Handle With Care: How Sharia Law and U.S. Tax Law Affect the Foundations Regime in the United Arab Emirates

In many parts of the world, particularly in the Gulf Cooperation Council (GCC) region, the typical family business has a single family member responsible for driving the enterprise, with other family members holding significant positions and providing input into its operations. Growth for this type of enterprise is often stunted to at least some degree because sophisticated asset protection and succession planning are often lacking. Rising to the next level means changing the dynamics of the business and its paradigm from having a single family member leading the entity to a more sophisticated and legally protected structure with professional management.

Commentators have noted that the need for proper business succession planning is particularly acute in the GCC region.¹ There are several reasons for this. Most businesses in the Gulf are family-owned, and the founders of these companies are now deceased or becoming elderly. Further, the family businesses typically involve large Arab families with many potential heirs who may disagree on the direction the enterprise should take or who may be competing for control of the business. Finally, many Arab businesses are sole proprietorships, and others lack any formal structure or documentation.

Foreigners living and working in the GCC, particularly in the United Arab Emirates, are also establishing businesses here and making other local investments, especially in the UAE real estate market. With the economy developing, many individuals who reside overseas are making investments in the UAE. All these investors want asset protection as well as proper wealth and succession planning. Notably, although a properly prepared and executed will may result in disposition of the UAE assets in accordance with the foreigner’s wishes, this is not always guaranteed.²

The UAE Foundation: A Useful Structure

With an eye to the future, expatriates, foreign investors, and GCC families alike may benefit from the use of a UAE foundation as a vehicle for asset protection, wealth and succession planning, and the restructuring of outdated family business models. Generally, using a foundation to own assets or historic family businesses not only offers asset protection, but also, by establishing a properly arranged council and an appointed guardian for the foundation, the former owner can retain some control and oversight of the assets or business. It also mitigates the risks of key business personnel suddenly passing away or becoming incapacitated. From a succession standpoint, it is noteworthy that a UAE foundation can permit an escape from other countries’ forced inheritance laws.

Economically, the use of a UAE foundation may offer significant tax benefits. Consider, for example, an expatriate in the GCC who hails from a country with a tax system based on residence (such as countries in the EU) rather than citizenship (such as the United States). When funding a UAE foundation while a nonresident of his home country, the individual can remove the assets he places in the foundation from his home country’s tax base. If the foundation is created in the UAE, no transfer tax will be imposed at the time when funding the foundation with assets. This is generally not the case when foundations are funded in many European countries.³

Also, the use of the foundation by an expatriate whose home country has a residence-based tax regime can generally alleviate later estate tax and wealth tax on assets that the individual has transferred to the foundation. Similarly, the income that the assets earn and other gains will no longer be taxed in the hands of the individual since he has transferred ownership to the foundation. Instead, the foundation can receive income and gains tax-free if the foundation is located in a tax-free environment like the UAE — as opposed to, for example, a European jurisdiction, where the foundation would generally be treated as a corporation and subject to tax.

Foreigners who continue to reside in their home country and own assets overseas may also find a UAE foundation advantageous. UAE foundations can hold property located anywhere, unless the law of the place where the asset is located prohibits it. Careful research and planning is needed here. For example, it would be necessary to ascertain whether the founder’s home country or the country where the property is located imposes a transfer tax or taxes a deemed gain recognition event when assets are transferred overseas. The UAE has a vast treaty network — it is party to 115 double taxation agreements — that may help with such cross-border tax planning. Individuals who are citizens, green card holders, or otherwise considered tax residents of the United States will have special tax concerns, which this article will also examine.

All in all, the UAE foundation is a very interesting paradigm for wealth, succession, and tax planning, including for residents and nonresidents of the UAE and for both UAE assets and foreign assets.

Having established its importance, this article will proceed to discuss the fundamentals of a foundation, which is a type of entity that is not very familiar to professionals working in common law systems who may be more accustomed to the concept of a trust. In contrast, the trust concept is not readily recognized or accepted in the Middle East, and a foundation may be a more palatable option for owning local assets or transitioning a regional family business.

Next, the article will examine the newest foundation law in the UAE, which the Emirate of Ras Al Khaimah launched through the RAK International Corporate Centre (RAK ICC) in January. This discussion will necessarily cover some aspects of Sharia law, including some of its prohibitions and tenets and how they may affect RAK ICC foundations.

Finally, the article will examine the issues that arise when U.S. tax laws interact with RAK ICC foundations. One key question is whether a foundation will be treated as a corporation or a trust for U.S. tax purposes. This and other inquiries will be critical if, for example, the founder or any beneficiary is (or later becomes) a U.S. person.

