Reporting trust and estate distributions to foreign beneficiaries.
The increasing interaction of global economic issues and a mobile society make international tax issues more commonplace, even for smaller practitioner firms. New tax laws, especially the Foreign Account Tax Compliance Act (FATCA) provisions enacted in 2010 that will be effective in 2013 (1) and corresponding Treasury regulations and rulings, affect the correct reporting by fiduciaries and practitioners of domestic trust and estate distributions to foreign beneficiaries. What may seem rather straightforward fiduciary administrative and reporting procedures can involve numerous complexities, sometimes with unexpected consequences. The complex rules necessitate early coordination between practitioners and fiduciaries to carefully plan the distribution and accounting procedures before embarking on reporting the results for tax return purposes.
Careful planning and prudent administration should consider a number of factors, including:
* Each beneficiary's income tax filing status, both in the United States and in the country of residence;
* The potential relevance of tax treaty provisions advantageous to the beneficiaries applicable to each foreign jurisdiction;
* The practical aspects of trust/estate administration, focusing on "flexible" aspects, if possible;
* Being informed on applicable law changes, including the standards for making distributions and reporting them in the beneficiary's foreign jurisdiction to ensure the proper reporting; and
* Proper allocation of receipts and disbursements between income and principal under local law and the governing instruments. (2)
Determination of Tax Status of the Beneficiary
U.S. persons for U.S. tax purposes include U.S. citizens, resident aliens (green card holders), and U.S. residents who meet the "substantial presence" test of Sec. 7701( b) (generally those present in the United States for more than 183 days over a three-year period) or make a first-year election. (3) There are certain exceptions for residents of Canada or Mexico who regularly commute to employment in the United States, foreign-government-related individuals, certain teachers and students, and individuals with medical conditions that arose while present in the United States. (4)
An individual who fails the substantial presence test may nevertheless avoid being classified as a U.S. resident if he or she can establish a closer connection to a foreign country. An individual may satisfy the "closer connection test" if the individual can establish that he or she (1) was present in the United States for fewer than 183 days during the current year; (2) maintains a tax home in a foreign country; (3) has a closer connection during the current year to the foreign country where his or her tax home is located than the U.S.; and (4) has not applied or taken affirmative actions to change his or her status to that of a lawful permanent U.S. residents (5) The determination of whether an individual has maintained a closer connection to a foreign country is determined based on facts and circumstances, including the location of family, personal belongings, and business connections; where the individual holds a driver's license; and where he or she votes. (6) Form 8840, Closer Connection Exception Statement for Aliens, must be filed to claim the closer connection exception to the substantial presence test (attached to a timely filed Form 1040NR, U.S. Nonresident Alien Income Tax Return).
A nonresident alien is any individual who is neither a U.S. citizen nor a resident alien. (7) After determining the beneficiary's tax status, the fiduciary should obtain the nonresident's identifying tax number and tax withholding certificate (as indicated on Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding) to withhold the tax required to be withheld on certain items of income distributed to nonresident alien trust or estate beneficiaries.
Withholding Tax for Foreign Beneficiary Distributions of Income
Fiduciaries may be required to withhold tax on distributable net income that is distributed by estates and complex trusts or required to be distributed by simple or complex trusts to a foreign beneficiary. (Foreign beneficiaries can include foreign trusts, but that topic is beyond the scope of this article.) Taxes are withheld when the distributions consist of amounts subject to withholding (i.e., the income portion, not corpus). The withholding requirements apply to foreign persons (i.e., nonresident aliens), but not resident aliens. A grantor trust is subject to tax withholding when a foreign person is treated as its owner and the trust has income subject to withholding.
The payer (or a person with control, receipt, or custody or who can disburse or make payments) is responsible for withholding the tax before the "net distribution" is paid. The withholding tax rate is ordinarily 30%. The Sec. 1444 regulations provide detailed rules for when a payer is required to withhold tax, the documentation that can be relied on to establish the status of a payee, and whether an exemption or a reduced rate of withholding should apply. The gross amount of income subject to withholding tax may not be reduced by any deductions, except to the extent that a nonresident alien is allowed a personal exemption for remuneration for personal services rendered in the United States. (8)
A fiduciary is not required to withhold tax if a foreign person assumes responsibility for withholding as a qualified intermediary or an authorized foreign agent. (9) A "qualified intermediary" is a foreign financial institution or foreign clearing organization that has entered into a qualified intermediary withholding agreement with the IRS, as represented on Form W-8IMY, Certificate of Foreign Intermediary, Foreign Flow-Through Entity, or Certain U.S. Branches for United States Tax Withholding. The fiduciary should request a copy of the form from the intermediary.
