Tax accounting issues for foreign trusts: this two-part article describes tax accounting and reporting consequences of foreign and domestic trusts. Part I defines these trusts and discusses some advantages and disadvantages of foreign trust status.
* A foreign trust is any trust that fails to satisfy the court or control test for establishment of U.S. domestic trust status.
* The AJCA expatriation rules give tax advisers and fiduciaries more standards to measure the control test as a result of new, information return filing requirements.
* Foreign trusts created by a nonresident alien or U.S. person no longer living in the U.S. can provide deferral or avoidance of U.S. income tax.
The Small Business Job Protection Act of 1996 (SBJPA) changed Sec. 7701(a)(30) and (31) to effectively allow a trust to have foreign status even if it was created by a U.S. person, all of its assets were in the U.S., and all of its beneficiaries were U.S. persons. The requirement of "one foreign person" having control over "one" substantial type of trust decision favors foreign residents. (1) The U.S. is attractive for international planners when their clients seek unique trust law advantages (i.e., no rule against perpetuities in certain states, protection from forced heirship and private trust company trusteeship) that the U.S. offers, without subjecting themselves to unnecessary tax costs. (2) In addition, many fiduciary accounting issues have become paramount with the passage of the American Jobs Creation Act of 2004 (AJCA) and affect trusts. The AJCA created new "expatriation" rules for both trustees and beneficiaries that further complicate the tax and accounting requirements, especially in recording tax payments and applying foreign tax credits.
This article compares domestic and foreign trust status for fiduciary, reporting and tax accounting purposes. Part I, below, points out the differences between foreign and domestic trusts and describes the advantages and disadvantages of foreign trust status. Part II, in the July 2006 issue, will illustrate some tax consequences of foreign and domestic trusts that fiduciaries and tax advisers need to understand to report trust transactions properly under local law and in accordance with the trust instrument.
A recent $21 million judgment in New York against a foreign fiduciary for lack of prudent investor standards illustrates what can happen when the due diligence and care needed to understand trust transactions under international law are lacking. (3) For example, many states do not honor U.S. tax treaties with foreign countries. California does not conform to the Code as it relates to treaties that exempt certain income from Federal taxation. In support of California, as well as other states, the U.S. Supreme Court has ruled (4) tax treaties between the U.S. and foreign governments generally do not prohibit the taxing authority of subnational governments (such as states) to regulate in their own best interests.
Another recent Supreme Court decision (5) threatens attorneys with criminal prosecution when their advice "assists in deprivation of property of others, including depriving a foreign tax authority of tax revenue." The long-term effect of this decision remains to be determined. Regardless, advisers should hold themselves to the same standards of conduct as they do for U.S. tax matters. (6) Professionals who advise in structuring transactions that use foreign-source income on which taxes are evaded risk prosecution under Federal money laundering statutes.
What Is a Foreign Trust?
Under the SBJPA, a "foreign trust" is "any trust other than a domestic trust." Under Sec. 7701(a)(30(E), a trust is a domestic trust under U.S. income tax laws if it satisfies two conditions:
1. Court test: A court within the 50 states or the District of Columbia has primary jurisdiction over the administration of the trust.
2. Control test: One or more U.S. fiduciaries have the authority to control all substantial trust decisions. (7)
The terms of the trust instrument and applicable law must be reviewed and analyzed to determine whether both tests are met. An analysis will also encompass the actions and residency of the fiduciary
The court test covers any Federal, state or local court (within the U.S.) that has the authority or would have the right to render orders or judgments resolving administrative issues. Jurisdiction over a trustee, a beneficiary or trust property is not sufficient; primary supervision (jurisdiction) is required. (8) Regs. Sec. 301.7701-7(c)(4) sets forth some of the specific situations in which a trust satisfies the court test:
1. Uniform Probate Code: The standards of the court test are met if a fiduciary registers the trust in a court within the U.S. under a state statute that has provisions substantially similar to those contained in Article VII, Trust Administration, of the Uniform Probate Code.
2. Testamentary trust: The court test is satisfied flail fiduciaries of the trust have been qualified as trustees by a court within the U.S.
3. Inter vivos trusts: The court test is satisfied if the fiduciaries or beneficiaries take affirmative steps with a U.S. court, to subject trust administration to the primary supervision of the court.
4. Multiple court supervision: The court test is satisfied if both a U.S. court and a foreign court can exercise primary supervision over trust administration.