Fundamentals of a UAE Foundation

No common legal definition of the term “foundation” exists; rather, readers must bear in mind that foundations are creatures of the law of a particular country. Legislation governing foundations varies from country to country, reflecting the culture, traditions, and context in which the legal system and the concept of a foundation have developed in a given jurisdiction.⁴ Nonetheless, some common principles generally underpin the legal and tax treatment of foundations.

Unlike a trust, a concept with which many common law practitioners are familiar, a foundation, which is a concept that originates from civil law jurisdictions, is an independent legal entity that holds assets in its own name and in its own right. While not strictly a hybrid of a company and a trust, the foundation shares functions and mechanisms with both.

To start, with few exceptions, foundations must be registered and enjoy an unlimited lifespan just like corporations. Trusts, however, are typically not registered, and thus offer more confidentiality — but a trust’s term is often limited. A foundation is similar to a company in that it has its own legal personality; the foundation itself can enter into contracts with third parties. This is distinguishable from a trust, which is not a separate legal entity and must have a trustee enter into contracts. The foundation itself holds both the legal and beneficial title to its property, as opposed to a trust property, which is held by and titled to the trustee.

Unlike a company, a foundation does not issue shares or any other form of legal title of ownership. A foundation has no shareholders or members — it is a so-called orphan structure. As a general matter, unlike a company, a foundation itself cannot carry out commercial activities other than those necessary, ancillary, or incidental to its purposes, though it can, of course, own shares in active businesses and commercial ventures. Much like a company, a foundation is governed by its charter and bylaws, which together reflect the wishes and aims of its founder. Similar to a corporation’s board of directors, a foundation is managed by a governing board, although these may go by different names (for example, a council manages an RAK ICC foundation). Foundations may further be supervised by a guardian, a role similar to a trust’s protector.

A foundation may pursue any lawful purpose. It must have one or more stated purposes or objects, which may include a private purpose or serving for the benefit of its beneficiaries, just like a trust. A foundation’s beneficiary has no interest in the foundation’s assets and is not owed fiduciary duties by its council or guardian. This contrasts with the beneficiary of a trust, to whom the trustee owes a fiduciary duty. This difference may make the foundation a very attractive vehicle, for example, for holding some types of high-risk assets that a trustee might not consider holding in a trust.

Foundation Regimes in the UAE

Within a relatively short timespan, the UAE — a small country perched at the tip of the Persian Gulf — has become a major hub for many different economic sectors, including international business. The UAE has become a magnet for cross-border business thanks to its no-tax/ultra-low-tax environment (the UAE introduced a VAT in 2018 at a 5 percent rate), reputable regulation, and convenient time zone for countries in both the East and West. The UAE imposes no limits on the repatriation of capital or profits, and globally it remains one of the least complex jurisdictions for doing business, with minimal administrative, tax, and compliance burdens.⁵

Much of the attraction of — and a substantial reason for the ease of doing business in — the UAE stems from the country’s creation of so-called free zones or free trade zones. Essentially, these are economic areas where goods and services can be traded in accordance with special rules. These regimes permit 100 percent foreign company ownership and usually offer preferential rates for tax, customs, and imports.

Given its innovative strides and having proven its potential to the world by becoming a global leader among business hubs, it is not surprising that the UAE has been expanding its laws to accommodate asset protection, global wealth management, and succession planning rules in line with Europe and North America.

Against this backdrop, the UAE has introduced three foundation regimes in the past three years. All the regimes permit 100 percent foreign ownership and the use of foreign employees with no restrictions on capital repatriation. While the most recent — the RAK ICC foundations regime launched in January — is the focus of this article, the following two subsections offer a brief overview of the earlier UAE foundations laws.

ADGM: The Foundations Law Pioneer

The Abu Dhabi Global Market (ADGM) was established in 2015 as a financial free zone with its own civil and commercial laws in the Emirate of Abu Dhabi.⁶ In 2017 ADGM created the region’s first framework for the establishment of foundations. Foundations created in accordance with the ADGM Foundation Regulations 2017 are subject to the jurisdiction of the ADGM court system. This system is distinct from the UAE civil courts and follows the common law, providing familiarity and comfort to international investors that choose Abu Dhabi for their planning needs. The ADGM foundation model provides for no tax on profits, capital, or assets for a 50-year period, and there is no tax on personal income.

DIFC Foundations Law

In March 2018 the Dubai International Financial Center (DIFC) free zone, following on the heels of the ADGM, enacted the DIFC Foundations Law No. 3 of 2018 and introduced the concept of a foundation into its legal framework.

