LEX FORI INTERNATIONAL LAWYERS
Presented to the
Colorado Bar Association
September 12, 1998
Attorney at Law
Peterson & Basha, P.C.
8214-C Old Courthouse Road
Vienna, Virginia 22182
fax: (703) 448-1834
I TAX TREATIES 3
II QDOTs 4
III EXPATRIATION 5
IV OVERVIEW OF PERCEIVED ABUSIVE SITUATIONS 6
V DEFINITION OF FOREIGN TRUST/RESIDENCE OF TRUST, §643 INTERMEDIARIES, and §671 GRANTOR 7
VI INBOUND GRANTOR TRUST RULES (Foreign Grantor Creates Trust for U.S. Beneficiaries) 9
VII OUTBOUND GRANTOR TRUST RULE CHANGES
(U.S. Person Creates Foreign Trust) 11
VIII FOREIGN NON-GRANTOR TRUST CHANGES 13
IX U.S. PERSONS SUBJECT TO REPORTING
REQUIREMENTS FOR FOREIGN GIFTS 14
X INFORMATION REPORTING AND PENALTY PROVISIONS 14
XI MISCELLANEOUS 19
XII CONCLUSION 19
RECENT TAX LAW CHANGES AFFECTING
Practitioners are experiencing a tidal wave of changes affecting non-U.S. citizen and U.S. citizen clients with international interests. The major sources of these changes include the Small Business Job Protection Act, ("1996 Act") signed by President Clinton on August 20, 1996, the Taxpayer Relief Act of 1997 ("TRA 1997"), the Internal Revenue Service Restructuring and Reform Act of 1998 signed on July 22, 1998 ("1998 Act"), proposed regulations, and an onslaught of Internal Revenue Notices 97-18, 97-19, 97-34, 97-42, 98-16, 98-17, 98-22, 98-23, 98-25, 98-27, 98-30, 98-34, and 98-35. No sooner are articles and commentaries published analyzing the latest tax changes when new guidance or law is made repealing, in whole or in part, the tax law being discussed. The following is a summary of a few of the highlights of the latest round of tax changes.
Tax treaties are an often forgotten lynchpin in advising the international client. Structures are often put together which complicate a client’s situation when the simple, straightforward foreign investment in U.S. assets would have yielded more favorable tax results under a treaty. As of May 31, 1998, the United States has entered into new income tax treaties with several countries including:
Country Recent General Effective Date
With respect to estate and gift tax treaties in force, as of May 31, 1998, the U.S. had seventeen (17) estate and/or gift tax treaties in force with the following countries:
Canada (this treaty ceased to have effect for estates of persons deceased on or after January 1, 1985; however, see the U.S.-Canada Income Tax Treaty regarding the application of estate and gift taxes)
Several tax treaties are awaiting approval, signature, or are under active negotiation. Others have been terminated (mostly income tax treaties). The estate and gift tax treaties under active negotiation include: France and Germany.
Notice 98-23 provides a question and answer format as guidance regarding recent changes to the taxation of cross-border social security benefits under the U.S.-Canada Income Tax Treaty. A 1997 protocol established a system of taxation based on residency of the recipient and allowing the country where the recipient resides to exclusively tax these benefits.
The TRA 1997 introduced new §2046A(c)(3) which is effective for estates of decedents dying after August 5, 1997. The TRA 1997 grants Treasury regulatory authority to treat legal arrangements that have substantially the same effect as trusts for purposes of qualifying as 2056A qualified domestic trusts (QDOTs) to obtain the marital deduction for non-U.S. citizen spouses. This change was enacted because in civil law jurisdictions, trusts sometimes do not exist and/or trusts cannot have any U.S. trustees.
A. U.S. Trustee Requirement. Section 2056A(a)(1)(A) was effected for estates of decedents dying after August 5, 1997 to permit the establishment of a QDOT in situations in which a country prohibits a trust from having a U.S. trustee. The TRA 1997 provides the Treasury Department with regulatory authority to waive the 2056A(a)(1)(A) requirement that a QDOT have at least one U.S. trustee. It is anticipated that such regulations will provide an alternative mechanism under which the U.S. would retain jurisdiction and adequate security to impose U.S. transfer tax on transfers by the surviving spouse of the property transferred by the decedent.
B. Usufructs. The Treasury Department is also authorized to provide in regulations that certain arrangements having substantially the same effect as a trust can constitute a QDOT. This change would cover those jurisdictions where trusts are not permitted. Many civil law countries use an entity similar to a trust called a "Usufruct." The regulations could permit such arrangements to qualify for QDOT treatment, although the U.S. would need to retain jurisdiction over such arrangement and impose adequate security to ensure the collection of transfer tax on transfers by the surviving spouse of property in the QDOT.
C. Security. One such arrangement to provide adequate security and jurisdiction includes the adoption of a bilateral treaty that provides for the collection of U.S. transfer tax from the non-citizen surviving spouse, or a closing agreement process under which the surviving spouse waives treaty benefits, allows the U.S. to retain taxing jurisdiction and provides adequate security with respect to such transfer taxes.
Effective February 5, 1995, an exit tax was imposed pursuant to the Health Insurance Portability and Accountability Act of 1996 (the "Expatriation Act") signed by President Clinton on August 21, 1996, and the Illegal Immigration Reform and Immigrant Responsibility Act of 1996 (the "Immigration Act") signed into law on September 30, 1996. The Expatriation Act amended §§877, 2107 and 2501 and added new information reporting requirements under §6037F(G).
A. Bright-Line Test. The Expatriation Act creates a presumption of tax avoidance through a new Bright-Line Test. If a taxpayer is deemed to have expatriated with the principal purpose of tax avoidance, then the U.S. income tax will be imposed at ordinary, graduated rates or the alternative minimum tax rate on items of U.S. source income. The expatriation provisions apply to both U.S. citizens and long-term residents (i.e., those who are lawful permanent residents of the U.S. in at least eight (8) taxable years during the period of fifteen (15) taxable years, ending with the year the taxpayer ceases to be a U.S. resident).
