simple fact that they do not have a network of tax treaties and thus for the purposes of this article are not relevant, likewise jurisdictions in the South Pacific and Caribbean such as Anguilla, Nevis, Cayman Islands, the British Virgin Islands and so on. It is surprising therefore that Barbados is one such jurisdiction that manages to combine the advantages of a traditional tax haven with the benefits of a network (albeit limited) of double tax treaties.
Barbados presently has seven double tax treaties, all of which are in force, with Canada, Denmark, Finland, Norway, Sweden, Switzerland, the United Kingdom and the United States of America. Bearing in mind the US position vis-à-vis tax avoidance it is no surprise to learn that the Barbados/US tax treaty contains an anti-trust clause. However, notwithstanding this, Barbados can provide numerous opportunities for the international tax planner none more so than in respect of Canada with whom Barbados has an excellent treaty 3.
Taking Barbados therefore as an example, we may go through the steps outlined above in order to come to the conclusion that Barbados trusts may be used effectively in harmony with double tax treaties.
- Under Barbados law trusts are taxed as resident individuals 4
- Payments to beneficiaries are deductible from the trustees’ taxable income
- Article IV of the Barbados/Canada double tax treaty defines the term residence as ‘any person who, under the laws of that state, is liable to taxation therein by reason of his domicile, residence, place of management or any other criteria of a similar nature’. Thus this critical definition is drawn widely enough for a trust to be included
- Trusts established by non-resident settlor’s for non-resident beneficiaries are taxed on a remittance basis only 5
- Barbados imposes no tax on capital gains, yet all its tax treaties contain a Capital Gains Article, and thus Barbados lends itself to capital gains tax planning
As in any situation where a treaty is being relied upon as the crux to any structure, the treaty should override domestic law. Again using the Barbados/Canada treaty as an example, for capital gains tax purposes one would aim to have gains derived from the alienation of property taxed in Barbados as opposed to Canada, there being no capital gains tax in Barbados. There are however certain points the practitioner should look out for and these relate to property, which is classified as taxable Canadian property under the Canadian Income Tax Act. Such property includes Canadian real estate and shares in Canadian companies, and the effect of the CITA is that gains from such a source may still be subject to Canadian tax.
It is interesting to note that under the Barbados/Canada treaty companies that enjoy special tax benefits as prescribed by Barbadian law are excluded from benefiting under the treaty. However no such limitation on benefits exist in relation to trusts which may similarly be exempt from Barbadian tax. This is an excellent example of when a trust may be used in preference to a company.
Surprisingly enough a Barbados trust may also act as a vehicle for extracting Canadian source income by virtue of the reduced rates of withholding tax under the treaty. For example, dividends paid by a Canadian company to a Barbados resident trust will be subject to no more than fifteen per cent of the gross amount of the dividend. The same rate of withholding tax is applicable to interest; however like many other treaties interest derived from government bonds will be exempt from Canadian withholding tax. With respect to royalties the withholding tax is reduced to ten percent. In order to access the treaty benefits the trust must be subject to tax in Barbados; however payments to beneficiaries are deductible from the trustees’ taxable income the effect of which is that the trustees may control the amount of tax actually paid in Barbados. One stipulation of the treaty (as far as the dividend and interest articles are concerned) is that the trust must be the beneficial owner of the property giving rise to the trust income.
New Zealand is another jurisdiction where trusts may be resident yet be able to benefit from the substantial network of double tax treaties entered into by New Zealand. The United Kingdom may itself be very useful for the establishment of trusts if either the income can be taxed only on a remittance basis if the trustees are non-domiciled, or if capital gains are outside the scope of domestic taxation where settlors and beneficiaries are non-resident of the UK.
Cyprus, which has twenty five treaties, is very much a viable option since many of the treaties, for example the treaty with the Republic of Ireland are old and do not contain anti-trust clauses or make mention of beneficial ownership. Mauritius is also an other jurisdiction, which may be used in this capacity, as well as Malta; the list of such countries, although small, is growing and the use of tax treaty trusts may therefore be an increasingly common phenomenon.
Trustees and Beneficial Ownership
The common law definition of the term beneficial owner is hardly conclusive but may be summarised as being the person wh ultimately enjoys the benefit of an asset, as opposed to the legal owner, who may hold as a nominee. It is common for the legal title and beneficial title of the same property to be vested in different persons, especially in tax planning situations. Articles 10, 11 and 12 of the 1977 Model seek to prevent treaty abuse by limiting the benefit of those articles (dividends, interest and royalties respectively), to the beneficial owner rather than the legal owner who may, for example, be a trustee of the recipient trust. The problem with the application of the 1977 Model is that it does not help to define further the term beneficial owner, and this problem is exacerbated in light of the fact that the 1977 Model is intended to apply to all OECD members which will naturally extend to common and civil law countries. Looking at the commentary to the 1977 Model, it would appear that treaty benefits will not be extended to intermediaries, such as agents or nominees, so which side of the line does the trustee stand, and moreover what about the nebulous concept of the beneficial owner?
