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How you structure into US public and private markets depends on whether you invest for cash flow or capital growth.
US Public and Private Markets
How should you structure your passive investments in the US? Set up a US entity or trade through your Australian entity?
These are just some of the questions we asked Peter Harper of Asena Advisers in New York, Florida and California in this episode.
Here is what we learned but please listen in as Peter explains all this much better than we ever could.
To listen while you drive, walk or work, just access the episode through a free podcast app on your mobile phone.
US Public and Private Markets
When you invest into US public and private markets, you have the following seven factors to consider:
1 – Public or Private
2 – Australian or US Entity
3 – Cash Flow or Capital Growth
4 – On Capital or Income
5 – Zero or High Withholding Tax
6 – Tax Leakage or Flow Through
7 – Active or Passive
These seven factors will determine what works best for you.
1 – Public or Private
Do you invest into a public or private market?
If you invest into a public market (NASDAQ and the lot), you usually do that directly through an Australian entity – be it yourself or your company or trust.
Investments into a private market – e.g. venture capital, seed funding – usually happen through a US vehicle.
2 – Australian or US Entity
Do you invest through an Australian or US entity?
Australian Entity
Shares are personal property and hence only subject to tax in the country in which the owner is a resident. So investing through an Australian entity means that you avoid entering the US tax net.
It is rare to structure via US entities for a passive investment on public markets. If you were coming from a country with civil unrest or concerns about governance, then you might structure into a US vehicle. But coming from Australia there is no need for that.
So you hold your US securities through an Australian entity, be it yourself or a company or trust. No taxing point in the US re capital gains. It all happens in Australia. Dividends on the other hand will be subject to US withholding tax. And then you deal with the resulting FITO and CGT under Australian tax law.
US Entity
Things change if you don’t invest on a public market but instead through a private deal.
Most private market deals are structured through a US partnership, either a US multi-member LLC or a US Limited Partnership.
3 – Cash Flow or Capital Growth
Are you investing for cash flow or capital growth?
Cash Flow
If you invest for cash flow, you need to structure for flow through, so that any Foreign Income Tax Offset (FITO) for withholding tax you paid can flow all the way through to the ultimate owners. So your focus is on claiming the full FITO.
One way to do that is to trade through an Australian trust which makes an 8833 election in the US to be treated as a corporation. So the Australian trust pays US income tax but those tax payments then flow through to the beneficiaries as foreign income tax offsets. By having an Australian trust make the 8833 election, you relieve the beneficiaries from the obligation to file a US tax return.
Capital Growth
Shares, units and the lot are personal property. Personal property is anything that can be moved. Capital gains from personal property are taxable in the country where the owner is a tax resident. This is different to real estate, ie real property. That is taxable wherever the property is.
So if capital growth is your focus, you look for either lower CGT tax rates in the US or the 50% CGT discount in Australia.
4 – On Capital or Income
Are your trades on capital or income accounts?
Capital
If your trades qualify for a 50% CGT discount since you hold them for at least 12 months as an investor on capital, then avoid a company and instead either trade through a trust or as an individual.
If you hold your investments for less than 12 months, then you wouldn’t qualify for the 50% CGT discount anyway. So then you might as well use a company – if the loss of FITOs is not an issue.
Income
The same applies if you are a trader on an income account. You wouldn’t qualify for the 50% CGT discount anyway, so you might as well use a company – if the loss of FITOs is not an issue, since you mainly invest for capital growth anyway and not for cash flow.
5 – Zero or High Withholding Tax
Would dividends and interest be subject to withholding tax?
Withholding Tax
The US charges withholding tax on so-called FDAP income. FDAP as in Fixed or determinable annual or periodic income. FDAP income has a 30% withholding tax per s871a IRC / s881a IRC. But then the Australian – US Double Tax Agreement reduces the withholding tax to 10% for interest (Article 11) and to 15% or 5% for dividends (Article 10).
If you pay substantial withholding tax, you need to structure for a flow through so that you get a foreign income tax offset per s770 ITAA97. Because you don’t want to pay tax twice on this dividend and interest income. The issue is that companies can’t pass on FITOs. So for a flow through you need to structure through an Australian trust or directly in individual names.
No Withholding Tax
For FDAP income you can’t avoid withholding tax unless you invest into a different country – the UK for example doesn’t charge withholding tax. But if you are set on the US, then withholding tax on FDAP income is a given, unless you want to structure this through a US vehicle.
While you have little choice around FDAP income, for the business income you usually do have a choice to avoid withholding tax and instead pay tax on business income or not at all.
6 – Tax Leakage or Flow Through
Do foreign tax credits flow all the way through or do you have tax leakage?
Tax Leakage
When you hold the shares via a company, you have tax leakage on the withholding tax you paid for dividends and interest. Meaning the FITO you received to start with gets lost upon distribution to shareholders.
So the company gets the FITO but not the shareholders. That is because the FITO doesn’t hit the franking credit account. Franking credits is the only credit a company can pass on. So a company gobbles up the FITO but can’t pass it on.
Flow Through
So if you have significant withholding tax in the US, avoid holding the securities in a company and use individuals or trusts instead.
Having said all this, FITOs are usually the smaller of your problems. US entities tend to pay relatively low dividends. A 2% or 3% dividend yield in the US is considered high. In Australia that is a pretty average return.
So you are less likely to invest in the US for cash flow, ie dividends, and hence less likely to have a withholding tax issue. And more likely to have a CGT issue.
7 – Passive or Active
Passive > Australian Entity
Passive investments are usually done through an Australian entity.
Active > US Partnerships
Investments into a business often happen through a US entity, often a US multi-member LLC or a US Limited Partnership. LLCs are really the domain of private operating businesses or small-scale investment vehicles. In the regulated investment world, all the big funds are structured through limited partnerships.
A multi-member LLC is taxed as a partnership. It is often an aggregation vehicle for investors. That vehicle in itself is not necessarily going to produce US-sourced income. If the partnership invests into an entity that is generating US income, then this income would flow through the partnership to the partners. If a partner is a foreign entity, it would get pulled into the US tax net and need to file a US tax return since it received effectively connected income.
The tax treatment of US partnerships has significantly changed in the past few years as a result of the Grecian Magnesite case.
Grecian Magnesite
The Grecian Magnesite court case – passed down in 2017 and then confirmed by the D.C. Circuit Court of Appeals in 2019 – triggered a complete overhaul of the taxation of US partnerships. Despite this, it is not a widely publicised case.
Prior to Grecian Magnesite, active partnership income was segregated from the individual partners. So there wasn’t this notion of an automatic flow through. US sourced partnership income didn’t automatically flow through to the underlying partners. That was an issue – especially in the hedge fund world.
As a result, substantial US operating businesses would generate US sourced income within a US partnership. And then trade the interest in these partnerships offshore without any US taxation. Grecian Magnesite came down and confirmed that position.
As soon as that happened, the Trump administration changed the law so that any activity of a US-based partnership generating US-sourced income will flow through to the underlying owners and create a US tax footprint.
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So this is a short summary of what we took away from this interview with Peter Harper. But please listen in since Peter explains all this much better and in more depth than we do here.
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Disclaimer: Tax Talks does not provide financial or tax advice. All information on Tax Talks is of a general nature only and might no longer be up to date or correct. You should seek professional accredited tax and financial advice when considering whether the information is suitable to your or your client’s circumstances.
Last Updated on 13 December 2022
