I
SUMMARY

   The following is a general summary of tax laws in the United States which relate to possible investments by foreign persons.  Each such investment will require consideration of many different laws and other issues, some of which are technical and complex.  This summary only provides a general description.

                Direct investment by a foreign person will sometimes be the best approach.  For example, this may provide the lowest overall tax rates.  However, certain disadvantages must be considered.  For example, a foreign direct investor will be required to file personal tax returns and other disclosure forms.  If the investor is an individual, other disadvantages relate to treatment of assets if the investor dies.  In such a case, there will be US probate proceedings (unless assets are held through a trust) and US estate tax liabilities.

                Investments may also be made through partnerships. A decision to establish a partnership usually depends upon business considerations dealing with the relationship of various investors involved.  The tax and other laws which apply to partnerships can be particularly complex.  For tax purposes, a partnership is largely a “conduit.”  Thus, each of the partners should file US income tax returns (federal and state) regarding his share of profits.

                A limited liability company or LLC is usually treated as a partnership for income tax purposes and is similar to a partnership in many respects.  For example, an LLC is a versatile vehicle which allows for special allocations among investors.  An LLC is more like a corporation in some other respects, notably in that owners have limited liability.

                US businesses are usually operated through corporations incorporated in some state of the United States.  Eventually, this causes net income to be taxed twice.  That is, a corporation pays income taxes on its net income in addition to the tax imposed on owners when profits are distributed.  However, these disadvantages can be minimized in most situations and use of one or more corporations to hold US properties provides some other advantages.  A corporation limits legal liabilities of the investor-shareholders.  If a foreign corporation is used, this could avoid estate or death taxes if the shareholder is not a US citizen and does not actually live in the United States.

                In any case, US tax issues should be evaluated along with tax and other issues in the country where the owner resides.  US taxes may be allowed as a credit against foreign taxes.  A US corporation may amount to a tax shelter from the perspective of another jurisdiction.

                Since US income tax is applied to net income, it is important to plan for deductible expenses.  A particularly important matter is using debt to finance part of the investment in a US project.  Of course, the leverage offered by debt to third parties can magnify the profits (or losses) realized by equity investment.  Tax considerations may favor use of debt (to third parties or to affiliates) in various forms.  Some of these considerations are described below.

The foregoing conclusions are very general.  Some of the principles described below may suggest different approaches for various investments and personal situations which could arise.

II
GENERAL UNITED STATES TAX PRINCIPLES

                A.     Principal Taxes.  There are several different taxes which will be paid in the case of a business or investment in the US  Usually, the most significant is federal income tax.  This applies to certain US source income of non-resident aliens and to all income worldwide of US citizens, residents and corporations.  Most states (including California) impose a similar tax at lower rates.  Some local governments impose a tax on gross receipts.  Most or all localities have property taxes.  In California, these usually are at a rate equal to a little over 1% of the original purchase price of assets, payable annually.

                The federal government currently imposes gift and estate taxes at rates up to 50%, although these are currently scheduled to expire in 2010.  These apply to transfers of certain US located assets by non-residents and to transfers of assets worldwide by US residents.  States may also impose death taxes.

                B.     Estate Tax Considerations.  The United States currently imposes a tax upon transfers of property by lifetime gifts or upon death.  The rules differ depending upon whether the transferor (the donor or decedent) is a US resident.  If so, the first $675,000 ($1,000,000 in 2002) of total worldwide gifts and transfers is non-taxable.  Above that level, rates start at about 37% and increase for larger estates to about 55% (50% in 2002).  Amounts passing to a spouse are tax free if the spouse is a US citizen or if the amounts go into a trust with certain specific restrictions.