At the same time, the DIFC authorities revamped laws they had issued in 2005 that permitted the establishment of trusts in the DIFC. The new Trust Law No. 4 of 2018 superseded the older regime, modernized the law, and provided greater flexibility in the use of trust vehicles. The addition of a foundations law regime provided a nice complement to the financial and wealth planning options available in the DIFC — and the DIFC free zone is the only location in Dubai where one can establish either a trust or a foundation. For matters occurring within the DIFC, the DIFC courts have jurisdiction and follow the common law largely modeled on the Commercial Court of England and Wales.⁷

The RAK ICC Foundations Law

In January the RAK ICC announced the launch of its very own foundation regime with the RAK ICC Foundations Regulations 2019, making it the third jurisdiction within the UAE to provide the option of such a planning structure.

Key Players in RAK ICC Foundations

According to the RAK ICC Foundations Regulations, the key players in a foundation are:

• Founder: Under regulation 3, the founder is an individual or legal entity that contributes property to a foundation in order to establish it. The founder has specific rights and powers related to the foundation and its assets, which are set out in regulation 16.

• Guardian: According to regulation 20, a guardian is an individual or legal entity responsible for ensuring that the foundation and its council comply with the charter, bylaws, and the provisions of the RAK ICC Foundations Regulations. The guardian also supervises the activities of the council in managing the foundation. Generally, having a guardian is not mandatory unless the foundation has a charitable or specified purpose. The guardian has access to all information necessary to exercise its powers, including accounting records, accounts, and returns of the foundation. The role of a guardian and the supervision that it provides is part of most foundation models throughout the world.

• Council: The council is similar to a corporation’s board of directors. Regulation 17, which addresses the council, provides that its role is to administer the foundation’s property and to carry out its objects. Council members must “act honestly and in good faith with a view to the best interests of the Foundation,” and they owe a fiduciary duty to the foundation. The council must have at least two members. A founder or a corporation may serve as a member of the council, but a guardian cannot be a council member.

• Qualified Recipients/Designee: Qualified recipients are the persons that obtain benefits from the foundation, a role similar to beneficiaries of a trust that is laid out in regulations 3 and 28. A qualified recipient has no right to or interest in the foundation’s assets or property other than a right to payment of amounts in accordance with the bylaws or a contract with the foundation (including a contract in relation to a depository receipt). Under regulation 24, a designee is the default recipient to whom all foundation property shall pass in the event of the foundation’s termination unless a different provision has been made.

Key Features of RAK ICC Foundations

In accordance with regulation 4 of the RAK ICC Foundations Regulations, a foundation is a corporate entity with a legal personality separate from that of its founders and any other person. Its assets are not held by it in trust for any other person (although the foundation may hold other property in line with the terms of a trust). A foundation can continue in perpetuity or for a specified term, as set out in its charter. Regulations 41 through 48 explain that foundations located in other countries can migrate to the RAK ICC — and foundations in the RAK ICC can migrate out — unless the founding documents or laws of the other jurisdiction prohibit it.

A key feature with use of an RAK ICC foundation is the founder’s ability to continue exercising significant control over the foundation’s assets through a carefully drafted charter. Regulation 16(2) provides:

These powers — along with the founder’s ability to serve on the council — allow individuals who transfer assets or business enterprises into a foundation to retain a high degree of control. For many founders, this is very important.

A foundation must have a registered agent (regulation 25), and it must also maintain a registered office located in the UAE (regulation 31).

Regulation 38 mandates that an RAK ICC foundation must file an annual return with the RAK ICC Registrar of Companies (registrar) following the form and manner prescribed by the registrar and containing the information it requires. To the author’s knowledge, however, the registrar has not yet provided these details.

Foundations established with the RAK ICC are subject to the jurisdiction of either the DIFC courts or ADGM courts, whichever is selected in the charter and bylaws of the foundation.⁸ Thus, the UAE civil courts are not involved. As noted previously, both the DIFC courts and ADGM courts follow the common law.

A few features of the RAK ICC foundations law deserve special attention — namely, the provisions concerning confidentiality, foreign law and judgments, and forced heirship.

Confidentiality

Confidentiality is a very important issue because, unlike trusts, foundations are registered entities, and therefore they are publicly visible. The RAK ICC Foundations Regulations ensure that only a “Person With Sufficient Interest” — a term defined in regulation 3 and discussed in regulation 68 — can obtain substantive information about the foundation, such as financial statements and information about foundation assets. Obtaining this information is even more difficult if the foundation’s charter or bylaws prohibit disclosure, in which case regulation 68(3) applies and the party seeking the information must obtain a court order.

Like the ADGM⁹ and DIFC¹⁰ foundation regimes, the RAK ICC Foundations Regulations provide confidentiality and privacy, and their protections appear to be quite robust.

