Editorial Features

Tax practice sometimes has its amusing moments. The most recent for me came about from a telephone call I received from an American in Panama. Apparently he did not like my response that a Panamanian foundation may very well not be taxable in Panama, but it certainly will create tax consequences in the US. Along with his subsequent e-mailed comments that I obviously was not much of an international tax expert, he sent me copies of information from Internet sites which, he claimed, proved that I was wrong. I wondered whether he would be telling the same story to the Internal Revenue Service (IRS) when they socked him with tax, interest and penalties if they didn’t indict him for criminal evasion of tax.
It wasn’t too long ago, as I recall, that a Panamanian offshore service provider called Marc Harris went to jail for various tax offences in the US. He, in fact, got caught in Nicaragua and was then deported to the US. According to the US Department of Justice press release, he was found guilty of conspiring to defraud the IRS, two counts of evading taxes, conspiracy to launder money, and twelve counts of money laundering. He was then allocated a room at the Gray Bar Motel operated by the federal prison service. Among the various services that were part of these tax evasion or money laundering schemes were the establishment of Panamanian foundations.
The Internet information, which this guy in Panama sent me, focused on such statements as “the only tax payable by a Panamanian foundation is USD150 as a fixed annual tax”; “Panama is a 100% ‘tax haven’”; and “Panama foundations offer the following tax advantages: no tax reporting requirements, no income tax., no capital gains tax., no interest income tax, no sales tax, no tax to beneficiaries, no beneficiary transfer tax., no capital tax, no property tax (for non-Panamanian property), no estate tax., no gift tax, no inheritance tax, no stamp tax, no succession tax, no inventory tax.” About a half dozen Internet links sent to me had similar information about how Panamanian foundations are not subject to tax.
This obviously was the same line that the Marc Harris organisation fed to its clients. The answer for US persons, at the very least, is that while a Panamanian foundation may not be taxable in Panama for US persons, there will be tax consequences in the United States.
This is not to say that Panamanian foundations are useless entities for international planning. The fact that a foundation is exempt from taxes in Panama can be very useful. Clearly it is a flexible and affordable estate planning vehicle for people around the world. Many professionals in Panama have spent some time with me explaining why assets placed in a Panamanian foundation can be protected from lawsuits, legal manoeuvres by creditors, beneficiaries, and other third parties. They express the view that the assets cannot be seized, attached or otherwise encumbered. Of course, this is true for the run of the mill plaintiff but certainly not the IRS who has the powers to grab a person for evasion of tax and put them in the Gray Bar Motel rather than seizing the assets.
Panama does provide confidentiality which is helpful in everyday civil litigation. There is no particular legal requirement to disclose the name of the real founders of the foundation, the beneficiaries, or the foundation protector. There is no specific requirement to file any annual tax return, financial statement as well as there is no obligation to hold an annual meeting.
As regards capital, the contribution of capital is not required at the initial incorporation of the foundation and there is no maximum time frame in which a contribution should be made. Administration and management of the foundation are also simple. The founders, the protectors and the members of the foundation council can also be beneficiaries of the foundation and may be individuals or corporations of any nationality. Meetings can be held in any country and can be represented by proxy. In fact, the foundation charter can be signed by an attorney-in-fact or by a trustee without the need to disclose the name of the founder.
There are a number of legitimate uses for a foundation. Historically, foundations have been used to hold shares of privately held companies but also to hold listed shares. For estate planning, it is a well established vehicle to allow for the inter-generational continuity of a business and to facilitate the distribution of money or other assets to members of a family allowing for education, housing, health needs, maintenance or just a structure to share the profits of the family business. Some foundations are established for scientific, religious, philanthropic, or humanitarian purposes or they can be used in the business environment as a profit sharing arrangement or a pension plan. Clearly, the various Internet sites tout the Panamanian foundation as a means to protect assets against lawsuits and other claims by creditors, excessive taxes, political instability or forced heirship. All in all, there are a number of significant advantages offered by a Panamanian foundation which can be very useful at achieving various planning goals.
However, US taxation is, as described in the Wizard of Oz, “a horse of a different colour”. The US has an extensive anti-abuse regime which is directed towards making sure that US persons are severely limited, if not prohibited, from using offshore structures – such as Panamanian foundations – to avoid or evade US tax. For US tax purposes, regardless of what term is used by a foreign country, everything is classified as an individual, partnership, corporation, trust or estate. There are specific Code provisions regarding the establishment of a foundation which will be recognised in the US with its accompanying extensive administrative and filing regime.
The IRS not only has specific Code provisions which are directed towards offshore tax abuse but also has general powers to recharacterise transactions. If all else fails, the IRS can fall back on the legal theory of substance over form or form over substance to eliminate structures which it just doesn’t like. While there are some factual situations which would allow an offshore entity to be structured to avoid US taxation, these are certainly the rare limited exceptions to the otherwise general rule which is that offshore vehicles cannot be used by US persons to avoid US taxation.
The foundation is advertised as some sort of cross between a common law trust and a corporation. However, even though a civil law foundation uses the same nomenclature as the IRS section 509 “Private Foundation” these are quite distinct entities. A Panamanian foundation may be classified as a trust although that might be the result in a limited number of cases. It is more likely to be a corporation. For US tax purposes, a trust is an arrangement by which property is held under the rules of the probate court for the benefit of the beneficiaries. The foundation in Panama, however, is a separate juridical entity and is by itself the legal owner of the assets which it holds. Management and distribution of the assets of a civil law foundation is vested in the foundation council which is essentially a board of directors rather than a trustee.
There is a critical difference where a foundation is established by a founder on a revocable basis versus an irrevocable basis. Obviously, corporations’ corporate shares are not generally established on a revocable basis although that is a characteristic of an arrangement which is recognised as a trust. In fact, this was the subject of a case called Swan Est. v Commissioner, where a revocable foundation was held to be a trust instead of a corporation. However, a civil law foundation which is irrevocable by the founder would likely be a corporation.
This means that, for US tax purposes, whether the offshore entity is a trust or a corporation, it will be treated as a pass through vehicle and income will be treated as taxable in the United States. A foreign trust established by a US person with US beneficiaries would be treated, by virtue of Code Section 679, as a grantor trust. Therefore the US person would be treated as the owner of all items of income, deduction and credit and also would have to comply with filing on an annual basis in the United States. Similarly, if it were a foreign corporation, then it would fall under the controlled foreign corporation rules, or be treated as a passive foreign investment company and, similarly, the income of which would be deemed to be taxable to its US shareholders. While a Panamanian foundation by a US person may not be taxable in Panama, there will be US tax consequences.