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Proposed section 671 regulations relating to application of grantor trust rules to nonexempt employee trusts.

On February 13, 1997, Tax Executives Institute submitted the following comment to the Internal Revenue Service on proposed regulations under section 671 of the Internal Revenue Code, relating to the application of the grantor trust rules to nonexempt employee trusts, including trusts established to provide retirement benefits to foreign-based employees. The comments were developed under the aegis of TEI's International Tax Committee, whose chair is Joseph S. Tann, Jr. of Ameritech Corporation, and its Federal Tax Committee, whose chair is David L. Klausman of Westinghouse Corporation. The following members of the Institute contributed to the development of the Institute's position: Derek A. Terenzi of General Motors Corporation and Raymond Haas of Marsh & McLennan Companies.

On September 26, 1996, the U.S. Department of the Treasury and the Internal Revenue Service issued proposed regulations under section 671 of the Internal Revenue Code, relating to the application of the grantor trust rules to nonexempt employee trusts. The proposed regulations were published in the Federal Register on September 27, 1996 (61 Fed. Reg. 50778) and in the Internal Revenue Bulletin on October 15, 1996 (1996-42 I.R.B. 10).(1)

Background

Tax Executives Institute is the principal association of corporate tax executives in North America. Our 5,000 members represent more than 2,700 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and that taxpayers can comply with in a cost-efficient manner.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations under section 671 of the Internal Revenue Code, relating to the application of the grantor trust rules to nonexempt employee trusts.

Subchapter J of the income tax law sets forth the rules for the income taxation of estates, trusts, beneficiaries, and decedents. Subpart E of that subchapter provides the rules for determining when a grantor is treated as the owner of trust assets and thereby is taxable on the income. These rules may apply to employers who establish trusts in a foreign jurisdiction that provide pension benefits to their foreign employees. The proposed section 671 regulations provide the rules for determining when an employer will be considered the "owner" of the assets in the foreign employees' trust.

Prop. Reg. [sections] 1.671-1(h) provides the general rule that, except as provided in section 679 of the Code, an employer is not treated as an owner of any portion of a foreign employees' trust.(2) The proposed regulations also provide, however, that the grantor trust rules will apply to determine whether a controlled foreign corporation (CFC), a U.S.-related foreign partnership, or a U.S. employer will be treated as the owner of a "fractional interest" in the foreign employees' trust. Such a determination which will trigger significant tax consequences, for example, under Subpart F where the fair market value of the trust assets exceeds the plan's accrued liability. In addition, the assets in the trust may be considered "owned" by the employer for purposes of the passive foreign investment company (PFIC) and (now repealed) section 956A rules.

Prop. Reg. [sections]

1.671-1(h)(3)(ii)(A)(1):

Calculation of Surplus Assets

Under Prop. Reg. [sections] 1.671-1(h)(3)(ii)(A)(1), the determination whether a surplus exists is made using the projected unit credit funding method -- an extremely complicated method that will prove burdensome to the taxpayer and difficult for the IRS to use on audit.

TEI believes that taxpayers should be permitted to use U.S. generally accepted accounting principles (GAAP) to determine whether there is a surplus in the trust. Statement of Financial Accounting Standards (FAS) No. 87 provides comprehensive rules governing contributions to foreign pension plans, including calculation of the projected benefit obligation (PBO). Companies already computing valuations in conformity with FAS 87's PBO rules should not be required to perform another costly calculation. Although FAS 87 does not perfectly track the tax rules -- FAS 87, for example, permits companies to take into account future benefits (such as post-retiree health benefits) that are reasonably expected to be paid -- the purpose of the regulations is not to impose a rigid, inflexible standard but to ensure that the method used to determine the funding is reasonable -- and compliance with FAS 87 would clearly do that.

The use of GAAP standards would substantially reduce complexity and result in a significant decrease in compliance burdens for the taxpayer and government alike. In addition, the use of GAAP principles would be consistent with the regulations' definition of accrued liability, which the preamble confirms is "intended to track the method used for calculating pension costs under FAS 87." 1996-42 I.R.B. at 14. FAS 87 should be adopted as an alternative method to determine whether a surplus exits.

Prop. Reg. [sections] 1.671-1(h)(3)(iii):

Exception for Reasonable

Funding

A. Reasonable Funding Methods. Prop. Reg. [sections] 1.671-1(h)(3)(iii) provides an exception from taxation of surplus assets where the taxpayer demonstrates that the surplus is attributable to either (i) a "reasonable funding" method, applied using actuarial assumptions that the Commissioner deems to be reasonable, or (ii) experience that is favorable relative to any actuarial assumptions used to determine reasonableness.

TEI is pleased that the proposed regulations include an exception for taxpayers using reasonable funding methods. We strongly recommend, however, that alternative methods not be limited to the methods permissible under section 412 of the Code. For example, the final regulations should provide that a funding method satisfying the requirements of foreign laws will be considered per se reasonable under this exception. Many foreign jurisdictions require employers to make certain payments to their pension plans in order to protect worker interests. In countries where such requirements are imposed, a taxpayer that complies with the rules should not be penalized; hence, satisfying the local funding rules should be deemed reasonable under the regulations.

