Switzerland: Investments In US Securities

Last Updated: 5 October 2017
Article by Matthew Ledvina and Milan Patel
Most Popular Article in Switzerland, October 2017

When nonresident aliens ("NRAs")1 invest in the US securities market they must take the bitter with the sweet. On the sweet side, the US entices NRAs by offering quite favorable income taxation on US securities: no income tax on US capital gains, income tax-free "portfolio" interest paid from US sources, and US dividend tax rates reduced from 30% to special rates as low as 5% (depending on country specific treaty provisions). The bitter side is that if an investment in US securities is not structured properly the US estate tax can take a 40% tax bite out of the fair market value of the NRA's investment in US securities at time of death and create an administrative nightmare for transferring those assets to their rightful beneficiaries and heirs.2

The US securities market continues to be a great investment opportunity for individuals and families from outside the United States (NRAs); however, many NRAs are not aware of or informed about the US estate tax exposure of 40% on all investments in US securities directly held by the NRA. As a result the NRA's surviving family is often surprised by the application of the US estate tax to the NRA family's investment in US securities (and other deemed US-situs assets, e.g., US real estate), which results in a high administrative burden for the heirs.

The Estate of Charania highlights the US estate tax problem for NRAs.3 The US Internal Revenue Service ("IRS") assessed the Estate of Noordin M. Charania for US federal estate tax on the full value of 250,000 shares of Citigroup common stock held in safekeeping for Mr. Charania by Fortis Bank, Hong Kong until he died in 2002, which resulted in an increased estate tax deficiency of US $2,070,000, plus interest and penalties. Although the actual legal issue addressed by the case concerned what portion of the Citibank shares were includible in Mr. Charania's estate for US estate tax purposes, even though he was an NRA at the time of his death and resident of Belgium, the case is a good example where had the US investment in the Citibank shares been structured properly, the likely US estate tax bill could have been 0.

We briefly cover below three critical issues for an NRA investing in the US: (1) US Income Tax (which includes the US capital gains tax), (2) US Estate Tax, and (3) US Gift Tax.

1. US Income Tax

Generally, NRAs are taxed on only US source income. Subject to exceptions, US source income not effectively connected with a US trade or business received by an NRA is subject to a 30% withholding tax. That is, 30% is deducted and withheld from the gross amount of the US source income by the withholding agent (e.g., the payer).4 A reduced rate of withholding or an exemption may apply under the US tax code or income tax treaty between the NRA's country of residence and the US.

The following example illustrates the withholding tax:

Mr. X is an NRA who is a resident of Singapore, which currently does not have an income tax treaty with the US. Mr. X owns 100 shares of US Co. US Co declares of a dividend of $1 per share. When US Co pays the $100 dividend to Mr. X., US Co is required to deduct and withhold $30 from the dividend and so Mr. X will receive $70 net. By contrast, if Mr. X were a resident of Switzerland, US Co would withhold $15 from the dividend and pay $85 to Mr. X because the income tax treaty between Switzerland and the US lowers the rate of tax to 15%.

The following table summarizes the taxation of three common categories of income derived from securities.

Category of income5 General sourcing rules6 Taxation under the US tax code Taxation under a treaty7
Interest US source interest if the interest is from the US, a US state, the District of Columbia, or a US resident or US corporation8 30% withholding tax, unless the interest qualifies as "portfolio interest".9 Not taxed by the US or reduced rates (e.g., 10% or 15%) under many treaties
Dividend US source dividend if the dividend is from a US corporation10 30% withholding tax 5-15% under most treaties
Capital gain US source capital gain if the NRA has a "tax home" in the US11 30% withholding tax, if the NRA is present in the US on 183 days or more in the tax year12 Not taxed by the US under most treaties

An NRA is not required to file a US federal income tax return (IRS Form 1040-NR) unless the tax is not fully withheld at the source or the NRA seeks to reclaim an amount that has been over-withheld. Ordinarily, the NRA will be asked by the withholding agent to provide documentation (e.g., IRS Form W-8BEN) to certify his/her non-US status and, if applicable, qualification for a reduced rate of withholding under a treaty. In addition, if the NRA directly invests in the US, e.g., in a US hedge fund, US private equity fund, or US venture capital fund, information concerning the NRA and his/her US investment may be disclosed to the NRA's country of tax residence pursuant to an intergovernmental agreement between such country and the US to implement the provisions of US law commonly known as the Foreign Account Tax Compliance Act (FATCA).

2. US Estate Tax

The US estate tax often takes an NRA's family by surprise. During the NRA's lifetime, there is a general belief that the US estate tax will not apply, or that the US Internal Revenue Service ("IRS") will not discover that the NRA held the US assets. To the surprise of the NRA's heirs, the most likely to take action to enforce the US estate tax is a non-US bank (which is not that surprising these days). With FATCA in place since July 2014, many non-US banks are beginning to enforce the US estate tax against unsuspecting NRA clients who only too late discover that the US will apply a 40% estate tax to the entire lot of US property. We have observed a remarkable increase in the amount of US estate tax enforcement by non-US banks where an NRA directly holds US shares (e.g., Google, Apple). NRA families should take action with their advisers to ensure that they take precautions against the application of the US estate tax.

The US estate tax applies to property situated in the US ("US situs property") in which an NRA decedent had an interest at the time of his or her death is includible in his/her US gross estate. The excess of the value of the US gross estate at the time of the NRA decedent's death less allowable deductions is subject to the US federal estate tax. Currently, the maximum estate tax rate for a taxable estate having a value over USD 1,000,000 is 40%. A credit of USD 13,000 is allowed against the estate tax liability. This credit is the equivalent of an exemption from taxation equal to USD 60,000 of US estate's value. An applicable estate/inheritance tax treaty between the US and country of the NRA decedent's domicile may modify the US taxation of the NRA decedent's estate.