These provisions notwithstanding, the registrar will maintain an RAK ICC foundations register with only basic information being made public. According to regulation 37, the foundation register will contain the following information: the foundation’s name, registration number, and registration date; the name and address of the foundation’s registered agent; and each council member’s name and address. Notably, regulation 36, which governs disclosures by the registrar, indicates that foundations must comply with disclosure laws, regulations, or rules of the UAE. Thus, it is likely that in due course foundations will be listed in the National Economic Register. This is a recent initiative designed to enable government entities, businesspeople, researchers, and customers to get instant, accurate, and comprehensive information such as details about existing economic licenses.

While an RAK ICC foundation must keep accounting records, accounts, and returns, which must be made available to the registrar upon request according to regulation 34(5), regulation 34(6) clarifies that none of these records will be subject to public disclosure by the registrar. The registrar can make limited disclosures under the specific circumstances set out in regulation 36(1)(a)-(b), such as when permitted or required under the laws, regulations, or rules of the UAE (including those noted in the previous paragraph); to a government or regulatory authority relating to anti-money-laundering; or to a civil or criminal law enforcement agency.

Asset Protection

A critical function of a foundation is asset protection, including protection from bankruptcy claims, personal claims (such as those related to divorce), and forced heirship rules. The property of a foundation is separate from the property of the founder, just as the assets of a company are separate from those of its owners or shareholders. Firewall provisions — a familiar feature in both common law trust jurisdictions and foundations jurisdictions — generally try to address the laws in many countries that attempt to retroactively set aside transactions that defeat the claims of creditors, former spouses, or heirs.

RAK ICC has incorporated very strong asset protection mechanisms into its foundations regime. The provisions in regulation 7 generally protect the assets of the foundation from claims of creditors based on foreign law or foreign court judgments, administrative orders, or arbitration awards.

Further, the robust firewall provisions in the RAK ICC Foundations Regulations — specifically, regulations 6, 7, and 8 — include the following:

• All matters relating to the legal validity of a foundation and any dispositions of property are determined exclusively under the law of its jurisdiction of incorporation. As discussed above, an RAK ICC foundation is either governed by the ADGM or DIFC court system, as stipulated in its charter and bylaws.

• Foreign laws that do not recognize foundations will not affect the validity of an RAK ICC foundation.

• Rights asserted under foreign heirship laws or other claims derived from a personal relationship to the founder will not affect the RAK ICC foundation.

• Judgments purporting to give effect to heirship rights or claims arising from a personal relationship to the founder will not be recognized or enforced.

RAK ICC has sought to protect the rights of foundation beneficiaries and preserve foundation assets without compromising its international standing. For example, not every transfer to a foundation will be respected. Regulation 7 mentions creditors’ claims against assets in the foundation based on the liquidation or bankruptcy of the founder. In keeping with international principles of law and equity, if a court determines that there was an intent to defraud a creditor when the assets were transferred to the foundation, then the court may declare the transfer void. The regulation mandates that the burden of proof in these cases is firmly on the creditor.

Further, the regulations recognize some limitations to their effectiveness. For example, regulation 6(2)(b) refers to immovable property located in a foreign jurisdiction that prohibits the transfer.

Sharia — A Brief Overview

To fully understand the context of the RAK ICC foundation, one must consider Sharia law, because the UAE follows Sharia law.¹¹ But the foundation is a civil law concept, and both Muslims and non-Muslims may freely use the foundation structure. Some understanding about Sharia will help pull the different elements into perspective.

In Arabic, the word “Sharia” means “the path,” and Sharia serves as a guide (or pathway) for Muslims that demonstrates how to follow the Islamic way of life. It is not a “law” in the sense that most Westerners understand the term; it is not a code of statutory rules, regulations, or judicial precedents set out by a government. But despite this, Sharia governs many aspects of everyday life for Muslims, including how to invest and manage other financial dealings, how to conduct business, and how to distribute the estate of a deceased individual.

Sharia is predominantly derived from the Quran and the Sunna — a term for the sayings, practices, and teachings of the Prophet Muhammad. Sharia is also derived from Qiyas, which are scholarly works, and Ijma, the consensus of the Muslim community.

Sharia, as it is understood today, was developed by Muslim scholars several hundred years after the death of Muhammad. Scholars collected Muhammad’s sayings and practices into the hadith. Different localities’ attempts to reconcile their local customs with Islam resulted in the growth of hadith literature, and the development of two distinct schools of Islamic thought: the Sunni and the Shiite. Each school of thought took inspiration from different scholars. As a result, there are multiple interpretations of some issues under Sharia.