If the fiduciary, as the withholding agent, makes a payment to a person that can be treated as an intermediary, the payee is the intermediary to the extent that the intermediary assumes primary withholding responsibility for the payment. (10) In that case, the fiduciary is not required to withhold tax on the payment. For a payment to an authorized foreign agent, that agent can fulfill the withholding obligations of the U.S. fiduciary only if (1) there is a written agreement between the withholding agent fiduciary and the foreign person acting as agent; (2) the fiduciary satisfies certain notification procedures; (3) books, records, and relevant personnel of the foreign agent are available (on a continuous basis, even after the termination of the relationship) for IRS examination to evaluate the fiduciary's withholding and reporting compliance; and (4) the fiduciary remains fully liable for the acts of its agent and does not assert any defenses to avoid any tax liability under the Code. (11)
The fiduciary, by appointing an authorized foreign agent, must file notice of the appointment with the Office of Assistant Commissioner (International) before the first payment for which the authorized agent acts as such and acknowledge the withholding liability as described above in (4). (12) The fiduciary, for example, may be compelled to engage an authorized foreign agent to assist an incapacitated or minor foreign beneficiary in order to maintain security for the ultimate distribution to its beneficial owner.
IRS Guidance for Withholding Requirements for Trusts and Estates
Regs. Sec. 1.1441-5 has specific guidance for tax withholding in the case of U.S. simple trusts, complex trusts, and estates. See Exhibit 1 for a summary of the rules for simple trusts. See Exhibit 2 for a summary of rules for complex trusts and estates. The regulation makes specific reference to the "entity" as having the responsibility for withholding and paying the tax in coordination with filing Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, with the IRS for the applicable calendar tax year. However, for U.S. trusts and estates, the fiduciary has many duties and responsibilities under applicable state laws.
Exhibit 1: Withholding requirements by U.S. simple trusts
1. A U.S. simple trust (i.e., a trust that is required to distribute its income currently, Sec. 651(a)) is required to withhold under Chapter 3 as a withholding agent on the distributable net income includible in the gross income of the foreign beneficiary to the extent that the distributable net income is an amount subject to withholding (Regs. Sec. 7.1447-2(a)).
2. The tax withholding is required when the distribution is made.
3. The fiduciary may make a reasonable estimate of the portion of the distribution that constitutes distributable net income consisting of an amount subject to withholding and apply the appropriate rate of withholding tax to the estimated amount.
4. If the fiduciary determines that tax was underwithheld under Sec. 1441 or 1442, the fiduciary of the trust can be held liable for the underwithheld amount under Sec. 1461.
5. No penalties are imposed for failure to withhold and deposit the tax, if the estimate was reasonable and the trust pays the underwithheld amount for the applicable tax year on or before the Form 1042 due date.
6. If the trust pays the underwithheld amount, it will not be treated as additional income to the foreign beneficiary subject to additional withholding, unless the amount is income because of a contractual arrangement between the fiduciary and beneficiary regarding the satisfaction of the beneficiary's tax liability.
7. If the U.S. simple trust is required to distribute distributable net income to a foreign beneficiary but does not do so in the current tax year, it must withhold tax on the beneficiary's allocable share at the time the income is required to be reported on Form 1042-S (without extension) under Regs. Sec. 1.1461-1(c).
Source: Regs. Sec. 1.1441-5(b)(2)(ii).
Exhibit 2: Withholding requirements by U.S. complex trusts and U.S. estates
1. A U.S. complex trust (generally, a trust that is not required to distribute its income currently) is required to withhold under Chapter 3 as a withholding agent on the distributable net income includible in the gross income of a foreign beneficiary to the extent that the distributable net income is an amount subject to withholding (Regs. Sec. 1.1441-2(a)) that is distributed or required to be distributed in the current year.
2. The U.S. complex trust may use the same procedures to estimate the income amount subject to withholding as a U.S. simple trust (Begs. Sec. 1.1441-5(b)(2)(ii)).
3. To the extent that the allocable share of income is not actually distributed in the current year, the U.S. complex trust must withhold on the foreign beneficiary's allocable share of distributable net income at the time the income is required to be reported on Form 1042-S under Regs. Sec. 1.1461-1(c), without extension.
4. A U.S. estate is required to withhold under Chapter 3 on the distributable net income includible in the gross income of a foreign beneficiary to the extent that the distributable net income consists of an amount subject to withholding under Regs. Sec. 1.1441-2(a)that is actually distributed.
5. A U.S. estate may use the reasonable estimate procedures in Regs. Sec. 1.1441-5(b)(2)(ii) to calculate the withholding tax amount(s). However, if the estate has a fiscal year end, those procedures can be applied only if the estate files an amended Form 1042 return for the calendar year in which the distribution(s) was paid and pays the underwithheld tax (and any interest) within 60 days after the close of the tax year in which the distribution was made.
6. With regard to a U.S. grantor trust, it must withhold tax on any income includible in the gross income of a foreign person that is treated as an owner of the grantor trust to the extent that the amount includible consists of an amount that is subject to withholding tax (see Regs. Sec. 1.1441-2(a)). The tax must be withheld at the time that the income is received by, or credited to, the trust (Regs. Sec. 1.1441-5(b)(2)(iv)).
Source: Regs. Sec. 1.1441-5(b)(2)(iii).
The fiduciary, whether an executor or a trustee (or both), is expected to act prudently in exercising a standard of care that is measured in part by his or her adherence to tax compliance issues in performing his or her duties. Accordingly, this article is written assuming that the fiduciary has the ultimate withholding responsibility, even though he or she may employ agents to satisfy that task.