The Bright-Line Test is met if:
the individual’s average, annual net U.S. income tax for the five (5) tax years before expatriation is greater than $100,000.00 (the "Tax Liability Test"); or
the individual’s net worth on the date of expatriation is $500,000.00 or more (the "Net-Worth Test").
Either of these tests is sufficient, but not necessary, to impose additional U.S. tax.
A. Ruling Request. One may obtain a ruling request under certain circumstances to rebut the presumption and to show that tax avoidance was not one of the principal purposes.
Guidance was issued in Notice 97-19. This guidance has eleven (11) sections which are anticipated to be incorporated into regulations. However, in Notice 98-34, the IRS revised the procedures in Notice 97-19 for ruling requests by expatriates, liberalizing the procedures for expatriates to claim their expatriation was not tax motivated. The new procedure under Notice 98-34 replaced that of Notice 97-19. Now an expatriate is only required to submit a completed good faith ruling request, rather than to actually obtain a substantive ruling that his or her expatriation is not tax motivated. The new procedure is effective for pending ruling requests and those submitted after July 6, 1998. Under the new notice, a ruling that expresses no opinion on the tax avoidance issue is sufficient to rebut the presumption of a tax-avoidance purpose, but the IRS can, in a subsequent examination of the expatriate’s individual returns, find a tax-avoidance purpose based on the facts and circumstances.
If the taxpayer expatriates and satisfies one of the objective criteria under §877(a)(2) and does not obtain a favorable ruling or submit a good faith request, then he or she will continue to be subject to U.S. income tax under the expatriation provisions.
B. Tax Consequences. From an estate tax perspective, the value of the expatriate decedent’s gross estate is broadened to include certain categories that otherwise would be excluded, including stock in some foreign corporations.
With respect to gift tax, an individual who expatriates for tax avoidance purposes will be subject to gift tax on all gratuitous transfers of property that occur within ten (10) years of expatriation. The additional blow is that the reduced unified credit ($13,000.00) exemption amount ($60,000) is unavailable to non-resident aliens and expatriates.
C. Immigration Consequences. The Immigration Act provides that any alien who is a former citizen of the United States who officially renounces U.S. citizenship and who is determined by the Attorney General to have renounced for the purpose of avoiding taxation is excludable. This provision applies to those who renounced U.S. citizenship after September 30, 1996, and effectively bars from reentering the U.S. a former U.S. citizen who expatriates where he does not obtain a favorable ruling. There is no companion provision barring from reentry a long-term resident alien who expatriates.
D. Change in Tax Definition of U.S. Citizen. The Treasury Department is considering whether to redefine the term "U.S. citizen" under §7701(a)(30) to minimize the extent to which citizens can minimize U.S. taxes that would arise upon expatriation. Currently, a "U.S. citizen" is determined by the Immigration and Naturalization Act ("INA") which states that the loss of citizenship is effective on the day an expatriating act is committed. Thus, a person can retroactively expatriate because one is presumed to intend to retain citizenship until the intent to expatriate is documented. An expatriate determines the timing of relinquishment and can escape the application of §877(a)(1). For example, a U.S. citizen may perform a voluntary expatriating act and wait for the expiration of the ten-year taxation period under §877(a)(1) and then document the intent to relinquish U.S. citizenship. Gain from the sale of capital assets after the ten-year period has expired will escape U.S. taxation. Under §6511(a), the statute of limitations is only three (3) years, thus, many taxable years following the date of the voluntary expatriating act will be closed by the time an expatriating individual provides documentation of intent to relinquish U.S. citizenship. The amendment under consideration would treat a person as a U.S. citizen for tax purposes until the date on which the person documented the expatriating act and the intent to relinquish U.S. citizenship. The ten-year period under §877(a)(1) would begin on the date of documentation, not on the date of the expatriating act.
IV. OVERVIEW OF PERCEIVED ABUSIVE SITUATIONS
The new tax law changes impose additional tax obligations and reporting requirements on U.S. beneficiaries of foreign trusts; they create significant tension among foreign trustees, U.S. beneficiaries and non-U.S. beneficiaries; they require foreign settlors and foreign trustees to be knowledgeable of U.S. tax rules at the time trusts are created; and they create uncertainty about peripheral issues which result from the changes. The new law addresses residency of trusts, reporting of foreign gifts and the information reporting and penalty provisions for foreign trusts.
All these changes are aimed at the perceived abuse with the use of trusts. The following areas were perceived as abusive:
Loans from foreign trusts were being made to U.S. beneficiaries on less than arm’s length terms;
A proliferation of asset protection trusts has occurred with a corresponding drop in reporting of income;
A lack of any accountability existed concerning gifts made by foreign persons to U.S. citizens and residents;
Penalties under the statute were too mild;
A lack of parity in reporting ownership of controlled foreign corporations and foreign trusts; and
There was no clear definition of what constitutes a foreign trust.
Pre-1976, a U.S. grantor could set up a foreign accumulation trust with U.S. beneficiaries in a tax haven jurisdiction and, provided the trust consisted of only foreign assets, no U.S. tax would result until amounts were distributed to the beneficiaries. The Tax Reform Act of 1976 added I.R.C. §679 which taxes the income accumulated by the foreign trust to the U.S. grantor. In addition, a 6% interest charge was assessed on any tax paid by a U.S. beneficiary who received an accumulation distribution where the foreign trust income was not taxable to the grantor.
