DIFC/ADGM foundations: US estate tax issues with Sharia compliant structures

As an international private wealth firm, we act for a large number of UHNW clients from the MENA region who are Muslims.

A considerable number of those clients are either US persons or have spouses or children who are US persons, in some cases due to citizenship having been acquired through birth in the US. These clients are increasingly asking for our advice in structuring tailor-made Dubai International Financial Centre (DIFC) or Abu Dhabi Global Market (ADGM) foundations to provide governance to their family businesses and invested wealth, long-term asset succession, and asset protection. For these clients, there is often a tension between structuring their foundation to enable the transfer of assets to the structure to be compliant under Sharia inheritance law, and at the same time enabling them to create a structure which best mitigates the impact of US tax.

These matters are often complex, as such we collaborate with Sharia law Scholars to ensure compliance with Sharia law. However, in overview terms it is thought that if a Muslim client transfers assets to a DIFC or ADGM foundation and cannot then benefit from the assets, he or she will have gifted the assets during his or her lifetime and that would be a valid lifetime transfer (known as a ‘Hiba’). If so, the transfer would not breach Sharia inheritance law. Whilst the structure design should depend on each client’s circumstances, this often results in advice that the foundation should not be revocable by the client (the founder) and the client cannot benefit from the foundation as a recipient.

Foundations are not recognised under the US tax code and, as is the case in the UK, a foundation will be categorised as either a trust or a corporation for US tax purposes. In order to mitigate the impact of US tax, it is often recommended that a DIFC or ADGM foundation should be structured in a manner which would enable it to be categorised as a foreign grantor trust. In overview terms, a foreign grantor trust would provide favourable US federal tax treatment for the US person's family members, including no annual tax or reporting of trust income or gains from non-US sources during the lifetime of the founder and no US estate tax on the foundation assets (which are most likely all non-US situated assets). In addition, US beneficiaries would be able to receive distributions from the trust free of any US taxes during the lifetime of the foreign grantor/founder.

The tension is that to achieve this treatment, the foundation would need to be either revocable by the founder during his or her lifetime, or if irrevocable, only the founder and his or her spouse could receive income or capital during the founder’s lifetime. For the reasons mentioned above, these options are often seen as contradictory to the Sharia requirements and also might not reflect the distributions which the client would anticipate being made by the foundation council. The appointment of a Foundation guardian may cause further complications from the US tax perspective.

If you or your clients have any questions on structuring DIFC or ADGM foundations (or other asset holding vehicles) where international tax considerations need to be considered, please let us know and we would be pleased to support.