This limitation on benefits would therefore seemingly prevent a trustee from benefiting under a treaty; however it would seem that the relationship between the trustee and the beneficiary is tantamount to whether the trustee can be regarded as the beneficial owner or not for the purposes of the tax treaty in question. Taking again Barbados as an example; if the trustee is bound under the terms of the treaty to pay all the income he receives to a named beneficiary with no further part to play, then clearly the beneficial owner is the beneficiary. If, however the trust is one where the trustees are required to exercise control over the trust income as would be the case in a discretionary trust for example, and not compelled to pay out all received funds to a specific person then, for the purposes of the treaty it is the trustee who is the beneficial owner.
A response of the Dutch Government to the Committee for Finance of the Lower House of the Dutch Parliament is consistent with this analysis: they would not regard as a beneficial owner a person who was contractually bound to pay on to a third party most of the dividend, interest or royalties received by him.
The question of beneficial entitlement and trusts has come up on several occasions under Dutch law. In 1954 the Dutch Supreme Court ruled that the assets of a trust could not be attributed to the trustee since his rights could only be exercised for the benefit of the beneficiaries. Thus, as a result of this decision, which is thought to be legally correct, a transfer of assets to a trust is not likely to be regarded as a taxable acquisition for the trust or trustee.
Recent case law has re-opened the debate in the Netherlands surrounding the tax treatment of common law trusts. It seems that the creation of an irrevocable discretionary trust will not constitute a taxable acquisition by the beneficiaries from the settlor since they have not yet benefited, whereas a transfer to an irrevocable non-discretionary trust, such as an interest in possession trust, will generally constitute a taxable transfer subject to Dutch gift or inheritance tax. In connection to revocable trusts, case law exists in Holland which confirms that if a taxpayer can use the property of a foundation or trust, as if it were his own private property, then for income tax and net wealth tax purposes the property will be regarded as his.
The income tax position of the beneficiaries is determined by whether the property of the trust and the income arising to the trust can be attributed to them. Article 29(a) of the Dutch Income Tax Law, which imposes taxation on certain foreign entities, does not apply to beneficiaries of trusts if they have no more than a mere expectation that the trustees will make distributions to them. The above position has recently been confirmed by a the Lower Court of the Hague in 1995 6, and it should not be forgotten that the Netherlands is a signatory to the Hague Convention on the Recognition of Trusts.
Of course there is going to be conflict wherever this loosely defined “beneficial owner” is in question. In common law jurisdictions the definition of beneficial owner would almost always exclude a trustee, however can we expect a common law judge presiding over a case involving a bilateral tax treaty to use the common law definition or that wider definition provided for by international tax law? The area is certainly grey and only case law will help to resolve this issue.
Under Article 13(4) of the 1977 Model “Gains from the alienation of any property…shall be taxable only in the contracting state of which the alienator is resident.” This paragraph is often amended so as to make taxable a disposition of shares in the source country, which would otherwise be taxed where the alienator is resident. In most cases the alienator will be the trustee since he will, or should be, acting without influence from outside; if however the trustee does not have unfettered discretion and is acting in more of a nominee capacity then it is likely that the gains will be taxed where the beneficiary is resident as opposed to the tax jurisdiction that the trustee inhabits. For this reason care should always be taken when reading through the individual terms of a particular tax treaty, for whilst it may be based on the 1977 Model this is no guarantee that that the text has not been amended to counter treaty shopping and other tax avoidance measures.
We have discussed the alienation of real property under the Barbados/Canada tax treaty; however it is possible for the beneficial interest in a trust to be disposed of as opposed to the real estate for example. Where this is done the source of the gain is not in the country where the real estate is situate but rather where the beneficiary is resident. This method of converting immovable property to movable property has led some states to counter this in their tax treaties so that the alienation of an interest in a trust, the property of which consists primarily of immovable property, may be taxed where that property is situated.
In summary we can conclude that trusts may often be more beneficial than companies if accepted under double tax treaties. Trusts, by their very nature are a more secretive vehicle than a company, information about which is often freely available on public record. Companies are more than likely to be subject, especially in this day and age, to rigorous accounting and auditing requirements whereas the trust is, in general, not. Certainly trusts may be accepted in situations where companies are not, take the Barbados/Canada double tax treaty for example, where companies benefiting under a special tax regime are specifically excluded from the treaty.
From the above discussion we can conclude that trusts should be accepted under the terms of double tax treaties. Residence in one contracting State is vital and provided therefore the trustees are so resident and they carry out the day-to-day management of the trust without being distracted by the settlor and/or beneficiaries there is no reason why trust should not be accepted, unless of course the treaty specifically excludes trusts. This last point is unlikely since most treaties are in fact silent on the subject. The only question mark which seems to exist is that against “beneficial interest”, but in cases of discretionary trusts, Dutch law is clear that named beneficiaries cannot be regarded as having a beneficial interest if the trustees are not obliged to remit the income to them. Therefore trustees must have a beneficial interest as well as a legal interest if the settlor is to have relinquished all rights under an irrevocable arrangement.
Whilst the list of countries that can be used is currently not very large it may well grow as the double tax treaty networks continue to grow. Unless specifically proscribed within relevant treaties, trusts may be usefully employed in international tax planning.