After the Tax Reform Act of 1976, foreign trusts were still used for tax reasons, primarily where nonresident aliens set up foreign accumulation trusts with possible U.S. beneficiaries and invested the assets in foreign holdings or U.S. tax-exempt income. Since the trust income was typically taxed to the foreign grantor under the grantor trust rules, no U.S. tax was incurred on distributions from these trusts. The distributions to U.S. beneficiaries were considered gifts by the nonresident alien, so they were nontaxable to the U.S. beneficiary. Further, there was no accumulation distribution interest charge because the trust was a grantor trust under §§671 through 679. The 1996 Act and the TRA 1997 significantly changed the rules for creating and maintaining such trusts.
V. DEFINITION OF "FOREIGN TRUST"/RESIDENCE OF TRUST, §643
INTERMEDIARIES, and §671 "GRANTOR"
A. Definition of "Foreign Trust." The old rule determining the residence of a trust was based on facts and circumstances and, generally, most weight was given to the residence of the trustees and where the trust was being administered. The 1997 law provides a new two-pronged objective test and the Regulations provide a new "safe harbor."
The Proposed Regulation §301.7701 defines domestic trusts and foreign trusts. The default rule under the proposed regulation is all trusts will be considered foreign unless a trust meets the requirements of a domestic trust. A trust will be a domestic trust if it passes the "court test" and the "control test" or passes the "safe harbor" rule.
The "court test" is met if a court (any federal, state or local court) within the U.S. (only the 50 states and District of Columbia) is able to exercise primary supervision over the administration of the trust.
The "control test" is met if one or more U.S. persons have the authority to control all substantial decisions of the trust.
The "safe harbor" rule is met and a trust will be considered a domestic trust if (1) the trust has only U.S. fiduciaries, (2) the trust is administered exclusively in the U.S. pursuant to the terms of the trust instrument, and (3) the trust is not subject to an automatic migration provision. The automatic migration provision provides that if an attempt by any governmental agency or creditor to collect information from or assert a claim against the trust would cause one or more substantial decisions of the trust to no longer be controlled by the U.S. fiduciaries, then the U.S. fiduciaries are not considered to control all substantial decisions of the trust and, therefore, the trust is not a domestic trust. The "safe harbor" rule was developed in recognition of the difficulty in satisfying the "court test" prong of §7701(a)(30)(E)(I).
This definition of "domestic trust" caused many involuntary conversions from domestic to foreign trusts and the attendant §1491 excise tax. As a result, §1161 of the TRA 1997 added a transitional rule to amend the definition of a foreign trust. The rule allowed the IRS, by regulation, to provide that a nongrantor trust that was in existence on August 20, 1996 and was treated as a U.S. person on the prior day may elect to continue to be treated as a domestic trust notwithstanding the §7701(a)(31)(B) amendment.
More recently, in Notice 98-25, the IRS issued guidance on how trusts may retain their domestic status.
A. Intermediaries. The new grantor trust rules under Treas. Reg. §1.643(h)(1) attack transactions by certain foreign trusts through intermediaries. The abuse with the use of intermediaries centered around the technique of nonresident alien family members immigrating to the U.S. who would transfer assets to a friend or relative who would establish a grantor trust. After the nonresident alien immigrated to the U.S, the foreign friend or relative would transfer funds to the U.S. person through the trustee, and often with the approval of a protector. Under the old rules, given the grantor trust status of the trust, the transfer was nontaxable.
Basically, an intermediary will be considered an agent of the foreign trust or an agent of the U.S. person under various analyses including related intermediary, "but for" condition, tax avoidance purpose, and amount not derived from foreign trust. There is a de minimis exception which says the section shall not apply if, during the taxable year of the U.S. person, the aggregate amount that is transferred to such person from all foreign trusts through one or more intermediaries does not exceed $10,000.00.
B. Definition of "Grantor." Treas. Reg. §1.671-2 defines a grantor as " …any person to the extent such person either creates a trust or directly or indirectly makes a gratuitous transfer of property to a trust." These provisions attempt to re-characterize who the grantor is of certain trusts established by foreign persons. A grantor includes a person who acquires an interest in a trust in a non-gratuitous transfer from a person who is a grantor of a trust.
VI. INBOUND GRANTOR TRUST RULES (Foreign Grantor Creates Trust for U.S. Beneficiaries)
Prior to the 1996 Act, the grantor trust rules of §§671 – 679 provided that if a grantor retains certain rights or powers over the trust assets, the grantor will be treated as the owner of the assets regardless of whether the grantor was a U.S. person or a non-U.S. person. Thus, if a foreign person created a foreign trust for the benefit of U.S. beneficiaries and the foreign person was not subject to U.S. tax because he was a nonresident alien, distributions from such trust to U.S. beneficiaries were not subject to U.S. tax. There could be no tax in any jurisdiction if the foreign person created the trust in a tax haven and the assets were not subject to tax in his country of residency. For example, a Hong Kong father could set up a trust in Bermuda and fund it with $10 million. It could distribute $1 million of income to his daughter in the U.S. free of tax.
A. Non-Application of Grantor Trust Rules. Effective August 20, 1996, the new law provides that the grantor trust rules of §§671 – 679 apply only to the extent that they result directly or indirectly in amounts, if any, being currently taken into account in computing the income of the U.S. citizen, resident or domestic corporation subject to a few exceptions. The result is the grantor trust rules do not apply where a foreign person would be considered the owner of the trust. Therefore, many inbound grantor trusts will be treated as foreign nongrantor trusts as opposed to foreign grantor trusts and will be subject to different tax rules. The following are exceptions to the general rule denying grantor trust status and grantor trust status will be allowed:
the foreign trust is revocable by the grantor without the approval or consent of any other person, or with the consent of a related or subordinate party who is subservient to the grantor; or
the trust is established to pay compensation for services rendered (i.e., "Rabbi Trusts"); or
the only amounts distributable during the lifetime of the grantor are amounts distributable to the grantor or the spouse of the grantor, or in discharge of their legal obligations; or
a trust in existence on September 19, 1995 (but not to the portion of the trust attributable to transfers to it after September 19, 1995), which is treated as owned by the grantor or another person under §676 or §677.