The following table summarizes the situs of common categories securities:

Category of security US situs property Not US situs property
Debt obligation If the obligor is a US person, the US, a US state, or the District of Columbia (however, please see the next column) If interest paid under the debt obligation to the NRA decedent would be exempt from the 30% withholding tax as portfolio interest (without regard to whether the required statement was received)
Share of stock If the stock is issued by a US corporation, irrespective of the location of the stock certificate If the stock is issued by a non-US corporation, irrespective of the location of the stock certificate, and if the stock is an American Depository Receipt
Partnership interest13 If the partnership engages in a US trade or business If the partnership is a non-US partnership that does not terminate upon the death of a partner and does not engage in a US trade or business

A NRA's estate must file the US federal estate tax return (IRS Form 706-NA) if the US gross estate exceeds USD 60,000, whether or not tax is owed. To avoid tax liability and penalties, US corporations and their transfer agents must first obtain a "transfer certificate" before transferring such corporations' stock registered in the name of a nonresident decedent.14 The US tax authority issues the transfer certificate only after it is satisfied that tax has been paid, is provided for, or is not owing. In many cases, we have observed a non-US bank freezing the US situs shares until a Federal transfer certificate is issued to the estate. This can mean a significant delay between the death of the NRA and the IRS's issuance of the federal transfer certificate.

3. US Gift Tax

A gift transfer of US real or tangible property by an NRA donor is taxed at the same rates as the estate tax if the value of the gift exceeds the annual exclusion amount. In 2017, the annual exclusion amount is USD 14,000. Accordingly, if an NRA transfers US real estate, then the NRA could trigger a significant US gift tax. In contrast, an NRA transferring US securities will not trigger any US gift tax as US securities are generally considered as intangible property. Accordingly, an NRA can donate US securities to family members and others without US gift tax. In the rare event that the gift tax is triggered, the US federal gift tax return is IRS Form 709-NA.

4. Concluding Remarks

Planning opportunities are available to ensure that an NRA's investment in US securities will be tax efficient or completely eliminate the exposure to the US estate and gift taxes. The solution will depend on the specific facts and circumstances concerning the NRA and may involve the use of a non-US company, partnership, or trust and/or invocation of treaty benefits. Planning becomes more complex if the NRA has US family members. Any solution for an NRA investing in the US securities markets must also contemplate the local jurisdiction as well, and we recommend that an NRA seek proper legal advice from both an experienced US tax attorney and a tax adviser in the NRA's country of residence.

Footnotes

1. An NRA is an individual who is neither a US citizen nor a US resident for all US federal taxes.

2. For the purposes of this article, the term "security" includes a share of stock in a corporation, evidence of indebtedness (debt obligation), partnership or beneficial ownership interest in a widely held or publicly traded partnership or trust, notional principal contract, and derivative financial instrument. Also, it is assumed that the US securities are not used in or held for use in the conduct of a US trade or business or forming part of business property of a permanent establishment or fixed base in the US, and the trading of or any other activities with respect to the US securities within the US are not considered as engaging in the conduct of a US trade or business.

3. Estate of Charania, 133 T.C. 122 (2009), aff'd in part and rev'd in part, 608 F.3d. 67 (1st Cir. 2010).

4. The withholding agent remits the withheld amount as a tax to the US Treasury and may be liable for the tax if it fails to do so.

5. "Interest" or "dividend" includes a "substitute" interest or dividend payment received pursuant to a securities lending transaction or a sale-repurchase transaction. "Dividend" also includes a dividend equivalent payment, e.g., a payment made pursuant to a notional principal contract (swap), futures contract, forward contract, or option that references the payment of a dividend from an underlying security.

6. The general rules are summarized. Certain exceptions may apply.

7. A taxpayer should always consult the provisions of the treaty, including provisions governing residency and category of income, to confirm the applicable tax rate.

8. For this purpose, a "US resident" can also include a US or non-US partnership engaged in a US trade or business.

9. Subject to exceptions, portfolio interest is interest paid on an obligation which is in registered form (e.g., not a bearer note) and with respect to which the payer receives a statement (e.g., IRS Form W-8BEN) that the NRA is not a US person. The preceding sentence applies to obligations issued after 18 March 2012.

10. Dividends from certain non-US corporations can also be US source income.

11. An individual's tax home is considered to be located at: (i) his/her regular place of business or, if he/she has more than one regular place of business, principal place of business, or (ii) his/her regular place of abode in a real and substantial sense if he/she has no regular or principal place of business because of the nature of the business. If the US security is a US real property interest, the gain from a disposition of such interest is US source income.

12. The days of physical presence in the US as an "exempt individual" (e.g., diplomat, employee of an international organization, teacher, trainee, or student) are not excluded for the purposes of counting this 183-day threshold. If the US security is a US real property interest, the gain is taxed at a maximum 20% if the security is held for longer than 1 year.

13. The situs of partnership interests is unclear and subject to legal uncertainty and debate.

14. A transfer certificate is not required for property which is being administered by an executor or administrator appointed, qualified, and acting within the US or US estate whose value does exceed USD 60,000. Banks, trust companies, and custodians in actual or constructive possession of the nonresident's property can ensure avoidance of tax and penalties by demanding and receiving a transfer certificate prior to making the transfer. With respect to US estates not exceeding USD 60,000, the transferor will ask the executor or other person responsible for the decedent's property for a statement of facts establishing the estate's value so that no transfer certificate will be required. A transfer certificate may be obtained from the US tax authority even if the estate does not exceed USD 60,000.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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