Importance of the Withholding Certificate
The fiduciary may rely on the information and certifications stated on the Form W-8BEN and/or other documentation without having to inquire into the truthfulness of the information, unless he or she has actual knowledge or reason to know that it is untrue. A withholding certificate may be signed by a person authorized to sign a declaration under penalties of perjury on behalf of the person whose name is on the certificate as provided in Sec. 6061. (13) There are certain presumptions about a payee who is a foreign beneficiary that the fiduciary must be aware of during a grace period to establish foreign tax status. See Exhibit 3 for a summary of these rules.
Exhibit 3: Presumption rules regarding the foreign beneficiary payee during a designated grace period
1 The fiduciary, as a withholding agent, may apply a 90-day grace period and treat the account holder (beneficiary) as a foreign person while awaiting documentation where the distribution consists of certain income, primarily fixed or determinable annual or periodic (FDAP) income.
2. There is evidence that the payee beneficiary is a foreign person, if, at the beginning of the grace period, (1) the address in the fiduciary's (payer's) records for the payee is in a foreign country; (2) the fiduciary has been furnished with the information contained in a withholding certificate by way of a facsimile copy of the certificate or other nonqualified electronic transmission of the information required to be stated on the certificate; or (3) the fiduciary holds a withholding certificate that is no longer reliable, other than because its validity period has expired (Rags. Sec. 1.6049-5(d)(2)(ii)).
3. The payer must withhold at the unreduced 30% rate at the time that the amount(s) is credited to the account (or paid to the payee). However, the payer who can reasonably associate the payment with a certificate that is otherwise valid within the applicable requirements, except for the fact that it is transmitted by facsimile, may rely on that Form W-8BEN for purposes of withholding at the claimed reduced rate.
4. At the expiration of the grace period, the following adjustments must be made: (1) If at the end of the grace period, the documentation is not furnished in a manner required, then "backup withholding" applies only to the amount credited to the account of the payee after the expiration of the grace period. Amounts credited to the account during the grace period are treated as owned by a foreign payee, and adjustments must be made to correct any underwithholding tax on those amounts as described in Rags. Sec. 1.1461-2; and (2) if at the end of the grace period, the documentation is not furnished in the manner required, but the payee is presumed to be a foreign person, or if documentation does not support the claimed rate reduction, then adjustments must be made to correct any underwithholding on the amount paid during the grace period, as described in 4.(1), above.
Source: Rags. Secs.1.1441 -1(b)(3) and 1.1441-5(e)6)(i).
Form W-8BEN has recently been revised (as of May 31, 2012) in the "Draft W-8BEN Form" (for use by foreign individuals) in anticipation of new Chapter 4 provisions in the Code (i.e., FATCA withholding taxes to enforce reporting on certain foreign accounts, Secs. 1471-1474) effective after Dec. 31, 2012, to accommodate both Chapter 3 (withholding of tax on nonresident aliens and foreign corporations, Secs. 1441-1464) and Chapter 4 withholding taxes, so that withholding agents will not be required to maintain two separate forms. The draft form is expected to be final by December 2012, resulting in the prior version's being obsolete after six months. The new "Draft W-8BEN-E Form" is for use by entities for purposes of Chapters 3 and 4. Fiduciaries and practitioners should follow these developments closely.
Draft Form W-8BEN requires filers to provide a "foreign tax identification number," an optional entry in the predecessor form. Such requirement may be an attempt under MICA procedures to collect non-U.S. taxpayer information that could be transmitted under recently announced intergovernmental agreements between the U.S. and treaty countries. Exhibit 4 summarizes the withholding certificates described in Regs. Sec. 1.1441-1(e)(2).
Exhibit 4: Withholding certificates described in Regs. Sec. 1.1441-1(e)(2)
1. Form W-8BEN is used to certify that the individual is the beneficial owner of income (not income effectively connected with a U.S. trade or business), is not a U.S. person, and is subjectto Sec. 1441 withholding tax. It may be used to establish a reduced withholding rate or exemption from withholding under a designated tax treaty.
2. Form W-8ECI, Certificate of Foreign Person's Claim That Income Is Effectively Connected With the Conduct of a Trade or Business in the United States, is used to certify that some income received by a foreign beneficiary is income effectively connected to a U.S. trade or business. That income is exempt from withholding under Secs. 1441,1442, and 1443. By treating the income as effectively connected, it is subject to "net basis" taxation, rather than gross basis taxation.
3. Documentation for a disregarded entity, if applicable, is submitted by its owner.
4. A foreign beneficiary that is a grantor trust submits documentation to permit the fiduciary to determine the withholding tax applicable to the grantor.
Source: Regs. Secs. 1.1441-1(e)(2) and 1.1441-5(e)(5)(ii).
Income Items Subject to Withholding
Tax must be withheld on payments of interest, dividends, and other fixed or determinable annual or periodic (FDAP) U.S.-source income paid to foreign persons. The Form 1042-S instructions provide detailed instructions and examples for fiduciaries and practitioners to follow. Information required by the foreign beneficiary claiming foreign tax status through a beneficial owner withholding certificate is indicated in Exhibit 4. The beneficiary may be eligible for a reduced withholding rate (below 30%) or an exemption from withholding, if he or she is entitled to benefits under provisions in a U.S. income tax treaty.
