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US tax issues hidden in foreign trust inventories
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US tax issues hidden in foreign trust inventories

Imminent onset of FATCA gives rise to complex tax issues in trust structures

The Bahamas Investor Magazine
January 21, 2014
January 21, 2014
Kathryn von Matthiessen

There is a lot of movement in the foreign trust industry. Many foreign trust companies are acquiring new business by purchasing smaller trust companies. Some foreign trust companies are buying inventories in jurisdictions which other trust companies are exiting. In addition, as many foreign trust companies try to shed trusts with US connections given the imminent onset of the Foreign Account Tax Compliance Act (FATCA), more US friendly foreign trust companies with an eye to developing a niche in this area are buying these very same inventories.

Purchasers of foreign trust inventories should be warned that many complicated tax issues may be lurking in the history of these trust structures, with US beneficiaries, some not too far below the surface.

Such issues include identification of the real “grantor;” accurate classification of the grantor trust status of each trust and status as a foreign or domestic trust for US tax purposes; correct and timely identification of US beneficiaries; and proper US tax planning for foreign trusts with US beneficiaries in the trust documents.

Other issues include identification of US anti-deferral regimes for foreign corporations in which US beneficiaries may have an indirect interest through a foreign trust, and exit strategies from ownership of these foreign corporations.

Definitions under US tax law. To fully grasp these issues and the complexity of the analysis required, it is helpful to review some simple definitions under US tax law.

Foreign grantor trust
If a foreign trust company is the trustee of a trust, the trust will most likely be classified as a “foreign trust” for US tax purposes. Confirmation of this fact, however, must be made on a trust by trust basis.

A foreign trust is a grantor trust (which means income is taxable to the grantor) only if (1) the grantor retains the right, exercisable either alone or with the consent of another person who is a related or subordinate party who is subservient to the grantor, to revoke the trust; or (2) the only amounts which may be distributed from the trust during the grantor’s life are amounts distributable to the grantor or his/her spouse. Another way of thinking about foreign grantor trust status is that the foreign grantor is deemed to “own” the assets of the trust for US income tax purposes.

The rules for a trust with a foreign grantor to qualify as a “grantor” trust are much narrower than the rules for a trust with a US grantor to qualify as a “grantor” trust for US tax policy reasons.

A foreign grantor will not be within the US tax system with respect to the trust’s income unless the trust is, for example, engaged in a US trade or business or has US source income. If the grantor is treated as the owner of the assets of a foreign trust for US income tax purposes, no distribution from such trust made to the US beneficiary would be taxable income to the US beneficiary. The US beneficiaries of a foreign trust which qualifies for foreign grantor trust status benefit from the ability to receive distributions from the trust which are not subject to US income tax during the life of the foreign grantor, and the foreign grantor may be outside of the US tax system as well. In addition, US beneficiaries of a foreign grantor trust are not subject to the “throwback” rules upon receiving a distribution during the life of the foreign grantor.

Foreign nongrantor trust and throwback rules
A foreign nongrantor trust is a foreign trust which is not a foreign grantor trust. The “throwback rules” are essentially an anti-deferral regime for US beneficiaries of foreign trusts which are NOT foreign grantor trusts so that US beneficiaries may not benefit from the deferral of tax that has occurred in the trust offshore when the beneficiary receives a distribution.

If a US beneficiary receives a distribution from a foreign nongrantor trust that is comprised of income or gain earned and accumulated by the trust in a prior year, the US beneficiary may be subject to both an interest charge and the back tax of the “throwback rules.”

Tax issues
These concepts are important to understand a number of “tax traps” that can create problems for trustees and US beneficiaries of a foreign trust unless a qualified US tax attorney has provided thorough and accurate advice concerning the foreign trust.

1. Identifying the “real” grantor

A person is the “grantor” of a trust to the extent that he either created the trust or made a gratuitous transfer to the trust. In order to achieve favourable grantor trust status, only the person who actually contributed the assets to the trust may be treated as the “owner” of the assets for US income tax purposes.

Members of foreign families commonly hold assets for each other, so it is important to understand the true source of funds and whether there were any nominee agreements in place. If the person who has the power to revoke the trust or is (or whose spouse is) the beneficiary of the trust is not the “real” contributor of the assets, the trust will not qualify for foreign grantor trust status. Similarly, if a married person who contributed assets to the trust was from a jurisdiction with a community property regime, then his spouse may be a partial grantor. Without proper drafting of the trust instrument, full grantor trust status could be lost.