                These transfer taxes apply, under special rules, to transfers of certain United States property owned by a nonresident alien.  However, the first $675,000 of transfers is not exempt unless there is a treaty that alters this result.  Instead, the exemption is limited to $60,000.  These taxes apply to transfers of real estate and other property within the United States which was owned directly by the foreign individual.  The estate tax (but not the gift tax) also applies to the value of stock of a US corporation if such stock was owned directly by such individual.  However, if any of such property is owned by a foreign corporation, rather than by a foreign individual directly, this entirely avoids the estate and gift taxes because the foreign individual only owns foreign property.  The same result may apply when an active foreign partnership owns US property, although this is unclear.  As a result, it is usually advisable for nonresident aliens to own US property (including shares of a US corporation) through a foreign corporation to avoid the potential of US estate tax unless there are significant income tax detriments from such an approach (which there may be).  This approach will also avoid related probate requirements.

                C.     General Income Tax Rules.  A brief summary of US income tax rules should be helpful in understanding the remainder of this memorandum.  The United States income tax is a tax on net income.  Net income equals gross income reduced by allowable expenses and other allowances.  A taxpayer does not have gross income until some benefit is clearly “realized.”  That is, tax does not usually arise at the time an asset changes value, but only upon a sale or disposition.  The receipt of a loan, the repayment of the principal amount of a loan, or the return of capital are not taxable.

                A corporation is viewed as a person in the eyes of the law.  Therefore, the income tax applies separately to individuals and to corporations.  Generally, each corporation is treated as a separate taxpayer, even if there is common ownership of sister corporations.  In some cases (but not all), a corporation may elect to be ignored for tax purposes so that its income is taxed directly to its shareholders.  This will not apply if any shareholder is a nonresident alien or a corporation.  Basically, the federal income tax rate for a corporation is 34%.  However, the first $50,000 is taxed at 15% and the next $25,000 at 25%.  Various complicated issues affect the true income tax rate for individuals.  Basically, the maximum rate is 36% but is scheduled for reduction to 33%.

                The expenses which may be deducted by a taxpayer to determine taxable income include (among many others) certain interest expenses.  Rental payments made by a business are deductible.  The taxpayer also may deduct an expense for depreciation of property (other than land) owned by the taxpayer and used in a business under various specialized rules following the time when the property is placed in service (but not during construction periods).  No depreciation is allowed for property which is held for sale.

                After considering depreciation deductions, it is not unusual for an investment in rental real property to have negative taxable income for a substantial number of years after initially being placed in service.  It is significant to note that net operating losses usually can be carried over and deducted against future profits.  Thus, deductions in excess of current income may be worthwhile.

                D.     Taxation of Distributions to Shareholders.  Distributions made to a shareholder by a corporation (i.e., dividends) are generally treated as gross income to the shareholder with no credit for the tax paid by the corporation.  Thus, one dollar of net profit to the corporation might be taxed at a rate of 34%.  If the remainder is distributed to the shareholder as a dividend, it might be taxed at a rate of 33%.  Therefore, the federal income tax on that one dollar might be as high as 56% (34% + 33% x 66%).

                Most income which is paid by a US corporation to a foreign investor (and which is not otherwise taxable to the shareholder) will be taxed under rules applying to “fixed or determinable annual or periodic income” of foreign investors.  These rules apply, for example, to payments of interest, dividends, rent, and royalties.  Generally, unless some tax treaty intervenes, these amounts are taxed at a rate of 30%.  This tax is withheld by the person making the payment.

                Amounts which are paid to related companies for goods, services, or interest on loans may be deducted under the general rules regarding expenses, except that a series of special limitations may apply.  In this case, only the shareholder-level tax applies.

                Amounts which are payable to a shareholder as a repayment of the principal portion of a loan will not be deductible by the corporation making the payment but also will not constitute income to the shareholder receiving the distribution.  In this case, only the corporate-level tax applies.  Also, if payments of cash are made before the corporation has any profits, the distribution is a return of capital, not a dividend, and is not taxed to the shareholder as long as the amount of the distribution does not exceed the shareholder's basis in his stock.

