Recent legislation imposes new compliance and tax burdens on individuals with foreign connections.

During the summer of 1996, two of the four bills enacted with tax provisions contained substantial changes to the Federal tax treatment of US. individuals and trusts with foreign connections. The Small Business Job Protection Act of 1996 (SBJPA) is principally economic and tax policy legislation, while the Health Insurance Portability and Accountability Act of 1996 (HIPAA) is generally social policy legislation that contains certain tax provisions to "finance" targeted policy objectives. This summer's legislation produced a comprehensive change to the Federal tax system. Many of the provisions will undoubtedly affect taxpayers in numerous (and perhaps unexpected) ways. Individuals with certain existing or planned foreign connections or transactions are particularly affected, because Congress used as revenue raisers several "off the shelf" provisions that had been considered for years.

Increasing Compliance

Various new compliance features have been added to the tax system, including:

* Annual reporting of foreign gifts. * Enhanced reporting responsibilities for foreign trusts and their beneficiaries. * Penalties for noncompliant U.S. persons involved with trusts. * Departure and post-departure reporting obligations for expatriating citizens and departing long-term aliens. * A future study to improve tax compliance.

Gift Reporting

SBJPA Section 1905 (a) imposes a new reporting requirement, Sec. 6039F, on U.S. persons receiving gifts or bequests from foreign persons during the year totaling, in the aggregate, more than $10,000.(1) According to SBJPA Section 1905(c), this provision is effective for gifts and bequests received after Aug. 20, 1996, and is a change in reporting only. Gifts by foreign persons to U.S. persons of tangible personal property located outside the US. and intangible property wherever situated are still not subject to Federal gift tax. Because the IRS has yet to prescribe the information that needs to be provided with respect to such foreign gifts, there is no current requirement to report them, but any regulations will probably require retroactive reporting to Aug. 20, 1996. A failure to file such information without reasonable cause authorizes the IRS to determine the tax treatment of foreign gifts. Judicial review of any such determination will be overturned only if the determination is "arbitrary or capricious," a very difficult standard to satisfy.(2) In addition, the U.S. person is subject to a penalty under Sec. 6039F(c) of 5% of the amount of such gift for each month for which the failure continues (up to a maximum of 25%).

Foreign Trust Reporting

Foreign trusts are now subject to several enhanced reporting requirements. The creation of, or the transfer (directly or indirectly) of money or other property to, a foreign trust by a U.S. person must be reported within 90 days. While this reporting requirement is not new,(3) the severe new penalties enacted will aid enforcement efforts.

SBJPA Section 1901(a) amended Sec. 6048(c) to require that a U.S. person who receives (directly or indirectly) after Aug. 20, 1996 any distribution from a foreign trust must report the name of the trust, the aggregate amount of distributions received for the tax year and any other information the IRS may prescribe.

Grantors are also subject to increased compliance burdens. Under Sec. 6048(b)(1), as amended, a U.S. person treated under the grantor trust rules as the owner of any portion of a foreign trust is responsible for ensuring that the trust (1) files a return containing a full and complete accounting of trust activities for the year, the name of its U.S. agent and any other information the IRS prescribes and (2) furnishes information to be prescribed by the IRS to each U.S. person treated as a trust owner or who receives (directly or indirectly) a trust distribution.

The enhanced beneficiary and grantor reporting provisions apply to tax years of U.S. persons beginning after 1995, and should increase the IRS's ability to collect taxes from U.S. persons receiving benefits from foreign trusts.

Enforcement Mechanisms

Important new measures enhancing the enforcement of these provisions add tax traps for the unwary. Sec. 6048(b)(2) provides that if a U.S. person is treated as the owner of a foreign trust, a U.S. person must be authorized as a limited agent of such trust to accept (1) service of process with respect to IRS requests to examine records or take testimony and (2) a summons (subpoena) for such records or testimony in connection with the tax treatment of any items related to the trusts. If no such agent is appointed, the IRS can determine the tax consequences under the grantor trust rules.

In the case of a US. person who receives (directly or indirectly) a distribution from a foreign trust, Sec. 6048(c)(2) requires that adequate records be made available to the IRS to determine the proper treatment of the distribution. Beneficiaries beware; failure to do so will result in the distribution being includible in the U.S. distributee's gross income and treated as an accumulation distribution from the middle year of the foreign trust (i.e., computed by taking the number of years of the trust's existence divided by two) for purposes of computing the interest charge applicable to such distribution, unless the foreign trust elects to have a U.S. agent for the limited purpose of accepting service of process (as described above).