During the January 15, 1997, hearing on the proposed regulations, government representatives expressed concern that some foreign jurisdictions may permit taxpayers to overfund their plans, thereby enabling taxpayers to shield income-generating assets from the reach of U.S. taxation. TEI believes that the government's concern is overstated.

First, TEI is unaware of any jurisdiction that permits employers to move assets in and out of an employees' trust at will. Employers are not able to "park" funds in a trust to avoid U.S. tax consequences; rather, to the extent overfunding occurs, it is most likely the result of downsizing and the excess funds will be used to reduce future contributions. Second, it makes no business sense to transfer assets to an entity outside the employer's control, especially in respect of foreign entities that are not wholly owned. Giving up control over assets to avoid U.S. tax on those assets would be the equivalent of cutting off your nose to spite your face. Finally, foreign jurisdictions often have laws limiting the tax deduction for overfunding plans or, as in Switzerland, forbidding the reversion of pension assets. Indeed, even in those jurisdictions that permit some reversion of assets in overfunded plans (such as the United Kingdom, Canada, Australia, and New Zealand), removal of trust assets is not without severe local tax consequences to the employer. In those jurisdictions, any asset reversion will be subject to extensive negotiation with trustees, government agencies, and employee representative bodies -- a not insignificant proposition.

The United States is not alone in its desire to protect the funding of retirement plans; OECD countries, in particular, have strong funding laws. Imposing U.S. funding laws on such jurisdictions is overreaching and smacks of fiscal imperialism. TEI believes that reliance by employers on foreign funding laws and regulations is reasonable and should be recognized as such by the final regulations.

B. Form 5471 Requirement. Prop. Reg. [sections] 1.671-1(h)(3)(iii) also provides that the reasonable funding exception is available to a CFC employer only if the taxpayer attaches a statement to a timely filed Form 5471. TEI finds this requirement puzzling. What purpose is served by the attachment of a statement? Why are CFCs the only entity required to make an "election" of reasonableness? The requirement will force companies to make protective elections, even where no surplus currently exists. The burden of taxpayers will be matched by a burden on the IRS -- to process, file, and act upon the elections.

A U.S. taxpayer's relationship with a foreign pension plan will be subject to audit by the IRS and any questions about the funding can be reviewed at that time. If a funding mechanism is found to be reasonable, a taxpayer should not be denied the benefit of the exception merely because it failed to attach a statement to its Form 5471.

Prop. Reg. [sections] 1.671-1(h)(2):

Definition of Foreign

Employees' Trust

A "trust" is commonly defined for U.S. tax purposes as involving a transfer of legal title to property to a trustee. See Treas. Reg. [sections] 301.7701-4(a). Such a transfer is not required and typically does not occur in arrangements that are intended to qualify as the "equivalent of a trust" under Prop. Reg. [sections] 1.404A-1(e). The section 404A rules assume that a taxpayer will not be subject to U.S. taxation -- including the PFIC rules -- in respect of the assets in an arrangement qualifying as the "equivalent of a trust."(3)

Prop. Reg. [sections] 1.671-1(h)(2) defines the term "foreign employees' trust" as a nonexempt employees' trust described in section 402(b) that is part of a deferred compensation plan and that is a foreign trust within the meaning of section 7701(a)(31). It is unclear, however, whether a transfer of pension assets only to a "trust" will be sufficient to remove the assets from the employer's tax balance sheet for PFIC and other purposes.

There is no sound tax policy why a transfer to an "equivalent of a trust" should be recognized to transfer ownership under section 404A, but not under the grantor trust rules. In such a case, the foreign employer effectively surrenders the benefits and burdens of ownership in order to meet the "equivalent of a trust" rule. The final grantor trust rules should confirm this point.

Conclusion

Tax Executives Institute appreciates this opportunity to present our views on the proposed regulations under section 671 of the Code, relating to the application of the grantor trust rules to nonexempt employee trusts. If you have any questions, please do not hesitate to call Joseph S. Tann, Jr., chair of TEI's International Tax Committee, at (312) 750-5074, David L. Klausman, chair of TEI's Federal Tax Committee, at (412) 642-3354, or Mary L. Fahey of the Institute's professional staff at (202) 638-5601.

(1) For simplicity's sake, the proposed regulations are referred to as the "proposed regulations"; specific provisions of the proposed regulations are cited as "Prop. Reg. [sections]." References to page numbers are to the proposed regulations (and preamble) as published in the Internal Revenue Bulletin.

(2) Section 679 provides that a U.S. person who directly or indirectly transfers property to a foreign trust -- other than a trust described in section 404(a)(4) or 404A -- shall be treated as the owner for the taxable year of the portion of such trust attributable to such property if there is a U.S. beneficiary for any portion of the trust.

(3) Section 404A permits taxpayers to elect to deduct from earnings and profits contributions to certain foreign pension plans designed for nonresident aliens who work outside the United States, even though the plans do not meet the requirements of U.S. law.
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Publication:Tax Executive
Date:Mar 1, 1997
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