The SBJPA has "automatic migration provisions." If the trust instrument provides that a U.S. court's attempt to assert jurisdiction or otherwise supervise the administration of the trust directly or indirectly would cause the trust to migrate from the U.S., a court within the U.S. is not considered to have primary jurisdiction over the trust. (9)
Under a safe-harbor rule, a trust is a domestic trust if(1) the trust is administered exclusively in the U.S.; (2) U.S. persons control all substantial trust decisions; (3) the trust instrument does not direct the trust to be administered outside the U.S.; and (4) the trust is not subject to an automatic migration provision. (10)
Under Sec. 7701(a)(30)(E)(ii), the control test requires that U.S. persons, which include fiduciaries and beneficiaries, have the authority to control all of a trust's decisions and its assets. Substantial decisions are those that persons are authorized or required to make under the terms of the trust instrument and applicable law, and are not ministerial. Regs. Sec. 301.7701-7(d)(1) (ii) lists several substantial decisions, including whether and when to distribute income or corpus; the amount of distributions; the selection of a beneficiary; the power to make investment decisions; whether a receipt is allocable to income or principal; whether to terminate the trust; whether to compromise, arbitrate or abandon claims of the trust; whether to sue on behalf of the trustor to defend suits against the trust; whether to remove, add or replace a trustee; and whether to appoint a successor trustee.
Control means the power by vote or otherwise to make all of the substantial trust decisions, and no foreign fiduciary has the power to veto such decisions. To determine whether U.S. persons have control, it is necessary to consider all persons who have the authority to make a substantial decision regarding trust matters, not just the fiduciaries. (11) If a U.S. person has only the power to veto the decisions of the foreign fiduciary, the control test is not satisfied. (12) If the trust instrument provides all substantial decisions are to be by a majority vote among the fiduciaries, the control test is satisfied if a majority of the fiduciaries are U.S. persons (i.e., U.S. persons control all substantial decisions). (13)
Inadvertent change: In the event of an inadvertent change in the fiduciary that would cause a change in the residency of the trust, the trust is allowed 12 months from the date of the change to adjust either the fiduciary or the residence of the fiduciary so as to avoid a change in the residence of the trust. Inadvertent changes include the death or abrupt resignation of a fiduciary; if the adjustment is not made within 12 months, the trust status (foreign versus domestic) is deemed changed as of the date of the inadvertent change. (14)
The control test is not met if an attempt by a governmental agency or creditor to collect information from a trust, or assert a claim against it, cause one or more substantial decisions to no longer be controlled by the U.S. fiduciary. (15) Some trust instruments have automatic migration or "flee clauses" to repel such actions.
Caution: Practitioners need to ask more questions about foreign accounts, foreigners making decisions and trust amendments while they conduct their annual procedures. Practitioners should be knowledgeable of foreign-trust-status criteria to alert the fiduciary of these complex reporting issues.
New Filing Requirements
New AJCA expatriation rules give practitioners and fiduciaries more standards to measure the control test, due to new information-return filing requirements.
AJCA expatriation changes: Under Sec. 877, an individual who gives up U.S. citizenship, and a long-term U.S. resident who terminates U.S. residency, may be liable for U.S. tax at regular graduated rates under an alternative tax regime for 10 years after expatriation or cessation of U.S. residence. The AJCA made substantial changes to the tax and information reporting rules (and associated penalties) that apply to U.S. citizens and long-term residents who lose their citizenship or terminate their long-term resident status after June 3, 2004. (16) As a result of these changes, Sec. 877 generally applies to any former U.S. citizen or long-term resident: (1) whose net worth as of the date of loss of citizenship or termination of long-term resident status equals or exceeds $2 million; (2) whose average annual net income tax liability for the five preceding tax years exceeds $124,000 (as adjusted annually for inflation); or (3) who fails to certify under penalty of perjury that all of his or her Federal tax obligations for the five preceding years have been met.
Under Sec. 7701(n), an individual who loses U.S. citizenship or terminates long-term resident status will continue to be a citizen or long-term resident of the U.S. for Federal tax purposes until he or she (1) gives notice of an expatriating act or termination of residency (with the requisite intent to relinquish citizenship or terminate such status) to the State Department or Department of Homeland Security and (2) provides a statement to the IRS that meets the revised Sec. 6039G requirements (initial expatriation information statement).
Sec. 6039G also requires annual information reporting for each tax year during which an individual is subject to Sec. 877(a).The annual information statement, which requires detailed information on income, assets and liabilities, is due on the date the individual's U.S. income tax return for the tax year is due or would be due, if the individual was required to file such a return.
Revised forms: The IRS revised Form 8854, Initial and Annual Expatriation Information Statement (March 2005), to permit individuals to meet the new notification and information reporting requirements. In particular, it expanded the form to function as both the initial and the annual expatriation information statements required by the AJCA. The revised form and its instructions also address how individuals should certify (in accordance with the new law) they have met their Federal tax obligations for the five preceding tax years and what constitutes notification to the State Department or the Department of Homeland Security.