RAK ICC Foundations and Sharia

A Few Relevant Elements of Sharia Law

Foundations are often used in succession planning. Sharia inheritance laws differ greatly from those of other legal systems, especially Western ones. In Western legal systems, when a person dies, he generally has the ability to dispose of his property as he wishes. Often, the bulk of a person’s estate is left to his surviving spouse and children. Under Sharia law, however, unfettered freedom to dispose of one’s assets at death is curtailed; instead, the deceased’s relatives are allocated fixed shares of the estate that vary based on the degree of kinship. Also, under Sharia law, a non-Muslim cannot inherit from a Muslim.

According to the Shia interpretation of Sharia law, a person can only dispose of one-third of his estate as he sees fit (for example, he can leave one-third entirely to his spouse or to others — assuming the selected individuals are Muslims). The remaining two-thirds is distributed according to Sharia law, with some heirs receiving fixed shares while others get a residuary portion.¹²

These limitations do not apply when a Muslim makes a gift during his lifetime. While there are generally no restrictions on lifetime gifts, they cannot be made while the donor is ill and believes death is imminent if death does, in fact, occur. The same principles apply when a foundation is established by its founder: The founder transfers assets during life, and the formation documents dictate the founder’s wishes concerning investment and, among other things, ultimate disposition of the property.

Notably, Islamic theology gives priority to providing for one’s family. The Prophet Muhammad has been quoted as saying that providing for one’s family is “the most excellent of sadaka” (charity).¹³ Bearing this Islamic tenet in mind, a foundation that benefits the founder’s family is similar to the Islamic waqf — a concept that is, in many respects, similar to a common law trust.¹⁴ A waqif (the creator of a waqf) often establishes a waqf for the benefit of his or her family and for longer-term religious or charitable purposes.¹⁵ One advantage of the waqf is the potential ability to avoid Islamic inheritance rules and make bequests that differ from the fixed shares of Islamic inheritance. Greater flexibility is permitted with a waqf, suggesting that deviation from the strict Sharia inheritance rules is not unheard of, and this might lend support to using a foundation for similar purposes.

Another important element of Sharia for our purposes is its view of interest. Making loans that include provisions regarding the payment of interest is commonplace and generally expected in the commercial world. However, in Muslim-majority countries — as well as in non-Muslim countries when the transaction involves Muslim debtors or creditors — the right to claim interest is an area of extreme uncertainty. There is a consensus among Muslims that Sharia law prohibits the payment of interest (or Riba). This belief forms the foundation for the $2 trillion Islamic finance industry.

Different schools of Sharia thought have different beliefs about Riba. Not all Islamic scholars equate Riba with all forms of interest. Further, there is also disagreement over whether charging interest is a major sin that goes against Sharia, or whether Sharia merely disapproves of interest. The underlying principle of Riba is to eliminate unfair, exploitative gains made in trade or business dealings and to prevent unjust enrichment. If a lender charges interest, repayment of the loan may result in unjust gains. The principle of Riba is reflected in the codified laws of some Muslim countries.

The UAE follows Sharia law and has enacted statutory provisions codifying Riba, but the law also contains numerous exceptions to the principle, and the result will depend in part on whether the UAE’s civil code or commercial code applies.¹⁶

Using Foundations Amid Sharia

A Muslim founder can establish a foundation in a manner that complies with Sharia. For example, the foundation’s charter and bylaws can be drafted to incorporate Sharia restrictions against investments in prohibited businesses, such as alcohol or gambling, as well as prohibitions against interest. Likewise, the formation documents could incorporate Sharia requirements on mandatory distributions to heirs.

Might a foundation established by a Muslim provide greater flexibility in terms of the Islamic inheritance and interest rules? A Muslim founder might establish a foundation that continues in perpetuity, thus avoiding the inheritance issue altogether. Or perhaps, like a waqf, a foundation might have a charitable or religious purpose in the distant future — that is, after taking care of the founder’s family — and so greater flexibility may possibly be allowed regarding the fixed inheritance shares. If the founder wants to distribute property in a manner that is not in conformity with Sharia inheritance restrictions, one option might be to prepare foundation-organizing documents that make no reference to the effect of the founder’s death on foundation assets. For example, the organizing documents might provide that assets will be distributed to a qualified recipient when the recipient reaches a particular age, or when the assets reach a specified fair market value.

As for investments involving interest, as mentioned, not all Sharia scholars equate Riba with all types of interest, and, while the UAE follows Sharia law, it has enacted statutes containing various exceptions to the principle. Thus, with the assistance of a Sharia scholar and proper adherence to the UAE laws on the matter, a foundation could properly structure its investments to yield interest in a manner that is acceptable under Sharia mandates.