In the case of the failure to timely file the reports or to include all the information required in connection with (1) the creation of, or transfers to, a foreign trust or (2) the receipt of distributions from a foreign trust, Sec. 6677(a)(2), as amended by SBJPA Section 1901(a), imposes an initial penalty of 35% of the gross reportable amount (as defined in Sec. 6677(c)).

According to Sec. 6677(b) and (c)(2), a foreign trusts failure to provide an annual report of its activities will subject the U.S. person treated as the trust owner to a penalty of 5% of the gross value of the portion of the trusts assets treated as owned by the U.S. person at the close of the year.

If any failure continues for more than 90 days following the mailing of an IRS notice, an additional penalty of $10,000 per 30-day period thereafter can be imposed under Sec. 6677(a).

Renunciation of U.S. Citizenship, Departing Aliens

A great deal of publicity has surrounded wealthy citizens who left the U.S. to avoid future income and estate taxes. Under restrictive new rules enacted by HIPAA Section 512(a) and (c), retroactive to Feb. 6, 1995, persons renouncing U.S. citizenship (expatriating citizens) and departing "long term" permanent legal resident aliens (i.e., green card holders) are required by Sec. 6039G to provide statements of their departure that include their new residency and other data (including assets and liabilities) to facilitate Federal tax collection under the new anti-avoidance regime described below. In some cases, annual reporting for up to 10 years after departure will also be required. The Sec. 6039G(d) penalty for failing to file the statement for each year of the 10-year period is the greater of (1) 5%, of the expatriates tax liability or (2) $1,000, unless it is shown that such failure was due to reasonable cause and not to willful neglect. Generally, under Sec. 6039G(a)(2), the statement of an expatriating citizen must be filed with the U.S. Secretary of State (or other designated government entity), the statement of a departing long-term resident is to be included with the return for the year of departure, according to Sec. 6039G(f).

Treasury Study

HIPAA Section 513 requires Treasury to submit a report to Congress by Nov. 19, 1996, on improving tax compliance by U.S. citizens and green card holders living abroad. Many of these individuals may believe they are no longer US. citizens or residents, in spite of substantial publicity in recent years about compliance breakdowns, others may fail to report income to the U.S. annually in the belief (correct or incorrect) that no tax is due.

Enhanced Tax Regime

Several aggressive tax planning techniques have been attacked by the new legislation. Although prior law was unclear about the taxability of many of these activities, the new laws address many foreign tax issues as intentional revenue raisers (ostensibly, to fund various social programs).

Departure Tax

Pre-HIPAA Sec. 877 provided anti-avoidance measures in the case of an individual who lost his U.S. citizenship within the last 10 years with a principal purpose of tax avoidance; such measures included a tax calculated on U.S.-source income at the rates applicable to citizens and an expanded definition of such income. HIPAA Section 511 made three significant changes in this area.

The first change is a revision of the expatriation rules for citizens and the departure rules for a newly defined group of individuals - "long-term resident" aliens. Sec. 877(3)(2) defines a long-term resident as a non-U.S. citizen who is a permanent legal resident of the US. (i.e., a green card holder) for at least eight of the 15 tax years prior to departure.(4)

Second, there is now a general presumption that "wealthy" expatriates have left the US. for tax avoidance purposes. Accordingly, most gains from U.S. investments and business interests will be subject to Federal income tax if recognized within the 10-year, post-departure period. Under Sec. 877(a)(2), a principal purpose of tax avoidance is presumed if the individual had an average annual net income tax greater than $100,000 for five tax years ending before the date of loss of U.S. citizenship, or a net worth at departure of $500,000 or more. (Both figures will be indexed for inflation after 1996.) Exceptions from the tax may be granted under Sec. 877(c) to citizens who expatriate for certain reasons (e.g., to return to a birthplace or on attaining the age of majority) if they submit a ruling request within one year of expatriation or departure. Further, HIPAA Section 511(e) made changes to Secs. 2107 and 2501 to subject expatriates and former long-term resident aliens to estate and gift taxes in the 10-year post-departure period.

The third major change is the expansion of the definition under Sec. 877(d) of U.S.-source income recognized by an individual terminating US. citizenship or residency within the 10-year period to include the following:

* Gain from the sale or exchange of stock in a foreign corporation more than 50% owned (by vote or value) by the individual terminating U.S. citizenship or residency. * Gain realized by a controlled foreign corporation (treating the terminating individual as a U.S. person for this purpose) resulting from the transfer of property to such corporation by a US. shareholder within the 10-year period, if the gain from the sale of such property would otherwise have been U.S.-source gain. * Gain from an otherwise tax-free exchange within the 10-year period when the property surrendered would have produced U.S.-source gain and the property received would have produced foreign-source gain, such gain is deferrable if the taxpayer enters into a gain recognition agreement with the IRS.