Applying Foreign Trust Regulations
The final regulations under Sec. 7701 generally apply to trusts for tax years ending after Feb. 2, 1999. (17) However, they may also be relied on for tax years beginning after 1996. If a trust was created after Aug. 19, 1996 and before April 3, 1999, and it satisfied the control test as set forth in the proposed regulations, (18) but not as described in the final regulations, the trust could make the appropriate modifications until Dec. 31, 1999. If this was done, the trust will satisfy the control test for all tax years beginning after Dec. 31, 1996.
Election to Be Treated as a Domestic Trust
A trust in existence on Aug. 20, 1996, and treated as a domestic trust on Aug. 19, 1996, could elect to continue to be treated as a domestic trust after the latter date without having to comply with the new domestic trust criteria. (19) This election had to be made on the trust's 1997 or 1998 income tax return (20) in the manner prescribed by the regulations. However, a trust cannot make this election if it has previously elected to apply the new trust rules to its first tax year ending after Aug. 20, 1996. (21) There is no grandfathering provision which permits a trust that was treated as foreign prior to 1996 to elect to continue its foreign status, if it would otherwise not fall within the post-1996 definition of a foreign trust. (22)
Unintended Loss of U.S. Status
If a trust is a U.S. trust and by reason of its U.S. trustee ceasing to be a trustee or ceasing to be a U.S. person, the trust unintentionally loses its U.S. status, it will have 12 months from the date of such occurrence to give control over all substantial trust decisions to a U.S. person. If this is done within the 12-month period, the trust will be deemed to have maintained its status as a U.S. trust even when all substantial decisions were not controlled by a U.S. person. If control is not so given, the trust will lose its status as a U.S. trust on the date that the U.S. trustee ceased to act or ceased to be a U.S. person. (23)
Any property transfer by a U.S. person to a foreign trust is a sale or exchange for an amount equal to the fair market value (FMV) of the transferred property, and the transferor will recognize gain on the excess of (1) the transferred property's FMV over (2) the property's adjusted basis in the transferor's hands. (24) However, this general rule does not apply to a U.S. person's transfer's to a trust if any person is treated as the trust owner under grantor trust rules under Sec. 671.
If a domestic trust changes its situs and becomes a foreign trust, the change in situs is treated as the transfer of all trust assets to a foreign trust and requires recognition of gains. Such a situs change also triggers the information reporting requirements. (25)
Expanded information reporting requirements have been added for grantors and beneficiaries of foreign trusts on Forms 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Gifts, and 3520-A, Annual Information Return of Foreign Trusts.
Loans and Foreign Trusts
The full amount of a loan of cash or distribution of marketable securities from a foreign trust to a U.S. grantor or U.S. beneficiary, or related to such grantor or beneficiary, is treated as distributed income, unless the loan is structured with arm's-length terms. (26) This rule does not apply if the loan is made to a tax-exempt entity. It applies to loans made after Sept. 19, 1995. (27) The term "cash" includes foreign currencies and cash equivalents.
For purposes of this rule, the trust is not treated as a simple trust. Thus, a foreign trust treated under Sec. 643(i) as making a distribution shall not be allowed a Sec. 651 deduction (current income distribution deductible by the trust). (28)
Foreign Nongrantor Trusts
In general, a foreign trust that is not a U.S. grantor trust will be treated like an individual who is a nonresident alien (NRA) who is not present in the U.S. at any time. Thus, in general terms, to the extent the foreign trust is not engaged in trade or business within the U.S., it will be subject to U.S. tax only on its ordinary income received from sources within the U.S. (29)
U.S. beneficiaries of foreign non-grantor trusts may be subject to U.S. income taxes on distributions of cash or other property received from such trusts. The determination of a U.S. beneficiary's U.S. tax liability as to distributions and loans depends on a number of factors, including whether (1) the distribution was made during a year in which the foreign nongrantor trust earned income and the relationship between the size of that income and the amount(s) of the distributions made in that year to the U.S. beneficiary and to other trust beneficiaries, (2) the amount of the trust's distributions exceeded the amount of its income for the year of distribution, (3) the trust had undistributed income accumulated from prior years and (4) the trust previously paid U.S. income tax or foreign income tax. (30) The regulations require an annual determination of whether a foreign trust is treated as having a U.S. beneficiary. (31)
Advantages and Disadvantages of Foreign Trust Status
Tax deferral or avoidance: A foreign trust created by an NRA or by a U.S. person who is no longer living in the U.S. (see previous discussion for exceptions) permits the deferral of U.S. income tax. As long as a foreign trust accumulates rather than distributes income, does not receive U.S.-source income, and does not invest in foreign personal holding companies or control foreign corporations, neither the trust nor its U.S. beneficiaries will pay U.S. income tax on accumulations until distributions are actually made to them from the trust.
