The Panama trust in international tax planning

Trusts & Trustees Advance Access published March 26, 2011 Trusts & Trustees, 2011 1 The Panama trust in international tax planning Eduardo Gonza lez Garay* Abstract This article outlines the various commercial and private uses of trusts in Panama, as well as the position on taxation. The rules governing establishment, administration, and taxation of trusts have recently been modernized, and Panama has had a number of legislative tax initiatives establishing the regulatory framework for the adoption and enforcement of Double Taxation Treaties, 10 of which have been signed so far. It may not be common knowledge that Panama enacted the very first law of trusts in Latin America as far back as 1925. In the early 1920s, the accomplished jurist, Dr Ricardo J Alfaro, campaigned strenuously through publications and personal presentations before the legal community and at all levels of government, to finally obtain the promulgation of Law 9 of 1925 on trusts, a concept of limited property unknown by then in our civil law-based system. The law of trusts of Panama has suffered only two changes since 1925, and today we regulate trusts under law 1 of 5 January 1984, which is currently under review and should be amended significantly during the course of 2011. The work of Dr Alfaro is a testimony of Panama s enduring legacy of being a country at the forefront of innovation in the legal field, which over time has brought about, among other notable achievements, a contemporary and almost unchanged law of Corporations in 1932, the establishment of what would become in time the largest open ships register in the world in 1925. Panama trusts are employed in a variety of purposes, whether they be commercial, as in the case of guarantee, development, or securitization trusts, or for private purposes such as asset protection or succession trusts, and can be used indistinctively for either domestic or international transactions, because the law makes no difference between local or offshore trusts as it occurs in other countries. With Guarantee Trusts, the debtor surrenders one or several assets to the trust company, for the benefit of one or more creditors, in order to ensure compliance with his or her obligations. Guarantees on accounts receivable, rights, cash flows, and tolls, among others, can be structured through this mechanism, providing a more efficient, timely, and cost-effective alternative to other types of guarantees whose execution require judicial enforcement, such as, for example, pledges and mortgages. The Real Estate Development Trust is a special type of Management Trust, in which a property owner, a developer, and/or promoter, together with a bank and/or investor, pool assets together in the hands of a professional trust company, which is responsible for the supervision of the administration *Eduardo González Garay is a partner at Morgan & Morgan, Panama City, MMG Tower, 16 th Floor, 53 rd E Street, Marbella, Panama, PO Box 0832-00232 WTC PA. Tel: (507) 265-7777; Fax: (507) 265-7643; E-mail: Eduardo.gonzalez@mmgtrust.com. ß The Author (2011). Published by Oxford University Press. All rights reserved. doi:10.1093/tandt/ttr028

2 Article Trusts & Trustees, 2011 of the cash flows and construction timelines of a building project, transfer the built units to the buyers and the profits to the beneficiaries. The Traded Securitization Trust allows a company to issue bonds that may be freely traded in the stock market through a trust that also holds the repayment guarantee for the investors, thereby providing additional assurance as to the strength of the issue. The main purpose of Investment Trusts is the investment or placement of money or other assets in accordance with the instructions of the settlor. Management Trusts allow any type of asset that normally requires professional management to be held by a qualified Trustee, for the benefit of the settlor himself or of third parties, whether a spouse or minor children, creditors, venture partners, or business associates. In the field of international taxation, Panama has been more reactive than proactive in responding to the trends that in the past 15 years, under the relentless work of the Organization for Economic Cooperation and Development (OECD), have paved the way for the so-called G countries to do well away with Viscount Simonds well-known dictum that: My own opinion is that there is a well-recognized rule, which has been enforced for at least 200 years or thereabouts, under which these courts will not collect the taxes of foreign States for the benefit of the sovereigns of those foreign States; and this is one of those actions which these courts will not entertain. Panama has therefore slowly but methodically been adapting to the ever-changing landscape of international tax relations, and in doing so has fairly recently adopted new domestic legislation, departing in some ways from concepts that had withstood the test of time until little over a year ago, which has both introduced fairly aggressive concepts regarding income generated abroad by Panama nationals (albeit always strictly related with the generation of local income) and has opened the door to tax planning at levels not thought possible before. This is so mainly due to the fact that Panama is one of the very few countries in the world where the tax system is purely territorial, that is, only income generated in Panama or from a Panama-based source is taxable in the country. As such, until recently, there never had been a positive attitude towards any kind of tax agreements with other countries, with the fatal consequence that income earned in Panama by foreign individuals and companies alike, including subsidiaries, would be taxed both in the source country and in the home country of the taxpayer without any form of relief. Nevertheless, it is necessary to mention that the existing domestic legislation, or the General Directorate of Revenue (DGI for its initials in Spanish, Panama s tax collection authority) where the law is unclear or silent, already do provide tax relief for trusts that is not otherwise available to Panama corporations or individuals. For instance, in the case of commercial trusts such as guarantee or real estate development trusts, the position of the DGI is that all transfers of real estate property to these are exempt from capital gains tax, which has a rate of 10 per cent, as well as from real estate transfer tax, which has a rate of 2 per cent. A feature that made it attractive to channel income through trusts, being that these were taxed at the rate applicable to natural persons which is still lower than that for corporations for income over US$ 50,000, was terminated by Law 8 of 2010, since as of this year 2011, the income tax for both has been levelled at 25 per cent. Apart from the specific tax provisions found in the Law 1 of 1984, any references to trusts are few and scattered throughout the various tax laws of Panama, which adds to the urgent need to legislate specifically in this respect. The project of reform to the trust law currently being drafted should address this matter and, together with the already enacted statute for the creation of an independent tax court, the certainty regarding the application and interpretation of the tax law will be greatly enhanced in our country,