Because noncompliant foundations may be subject to challenge, Muslims using foundations should bear in mind that Sharia issues may arise. A Sharia scholar can and should be consulted when preparing formation documents to reduce the risk of objections arising at a later date. The Sharia scholar can also play an ongoing role and monitor the foundation’s activities for Sharia compliance. Keep in mind that there are multiple interpretations of Sharia, as discussed, for example, regarding the differing beliefs among Islamic scholars concerning Riba. Thus, a Sharia scholar may be able to offer an interpretation that accords with the goals that the founder wishes to achieve through use of the foundation.

RAK ICC Foundations and U.S. Taxation

U.S. tax laws have an expansive reach. This is largely a result of the U.S. tax system being based on citizenship rather than residency, and also because the United States taxes its taxpayers on a worldwide basis. For purposes of the U.S. income tax rules, green card holders and individuals who spend substantial time in the United States are treated like U.S. citizens (collectively referred to herein as U.S. persons).¹⁷

What does this mean for RAK ICC foundations? If any U.S. person is involved with the foundation — be it the founder who created it, someone who contributes to the foundation later, a qualified recipient, or perhaps even those responsible for administering the foundation — then there will be U.S. tax issues that must be addressed. The fact that the foundation is outside of the United States, and even the fact that it may hold only non-U.S. assets, does not insulate it from U.S. tax issues if there are U.S. persons involved.

Entity Classification for U.S. Tax Purposes

The classification of the foundation will greatly affect the U.S. tax liability of any U.S. person involved with it. Numerous tax consequences will arise from the interplay of the entity’s U.S. tax classification and the tax status (U.S. or foreign) of the various parties involved with the foundation.

Entity Classification: Guidance

Unfortunately, classification determinations for foreign entities are not an exact science. There are very few cases or rulings providing guidance.

The concept of a foundation did not derive from the common law — it is a civil law concept. The classification exercise is rendered even more difficult because the U.S. legal system is based on common law. As noted above, the RAK ICC foundation shares characteristics with both trusts and corporations. It is important to note that the classification of an entity depends not only on the implementing statute — here, the RAK ICC Foundations Regulations — but also on factors specific to the foundation being classified, such as the intent of the founder, the provisions in the charter and bylaws, and the activities carried out by the particular foundation at issue.

Trust Taxation vs. Corporate Taxation

Understanding the difference between trust taxation and corporate taxation — and why this difference exists — will help with the classification analysis.

Trust taxation operates on a conduit principle. A trust is a separate taxable entity that reports and computes its tax in a manner similar to the process an individual would use. An oversimplified explanation of how the tax laws operate for a trust is that the trust deducts various amounts from its total taxable income and takes a deduction for income that it has distributed to a beneficiary. The beneficiary — not the trust — will pay tax on that distribution. The deduction for the trust results in “one-time taxation” — either the trust or the beneficiary will pay tax on the income, not both.

Corporate taxation, on the other hand, results in double taxation: Income is taxed once at the corporate level, and again at the shareholder level when dividends are paid. Double taxation also arises when an entity is classified as an association taxable as a corporation.

Why is income earned by a trust taxed on a one-time basis while income earned by a corporation is subject to double taxation? Trusts escape the double taxation that the United States imposes on corporations because trusts are a form of property distribution that society values and seeks to protect.¹⁸

U.S. tax law encourages property owners to protect and conserve property for the benefit of others by offering a single level of taxation; in so doing, tax law seeks to give effect to the intent of the trust’s founder. Interestingly, these values are very similar to the values in Islamic theology. While the United States supports and endorses these values through the tax system, Islam may offer similar encouragement by offering greater flexibility in terms of the inheritance mandates of Sharia for those using a waqf.

In general terms, an arrangement will be treated as a trust if its purpose is to make a trustee responsible for the protection and conservation of property for beneficiaries who cannot share in this responsibility and who, as such, are not active participants and are indistinguishable from associates in a joint enterprise that is conducting business for profit.¹⁹ An association implies associates entering into a joint enterprise to transact business. A trust merely “protects and conserves” the property rather than operating as a profit-making business.

Courts have generally found that the presence of a business purpose and associates distinguishes an association taxable as a corporation from a trust.²⁰ The fact that an arrangement is technically organized using the trust form will not change its true substance if the arrangement is more properly classified as a business entity.

Any entity that the IRS deems to be an association taxable as a corporation must have a business purpose. Entities that consist of individuals who voluntarily come together to run a business for profit should be taxed accordingly. However, when the principle purpose for which the entity is organized is to preserve property and provide funds for a specified purpose (for example, to meet the needs of the members of the founder’s family), it is not appropriate to tax it as a profit-making business entity — even if the entity engages in or conducts a business incidental to the primary purpose for which it was organized.²¹

Guidance in U.S. tax law suggests that when deciding whether to classify an entity as a trust or an association taxable as a corporation, the grantor’s intent in forming the entity is a principal factor. The courts will carefully examine the literal language of the organizing instruments as the primary source of evidence regarding an arrangement’s purpose. Thus, the charter and bylaws of the RAK ICC foundation will be a major determinant of its U.S. tax classification — and they must be drafted carefully with this in mind.