Reporting of Withholding Tax on Forms 1042-S and 1042-T
The various categories of income subject to withholding and the applicable tax rates are reported on Form 1042-S, Foreign Person's U.S. Source Income Subject to Withholding. The payer must complete a separate Form 1042-S for each withholding rate pool (i.e., a payment of a single type of income), as determined by the "income codes" of Form 1042-S (according to the IRS instructions) that is subject to a single rate of withholding. (14) Other requirements in filing Forms 1042-S and 1042-T, Annual Summary and Transmittal of Forms 1042-S, are reported in Exhibit 5. Payment (e.g., "deposit requirements") of the withholding taxes to the IRS is reported on Form 1042. Further guidance and explanation will be provided in a comprehensive example in Part II of this article, in the January issue.
Exhibit 5: Other reporting requirements
1. Form 1042-S must be filed with the IRS on or before March 15 of the year following the year in which the income was paid. The payer must file the information return (Form 1042-S) for each foreign recipient of an amount subject to Sec. 1441 withholding that was paid during the preceding year. A copy (copies B, C, and D) of the form must be furnished to the recipient also by March 15.
2. Form 1042-T is the transmittal form (annual form to accompany the Forms 1042-S [copy A] to the IRS) to report the tax withheld and the tax deposited corresponding to the Forms 1042-S.
3. The IRS may grant an extension of time in which to file Form 1042-S. Form 8809, Application for Extension of Time to File Information Returns, must be used to request an extension of time to file Forms 1042-S and 1042-T. Form 8809 requires a statement of the reasons for requesting the extension and such other information as the forms or instructions may require.
4. The payer may decide or be instructed by the foreign beneficiary to make the distribution payment to an authorized foreign agent (or bank). in that case the payer should file Forms 1042-S treating the authorized agent as the recipient, provided that the authorized foreign agent properly reports the payments on Forms 1042-S and provides copies to each payment recipient. If the authorized foreign agent fails to report the amounts paid on Forms 1042-S for each recipient to which each payment is made, the U.S. fiduciary remains responsible for the tax reporting.
Source: Regs. Secs. 1.1461-1(b), 1.1461-1(c), and 1.1461-1(g).
The fiduciary is indemnified against the claims and demands of any person for the amount of any tax it deducts and withholds in accordance with the Sec. 1441 provisions. However, this indemnity does not relieve the fiduciary from tax liability under the Sec. 1441 requirements. Thus, the fiduciary can be personally liable, even if the payer reasonably believed that correct action was taken. (15)
Reporting of Specific Income Items on Form 1042-S
If distributions are made to a foreign beneficiary, tax withholding is required on amounts from U.S. sources, and those amounts are reported on Form 1042-S, including:
* FDAP income (fixed or determinable annual or periodic income (e.g., rents and royalties)).
* Certain gains from the disposal of timber, coal, or domestic iron ore with a retained economic interest.
* Gains related to contingent payments received from the sale or exchange of patents, copyrights, and similar intangible property.
* Distributions of effectively connected income from a publicly traded partnership.
Capital gains, other than those listed above and gains on the sale of U.S. real estate or real property interest or gains from effectively connected income property, are not subject to withholding tax on distributions to foreign beneficiaries.
Income that might be included in the distributable net income of a U.S. trust or estate, subject to Form 1042-S reporting, includes, but is not limited to, the following U.S.-source amounts:
3. Rents and royalties (gross amounts, if not effectively connected income);
4. Annuity income;
5. Pension and other deferred income, including IRAs;
6. Most gambling winnings;
7. Cancellation of debt income;
8. Effectively connected income, including bank deposit interest that is effectively connected income (see below);
9. Original issue discount (OID) from the redemption of an OID obligation; and
10. Amounts, whether or not subject to withholding, that are paid to a foreign payee and have been withheld on, including backup withholding under Sec. 3406, by another withholding agent under the "presumption rules" (see Exhibit 3 on p. 803).
Items Not Subject to Withholding on Form 1042-S Reporting
The following income items are exempt from Sec. 1441 tax withholding but should be reported by category and code identification (as described in the Form, 1042-S instructions):
* Interest on bank deposits, provided that the income is not effectively connected, including bank deposit interest (and OID) from foreign branches of U.S. banks or savings and loans. (16) The exemption also applies to interest paid to Canadian residents who are not U.S. citizens, but only if less than $10 per calendar year.
* Interest and OID from short-term obligations (i.e., those payable 183 days or less from the date of original issue).
* Accrued interest and OID.
When the normal conduit rules of trust and estate taxation apply, the interest income is ultimately received by the nonresident alien beneficiary. Otherwise, the bank interest income would be taxable to the U.S. trust or estate. As the interest income is not taxable to the nonresident under Secs. 871(h)(1) and (2), the fiduciary should not have to withhold tax on that income item.