Trusts & Trustees, 2011 Article 3 to provide settlors and beneficiaries alike with wellregulated and administered legal and tax regimes. The spate of legislative tax initiatives of the past year peaks, under an international point of view, with law 33 of 30 June 2010, which, for the first time in Panamanian history, establishes the regulatory framework for the adoption and enforcement of Double Tax Treaties. At the time of writing, Panama has signed 10 such treaties with Mexico, Spain, Singapore, France, Qatar, South Korea, Luxembourg, Barbados, Portugal, and The Netherlands, although at present only the one with Mexico has been ratified by both Congresses. All treaties follow the OECD model but with enough additions and modifications to allow us to speak of a Panama model; in doing so with the purpose of being taken off the OECD s grey list of uncooperative tax regimes, Panama is also paving the way towards a better structured tax regime that will undoubtedly boost foreign investment in our country. In this scenario, the Panama trust acquires some obvious advantages when considering it as a tool in one s asset planning structure, and it is to be hoped that the treaty network will grow so as to allow as much of the international community to claim treaty benefits where their panama trust generates income in their country, as we will see further on. One of the basic features of taxation of trusts in Panama is that, unlike in many other Latin American countries, where in the case of trusts with settlors as beneficiaries the taxpayer is the settlorbeneficiary himself, in Panama trusts, the taxpayer is always deemed to be the trustee in his capacity as such, but his obligation is limited to any taxable income generated by the trust fund in Panama, and only to the extent of the trust fund itself, in accordance with the principle that the trust is a separate patrimony from that of the trustee. Panama s strictly territorial tax system immediately assures the settlor that no income other than that generated within Panama, and only from non-exempt sources, will be taxed. Law 1 of 1984 contains only two articles on taxation of trusts, Articles 15 and 35: Art. 15: The assets of the trust shall constitute a separate patrimony from that of the personal assets for the trustee...consequently the trustee shall pay separately the taxes, duties and other levies caused by the trust. Art. 35: The acts by which a trust is constituted, modified, or extinguished, as well as the acts of transferring, transmitting, or encumbering the assets settled into the trust, and the revenue generated by such assets and any other acts regarding the assets is exempted from all taxes, duties, levies and contributions, provided that the trust concerns: 1. Assets situated abroad 2. Money deposited by natural persons or legal entities whose income is not of Panamanian source or taxable in Panama; or 3. Shares or stocks of any kind issued by corporations which revenue does not originate from a Panamanian source, regardless of the fact that such moneys, shares or stocks may be deposited in the Republic of Panama. The above concepts have been assimilated in the domestic tax legislation, namely, in Executive Decree 170 of 27 October 1993 which regulates Income Tax in Panama. Article 81 of the Decree includes all trusts established under the law (sic) as taxpayers, pointing out that in these cases the trustee is to regarded as the taxpayer, and all income is subject to the tax rate established in the Tax Code for natural persons, which is lower than that for corporations. Article 10(h) as amended by Executive Decree 98 of 27 September 2010 copies Article 35 of the Law 1 on trusts with respect to the non-panamanian source of the assets listed at numerals 1 3 of Article 35 mentioned previously. In considering the Panama Trust for tax planning purposes, it is of essence to take into account Article