Under regulation 5(5), an RAK ICC foundation may not carry out any commercial activities except those necessary for (and ancillary or incidental to) its objects. This provides strong support for classifying the RAK ICC foundation as a trust,²² provided that the founder’s intent, the foundation’s stated purpose, and its actual activities are in line with this classification.

U.S. tax law clearly indicates that the foundation’s activities are also a key factor in the classification analysis. In most cases, the foundation’s primary purpose is to protect or conserve the property transferred to the foundation for its qualified recipients; foundations are not usually established primarily for actively carrying on business activities. However, it is important to note that if the facts and circumstances in a particular case indicate that a foundation was established primarily for commercial purposes rather than for the purpose of protecting or conserving property, the entity may be properly classified as a business entity. Accordingly, one must carefully analyze the facts and circumstances of the case in order to make the most appropriate determination.²³

The following subsections offer an overview and provide examples of the tax consequences that might result from classifying an RAK ICC foundation as either a trust or an association taxable as a corporation. Given the complexity of the U.S. tax rules, it is not possible to detail every nuance, especially since the tax impact will be different for every U.S. player involved with the foundation.

Results of Classifying a Foundation as a Trust

The following discussion assumes that the RAK ICC foundation is characterized as a trust for U.S. income tax purposes.

Example 1: Non-U.S. Individual Founder

The foreign grantor trust (FGT)²⁴ is a traditional planning technique that typically involves a non-U.S. person settling a foreign trust for the benefit (now or in the future) of U.S. — and possibly non-U.S. — family members. The structure of the trust generally results in the foreign grantor being the owner of the trust assets for U.S. income tax purposes. As a result, there is no U.S. income tax on the trust’s non-U.S.-source income.

If the founder of an RAK ICC foundation is a non-U.S. individual who has retained the absolute right to revoke the foundation (in which case the property would revert back to the founder), U.S. tax principles would classify the entity as an FGT until the founder’s death. Any U.S. person who is a qualified recipient and receives funds from the foundation would be treated as if they received nontaxable distributions from the FGT. For U.S. purposes, the recipients would not be taxed on these amounts because the grantor is considered the taxpayer.²⁵ Further, with a revocable foundation, additional tax benefits could accrue to the U.S. qualified recipients after the founder’s death when foundation assets may qualify for a favorable basis — namely, a basis stepped up to the FMV on the date of death.²⁶

Upon the non-U.S. founder’s death, the foundation’s U.S. tax status would automatically convert to foreign non-grantor trust status. Assuming that the foundation held only non-U.S.-situs assets, this conversion would not have adverse tax consequences for the non-U.S. decedent. Planning, however, must be in place for this eventuality because there could be negative tax consequences for the U.S. qualified recipients under the so-called throwback tax regime in IRC sections 665 through 668. Under those rules, a distribution of income that the foundation earned in a prior year when it was a foreign non-grantor trust could be treated as an accumulation distribution includible in U.S. recipients’ gross income. Accumulation distributions carry very negative U.S. income tax consequences, including compounded interest charges, and, of course, involve complex tax filings. In this instance, it might be wise to consider changing the situs of the foundation to the United States so that it would be treated as a domestic U.S. trust, since the throwback tax regime does not apply to U.S. trusts.

Pre-Immigration Tax Planning

Pre-immigration trusts are worth special mention. Under special tax rules codified in IRC section 679(a)(4), a foreign trust that is settled within five years before an individual becomes a U.S. person (for example, by obtaining a green card) will be treated as a grantor trust for U.S. income tax purposes if the trust does not prohibit U.S. beneficiaries. This means that the individual will be taxed on all the income earned by the trust regardless of distributions to other persons.

