Around the globe, it’s tough to find a crevice of the earth’s surface untouched by the forces of globalization. The Industrial Revolution, Internet age, and cultural revolutions, both literally and figuratively, have redesigned how we connect, trade and engage in world commerce.

Out of all beasts shaken by the push and pull of a globalizing world, our financial markets and economic systems have been seriously disrupted. With the reduction of trade barriers, increased mobility of human capital, improved infrastructure, and market integration, international investors seeking diversification look to access U.S. investments more than ever.

However, many of these financial instruments are not accessible to international clients without the use of a financial intermediary. And although globalization has facilitated market integration and international investment, governments are nowhere near streamlining tax law, consistently enforcing regulations, or reaching agreement on many key tax issues.

This is where wealth management firms and financial advisors reap the benefits of market integration.

Growing International Clientele

The increase of high-net-worth and ultra-high-net-worth classes around the world results in greater mobility and additional assets under management. According to the 2015 World Wealth Report, “strong economic and equity market performance helped create 920,000 new millionaires globally in 2014.”

In turn, clients have a greater need to manage their wealth, and a heightened incentive to protect it. Since diversification hedges against risk, global investors are eager to recognize the benefits of getting into international investing.

According to an article on Reuters, the wealth management business at Morgan Stanley will hone in on the international segment of their clients. The firm hopes to develop this fast-growing branch of their services in the Latin American and Caribbean regions. Additional locations in Asia have been discussed, including Taiwan and China.

Morgan Stanley is not alone in their eyeballing of international markets for growth prospects. Bank of America Corp.’s Merrill Lynch is also strengthening their international team, specifically in Latin America and Canada. Along with these larger wealth management practices, family offices around the U.S. are hoping to profit from a new wave of international investors. (For more on family office trends, see: Top 3 Trends Affecting Private Wealth Management.) 

So, what is it that financial advisors can do for international clients to optimize taxation?

What Does Residency Mean for an International Client? 

Determining residency status for a foreign citizen can change the entire game for an international client. A client is deemed a resident alien of the United States if they have a green card, or have been been present on U.S. soil for 183 days, determined by looking back three years. If the days present on U.S. soil in the current tax year, plus 1/3 of the days in the year prior, plus 1/6 of the days in two years prior exceed 183, your client is out of luck.

If a foreigner passes the 183 day threshold, his or her residency begins the date that they entered the United States. However, they can override this start date if the initial trip to the United States was less than ten days. This is extremely important, since as a U.S. resident, foreign citizens are taxed on their worldwide income. Although residents will never be completely double-taxed due to foreign tax credits, they may still pay additional U.S. taxes on income that is either tax-advantaged in their home country, or otherwise tax free. Non-residents are taxed only on their U.S. source income, excluding foreign capital gainsdividends, rents, interest, etc.

Residency strategy and determination is a huge first step in dealing with taxation of international clients, as it will ultimately change their tax liability and reporting requirements. Nonresident aliens and part-year dual status taxpayers cannot file jointly with their spouse, claim their dependents or use foreign tax credits, and will lose other benefits associated with U.S. residency.

Optimal Asset Allocation

For many international clients, the main objective is obtaining optimal asset allocation by gaining access to U.S. financial and real estate investments. International investing provides a means to diversify a client’s asset base, protecting and proliferating their wealth. (To learn more, see: What effect has globalization had on international investments?)

For many international clients, the U.S. can seem like a safe haven for their investments. In a client's mind, higher taxes can be offset by a safe and profitable grounding in U.S. markets, particularly real estate. However, there are still ways to minimize tax liability. Knowledge on tax law will help advisors strategize on investment decisions.

Use of Tax-Deferred Accounts

When designing an asset allocation with your international client, you must know how the U.S. treats different investment practices from a tax perspective. Tax-advantaged accounts include 401(k) plans, 403(b)​, tax-deferred and IRA accounts.

Tax-deferred savings plans, such as foreign pension plans, may not translate to the same deduction for U.S. federal and state tax purposes, and therefore must be determined on a treaty-by-treaty basis. Generally, tax-efficient assets should be placed in taxable accounts, while the tax-advantaged accounts such as Roth IRAs should hold less tax-efficient assets.

Foreign pension plan contributions are allowable as a tax deduction by tax treaty, such as the United States and the United Kingdom Income Tax Treaty. However, any benefits will not exceed the relief that would be allowed in either country under local law. International clients should either use excess foreign tax credits or make a claim using tax treaties in order to receive the benefit of these tax-advantaged accounts.

Strategize with Offshore Structures

International investors can utilize offshore accounts and trusts to optimize their tax positions.