Another section applies for purposes of determining whether a foreign corporation is a PFIC under §1296.
A CFC is treated as a domestic corporation, so the grantor trust rules are permitted to apply since the U.S. person will be subject to tax under the CFC rules.
As a result of the new rules, many inbound trusts (i.e., offshore trusts created by foreign persons) that were grantor trusts are now nongrantor trusts. U.S. beneficiaries will be taxable on distributions received from these nongrantor trusts and may be subject to an interest charge on accumulation distributions. But, if a foreign trust accumulates income, does not distribute it, and invests it in assets that generate no U.S. source income, then neither the trust nor its U.S. beneficiaries will pay U.S. income tax. Granted, they get nothing in the meantime. If trust assets are ultimately distributed to nonresident alien beneficiaries, U.S. income tax can be avoided altogether.
A. §672(f) No Foreign Ownership.
1. Treas. Reg. §1.672(f)-1. The Proposed Regulation gives a two-step analysis for implementing the general rule. First, the grantor trust rules, other than §672(f) (the basic grantor trust rules), are applied to determine the worldwide amount and the U.S. amount. Second, the trust is treated as wholly or partially owned by a foreign person based on the annual year-end comparison of the two amounts. If the worldwide amount equals the U.S. amount, the basic grantor trust rules apply without the §672(f) limitation. If the worldwide amount is greater than the U.S. amount, under §672(f), the foreign person shall not be treated as the owner of the portion of the trust attributable to the excess of the worldwide amount over the U.S. amount. Otherwise, the basic grantor trust rules shall apply.
2. Treas. Reg. §1.672(f)-2 addresses trusts created by certain foreign corporations such as controlled foreign corporations (CFCs), passive foreign investment companies (PFICs), and foreign personal holding companies (FPHCs). The examples in the regulations illustrate how frequently foreign corporations that create and fund a trust shall be treated as domestic corporations for purposes of §672. In essence, if the grantor trust rules were applied, the CFC would be treated as the owner of the foreign trust, and all items of income of the foreign trust would be currently taken into account in computing the income of a domestic corporation, if all the income were Subpart F income. Therefore, the CFC is treated as a domestic corporation and the basic grantor trust rules will apply without the limitation of §1.672(f) to treat the CFC as the owner of the foreign trust. Distributions from the foreign trust to the domestic corporation are treated as distributions from the CFC to the domestic corporation.
3. Treas. Reg. §1.672(f)-4 attacks purported gifts from partnerships, foreign corporations and trusts created by partnerships or foreign corporations. In essence, if a U.S. person (U.S. donee) directly or indirectly receives a purported gift or bequest from a partnership, foreign corporation, and the like, the purported gift or bequest must be included in the U.S. donee’s gross income as ordinary income. The recharacterization of purported gifts will not apply if the U.S. partner or shareholder treats the transfer as a distribution to the U.S. partner or shareholder in a subsequent gift to the U.S. donee. The District Director may recharacterize the purported gift transfers to prevent the avoidance of U.S. tax or clearly to reflect income. A de minimis exception applies where the aggregate amount of purported gifts or bequests that is transferred to a U.S. donee directly or indirectly from a partnership or foreign corporation does not exceed $10,000.00.
1. Treas. Reg. §1.672(f)-5 looks at transfers by certain beneficiaries to foreign settlors.
Example: B, a U.S. citizen, makes a gratuitous transfer of $1,000,000.00 to his uncle, C, a nonresident alien. C creates a foreign trust, FT, for the benefit of B and his children. FT is revocable by C without the approval or consent of any other person. C funds FT with the property received from B. B is treated as the owner of the FT.
The IRS has the ability to recharacterize a transfer from a partnership or foreign corporation which the transferee treats as a gift or bequest as an attempt to avoid the rules under §672(f).
If a U.S. beneficiary has, either directly or indirectly, transferred property other than sales for full and adequate consideration to a foreign trust, the beneficiary will be treated as a grantor of that portion of the trust regardless of the fact that the grantor trust rules may no longer apply to the foreign grantor. The rule does not apply if the gift qualifies for the annual exclusion (i.e., the de minimis rule) of $10,000.00, or a sale for full and adequate consideration. Family member attribution rules apply to transfers to the trust.
A. Loans. If a U.S. grantor or beneficiary (or a relative) receives a loan of cash or marketable securities from a foreign trust, the value of such loan will be taxed as a constructive distribution. Certain grandfathering exceptions apply for loans entered into before September 19, 1995.
B. Transition Rules. If a domestic trust becomes a foreign trust before January 1, 1997, or if trust assets are transferred to a foreign trust before that date, certain transition rules apply.
C. Dropoff Trusts. Where a nonresident alien individual transfers property directly or indirectly to a foreign trust and later becomes a U.S. citizen within five (5) years after the transfer, the person is treated as making a transfer to the foreign trust on the individual’s U.S. residency starting date. Therefore, in order to effectively draft pre-immigration or "drop-off" trusts, the nonresident alien must set them up and fund them at least five (5) years prior to moving to the U.S. (See IX below.)
VII. OUTBOUND GRANTOR TRUST RULE CHANGES (U.S. Person Creates Foreign Trust)
A. §679 Changes. The Tax Reform Act of 1976 added Code §679, which provides that most foreign trusts established by U.S. persons are subject to the grantor trust rules so U.S. grantors will be subject to tax on the income.