                E.     Issues Related to Foreign Corporations.  Generally, a foreign corporation is subject to US income tax only to the extent it either receives income from the conduct of a US trade or business (in which case it pays a tax on that net income) or receives other US source income, such as interest, dividends, or rent (in which case the 30% withholding tax will usually apply).  The US also imposes a “branch profits tax.”  Under this law, if a foreign corporation receives income from conducting a US business and distributes the income to its shareholders (for example, as dividends or as interest), the corporation will be subject to regular income tax and also to a 30% branch profits tax (which is similar to the withholding tax which otherwise would apply).  This branch profits tax generally makes it undesirable for a foreign corporation to operate a US business directly without interposing a US corporation.

                Some exceptions might apply under income tax treaties between the United States and other nations.  However, in recent years, the United States has limited the application of treaty provisions to actual residents of the other country which is a party to the treaty.

                F.     Use of Tax Havens by US Taxpayers.  US tax laws contain several complex rules which limit the ability of a US person to avoid income tax by investing through a foreign corporation.  Income earned by a foreign corporation from an active business outside the United States is not taxed to US shareholders until it is distributed to them.  On the other hand, if a foreign corporation earns passive income, a pro rata portion of its income will be taxed to US shareholders.  These rules generally do not apply to certain corporations which are not closely held.  These rules include burdensome reporting requirements which may apply to US shareholders of a foreign corporation whether or not the corporation receives passive income.

                The rules described in the preceding paragraph apply to shareholders who are either US residents or US citizens.  Thus, the ability of a US resident to legally avoid US tax on non-U.S. income by use of a foreign holding company is limited.  Further, such a person will be subject to requirements to file a US income tax return reflecting worldwide income of such person and that of such corporations.

                G.     Comments Regarding Certain Tax Avoidance Arrangements.  Several methods are utilized to generate deductible payments from a project to foreign owners while avoiding withholding taxes mentioned above.  These methods include paying interest on indebtedness owed to shareholders and management fees for services performed outside the US

                Withholding taxes which apply to such interest (and to dividends) are commonly reduced or eliminated by virtue of provisions of income tax treaties between the United States and other countries.  These treaties may apply either if the corporation making the payment is incorporated in a country having such a treaty or if the person receiving the payment is incorporated or a resident in such a country.  However, generally, it is no longer possible to rely on such treaty provisions except those related to developed countries which have significant taxes applying to the payments involved.

                H.     Special Considerations Regarding Interest Expenses.  Use of debt may still offer significant tax advantages for a foreign investor.  Note, in this respect, that several US investments by nonresident aliens can be tax free.  These include: bank and savings and loan accounts; short-term Treasury bills; and various portfolio investments.  US income tax law expressly exempts certain interest income of a nonresident alien related to “portfolio” income from certain loans to unrelated borrowers.

                Similar effects might be achieved in other cases.  Consider a foreign investor who wishes to invest in a US real estate project.  He might borrow in the US to make that investment and leave his liquid funds in interest-bearing arrangements or other investments which are not subject to US tax.  This alternative may be more favorable from a tax standpoint than investing in the US project without using any debt.  The advantages will be similar to those previously realized by tax avoidance arrangements which depended on treaties.  That is, the US business would pay a deductible interest expense to a bank.  Also, profits of the business could generally be used to repay principal indebtedness; at the same time, the investor would retain access to his original funds.

                One of the costs of such alternative is that real interest expense related solely to funds borrowed under this arrangement might exceed real investment income related solely to the off-setting investment.  However, that cost is probably less than fees and costs of planning oriented to treaties (such as was once common) and should be less than potential taxes that will apply if the project is profitable.

                I.     The Concept of Ownership and Trusts.  It is necessary to know who owns assets to apply various tax laws.  In the United States, the owner is the person who is actually entitled to benefits of ownership.  Of course, if title is held in a person's name but a separate binding document provides that a second person is entitled to all benefits, the second person should be treated as the owner.  If the rights of the second person are based only on expected actions or generosity of the owner of record, the owner of record should be the owner for tax purposes, although the US tax authorities might challenge this result in some cases.

                Trusts are frequently used to hold assets with rights divided among different individuals subject to specific conditions.  US tax law related to trusts is complex.  However, if a person ultimately can control the entire disposition of trust property, he should be the owner of the trust's assets for tax purposes.