In Isidro Martin-Montis Trust, (17) the IRS agreed with the court's decision that, since the interest income was ultimately received by the nonresident alien, the fact that it was received in the first instance by the trust does not prevent the operation of the exclusion from U.S. sources as to that income item in the hands of the trust beneficiaries. (18) The IRS reached the same conclusion under similar facts and circumstances in Letter Ruling 8608013 (specific conclusion as to no withholding required under Sec. 1441) and Letter Ruling 8530051 (also no Sec. 1441 withholding required). (19)
This exemption from tax and reporting has been in the Code for more than 50 years. On April 17, 2012, Treasury issued final regulations (T.D. 9584) that require U.S. financial institutions to annually report bank deposit interest income of all nonresident individuals to the IRS. These new rules only affect reporting requirements and do not affect the taxation of the interest income. The final 2012 regulations are effective for payments made on or after Jan. 1,2013.
Reporting the Foreign Beneficiary's Share of Distributable Net Income on Form 1042-S
The fiduciary does not attach any documentation, such as withholding certificates, when filing Forms 1042-S with the IRS. As previously discussed, a separate Form 1042-S is filed for each type of income for each beneficiary. For example, a trust that distributed distributable net income consisting of dividends and rental income to two foreign beneficiaries is required to file four Forms 1042-S. Such reporting is required even if withholding was not made because of a treaty provision or an exception in the Code.
Special Reporting Rules
Box 1 of Form 1042-S requires a two-digit income code found in the form's IRS instructions. Box 2 requires reporting the gross amount of the income item type that was distributed or required to be distributed to the nonresident alien beneficiary. The withholding tax rate, typically 30%, unless a lower treaty rate or exemption applies, is reported in Box 5 (e.g., 30.00). If withholding tax is not required, a "-0-" is reported, and the proper corresponding code (as designated in IRS instructions) should be reported in Box 6.
The distributable net income of the estate or trust is typically determined for each beneficiary's Schedule K-1 in a three-step process: Step One (gross income by type), Step Two (allowable deductions allocated to each gross income item), and Step Three (the distributable net income as calculated in Steps One and Two is then compared to the distributions to each of the entity's beneficiaries).
The method of allocating amounts found in Step Two among trust beneficiaries depends on whether the trust is a simple or a complex trust. For the purposes of satisfying the Form 1042-S reporting and withholding requirements, the foreign beneficiary faces a higher effective tax rate than the U.S. beneficiary of the same trust or estate on some income items. However, by filing a Form 1040NR for the tax year, the foreign beneficiary may be able to file for a refund on a portion of the Sec. 1441 tax withheld on his or her Forms 1042-S because the 30% withholding tax is based on each beneficiary's distributable share of "gross income" from the entity. Part II of this article in the January issue will illustrate these requirements in a comprehensive example.
Effect of Treaty Provisions to Reduce Withholding on Foreign Beneficiary Distributions
The withholding rate can be less than 30%, under certain provisions in U.S. tax treaties. When a foreign beneficiary has an income type subject to a reduced withholding rate (based on his or her Form W-8BEN and his or her applicable foreign country's tax treaty provision), a separate Form 1042-S must be prepared to report that rate. As previously discussed, Part II of the beneficiary's Form W-8BEN, "Claim of Tax Treaty Benefits," contains information that the beneficiary must certify (under penalties of perjury, as attested by his or her signature in Part IV). The fiduciary, or a designated withholding agent, will determine the beneficiary's eligibility for a reduced rate according to the form's content and other documentation necessary to satisfy the responsible withholding party.
To prevent double taxation in an international context, the U.S. tax treaty system with many foreign countries protects foreign persons from U.S. tax in certain cases. Although there may be identical provisions in certain U.S. tax treaties, each treaty should be carefully interpreted in its own context. IRS Publication 901, U.S. Tax Treaties, is helpful in determining whether a particular tax treaty country provides for a reduced rate of (or a possible exemption from) U.S. income tax for residents of that particular country.
Determining Eligibility for U.S. Tax Treaty Benefits
The tax benefits incorporated in a U.S. tax treaty are generally available only to persons who are residents of one or both of the contracting states. Under Article 4 of the U.S. Model Income Tax Convention, a "resident of a Contracting State" is a person who is liable for tax under that state's laws by reason of his or her domicile, residence, or citizenship. The withholding agent will be required to analyze the facts and circumstances in each foreign beneficiary's case to determine if he or she is entitled to income tax treaty benefits in his or her resident foreign country under Sec. 894. (20)
Generally U.S. tax treaties negotiated after 1963 contain provisions that establish that certain types of income are taxed only to the beneficiary (by a distribution of distributable net income under Secs. 652(b) and 662(b)) as determined by the beneficiary's country of residence. There are also specific exemptions or exceptions to tax withholding under the Code, as previously discussed. For example, the exceptions for U.S. bank debt or "portfolio interest" are common income items. (21) An example of a "reduced withholding rate" is the provision in recent U.S. tax treaties for a limit on the rate of tax (15%) that may be imposed on its resident by the other country (i.e., the United States) on dividends. (22)
In another example, in the United States treaty with Germany, most of the types of income likely to be earned by a U.S. domestic trust would not be treated as fixed, determinable, annual, or periodic income if earned by the German beneficiary directly (Germany is a civil law jurisdiction that does not recognize the trust entity concept), such as dividends received from a U.S. corporation. Thus, the dividend income would be taxable in the United States at 15% (15% withholding tax on the dividends in the distributable net income portion distributed to the German beneficiary). In Germany the beneficiary would be subject to both German income tax (but allowed a tax credit for the U.S. 15% withholding tax against the German income tax liability), as well as a gift tax, which is levied on distributions to recipients, even from a trust settled by a foreign resident settlor. However, the German beneficiary would escape the liability of an inheritance tax in this case. (23) Prudent withholding agents should give proper attention to measures available to alleviate double taxation under the domestic laws of each jurisdiction and to the terms of any double taxation treaty between the contracting states. A careful and cautious analysis is required to achieve such objectives for the foreign beneficiary, but also to avoid underwithholding claims that might transpire at a later date.