4 Article Trusts & Trustees, 2011 12(r) of Executive Decree 170, where it is clearly stated that: all income from assets received as inheritance, bequest, or donation is exempt from Income tax. to be read together with Article 10 of law 1 of 1984 which states that:...the trust intended to take effect after the death of the settlor of the trust must be constituted by means of a will. Moreover, it may be constituted by a private instrument without the formalities of the will, when the trustee is a person or company duly licensed to carry out trust services. As a result, Panama law expressly provides that, once a beneficiary has received trust property from a trust intended to have effect after the death of the settlor, all income deriving from such transfer is income tax exempt in Panama, making an excellent case for looking into suitable residence arrangements either in Panama itself, or in a country where foreign source income is only taxed on remittances. This is particularly relevant when considering asset protection alternatives for property in countries with aggressive, worldwide tax regimes such as the United States. For example, a non-us resident with US property could effectively transfer such assets to a Panama company whose shares would be held by a Panama trust, structured in a proper manner so as to not be considered a US trust. The shares would then come to represent the effective assets held by the Trust, which are now represented by a foreign (not US) company shares, and therefore, being considered non-us assets, their transfer (and consequently that of the underlying assets) to the beneficiaries of the trust would not cause estate tax in the United States. It must be pointed out that there is no Estate tax, Succession tax, nor any kind of forced heirship legislation in Panama or recognition of foreign forced heirship rulings. Once an individual has transferred property into a Panama trust structure during his lifetime, no one can claim any rights over that property by way of right of inheritance unless they are named beneficiaries of the trust. Coming to the impact of double taxation treaties on trusts, the first thing we must bear in mind is that Panama trusts, as in Common Law and elsewhere in Latin America, are not legal entities, and therefore lack the capacity to legally obligate themselves, as this must be done through the trustee. The OECD model convention regards as subjects of a treaty only persons and companies, the definition of neither of which satisfies the essence of a trust. The Panama Mexico DTT states: Article 1: Included Persons This Treaty is applicable to persons resident of one or both contracting countries. Article 3: General Definitions... d) the term person includes all natural persons, companies, and any other society of persons; e) the term company means any body corporate or any other entity that is considered such form tax purposes;... Nevertheless, a Panama trust being a special purpose patrimony administered by a trustee, who is separately liable for the taxes that such patrimony s income generates, certain provisions of Panama s DTTs (under the assumption that they will all follow the same general pattern as the Mexico DTT) regarding the taxes listed therein would apply to them, specifically with respect to income from real estate (Article 6), dividends (Article 10), interests (Article 11), royalties (Article 12), and capital gains (Article 13). In the case of dividends, for instance, the adoption by Panama of the DTT with Mexico, not only should result in the former being struck off the latter s own list of tax havens, but despite it, immediately eases dramatically the tax burden on dividends paid by a Mexican company to a Panama beneficiary. Formerly, under the black list regime, all dividend

Trusts & Trustees, 2011 Article 5 payments to a Panama beneficiary from Mexico suffered a 30 per cent withholding; now, as Panama does not tax foreign income, the tax rate on dividends from a Mexican concern with a 25 per cent or higher ownership by a Panama beneficiary, is taxed at the source at the rate of 5 per cent, which is even lower than that levied by Panama on domestic dividend distribution. The Panama model convention also adopts an interesting position on Interests. Article 11(6) establishes that: interest shall be deemed to arise in a Contracting State when the payer is a resident of that State. Where, however, the person paying the interest, whether he is a resident of a Contracting State or not, has in a Contracting State a permanent establishment in connection with which the indebtedness on which the interest is paid was incurred, and such interest is borne by such permanent establishment, then such interest shall be deemed to arise in the Contracting State in which the permanent establishment is situated. The opportunity afforded by this article when structuring a transnational commercial structure cannot escape the reader. Furthermore, any income generated by the trust would benefit from the provision for the avoidance of double taxation established at Article 22 of the treaty, which allows the application of the exemption and credit methods, for the recognition of taxes paid by the trust in the other state. By way of example, in a scenario where the tax rate for certain dividends in the source country is nil and the treaty provisions allows that state to tax such dividends, once these are distributed to the Panama trust they become tax free for the trust, as Panama will consider that under the treaty that the tax on dividends has been paid at source. Conclusion The law of trusts was, since its inception, meant to apply to both family relationships as well as to business needs. The rules governing establishment, administration, and taxation of trusts have been modernized and continue to be the object of legislative attention as we write, to ensure that they are appropriate for contemporary commercial and private purposes alike. The adoption by Panama of certain international taxation standards through the entering into Double Taxation treaties clearly opens a plethora of opportunities for the tax planner and his clients, whether they will be looking for simple estate planning advice or a more sophisticated commercial structure. Panama s trust law and the current tax regime, provide a sound and attractive choice for any persons wishing to establish a suitable asset protection or business vehicle which will withstand the rigorous scrutiny of cross-border regulation.