                It appears that trusts may sometimes be created under which a side letter (sometimes called a “letter of wishes”) takes precedence over stated terms of the trust.  If that letter in fact binds the trust (but probably not otherwise), ownership should be determined under the terms of that letter.

                J.     California Income Tax.  California imposes income taxes on California residents, California corporations, and out of state or foreign individuals and corporations which have California income.  Taxable income is determined in more or less the same way as for federal income tax purposes, but residency is determined differently, as descried below.  The current maximum rate of these income taxes is about 9.3% for individuals and about 8.8% for corporations.  The effective rate is about one-third less since these taxes are deductible for federal purposes.

                Generally, California corporate tax is imposed by treating all commonly controlled entities as a single corporation.  This can have surprising adverse effects.  This approach can be limited to US affiliated entities by making a special “water’s edge” election.

III
DETERMINING US RESIDENCY

                A.     Residence for Purposes of Federal Income Tax.  It is very important to know that a person may be a US resident for some tax rules and not for others.  Federal income tax law uses a very specific test.  Other laws use a more general “facts and circumstances” test.

                For US income tax law purposes, US residence exists only if one of two tests is satisfied.  First, an individual is a US resident if the individual is “a lawful permanent resident of the United States.”  That is, if a green card is obtained, residency will be acquired on the first subsequent date of presence in the United States.  The law states that this status continues until there is a judicial or administrative determination that such status has been canceled.

                The second basis for establishing residency is the “substantial presence test.”  Under this test, it is necessary to determine the sum of the following three numbers:

-   The number of days of presence in the United States during the     current year, plus;

-   One-third of the number for the first preceding year, plus;

-   One-sixth of the number for the second preceding year.

If this sum equals or exceeds 183, then the individual being tested is a US resident (except, if fewer than 183 days are spent here in the current year, it is possible to establish non-residence based on existence of closer connections to another country).  Generally, US residence under this test is effective as of the first day of presence during the current year.

                In applying this test, certain days of presence in the United States may be disregarded.  These include days when the person tested is present in the United States as a student on an F or J visa or as a teacher or trainee under a J visa.  The law excludes days when the person is in the United States because of a medical condition that arose while the individual was present in the United States and that prevents departure.

                B.     Residence for Purposes of California Income Tax.  A resident of the State of California is taxed on income from sources in all sources worldwide.  Determination of whether an individual is a California resident is based on analysis of all of the person’s contacts.  This includes such issues as physical presence and immigration status.  California residence is presumed if a person is in the state for nine months during a year, but a much shorter stay could establish residence.

                C.     Residence for Purposes of Federal Estate and Gift Taxes.  The United States estate and gift taxes are imposed on the decedent or donor and depend upon his or her domicile or residence.  These taxes do not depend upon the domicile or residence of the heir or donee.  This fact could be useful.  For example, a person who may become subject to US income taxes might wish to give assets to a person who is not.  As another example, a gift (whether for purposes of living costs or otherwise) could be made by a foreign person to a US citizen or resident without any income or gift tax.

                The domicile or residence of a donor is determined by a general evaluation of that person's contacts.  The fundamental question for gift and estate tax purposes (but not for purposes of California income taxes) is whether the person has physically arrived in a new location with the intention of remaining in that location as his or her principal permanent home.  Thus, a person could establish substantial contacts with a jurisdiction and become a “resident” for income tax purposes, but not change domicile for estate and gift tax purposes (including by holding a green card).  However, if a person physically moves to the United States with the evident plan to make the US his or her home, the fact that he or she retains substantial contacts in another place would not prevent the person from being a US domiciliary as of the first day of presence in the United States.

IV
FURTHER INFORMATION

                This memorandum contains a general discussion of certain issues which are relevant to US investments by foreign persons.  Each significant investment should be analyzed separately, because unique considerations will usually exist.  For further information, contact:

Law Offices of John A. Strain
1611 South Catalina Avenue, Suite 212
Redondo Beach, California  90277

tel: (310) 944-3670        fax: (310) 944-9714
jstrain@ustaxlawyer.com