Other U.S. Tax Treaty Operative Provisions
One area of growing importance is the "other income" provision (a residual or default category) in U.S. bilateral income tax treaties. (24) In this provision--Article 21 of the model convention--the contracting states (the United States and the other signatory country) agree that any item of income that is not covered in one of the preceding articles (e.g., Business Profits, Dividends, Interest, Royalties, etc.) is taxable only in the jurisdiction of the recipient's residence. The tax exemption under Article 21 requires that (1) the recipient have beneficial ownership of the income item (i.e., the recipient cannot be an agent or nominee), (2) the taxpayer is a resident of the contracting state (to the treaty), and (3) the particular income item is not covered in another article. In addition, all recent U.S. treaties in force require that the limitation-on-benefits (LOB) article (which prohibits residents of third countries from obtaining treaty benefits) be satisfied (e.g., the recipient is not merely a resident, but a "qualified resident" of the contracting state). (25)
The "other income" provision n treaties has become much more important with the significant increase in the types of assets and income. At the same time, the IRS defines broadly what it considers to be U.S.-source income subject to Sec. 1441 withholding. Examples include viatical settlement contract income from life settlement contracts, income items from payments under a notional principal contract, and punitive (but not compensatory) damages. The statutory definition of a "specified notional principal contract" (found in Sec. 871(m)(3)(A)) is effective for payments after March 18, 2012. (26)
In Rev. Rul. 2009-14, (27) the IRS takes a broad view of what income should be subject to Sec. 1441 withholding. The ruling takes the position that if there is no specific guidance on the source of a particular type of income, the appropriate action is to compare and analyze the income item "to classes of income that are specified within the statute." (28) Practitioners and fiduciaries need to be aware of the IRS's lack of guidance in the "other income" category for Sec. 1441 purposes. (29)
Reporting Under Special Circumstances Distributions to Covered Expatriates From Nongrantor Trusts
Whether a nongrantor trust makes a direct or indirect distribution to a covered expatriate, the trustee may be required to withhold 30% of the "taxable portion" of the distribution. (30) The Heroes Earnings Assistance and Relief Tax Act of 2008 (31) designates a "covered expatriate" (32) as those U.S. citizens (or a U.S. resident for not more than 10 of the prior 15 years before expatriation) seeking expatriation who have (1) a net worth of at least $2 million on the expatriation date or (2) an average annual net income tax for the five tax years prior to expatriation greater than $124,000, adjusted periodically for inflation. (33) Under Rev. Proc. 2011-52, the inflation-adjusted amount for 2012 is $151,000. This withholding obligation on the U.S. trustee arises only if the covered expatriate was a beneficiary of the nongrantor trust on the day before the expatriation date. (34) Form W-8CE, Notice of Expatriation and Waiver of Treaty Benefits, filed within 30 days of expatriation, notifies the trustee that the person is a covered expatriate.
The covered expatriate is deemed to have made an irrevocable waiver of any rights to treaty benefits (which might otherwise reduce the tax), but he or she may preserve the right to claim a treaty benefit with respect to a distribution to which Sec. 877A(f)(1)(A) applies by electing on Form 8854 to be treated as having received the value of his or her interest in the trust on the day before the expatriation date. (35) To make such an election, the expatriate must obtain a letter ruling from the IRS as to the value of his or her interest in the trust as of the day before the expatriation date (requested as set forth in Rev. Proc 20104). (36) Until the trustee receives a copy of such letter ruling and a certification that the tax due on the value of the trust interest has been paid, the trustee must withhold the 30% tax on any distributions to the covered expatriate beneficiary. (37) The election is invalid if the IRS determines that the interest does not have an ascertainable value.
The amount of tax due on the value of the trust interest will be adjusted by the amount of tax withholding on or after the expatriation date and prior to receipt of the letter ruling. If the nongrantor trust distributes appreciated property to the covered expatriate, the trust must recognize gain as if the property was sold to the expatriate at its fair market value. (38) Subsequent to the expatriation date, if the covered expatriate is deemed to become the owner of the nongrantor trust, it is treated as a conversion under Sec. 877A(f)(1) (as a distribution in an amount equal to the value of the property he or she is deemed to own under the grantor trust rules, as set forth in Sec. 671 et seq.). (39)
Distributions in Foreign Currency
The typical foreign beneficiary would expect or desire a cash distribution be paid in his or her functional currency. To do so requires that the prudent fiduciary be knowledgeable of the applicable federal tax reporting issues, as well as future foreign currency conversion amounts, to maximize potential gains and minimize potential losses before making such distribution conversions. If the amount subject to withholding tax is paid in a currency other than U.S. dollars, the amount of withholding is determined by applying the applicable rate of withholding to the foreign currency amount and converting the amount withheld into U.S. dollars on the date of payment at the spot rate in effect on that date. (40) A withholding agent making regular or frequent payments in foreign currency may use a month-end spot rate or monthly average spot rate (but the method must be applied consistently from year to year). (41) The spot rate may also be used on the day that the withholding tax is deposited, if the deposit is made within seven days of the date of the payment that causes the withholding obligation.