In general, under HIPAA Section 511(g) these rules apply to individuals losing US. citizenship or terminating US. residency after Feb. 5, 1995. However, Sec. 877 also applies to individuals who renounced U.S. citizenship prior to Feb. 6, 1995, but after Feb. 5, 1994 if they failed to furnish the State Department with a statement relinquishing citizenship by the later date.

While these provisions have substantially toughened the rules, the final legislation is a comfortable compromise from the legislation originally proposed by the Clinton Administration,(5) which would have taxed these individuals as if they had sold all assets at the then fair market value (FMV) on departure.

Inbound Grantor Trusts With Foreign Grantors

Under pre-SBJPA Secs. 671-679, a foreign person (e.g., a parent) who created a grantor trust was treated as the owner of the trust's property and the income tax "recipient" for Federal tax purposes. As long as the trust invested in assets that produced income not taxable to nonresident aliens (e.g., Treasury note interest, interest on certificates of deposit, and non-U.S.-source income), no one was taxable in the U.S. on the trusts income. The cash proceeds from such income could have been distributed by the trust to the US. beneficiaries (e.g., children and grandchildren) free of Federal income tax during the grantor's life.(6) Now, the foreign grantor is no longer treated as the income recipient, rather; the trust is treated as a separate entity.(7) Thus, either the trust is subject to Federal income tax currently if it is a U.S. domestic trust, or the beneficiary of a foreign trust is subject to tax at distribution (and may be subject to the accumulation distribution rules if the trust does not distribute income and capital gains in the year realized(8).

However, Sec. 672(f)(2), as amended, provides that a trust with a foreign grantor will nevertheless be a grantor trust if (1) the grantor can revest in himself title to trust property without another's approval or consent or with the consent of a related or subordinate party subservient to the grantor or (2) during the grantor's lifetime, the only amounts distributable (whether income or corpus) from the portion of the trust treated as owned by the grantor are amounts distributable to the grantor or his spouse. An additional exception is provided by SBJPA Section 1904(d)(2) for certain trusts treated as grantor trusts under Sec. 676 or 677 and in existence on Sept. 19, 1995.

Outbound Foreign Trusts With U.S. Grantors

Under pre-SBJPA Sec. 679(a), if a U.S. person transferred assets to a foreign trust that had a US. beneficiary, the trust was a grantor trust and the income generated was taxable to the grantor, however, under pre-SBJPA Sec. 679(a)(2)(B), if the transfer was structured as a sale at FMV (including an installment sale), and the transferor recognized gain, the grantor trust rule did not apply.

A congressional concern was that if a U.S. person structured the transfer to a foreign trust as a sale for notes issued by the trust or a party related to it, the grantor trust rules would be avoided even though the notes were not repaid. Under Sec. 679(a)(2(B), as amended by SBJPA Section 1903(a), a transfer to a foreign trust in exchange for notes will not be disregarded if the sale is at FMV and gain is recognized by the US. person at the time of the transfer or under the installment sale rules. In determining whether the trust paid FMV, notes issued by the trust, the grantor, the beneficiary or a related person will be taken into account only to the extent provided by regulations The regulations should permit arms-length loans to be take into account in determining FMV, in all cases, principal payments actually made by the trust on installment obligations be taken into account."

Foreign Nongrantor Trusts

U.S. beneficiaries of nongrantor foreign trusts are now subject to enhanced taxes on any (real or deemed) deferred income accumulated through the trust.

Under pre-SBJPA Sec. 668(a), accumulation distributions from foreign trusts (unlike domestic trusts) were subject to a 6% simple interest charge, computed on the tax that would have been due had distributions been made when the trust income was earned. Interest on such distributions from non-US. reporting trusts is calculated based on the assumption that all income was earned in the trusts initial year. Realizing that the interest charge (which, starting in 1996, rises to the Sec. 6621 underpayment rate) plus the tax could exceed a beneficiary's entire distribution, Congress amended Sec. 668(a) to provide so-called "relief" that caps the sum of the two charges at the total distribution received. The new Sec. 6039F requirement that US. beneficiaries report the receipt of distributions from foreign trusts should greatly enhance compliance and enforcement. If the foreign trustee complies with US. reporting requirements, a US. beneficiary's tax on distributions can be greatly reduced through use of the rules relating to complex domestic trusts, including availability of certain credits for some or all of the Federal or foreign taxes borne by the trust. Failure to comply with reporting requirements subjects the beneficiary to the harshest possible tax on all distributions received, presumably, U.S. beneficiaries will put increasing pressure on trustees to provide the IRS with the required information.