Based on the above facts, if the trust income is ultimately distributed to NRA beneficiaries, no U.S. income tax would ever need to be paid by the trust or the beneficiaries.
1. Throwback rules: If the income from a foreign trust is not distributed currently (i.e., income is accumulated and later distributed), it will be subject to the "throwback rules." The throwback rules are the rules under which the tax on an accumulation distribution is computed. (32) They are designed to prevent the accumulation of trust income over a period of years with a distribution to a beneficiary only in low-income years. The rules have the effect of causing any distributions in excess of the trust's distributable net income (DNI) for the distribution year to be included in the gross income of the U.S. beneficiary in the same manner as if distributed in the year the income was accumulated from the trust. The SBJPA made changes to the throwback rules, which adversely affect accumulation distributions from foreign trusts. Domestic trusts are now exempt from the throwback rules. (33)
2. Interest on accumulation distributions: An accumulation distribution is the excess of the distributions over DNI (i.e., the amount of income required to be distributed currently). In addition to the beneficiaries having to pay tax on the previously undistributed income, an accumulation distribution from a foreign trust is subject to a substantial interest charge on that tax for distributions of income accumulated in prior years. (34) Under Sec. 668, the interest is calculated to the rate charged on underpayments of tax with daily compounding. In computing the interest charge, the accumulation distribution is allocated proportionately to prior trust years in which there is undistributed net income, provided the distribution is made to a U.S. citizen or resident beneficiary rather than to the earliest years that the trust had undistributed net income. (35) If all of a foreign trust is distributed currently, it will be taxed currently and Hill not be subject to the throwback rules. (36)
3. Capital gains: A foreign trust's accumulated capital gain income in the year of realization will be transformed into ordinary income in the hands of the ultimate U.S. recipients, (37) because capital gain is included in determining DNI of a foreign trust. (38) Thus, the interest charge would be payable not only on the tax generated by a distribution of ordinary income, but also on the tax resulting from a distribution of capital gain(s). Accumulated capital gain(s) would be taxed to the beneficiaries as ordinary income and the beneficiaries would not have the advantage of being taxed on the capital gains(s) at the lower capital-gain tax rates.
If, however, a mast is a U.S. trust, capital gain income would be taxed to the trust (if not allocated to the beneficiary under the "power to adjust" rules) and at capital-gain, not ordinary income, tax rates. Any ordinary income distributions would be taxed to the beneficiaries as ordinary income and the trust would receive a corresponding distribution deduction in calculating tax. (Under the new Sec 643 regulations, capital gains could be distributed to beneficiaries if certain requirements are met. (39)) Any income not distributed would be taxed to the mast as ordinary income on a current basis. While subsequent distributions of accumulated ordinary income would be subject to the throwback rules when distributed, capital gains would not be subject to throwback and there would be no interest charge (as there would be in the case of foreign trusts).
Tax deferral period for accumulation distributions from foreign trusts: A new method has been established for calculating the tax deferral period for which interest is charged. Thus, the change in the interest rate and the way in which it is computed will probably result in significantly higher amounts of nondeductible interest being due for beneficiaries of foreign trusts. This interest charge is calculated on the partial tax computed under Sec. 667(b) for the period, using the rates and methods applicable to underpayments of tax under Sec. 6621. (40) The "applicable number of years" is determined by dividing the sum of the "products" (the "product" of the undistributed net income for the year (each earlier year for which this is undistributed net income, other than a tax year during which years the beneficiary receiving the distribution(s) was not a U.S. citizen or resident) and the sum of the number of tax years between that year and the tax year of distribution. (41)
Tax withholding: Once a U.S. domestic trust becomes a foreign trust, U.S. persons who control the payment of income to the trust, such as interest, dividends, annuities or other fixed or determinable annual or periodic gains, profits and income, may be required to withhold from the payment of such items a tax equal to 30%. The lower treaty rates that are applicable in these cases are unlikely to apply to a mast that has been expatriated by the new definition of foreign trust status, because it will not ordinarily be treated as a resident, for treaty purposes, in any other jurisdiction.