Alternatively, the fiduciary could elect to calculate the withholding tax and withhold the tax before making the currency conversion for the distribution payment to the foreign beneficiary. However, in that case, if the currency conversion transaction results in a gain to the beneficiary, additional withholding tax may be due. If the fiduciary satisfies the additional withholding tax liability associated with the distribution, this payment may represent additional income attributed to the foreign distribution, for which additional withholding tax would be required. (42) The Code, through the mechanism of the "Sec. 988 transaction," sets forth rules governing the tax treatment of "exchange gain or loss" arising from a number of specific transaction types.
Family Governance Benefits Family Trusts
In many global high-wealth trust administrations, practitioners see that family governance provides positive benefits for family trusts. Such trust governance, in the case of a U.S. trust, can include family members, such as subgroups, to assist the fiduciary with distributions to the foreign beneficiaries and keep them informed on administrative issues. For example, the trust agreement could provide that the family council members maximize the after-tax distribution amounts to the beneficiaries by acting in their role to benefit the larger family. As discussed previously in this article, nonresident beneficiaries may be faced with more challenging technical issues before enjoying their net distribution benefits from a U.S. trust, compared to their fellow U.S. beneficiaries. Successful family governance systems succeed because they are based on the initial and ongoing participation of all the affected family members ("taxation with representation"). Such policies and procedures tend to maintain family harmony and avoid litigation. (43)
Best Practice Guidelines
The following best practice procedures and strategies will facilitate sound U.S. estate and trust administration for distributions to foreign beneficiaries.
1. Consider opportunities for reducing the Sec. 1441 withholding tax, in compliance with IRS regulations, provided adequate documentation is obtained from foreign beneficiaries.
2. Collect and maintain all necessary tax forms (W-8BEN, W-8CE, W-8IMY, and W-9, Request for Taxpayer Identification Number and Certification) and other documentation from beneficiaries needed to verify residence and to compute the correct withholding tax annually.
3. Review applicable U.S. treaty provisions with each applicable beneficiary's foreign country. Seek professional advice to ensure a proper understanding of the provisions as they affect the current year's Sec. 1441 tax amount(s).
4. Compute the correct Sec. 1441 tax before each applicable distribution, after performing procedures 1 through 3 above, using the appropriate rates. Be sure to consider (a) documentation indicating that a treaty provision allows a reduced income item withholding rate or an exemption from withholding; (b) proper handling, timing, and reporting of any foreign currency conversion to facilitate payment in the beneficiary's home country currency; (c) the strategic timing of the distributions based upon tax law changes, U.S. tax treaty changes or revisions, foreign currency exchange rates, and changes in beneficiary residences.
5. Reconsider any "reduced withholding tax" by analyzing any risks whereby the withholding agent can be held accountable for underwithholding.
6. File Forms 1042, 1042-T, and 1042-S in a timely manner each applicable tax year. Provide copies of Forms 1042-S to the applicable beneficiaries. Counsel each to seek professional advice in the tax filing in his or her home country as well as filing Form 1040NR in the United States
Part II of this article, in the January issue, will illustrate the technical issues analyzed and explained in Part I of estate and trust distributions to foreign beneficiaries in a comprehensive example. The example will encompass fiduciary accounting concepts and their determination of distributable net income to illustrate how to maximize net distributions to foreign beneficiaries. The example will also illustrate the application of certain U.S. tax treaty provisions in determining the correct withholding rates. Prudent fiduciaries will seek the advice of practitioners who are knowledgeable and experienced with these complicated issues to guide them in their estate and trust administrations.
RELATED ARTICLE: EXECUTIVE SUMMARY
* As the world becomes more mobiie, practitioners and fiduciaries must be familiar with international tax issues, including the complex withholding and reporting requirements that arise when U.S. trusts or estates make distributions to foreign beneficiaries.
* To comply with U.S. withholding and reporting rules, before making distributions to foreign beneficiaries, fiduciaries and practitioners must determine the beneficiaries' tax status and whether the income distributed is subject to withholding.
* Separate Forms 1042-S must be filed to report each type of income for each beneficiary.
* The 30% withholding rate may be reduced under a provision of a U.S. tax treaty.
(1.) Enacted as part of the Hiring Incentives to Restore Employment Act, P.L. 111-147.
(2.) See Robinson, "U.S. Trusts With Foreign Ben-eficiaries: Issues and Observations," 35-8 Estate Planning 25 (August 2008).
(3.) Sec. 7701(b)(1)(A).
(4.) Regs. Secs. 301.7701(b)-3(b) and (c).
(5.) Regs. Secs. 301.7701(b)-2(a) and (f).
(6.) Regs. Sec. 301.7701(b)-2(d).
(7.) Sec. 7701(b)(1)(B).