If a foreign corporation was the grantor and the trust was funded for a business reason of the corporation, the corporation will be respected as the grantor. If the trust was funded for personal reasons of one or more shareholders, the shareholder who had a personal reason for the funding of the trust will be treated as the real grantor. If a foreign trust is not categorized correctly as a foreign grantor or nongrantor trust, a US beneficiary cannot report distributions properly for US tax purposes, and the foreign trustee cannot meet its obligation to provide the correct information to the US beneficiary.

2. An unanticipated US beneficiary

For US income tax purposes, a US “resident” is any person who (1) is a “green card holder,” (2) is physically present in the United States for at least 183 days in the current year or (3) meets a test of a rolling, weighted three-year average of at least 183 days in the US (known as the “substantial presence test.”)

There are exceptions to the substantial presence test if an individual was present in the US for less than half of a year and if she can establish a closer connection to a foreign country. Other exceptions apply to certain categories of individuals such as students.

The student exception, however, which often stems from an F-1 visa, only lasts for five years unless the student can demonstrate a continuing closer connection to a foreign country after the five-year period. Trust beneficiaries may unexpectedly become US taxpayers even though they are in the US on a student visa. Alternatively, beneficiaries who are splitting their time with other countries may well be US taxpayers if they are spending more than half the year in the US and cannot claim a closer connection to a foreign country (in the absence of treaty relief). Beneficiaries who do qualify for the closer connection may also forget to file the required statement with the IRS so they are not treated as US taxpayers.

If a beneficiary discovers that he is a US taxpayer, the beneficiary and the trustee will have to coordinate to make sure that the beneficiary fulfills his US tax compliance obligations. As of next year, the trustee will also have to make sure that it is fulfilling its obligations under FATCA.

3. Foreign corporations with passive assets

There are two different anti-deferral income tax regimes in the US which effectively operate to deny certain US shareholders the benefits of owning an interest in a foreign corporation. First, a foreign corporation is a controlled foreign corporation (CFC) if more than 50 per cent of the foreign corporation “is owned by vote or value by “US shareholders,” who hold at least 10 per cent of voting power over the corporation’s stock. If the foreign corporation is a CFC, there will be a deemed “flowthrough” of passive income to the US shareholders even if they do not receive dividends from the foreign corporation.

Even if the foreign corporation is not a CFC, it may be a passive foreign investment company (PFIC). A foreign corporation is a PFIC if 75 per cent or more of its income is from passive sources or 50 per cent or more of its assets are held for the production of passive income. The PFIC regime applies regardless of the percentage ownership of the US shareholder, and there is a back tax and an interest charge on dispositions of the stock or certain “excess distributions,” similar to the throwback rules.

If a CFC or a PFIC is owned by a foreign nongrantor trust, US tax laws may attribute ownership of shares of the foreign corporation to a US beneficiary. The result may be that the US beneficiary is subject to US tax based upon activity occurring at the level of the foreign corporation or the trust, even if she did not receive a distribution from the trust.

Identification of these issues is key. If there is a foreign grantor trust there will be deferral of any CFC or PFIC issues during the grantor’s lifetime, but there should be an exit strategy in place so that there are no surprises upon the death of the foreign grantor.

4. Failure to plan for the death of the foreign grantor

Ideally, a foreign grantor trust will be drafted to provide for a step-up in basis for the assets of the trust to fair market value upon the death of the foreign grantor. There are specific provisions in the US Internal Revenue Code that permit a step-up in basis of foreign situs assets held in a foreign trust. The foreign grantor must have the power to direct trust income. This power should be coupled with either a power to revoke the trust or the power to alter, amend or terminate the trust. Matching the power to revoke the trust with foreign grantor trust status is relatively simple since a power to revoke is one of the tests for foreign grantor trust status. Matching a power to alter, amend or terminate with a trust where only the grantor or the grantor’s spouse may be a beneficiary is much more difficult. These provisions are often overlooked in foreign grantor trusts.

5. Failure to plan for the incapacity of the foreign grantor

Foreign grantor trust status is extremely valuable for any foreign trust with US beneficiaries. Another point often missed in the drafting of the trust instrument is to allow foreign grantor trust status to continue upon the incapacity of the grantor. There are different mechanisms for achieving the continuation of the foreign grantor trust status depending on whether the trust is revocable or not, but it is an important point that should be addressed in the trust document.

It is critical for a foreign trust company to address all of these issues when acquiring a new inventory of trusts by having an experienced US tax attorney review each trust in the inventory. In this review, the attorney should determine on a case-by-case basis the status for US tax purposes of each trust, as well as highlighting any potential problems, pitfalls or ambiguities for US tax purposes that should be addressed and resolved.

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