Avoiding Foreign Trust Status
To make a U.S. trust, a court within the U.S. must be able to exercise primary supervision over the trust's administration. Although Sec. 7701(a)(30)(E)(i) does not provide how the primary jurisdiction is to be determined, the House Committee report (42) provides that this test generally will be satisfied by any trust instrument that specifies that it is to be governed by the laws of any state. If allowed by the terms of the trust agreement, the designation by the trustees that the trust residence is the U.S. should satisfy the court test.
According to the House Committee Report, the control test will be satisfied in any case in which fiduciaries who are U.S. persons hold a majority of the fiduciary power (whether by vote or otherwise) and no foreign fiduciary, such as the "trust protector" or other trust adviser, has the power to veto important decisions of the U.S. fiduciaries. (43) Thus, if permitted by the terms of the trust agreement, potential solutions are:
1. The existing trustees appoint a sufficient number of U.S. trustees to put the foreign trustees in the minority: or
2. The existing trustees appoint a U.S. trustee or trustees and all or some of the existing trustees resign so that the U.S. trustees constitute a majority.
Part II, in the July 2006 issue, will describe and illustrate the tax consequences of foreign versus domestic trust status.
Lawrence H. McNamara, CPA
Lake Forest, CA
(1) Rubenstein and Muchin, "Basics of International Estate Planning," p. 29 (May 2005).
(2) E. Warren Whitaker "The US May Be a Good Trust Jurisdiction for Foreign Persons," p. 36, Estate Planning, Warren, Gorham, & Lamont (February 2006), Vol. 33, No. 2.
(3) Estate of Dumont, New York L. J. (7/13/04), p. 19.
(4) Container Corp. v. Franchise Tax Board, 463 US 159 (1983).
(5) David Pasquantino, U.S. Sup. Ct., (4/26/05).
(6) A. Leitner, "CA-2's Narrow View of Pasquantino Does Not Affect Enlarged Scope of Federal Fraud and Money Laundering," 104 J. of Tax'n 35 (January 2006).
(7) See also Regs. Sec. 301.7701-7(a)(1).
(8) Rubenstein, note 1 supra, at p. 30.
(9) See Regs. Sec. 301.7701-7(c)(4)(ii).
(10) Rubenstein, note 1 supra, at p. 30; see Regs. Sec. 301.7701-7(c)(1).
(11) See Kegs. Sec. 301.7701-7(d)(1)(iii).
(12) Preamble, TD 8813 (2/1/99).
(13) See Regs. Sec. 301.7701-7(d)(1)(v), Example 2.
(14) See Regs. Sec. 301.7701-7(d)(2)(i).
(15) See Regs. Sec. 301-7701-7(d)(3).
(16) See Notice 2005-36, IRB 2005-19, 1007; IR-2005-49, IRB 2005-49 (4/22/05); loss of citizenship or termination of long-term resident status for Federal tax purposes will be the later of the date that Form 8854 (as revised March 2005) is filed with the IRS or the date on which the taxpayer provides the requisite notice to the State Department or Department of Homeland Security.
(17) Rubenstein, note 1 supra, at p. 32.
(18) See REG-51703-96 (6/4/97) and Sec. 7701.
(19) See Regs. Sec. 301.7701-7(f)(1).
(20) See Regs. Sec. 301.7701-7(f)(3)(ii).
(21) See SBJPA Section 1907(a)(3)(B).
(22) Rubenstein, note 1 supra, at p. 32.
(23) See Regs. Sec. 301.7701-7(d)(2).
(24) See Sec. 684(a).
(25) See Secs. 684(c) and 6048(a)(3).
(26) See Sec. 643(i).
(27) P. L. No. 104-188, Section 1906(d)(3).
(28) See Sec. 643(i)(2)(D).
(29) See Secs. 861 and 871.
(30) See Sec. 679(b) and (c); and Regs. Secs, 1.679-2(a) and -3.
(31) See Regs, Sec. 1,679-2(a); and Sec, 679(c).
(32) See Secs. 665-668.
(33) See Sec. 665(c).
(34) See Sec. 667(b).
(35) See Sec. 666(a).
(36) See Sec. 666(b).
(37) See Secs. 662(b) and 667(a) and (d).
(38) See Sec. 643(a)(6)(C); Sec. 643(a)(3) does not apply to foreign trusts; as such, included in DNI are gains from the sale/exchange of assets, reduced by any such losses.
(39) See Regs. Sec. 1.643(b)-1; and TD 9102 (12/30/03).
(40) See Sec. 668(a)(1).
(41) See Sec. 668(a)(3).
(42) H Rep't No. 105-148, 105th Cong., 1st Sess., p. 650.
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|Title Annotation:||part 1|
|Author:||McNamara, Lawrence H., Jr.|
|Publication:||The Tax Adviser|
|Date:||Jun 1, 2006|
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