The new rules change §679(a)(1), which holds that when a U.S. person transfers property to a foreign trust, the U.S. person is considered the owner of the portion of the trust comprising the property for any taxable year in which the trust has a U.S. beneficiary. The old rule provided an exception for sales or exchanges at fair market value where all the gain was recognized at the time of the transfer or under the installment method. The new law provides, in determining if the trust paid fair market value, obligations issued by the trust, any grantor or beneficiary of the trust or any person related to such beneficiary or trust are not taken into account.
B. §679 – Foreign Trusts Having One or More U.S. Beneficiaries.
Transferor treated as owner
a. Under §679, if a U.S. person (U.S. grantor) transfers property to a foreign trust which has a U.S. beneficiary, the grantor will be treated as the foreign trust’s owner and may be taxed on all income of the foreign trust even though he has no rights to the trust income.
b. Exceptions to this rule include transfers at death of the transferor and transfers for fair market value. Section 679(a)(3)(B) provides special treatment of principal payments by a trust on obligations; e.g., related parties that otherwise would not fall within the fair market value exception. To fall under the exception, it must be a "qualified obligation." Notice 97-34 discussed below provides the definition.
c. If a foreign grantor later becomes a U.S. person within five (5) years of the transfer to the foreign trust, such grantor will be treated as a U.S. grantor and as having transferred such property to the foreign trust on his residency starting date.
d. If a U.S. person transfers property to a domestic trust which converts to a foreign trust, then such person will be deemed to have transferred such property to the trust on the date of conversion. This is referred to as the outbound trust migration rule.
1. A trust will be treated as acquiring a U.S. beneficiary or having a U.S. beneficiary unless no income is distributed to or accumulated for the benefit of a U.S. beneficiary. A foreign beneficiary who becomes a U.S. person more than five (5) years after the date of such transfer will not be considered a U.S. beneficiary.
B. Outbound Trust Migration. If a U.S. person transfers property to a domestic trust which becomes a foreign trust while the U.S. person is alive, such person is deemed to have made a transfer of property on the date the trust became a foreign trust equal to the portion of such trust attributable to the property, including undistributed net income previously transferred by the individual. The individual then becomes subject to the §679(a)(1) rule in any taxable year that the foreign trust has U.S. beneficiaries. Two exceptions exist: (1) charitable trusts, and (2) pension trusts. These changes are effective for transfers made after February 6, 1995.
C. Transfers to Foreign Entities
1. Capital Gains Tax Substituted for Excise Tax on Transfers to Foreign Entities.
a. Old §1491 imposed a 35% excise tax upon the appreciation in the fair market value of transfers to certain foreign entities including a foreign estate or trust. Section 1491 was repealed by TRA 1997. Effective August 5, 1997, TRA 1997, under new §684, provides that a transfer of appreciated property by a U.S. person to a foreign estate or trust is treated as a sale or exchange in an amount equal to the fair market value of the property. The gain is to be recognized to the extent of the excess of the fair market value over the adjusted basis of the property in the hands of the transferor. The rule does not apply to a transfer to a grantor trust of which the transferor is treated as the owner, under the grantor trust rules contained in subpart (E) of Part I of Subchapter J.
b. A domestic trust that becomes a foreign trust is treated, for purposes of §684, as having transferred immediately before becoming a foreign trust all of its assets to a foreign trust. This rule applies with respect to transfers after the date of enactment; hence, trusts which may have become foreign trusts as of January 1, 1997 by reason of a change in definition of foreign trusts under §7701(a)(31) would still owe tax under the old §1491 (i.e., the 35% excise tax).
Stated another way, TRA 1997 repeals §§ 1491 to 1494. In place of the excise tax that applied to transfers or property to foreign trusts or estates, the Act adds a provision which, except as provided in regulations, generally treats a transfer of appreciated property by a U.S. person to a foreign trust or estate as a sale of such property for fair market value. Such a transferor must recognize as gain the excess of the fair market value of the property transferred over its adjusted basis. For purposes of this general rule, if a trust which is not a foreign trust becomes a foreign trust (i.e., a domestic trust to foreign trust conversion), such trust is treated as having transferred immediately before becoming a foreign trust all of its assets to a foreign trust. The general rule does not apply to a transfer to the extent any person is treated as the owner of the foreign trust under §671 (i.e., the grantor trust rules).
In place of the excise tax that applied to transfers to foreign corporations, TRA 1997 adds a provision which states that, to the extent provided in regulations, if a U.S. person transfers property to a foreign corporation as paid-in surplus or as a contribution to capital in a transaction not otherwise described in §367 (such as a capital contribution by a non-shareholder), the transfer is treated as a sale of such property for fair market value. Such a transferor must recognize as gain the excess of fair market value of the property transferred over its adjusted basis.
In place of the excise tax that applied to transfers to foreign partnerships, the Act adds a provision which grants regulatory authority to the IRS to provide for gain recognition on a transfer of appreciated property to a partnership in cases where such gain otherwise would be transferred to a foreign partner.
Information Reporting. TRA 1997 adds a provision which requires foreign partnerships to file a partnership return for a tax year if the partnership has U.S. source income or is engaged in a U.S. trade or business, except to the extent provided in regulations.
The Act also adds reporting rules for controlled foreign partnerships which are similar to the reporting rules for a controlled foreign corporation.
Foreign or Domestic Partnership Determination. TRA 1997 gives the IRS regulatory authority to provide rules for determining the foreign or domestic status of partnerships.
Transition Rule for Certain Trusts. TRA 1997 grants the IRS regulatory authority to allow non-grantor trusts that had been treated as U.S. trusts prior to the enactment of the 1996 Act to elect to continue to be treated as U.S. trusts notwithstanding the new criteria for qualification as a U.S. trust contained in the 1996 Act.