(8.) Reg. Secs. 1.1441-4(b)(6) and 1.1441-3(a).
(9.) Regs. Sec. 1.1441-1(b)(1).
(10.) Regs. Sec. 1.1441-1(b)(2)(v)(B).
(11.) Regs. Sec. 1.1441-7(c)(2).
(12.) Regs. Sec. 1.1441-7(c)(3).
(13.) See Regs. Secs. 1.1441-1(e)(4)(i) and (viii).
(14.) Regs. Sec. 1.1461-1(c)(4)(1)(B).
(15.) Regs. Sec. 1.1461-1(e).
(16.) Sec. 1441(c)(10); Regs. Sec. 1.1441-1(b)(4)(ii).
(17.) Isidro Martin-Montis Trust, 75 T.C. 381 (1980), acq. 1981-2 C.B. 2.
(18.) Rev. Rul. 81-244, 1981-2 C.B. 151.
(19.) IRS Letter Ruling 8608013 (2/31/86); IRS Letter Ruling 8530051 (7/26/85).
(20.) Rev. Proc. 2012-7, 2012-1 I.R.B. 232, stipulates that the IRS will not issue a ruling or determination letter on this issue.
(21.) See Sec. 871(h) providing for exempt status for nonresident alien taxpayers.
(22.) The dividend provision has been added to several treaties, including those with Australia, Germany, and the Netherlands. See Bissell, BNA Tax Management Foreign Income Portfolios 907-2d, U.S. Income Taxation of Nonresident Alien Individuals, at VI.C.1.b (2005).
(23.) See detailed discussion in Lehmann, "Balancing Act," 20-4 STEP Journal 27 (May 2012).
(24.) The "other income" provision is found in Article 21 of both the 2006 U.S. model income tax treaty and 2010 OECD model income tax treaty. Every U.S. treaty in force has been separately negotiated, which results in a diversity of language in each treaty, as well as a diversity of interpretations.
(25.) See Lorence, "Why 'Other Income' Tax Treaty Provisions Are Important," 22-4J. Intl Tax 44 (April 2011).
(26.) Temp. Regs. Sec. 1.871-16T.
(27.) Rev. Rul. 2009-14, 2009-1 C.B. 1031.
(28.) Rev. Rul. 2009-14 does not analyze the exemption of Chapter 3, Sec. 1441 withholding; it is subject to criticism as poorly consummated and lacks proposed regulation criteria, including comment period and hearing.
(29.) See Lorence, "Why 'Other Income' Tax Treaty Provisions Are Important."
(30.) Sec. 877A(f)(1)(A).
(31.) Heroes Earnings Assistance and Relief Tax Act of 2008, P.L. 110-245, 6-1708. The HEART legislation created new Sec. 877A for expatriates. The manner in which the new statute applies, as well as exceptions, to those rules, differs for expats who expatriated prior to June 17, 2008 (Sec. 877 rules apply), based on the identity of the expat (i.e., whether the expat is a current U.S. citizen or green card holder).
(32.) Sec. 877A(g)(1)(A).
(33.) Even if the U.S. citizen does not have the specified net worth or income tax liability, if the citizen fails to certify under penalties of perjury (by filing Form 8854) that he or she has complied with U.S. tax laws for the five-year period prior to expatriation, the U.S. citizen will also be treated as a covered expatriate, subject to the rules (Notice 2009-85, 2009-2 C.B. 598, [section]8.C).
(34.) Sec. 877A(f)(5).
(35.) Notice 2009-85, [section]7.D.
(36.) Rev. Proc. 2012-4, 2012-1 I.R.B. 125.
(38.) Sec. 877A(f)(1)(B).
(39.) See Joint Committee on Taxation, Technical Explanation of H.R. 6081 UCX-44-08) (May 20, 2008); Notice 2009-85, [section]7.A.
(40.) Regs. Sec. 1.1441-3(e)(2); Notice 2001-43, 2001-2 C.B. 72, [section]3.
(41.) The term "spot rate" means a rate that reflects a fair market rate of exchange available to the public for currency under a spot contract in a free market and involving representative amounts. For example, the spot rate may be determined by reference to exchange rates published in the pertinent monthly issue of International Financial Statistics or a successor publication of the International Monetary Fund; exchange rates published in newspapers, financial journals, or other daily financial news sources; or exchange rates quoted by electronic financial news services (Regs. Sec. 1.988-1(d)(1)).
(42.) Regs. Sec. 1.1441-3(e)(1).
(43.) See Hauser, "International Family Governance: Integration With Family Trusts," in Trusts in Prime Jurisdictions, p. 585 (Globe Business Pub. Ltd. 2010).
By: Lawrence H. McNamara Jr., CPA, TEP
Larry McNamara is a sole practitioner in Bend, Ore. He was a member of the AICPATrust, Estate and Gift Tax Technical Resource Panel (2007 to 2010), its Foreign TrustTask Force, and its Trust Accounting Income Task Force--Technical Issues Working Group. For more information about this article, contact Mr. McNamara at larry@Ihmcpa.com.
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|Title Annotation:||part 1|
|Author:||McNamara, Lawrence H., Jr.|
|Publication:||The Tax Adviser|
|Date:||Dec 1, 2012|
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