In order to maximize the performance of tax-advantaged investment tools, it’s often successful to move assets into an Offshore Self Directed IRA. In this case, clients maintain greater control over their investment decisions. This situation also allows clients to manipulate U.S. tax law in order to turn taxable gains into tax-exempt income.

International clients may look to avoid citizenship in order to free themselves from Generation Skipping Transfer Tax (GSTT). In this case, Bill Loftus, founding partner at LLBH Private Wealth Management, suggests that advisors work with lawyers in order to build an offshore protection trust. He explains a similar scenario, “combining private placement life insurance (PPLI) and variable annuity vehicles, and other investments to achieve tax-free and tax-deferred growth in the offshore trust. Through utilization of an insurance dedicated fund, we could provide portfolios with best-in-class managers similar to those used by our U.S. clients but generally not accessible through Chinese banking institutions.”

Wealth management advisors are valuable assets themselves to international clients, as they serve as the necessary intermediary between the international family’s wealth and the tax benefits they seek. In addition, advisors can fund a PPLI insurance policy owned by the structured trust. In this order, the assets could integrate into the policy within the trust, appreciating tax free.

In regards to reporting, clients must be aware of the filing requirements due to the severe penalties in place for underreporting. The Foreign Bank and Financial Accounts Form FinCEN114 (FBAR) was implemented in 2011, to deter money laundering and improve tax compliance. Any resident of the United States must report their foreign bank accounts over a threshold of $10,000. Failure to disclose this information can result in a fine of half the balance of your account or the larger of $25,000, each year.

Value Investments

International value investors may want to look at world regions where the market looks relatively cheap. Gary Motyl, Chief Investment Officer of the Templeton Global Equity Group, suggests that value investors should look to Europe, “where the raging debt crisis has decimated stock prices.”

In the United States, long-term capital gains are investments held for over one year, and are taxed at a lower rate than are short-term holdings. Clients interested in buying value stocks and sticking with longer holding periods will be in an advantaged position in terms of tax rates.

International Small-Caps

Ralf Scherschmidt, overseas trader at Oberweis Opportunities Fund (OBIOX), urges international investors to consider smaller, less well-known international stocks. He suggests that although these stocks comprise only about 7% of the total international investment space, they present a unique opportunity to a space less populated with watered stocks.

This presents risk in form of high volatility, but may present unique access to relatively cheap small-cap and mid-cap companies. Although these more obscure options may turn out to be fruitful, international clients should still diversify across currencies, sectors and regions.

U.S. Real Estate Investments

The National Association of Realtors published their 2014 Profile of International Home Buying Activity, finding a 35% increase in total volume of sales to international clients, including residents and non-residents of the U.S. An estimated $92.4 billion worth of sales demonstrates the volume of international clients seeking to diversify their asset base and enter the unique space of U.S. real estate.

Clients must be aware of fluctuations in exchange rates affecting their real estate investments, due to the significant implications on purchase and sale value, and other factors including mortgage and principal repayments. The depreciation of the dollar in relation to foreign currencies may make U.S. real estate investments relatively cheaper to international clients.  

U.S. Federal tax law allows only a $60,000 estate tax exemption for non-residents, and $2 million for residents, in the event of a death. The additional joint spouse deduction will be allowable only if the spouse is a U.S. resident, or if the asset is turned into a Qualifying Domestic Trust (QDT). To avoid these issues, along with other considerations, clients may look to sell their real estate to an indirectly managed foreign corporation to avoid estate tax and incur a minimized income tax. 

In the case of acquiring real estate, international clients may greatly benefit from purchasing through the creation of an indirectly managed foreign corporation. This allows the family to avoid the U.S. taxation system, while maintaining a diversified portfolio containing assets in U.S. real estate. 

Clients must consider whether avoiding estate tax via this means will offset the higher federal corporate income tax rates associated with the foreign corporation. For individual income tax purposes, long-term capital gains rates are set at 15%.

Charitable Giving

Charitable giving is encouraged in the United States through tax deductions. A large list of qualified charities can be found in the IRS publication 78, Cumulative List of Charitable Organizations. If an international client is kind enough to give to these charities, the United States government is also kind enough to give them a tax break, regardless of residency status, of up to 30 or 50 percent of the giver’s Adjusted Gross Income.

The Bottom Line

International clientele often face complex, particular issues. Therefore they benefit from a small team of top-notch, niche providers. To optimize asset allocation, advisors should help international clients first plan for and understand residency determination. International clients will benefit from tax strategies aligned with diversifying their investments, structuring offshore accounts and pension plans, and manipulation of the U.S. real estate market. Wealth managers should capitalize on an international clientele seeking creative financial advisory services, in order to protect their assets and proliferate their wealth across the globe.

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