Pre-IPO US tax planning for US founders of companies seeking to list in Hong Kong

23 November 2020 | Applicable law: Hong Kong

As the US-China tension grows, the United States has rolled out more restrictions on Chinese companies seeking IPOs in the United States. The White House task force recommended that all future Chinese IPO candidates be required to allow US regulators to review their audit records as a condition of listing. The upcoming change in administration might steer the relationship between the United States and China one way or the other. Amid the growing uncertainties, some companies are looking at alternative markets, which has led to a growing number of companies seeking to list in Hong Kong. As US tax residents are subject to US income tax on the worldwide income regardless of where the person is located and US citizens and US domicilaries are subject to US gift and estate taxes on transfers of worldwide assets, it is imperative for those founders or employees to consider potential US tax implications and available US tax planning options.

Generally, the stock price after an IPO could appreciate significantly, and so will the founder's (and some employees') net worth. From a US income tax perspective, no US federal income tax is due until the founder disposes of his or her shares in the future. From a US federal gift and estate perspective, the founder has a bigger exposure. One of Biden's best known tax proposal is to cut the unified credit significantly (from current US$11.78 million to potentially US$3.5 million). This could mean an even bigger estate tax bill without proper planning. There are some planning techniques to mitigate such exposure, the goal of which is to "freeze" the value of assets. The mostly used are the following: GRAT and IDGT.

Grantor retained annuity trust ("GRAT")

A GRAT is a trust created by the founder for a fixed term. The founder is the sole beneficiary of the trust during the term and will receive an annuity payment each year, the total present value of which will equal the current value of the stock transferred to the trust. Because the present value of the annuity payments equals the current value of the stock transferred, the founder is deemed to have made a current gift of nill value (usually called a zero-out GRAT). If the stock price skyrockets (as it usually does after an IPO), a significant portion of the stock will remain in the trust after the annuity payments. Generally, the founder would also create a family trust, which will be the beneficiary of the GRAT after the expiration of the term. This planning is blessed by the Internal Revenue Code. However, it should be noted that, if the founder passes away during the term of the GRAT, this planning technique would fail and the entire value of the stock would be included in the founder's estate. In addition, proposals have been made to remove the statutory blessing for the zero-out GRAT.

Sale to an intentionally defective grantor trust ("IDGT")

A grantor trust is an irrevocable trust that is disregarded for US income tax purposes. In other words, trust assets within a grantor trust are considered to be owned by the grantor (generally the person who created and funded the trust) directly for US income tax purposes. However, a grantor trust can still serve as an effective estate tax blocker as long as the grantor does not have certain powers. A grantor trust can be beneficial in the sense that grantor can make gift tax-free gifts by paying income tax on the appreciation of the trust property. In addition, transactions between the grantor and the trust would not be considered in existence, allowing the grantor to sell stock to the trust tax free.

Through this planning technique, the founder will create a trust that is a grantor trust for US income tax but not for US estate tax purposes. The founder will then sell the interest in the company to the trust for an interest-bearing note prior to the IPO. Since the trust is a grantor trust for US federal income tax purposes, the sale would not trigger a gain in the hands of the founder. To the extent that the growth of the assets outgrow the interest rate (which is certainly the case after an IPO and also in light of the current low interest environment), the growth is forever excluded from the founder's estate.

This document (and any information accessed through links in this document) is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.


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