Distributions Through Nominees

Sec. 643(h), as amended by SBJPA Section 1904(c), treats amounts paid to a U.S. person, derived (directly or indirectly) from a foreign trust of which the payor is not the grantor (e.g., via a friendly intermediary), as if paid by the foreign trust directly to the US. person. Careful review of the new reports of gifts from foreign sources will likely be a fertile area for IRS enforcement.

Loans

Sec. 643(h), as amended by SBJPA Section 1906(c)(1), states that, except as provided by regulations, loans of cash and marketable securities by a foreign nongrantor trust to the US. (1) grantor or (2) beneficiary will be treated as a distribution by the trust to such U.S. person. The regulations will exempt from distribution treatment loans with arms-length terms.(10)

Trust Residency

New objective tests have been enacted to determine the residency (i.e., foreign or domestic) of a trust. Under Sec. 7701(a)(30)E and (31)(B), as amended by SBJPA Section 1907(a), a trust is a U S. trust only if (1) a U.S. (i. e., Federal, state or local) court can exercise primary supervision over trust administration and (2) U.S. fiduciaries have authority to control all substantial decision of the trust (generally accomplished by having a majority of US. fiduciaries).

Excise Tax on Residency Reclassification 

Certain US. trusts reclassified as foreign trusts under the new residency rules may be subject to a 35% excise tax under Secs. 1491 and 1494 as amended by SBJPA Sections 1907(b) and 1902. The Sec. 679 outbound foreign grantor trust rules have been amended by SBJPA Section 1903 to allow gain or loss recognition in certain circumstances.

Incoming Foreigners 

There has also been a modification of certain rules that allowed foreigners to put their assets in trust before entering the US. to avoid Federal income tax on earnings from wealth accumulated prior to arrival.(11) Under Sec. 679(a)(4), as amended by SBJPA Section 1903(c), if a foreign grantor becomes a US. resident within five years of a direct or indirect transfer of property to a foreign trust with US. beneficiaries, he is treated as transferring property to the trust as of his US. residency starting date.

Accordingly, to avoid Federal income tax, a foreigner would have to create and fund such a trust at least five years prior to arrival and could not receive any distributions during his residency period. The five-year window should eradicate most planning opportunities.

Abusive Transactions

Sec. 643(a)(7), as amended by SBJPA Section 1906(b), empowers Treasury to prescribe regulations as may be necessary or appropriate to carry out the purposes of the anti-abuse rules applicable to estates, trusts and beneficiaries.

Conclusion

The SBJPA and HIPAA are less than three months old and only time will tell their full impact, however, it is apparent that Congress and Treasury were aware of both existing "loopholes" in international trust and tax planning for individuals and of the lack of enforcement tools available to the IRS. As with actions taken in the past (e.g., in the transfer pricing area), some individuals will now be forced to pay their fair share of taxes. However, the tax advisers advice to clients as to careful compliance with the new measures and the new regime created for tax planning could save them considerable amounts and will require professional scrutiny of the new provisions. (1) Sec. 6039(d) provides that the $10,000 amount will be indexed for inflation for post-1996 tax years. (2) See H. Rep. No. 104-737, 104th Cong., 2d Sess. 183 (1996) (hereinafter, "SBJPA Conference Report"). (3) See, e.g., pre-SBJPA Sec. 6048; Temp. Regs. Sec. 16.3-1. (4) Regs. Sc. 301.7701(b)-5(a) imposes similar anti-avoidance measures on the U.S.-source income of certain individuals during their interim period of nonresidency if they were U.S. residents for at least three consecutive calendar years (initial residency period) beginning after 1984, then resumed such residency before the close of the third calendar year beginning after termination of the initial residency period. (5) See Turro, "Administration Proposes Antiabuse Rule For Foreign Trusts, Expatriation," 66 Tax Notes 915, 916 (2/13/95). (6) A common technique was to qualify a trust as a grantor trust for income (but not estate) tax purposes by giving the grantor the power under Sec. 675(4) to reacquire the trust corpus by substituting other property of an equivalent value. (7) See Secs. 672, 643, 665 and 901, as amended by SBJPA Section 1904 (8) See Secs. 668(a) and 643(a) and (i), as amended by SBJPA Section 1906. (9) See SBJPA Conference Report, note 2, p. 180. (10) See id., p. 179. (11) See Secs. 672, 643, 665 and 901, as amended by SBJPA Section 1904.