Asset Protection Trusts. Under the old rules, the typical foreign situs asset protection trust ("APT") was a "foreign trust" for U.S. tax purposes. Under §679, its income was taxed to the grantor and was subject to foreign trust reporting rules. APTs were considered domestic under the old rules with one U.S. trustee and one foreign trustee with the foreign law governing the trust. They were tax neutral because the income was includable on the grantor’s Form 1040 and the assets were includable in the grantor’s estate. However, under the new trust residency rules, APTs will be considered foreign and subject to the interim §1491 35% excise tax or the new §684 rules (i.e., the grantor will be deemed to have transferred the assets to the foreign trust based on the fair market value less the adjusted basis). Such a trust will also fall under the new reporting rules. (See IX information reporting below.)
VIII. FOREIGN NON-GRANTOR TRUST CHANGES
A. Accumulation Distribution. Under the pre-1996 rules, foreign trusts could accumulate distributions which, when distributed, would be taxed at the U.S. beneficiary’s average marginal rate over the last (5) five years, plus a fixed simple interest charge of 6%.
The new law continues the 6% simple interest charge on accumulation distributions only through 1995. Starting January 1, 1996, the interest rate on accumulation distributions from non-grantor foreign trusts floats with the interest rate applicable to underpayment of tax under §6621(a)(2) – currently, 9%.
A. Trust Loans. Pre-1996 law permitted a foreign non-grantor trust to make a loan to one of its beneficiaries. The loan was respected and no taxable income resulted.
The new law provides that the full amount of loans of cash or marketable securities directly or indirectly to any U.S. grantor or beneficiary of such trust, or any U.S. person who is related to such grantor or beneficiary is now deemed a distribution to the U.S. grantor or the U.S. beneficiary, except as provided in the regulations. The family attribution rules have been greatly expanded. The regulations provide that arm’s length terms with repayment will not be considered a distribution. The effective date for the interest rate change is August 20, 1996. The change to the loans is effective September 19, 1995.
A. Pre-Immigration or "Drop Off" Trusts. Under the old rules, nonresident alien individuals immigrating to the U.S. could drop off or deposit a substantial amount of their wealth in a tax haven jurisdiction en route from their former country to the U.S. Under the new law, such individuals must now wait five (5) years before entering the U.S. if they want such assets excluded from U.S. taxation. Under §679(a), a nonresident alien who directly or indirectly transfers property to a foreign trust and becomes a U.S. resident within five (5) years after the transfer is treated as making a transfer to the foreign trust on the individual’s U.S. residency starting date defined in §7701(6)(2)(A). The amount of the deemed transfer is the portion of the trust (including undistributed earnings) attributable to the amount previously transferred. Thus, the individual is deemed to be the owner of that portion of the trust in any taxable year in which the trust has U.S. beneficiaries. A beneficiary is not treated as a U.S. person under these rules if such beneficiary first became a U.S. person more than five (5) years after the transfer.
IX. U.S. PERSONS SUBJECT TO REPORTING REQUIREMENTS FOR FOREIGN GIFTS
A. Individual Gifts. TRA 1997 requires that where a U.S. person receives, in the aggregate, more than $100,000.00 in one taxable year, such person shall report the individual gifts (in excess of $5,000.00) without having to identify the individual donors. This applies to gifts from nonresident aliens and foreign estates. It does not include qualified tuition or medical payments under §2503(e)(2) or foreign trust distributions to a U.S. beneficiary that are properly disclosed on a return. Failure to so report subjects the U.S. person to a penalty of 5% of the amount of the foreign gift for each month such failure continues limited to a total penalty of 25% of the gift. The penalty will not apply if failure to file was due to reasonable cause and not willful neglect. The gifts should be reported on Form 3520 ("Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts"). Notice 97-34 describes the application of §6039F. The purpose of the annual reporting is to determine whether a purported gift is properly classified as a gift or income. Reporting is required for gifts actually or constructively received and only if the U.S. person knows or has reason to know the donor is a foreign person. The $100,000.00 shall be adjusted for cost of living. The provisions are effective for tax years ending after August 20, 1996.
B. Corporate/Partnership Gifts. The reporting threshold on gifts from foreign corporations and foreign partnerships is $10,000.00. The identity of such donors must be reported.
X. INFORMATION REPORTING AND PENALTY PROVISIONS
A. Overview. The old law required U.S. persons who created a foreign trust or transferred money or property to a foreign trust to report such event to the IRS within 90 days after the creation or transfer. [Old §6048.] The new law greatly expands the reporting requirements as well as the penalties for noncompliance. Under prior law, the U.S. person who established or transferred property to the foreign trust had to complete Form 3520 – Annual Return of Foreign Trust with U.S. Beneficiaries, by the 15th day of the fourth month (exclusive of extensions) following the end of the taxable year. Failure to so report was subject to a penalty of 5% of the amount transferred to the trust not to exceed $1,000.00. Failure to file was also subject to a 5% penalty based on the corpus in the trust at year end. These penalties were subject to a reasonable cause exception.
The new law requires the reporting by the responsible party (either the grantor/transferor or the executor) to report the occurrence of certain events on or before the 90th day after the event occurs. The 1996 Act imposes a reporting obligation on U.S. beneficiaries who receive distributions from foreign trusts. No prior requirement existed. The civil penalties imposed for failure to comply with the new reporting requirements were significantly increased by the 1996 Act. February 6, 1995 is the effective date for the 1996 Act’s substantive changes to outbound trusts. August 20, 1996 is the effective date applicable to inbound trusts as well as the reporting rules.
The IRS has issued several administrative Notices dealing with the reporting requirements in addition to proposed regulations.