Commonly called a drop-off trust, this structure can still be extremely useful to the prospective immigrant from an estate tax perspective. Even if the trust does not shield the income that the assets generate from U.S. income taxes, a properly structured drop-off trust can protect assets from U.S. estate tax by removing them from the individual’s estate.²⁷ This is a significant benefit for immigrants who plan to remain in the United States since, upon death, their worldwide assets would be subject to U.S. estate tax at rates of up to 40 percent. Assuming that it is classified as a trust for U.S. tax purposes, the RAK ICC foundation can be tailored to be a drop-off trust, and thus can be useful in pre-immigration tax planning. This would especially be the case when UAE real property is involved since restrictions on ownership apply even when the property in question is located in an area designated for 100 percent foreign ownership.²⁸

Example 2: U.S. Individual Founder

If the founder is a U.S. individual and the foundation has a U.S. person as a qualified recipient (or if its organizing documents do not prohibit U.S. persons from being qualified recipients), the foundation would still be treated as an FGT, albeit under different tax rules (specifically, IRC section 679(a)) with the founder treated as the trust’s U.S. tax owner. Because she is a U.S. person, the founder will be taxed on all the foundation’s income, even if she doesn’t receive any distributions from the foundation. Again, qualified recipients can receive tax-free distributions from the foundation. Depending on the facts, the transfer of assets to the foundation by a U.S. citizen or domiciliary might be treated as a taxable gift, which the founder would need to report on her U.S. gift tax return, subject to her lifetime gift tax exemption of $11.58 million (this is the exemption amount for 2020).

Upon the founder’s death, U.S. tax status would automatically convert to foreign non-grantor trust classification. In this case, however, depending on the precise facts, the conversion would have negative tax implications for the founder and U.S. recipients,²⁹ generally because the founder will be required to recognize gain deemed to arise before her death and the recipients denied a step-up in basis regarding the assets.

If U.S. persons are prohibited from being qualified recipients, the founder’s transfer was irrevocable, and the founder did not retain any significant powers, then the trust would be considered a foreign non-grantor trust from the start. While the founder would be liable for tax upon the transfer of any appreciated asset to the foundation,³⁰ she would no longer be taxed on the income the trust generates, and it would not be part of her eventual estate. This structure may be well suited when the beneficiaries are non-U.S. persons who would not be affected by the throwback tax regime.

As the foregoing discussion illustrates, U.S. tax planning can result in significant benefits, but it must be very carefully undertaken.

Trust Reporting

If a foundation is classified as a trust for U.S. tax purposes, various U.S. tax information reporting forms must be filed by any U.S. persons involved therewith such as the founder, a contributor, or qualified recipient.³¹

Also, special attention must be paid to ensure compliance with the Foreign Account Tax Compliance Act.³² The UAE has formally signed a FATCA intergovernmental agreement with the United States, bringing the full force of compliance to the Emirates.

Association Taxable as a Corporation

If the RAK ICC foundation is classified as an association taxable as a corporation, entirely different U.S. tax rules come into play when U.S. persons are involved. These could include the controlled foreign corporation³³ tax regime and associated subpart F and global intangible low-taxed income tax rules,³⁴ as well as the passive foreign investment company³⁵ rules. The rules would require complex U.S. tax filings,³⁶ including the so-called boycott report (Form 5713) if the foundation is treated as having operations in the UAE since it is on the list of boycotting countries.

For example, assume that the foundation was classified as a corporation and had a single founder who was a U.S. person. The rules would treat the founder as having transferred property to the corporation, and he would be responsible for various tax filings, including Form 926, Form 5471, and Form 8938.³⁷ Under these facts, the entity would be classified as a CFC and the founder treated as a U.S. shareholder.

A U.S. shareholder of a CFC must include as gross income, on a current basis, his proportionate share of specified income earned by the CFC. A U.S. shareholder of a CFC must include as gross income, on a current basis, his proportionate share of specified income earned by the CFC — so-called subpart F income and GILTI income.³⁸ Furthermore, none of the amounts distributed by the foundation — whether they are actually distributed or deemed distributed according to the CFC rules — would be eligible for a reduced tax rate as a qualified dividend.³⁹

While this may sound grim, depending on the precise facts, proper planning can usually mitigate the tax bite. Still, all things considered, classifying a UAE foundation as a trust rather than an association taxable as a corporation presents better planning opportunities and is likely to produce better tax results. With professional guidance, a foundation’s organizing documents can be prepared in a way that favors a trust classification.

Summary

The UAE has achieved global recognition as a top jurisdiction for international business. With the recently enacted foundations law regimes, the UAE is also coming to the fore as a first-rate location for wealth and succession planning, the safeguarding of assets, and planning for the future. The RAK ICC foundation is the newest addition to this system, and it can be used by Muslims and non-Muslims alike. With the input of a Sharia scholar, investors can create Sharia-compliant foundations.

When U.S. persons are involved with a foundation in any way, special U.S. tax concerns arise. Failure to recognize and adequately address these issues can lead to harsh tax consequences, but proper planning can lead to very beneficial results. Clearly, when foundations are used for international tax planning that includes the United States, an experienced U.S. tax adviser who understands the particular local foundations law regime is a necessity. Thankfully, the UAE offers both access to advice from top U.S. tax professionals and foundations regimes that can meet all manner of planning and business needs.