B. Trust Residence. The 1996 Act’s foreign trust definition caused certain trusts that had been treated as domestic trusts to become foreign trusts solely by application of the new law. This exposed them to the 35% excise tax under old §1491 or the new §684 tax on the gain in the transferred assets. In Notice 96-65, the IRS provided that a domestic trust in existence on August 20, 1996 should continue to file U.S. tax returns as a domestic trust if it meet three (3) requirements. Unfortunately, the relief provided by the Notice failed in many instances. Therefore, TRA 1997 authorized the IRS to issue regulations that would permit a trust that was a domestic trust on August 20, 1996 to elect to continue to be treated as a domestic trust. However, the election will not be available to trusts treated as owned by persons under the "grantor trust" provisions. Further, the election will not be available for a trust that elects to apply the 1996 Act’s trust definition retroactively. The IRS has announced that domestic trusts will not be treated as foreign trusts pursuant to the new definition until further guidance is issued. The additional guidance was issued in Notice 98-25.
Who is eligible to make the election under Notice 98-25 to be treated as a domestic trust? Any trust that was in existence on August 20, 1996 and was treated as a domestic trust on August 19, 1996 (i.e., trusts that otherwise will be involuntarily converted to foreign trusts).
Who is ineligible to make the election? Any trust that was wholly a grantor trust on August 20, 1998, or a trust that elected under §1907(a)(3)(B) of the 1996 Act to apply the new trust criteria to its first taxable year ending after August 20, 1996.
How do you determine if a trust was domestic on August 29, 1996? If the trustee filed Form 1041 for the period that included August 19, 1996 and had a reasonable basis for reporting as a domestic trust. If Form 1040NR was filed, there is a procedure to overcome this.
When do you make the election? With the trust’s 1997 or 1998 income tax return. An election notice must be attached to the return and include: (1) a statement of election; (2) a statement that the trustee had a reasonable belief that the trust was a domestic trust on August 19, 1996; (3) a statement that the trust filed Form 1041 for the period including August 19, 1996 or an explanation why the trust was not required to file one; and (4) the name, address and employer identification number of the trust.
The Notice is effective for taxable years beginning 1996 and can be relied on until regulations are issued. It is anticipated the election can be revoked. For those trusts that cannot satisfy the election requirements under Notice 98-25 (e.g., if they are wholly grantor trusts), then they may retain domestic status if they meet the requirements of Notice 96-65, which permits a two (2) year grace period. For most, however, Notice 98-25 replaces Notice 96-65.
To recap, the 1996 Act caused many domestic trusts to be converted to foreign trusts, subjecting them to the §1491 35% excise tax. Relief from this came in the form of elections to continue being treated as domestic trusts in the form of guidance under various Notices. Further, the §1491 tax was repealed and replaced with a new tax on gains under §684. Consequently, if a trust fails to meet the new definition of a domestic trust under the 1996 Act, it will automatically convert to a foreign trust and, upon such conversion, it will be deemed to have transferred all of its assets to a foreign trust and will be subject to the §684 tax on the gain on the assets transferred.
A. Reporting by U.S. Transferors to Foreign Trusts. A U.S. person who transfers property to a foreign trust must notify the IRS within 90 days of the event of the nature of the property transferred and the identity of the trustees and beneficiaries. Notice 97-34 has softened the requirements by requiring that notice be given on Form 3520 filed with the transferor’s annual tax return as opposed to within 90 days. A decedent’s executor also must furnish notice for testatmentary transfers of property, as well as the death of a U.S. person who was considered to own any portion of a foreign trust or in whose estate are included a foreign trust’s assets.
"Reportable events" occurring after August 20, 1996 include the following:
The IRS has created a distinction between gratuitous and non-gratuitous transfers. Gratuitous transfers of property to foreign trusts are reportable under §6048A. They are reported on Form 3520. The default rule is all transfers are gratuitous unless they are transfers for fair market value or corporate or partnership distributions. A sale of property by a U.S. person to a foreign trust must be reported as a transfer to a foreign trust unless the trust pays fair market value for the property.
Notice 97-34 provides that a credit sale will not be treated as a fair market value sale unless the obligation issued by the trust is a "qualified obligation"; i.e., it must be:
Notice 97-34 also requires non-gratuitous transfers to a foreign trust (i.e., fair market value transfers or corporate or partnership distributions) be reportable under former §1494 if the U.S. transferor does not immediately recognize all of the gain on the transfer (or recognizes gains solely by reason of an election under §1057); or the U.S. transferor is related to the trust. A non-gratuitous transfer must be reported on Form 3520. Failure to file a Notice to Transfer under §6048A incurs a penalty equal to 35% of the gross value of the property transferred to a trust by the person responsible for filing Form 3520 with the IRS. Failure to comply with the reporting requirements within 90 days after mailing of an IRS notice of failure to comply will generate an additional penalty of $10,000.00 per 30-day period or fraction thereof. A cap on the total penalty for failure to report a trust transfer is the amount of property transferred.
[Note: TRA 1997 repealed §§1491 –1494 for transfers occurring on or after August 5, 1997. The rules in Notice 97-34 governing §1494 reporting apply only to non-gratuitous transfers made prior to August 5, 1997. The TRA 1997 replaced §1491, which imposed a 35% excise tax on transfers of appreciated property to a foreign trust, with §684, which treats a transfer of appreciated property to a non-grantor foreign trust as a sale or exchange. The IRS has not issued guidance clarifying the application of the gratuitous/non-gratuitous dichotomy of Notice 97-34 following enactment of §684.]
A. Reporting by U.S. Owners of Foreign Trusts.
Annual Reporting – a U.S. grantor of a foreign trust is responsible for ensuring that the trustee: (1) files a return with the IRS for each taxable year of the trust setting forth a full and complete accounting of all trust activities and operations; and (2) furnishes specified income (i.e., Schedules K-1) and other information to each U.S. grantor and trust beneficiary who directly or indirectly receives a trust distribution for that year. This is effective for taxable years of U.S. persons beginning after December 31, 1995.
A foreign trust must file a Form 3520A revised in accordance with Notice 97-34 to satisfy the §6048(b) filing requirement and prevent penalties from being imposed upon the U.S. grantor. The trustee must attach a Foreign Grantor Trust Information Statement which requires a substantial amount of information to be furnished to the IRS. Failure to provide the required information triggers a penalty equal to 5% of the gross value of the trust’s year end assets deemed owned by the U.S. grantor, plus a $10,000.00 per 30-day period penalty for failing to report within 90 days after mailing of an IRS notice of failure to comply. The cap is the gross value of the trust’s assets considered owned by the U.S. grantor. Criminal penalties may also apply. Certain transition rules apply for taxable years that include August 20, 1996.
Designation of U.S. Agent for Service of Process – Effective for taxable years of U.S. persons beginning after December 31, 1995, the IRS can determine the amount of income taxable to the U.S. grantor from information it may obtain through testimony or otherwise unless the trustee of a foreign trust with a U.S. owner designates a U.S. agent for service of process upon the trustee. A trustee who appoints a U.S. agent should use the agreement contained in Notice 97-34. Both the trustee and the agent must execute the agreement prior to the due date of the U.S. owner’s Form 3520 for the taxable year, and the agreement must remain in effect during the period the statute of limitations remains open for the U.S. owner’s relevant tax year. The agency agreement is not filed with the IRS.
A. Reporting by U.S. Beneficiaries of Foreign Trust Distributions.
A U.S. beneficiary of a foreign trust must report all direct and indirect foreign trust distributions received after August 20, 1996 regardless of their taxability. Failure of a U.S. beneficiary to report a trust distribution on Form 3520 is subject to a penalty equal to 35% of the gross trust distributions received. Failure to comply with the reporting requirements within 90 days after mailing of an IRS notice of failure to comply triggers an additional penalty of $10,000.00 per 30-day period or fraction thereof. The cap on the beneficiary’s failure to file Form 3520 and report a foreign trust distribution cannot exceed the total trust distributions received by the beneficiary. Criminal penalties may also apply.
A beneficiary is required to report a distribution as a foreign trust distribution on Form 3520 only if the beneficiary knows or has reason to know that the trust is a foreign trust. Distributions are reportable if actually or constructively received. Certain exceptions apply such as, for trust distributions, tax as compensation to the recipient, and foreign trust distributions received by domestic tax-exempt organizations.
Beneficiary Statements – A beneficiary must provide adequate records to the IRS so it can determine the proper treatment of any distributions. If the IRS, upon examination, treats an entire distribution as an accumulation distribution, then §668 imposes an interest charge on accumulation distributions from a foreign trust at the rate applied to underpayments of tax, compounded daily – currently 9%. A trust distribution need not be reported as an accumulation distribution if the beneficiary is furnished with either a "Foreign Grantor Trust Beneficiary Statement" or a "Foreign Non-Grantor Trust Beneficiary Statement."
Loans to U.S. Grantors and Beneficiaries – A trust loan will be taxable to the extent of current or accumulated trust income for such loans made after September 19, 1995 to any U.S. grantor, U.S. beneficiary or any U.S. person related to a grantor or beneficiary. The §6677 penalty for failure to report a trust distribution will apply only for a failure to report post-August 20, 1996 loans. Loans in consideration for a "qualified obligation" will not be treated as trust distributions.
Reasonable Cause – No penalties will be imposed if the taxpayer demonstrates the failure to file was due to reasonable cause and not willful neglect. The fact that a foreign country would impose penalties for disclosing the required information is not reasonable cause. Reluctance on the part of a foreign fiduciary or provisions in a trust instrument that prevent the disclosure of the required information is not reasonable cause.
XI. MISCELLANEOUS PROVISIONS
A. Increased Dollar Limitation on §911 Exclusion. The TRA 1997 increased the limitation on the exclusion for foreign earned income from $70,000.00 to $80,000.00 in $2,000.00 increments each year beginning in 1998, and provides that the limitation is indexed for inflation beginning in 2008.
B. Excludable Debt Obligations for NRA is Expanded. The U.S. estate tax is imposed on U.S. assets of a nonresident alien individual, but §2105B creates an exception for that portion of the estate of a nonresident alien individual consisting of certain bank deposits and debt instruments, the income from which qualifies for the bank deposit interest exemption and the portfolio interest exemption as property from without the U.S. The TRA 1997 attempts to coordinate the income and estate tax treatment of short-term OID income debt instruments held by a nonresident alien individual by exempting such instruments from estate taxes. This exclusion applies with respect to estates of decedents dying after the date of enactment.
C. Generation-Skipping Transfer (GST) Tax. The IRS has issued final regulations effective December 27, 1995 regarding the application of the GST tax to transfers by nonresident aliens. It is now settled that only transfers of U.S. situs property on which a U.S. gift or estate tax would be imposed will trigger the application of the GST tax.
D. Throwback Rules. Section 507(a) of the TRA 1997 repealed the throwback rules for most domestic trusts, but retained them for foreign trusts and any domestic trust that was a foreign trust at any time. This is effective for distributions in taxable years beginning after August 5, 1997.
The reporting changes and substantive law changes aimed at perceived abuses by both U.S. and foreign persons with the use of foreign trusts are extremely complex. With respect to outbound trusts, U.S. grantors and transferors bear the burden of reporting the details of foreign trusts they have caused to be established or face severe penalties. With respect to inbound trusts, U.S. beneficiaries who receive distributions will have even less access to trust information and, therefore, are at greater risk of being exposed to penalties. Consequently, all practitioners should review existing trusts to ensure their clients are in compliance. The use of foreign trusts in light of the new tax rules has become less desirable except for the following situations: testamentary foreign trusts, foreign grantor trusts with foreign grantors, foreign asset protection trusts, and foreign trusts aimed at foreign investments.