When a US taxpayer becomes a beneficiary of a foreign (non-US) trust, the type of trust accounting required for US tax reporting purposes is quite different than otherwise necessary. Many trustees find it difficult to comply with the elaborate type financial reporting needed.
Your financial institution’s accounting department has spent hours producing financial statements for your client’s foreign (non-US) trust and the foreign company that it owns and now the settlor or the beneficiary’s US accountant is on the phone telling you that he can’t use what you’ve produced and the whole thing needs to be done over. Why does this happen and, does it have to happen?
US income tax and financial reporting rules are very complex but, more importantly, the rules are very different from the reporting rules for fiduciaries and companies under most foreign country laws. This article will highlight some of the important differences and will provide some suggestions for mitigating these problems in the future.
Before anything else, the proper characterisation of the structure under US income tax principles must be determined. A trust may be considered a grantor trust or a non-grantor trust1. A grantor trust is not considered a separate taxpayer for US purposes. Rather, the settlor (or owner) is subject to tax on the income derived from assets held in the trust as though he or she continued to own them.
A foreign non-grantor trust is treated like a separate person for US income tax purposes and is subject income to tax in the same manner as a non-resident alien individual.
Foreign grantor trust with a US grantor
Where the owner of the grantor trust is a US taxpayer and the trust owns a company that holds a financial investment portfolio or other investment assets, at the time of formation, a “check the box election” may have been made for US income tax purposes for the foreign company to be treated as a “disregarded entity2.”
The effect of this election would be to treat the foreign company as not being an entity separate from its owner. Any transactions between the trust and the company, therefore, are to be ignored for US income tax purposes and the income derived by the company is taxed as if earned directly by the grantor.
In this type of structure, it is important for proper US reporting that the financial institution where the investment portfolio is held treat the account as a “W-9” account (an account owned by a US taxpayer).
If the account is properly established as a W-9 account, many of the information reporting challenges may be avoided and much of the information needed by the US taxpayer may be derived from the Internal Revenue Service Form 1099 provided by the financial institution3.
If no check the box election was made, the foreign company will likely be considered a controlled foreign corporation (CFC)4 or a passive foreign investment corporation (PFIC)5. A US shareholder of a CFC is taxed annually on his or her pro rata share of the CFC’s “subpart F income” regardless of whether such income is actually distributed. Subpart F income includes most types of passive income such as dividends, interest, rents, royalties and capital gains.
None of the reduced tax rates discussed further below apply to subpart F income earned by a CFC. Further, if the foreign company receives income from the United States, a withholding tax may apply.
A foreign grantor trust with a US owner is required to file Form 3520-A, Annual Information Return of Foreign Trust with a US Owner. Form 3520-A provides certain information about the trust, the trustee and the US owner and it includes an income statement and a balance sheet.
The form also provides two information statements. One is the Foreign Grantor Trust Owner Statement, which provides the US owner (who is subject to tax on the income of the trust) with the information to be included in the US owner’s income tax return.
The other is the Foreign Grantor Trust Beneficiary Statement, which provides information for a US beneficiary (other than the owner) that received a distribution from the trust during the year.
The owner is also required to file Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, to report (1) his ownership interest in the foreign trust, (2) any contributions made to the foreign trust during the year and (3) and any distributions received from the foreign trust during the year.
Although not subject to tax on the amount of the distribution, a beneficiary, other than the owner, is required to file Form 3520 to report any distributions received from the trust. The fair market value of the use of property owned by the foreign trust (ie, a home or a boat) is considered a distribution from the trust unless the US beneficiary paid fair market rent for the use of the property.
If the US taxpayer owns a foreign bank or securities account (including an account owned by the foreign grantor trust) and the aggregate value of all such accounts owned by the taxpayer exceeded $10,000 at any time during the year, the US taxpayer is required to file Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (known as the FBAR).
This information return requires disclosure of the name and address of the foreign financial institution where the account is held, the account number, and the highest balance in the account at any time during the year. The highest balance is determined based on the highest balance that appears on statements issued by the financial institution.
In order to determine the highest balance in the account during the year, the US taxpayers tax preparer is likely to request copies of all of the monthly or quarterly statements for the investment account as well as for any cash account maintained in the name of the trust at a bank or in an escrow account.
Beginning with the 2011 tax year, US taxpayers may also be required to file Form 8938, Statement of Specified Foreign Financial Assets. The rules regarding the information required to be disclosed on this form are still being developed, but it will likely include similar information to what is currently required on other information forms.
Rules are being drafted to avoid duplicative reporting. Unlike some other information returns, however, Form 8938 will be attached directly to the US taxpayer’s US income tax return.
The fiscal period used for the preparation of the financial statements directly impacts on the preparation of US tax returns. US individual taxpayers prepare their US income taxes based on the calendar year.
When a grantor trust with a US owner is involved, financial information for the trust and for the company need to be prepared on a calendar year basis. Financial reporting on a fiscal year basis ending on any date other than December 31 has to be adjusted to put on a calendar year.
Cash basis versus fair value accounting
US individual taxpayers use a “cash basis” of accounting. In other words, they are subject to tax on items of income when those items are actually received or deemed to have been received. If the financial statements are kept on a fair market value basis, an adjustment is made on the income statement to account for unrealised items at year-end, such as accrued interest, gain or loss on the investment portfolio or for foreign currency fluctuations.
These items are not included in income currently for US income tax purposes and an adjustment would be required to remove them from income.
In contrast, the balance sheet for the trust must be determined on a fair market value basis. A fair market value balance sheet takes into account all of the unrealized items discussed above for which an income tax adjustment would be required.
The unrealised items of gain and loss for which income statement adjustments are required need to be separately stated on the balance sheet so that the US tax preparer can easily determine the amount of the annual adjustment and can reconcile the accumulated trust income account from year to year.
Income items requiring special treatment
Under US tax principles, many income items require special treatment and the trust is required to provide the US taxpayer with the information that the US person needs to complete their US income tax return accurately.
This places a significant burden on the trustee/management company either to properly understand US income tax rules or retain US tax counsel to assist them. There are certain income items that require special treatment that arise very frequently. These include dividends, capital gains, interest, and transactions in foreign currency.
Dividends may be taxed in the US under current law as ordinary income taxed at ordinary tax rates or as qualified dividends taxed at a special 15 per cent tax rate. A qualified dividend is a dividend on shares, subject to meeting a short holding period, that are received from a US company or a company organised in a country that has an income tax treaty with the United States6.
A qualified dividend does not include a dividend from a PFIC. A dividend from a United States mutual fund, unit trust or real estate investment trust (REIT) may also qualify as a qualified dividend, but usually not in its entirety.
The mutual fund will have to provide information on the portion of its dividends that are qualified dividends7. A foreign mutual fund is likely to be considered as a PFIC and, therefore, its dividends are not qualified dividends even if its underlying investments consist entirely of United States domestic stocks.
If a withholding tax was imposed on the dividend by the United States or by a foreign country, the amount of dividend income reported on the income statement should be the gross amount of the dividend with the amount of the withholding tax shown separately as an expense. US taxpayers may not report dividend income on a net basis.
Like dividends, capital gains may be taxed at ordinary rates or at a special 15 per cent tax rate depending on whether the gain is “long-term” or “short-term.” A long-term capital gain is a gain from the sale of an asset that was held for more than one year.
In order to determine whether a capital gain or loss is long-term or short-term, the tax preparer will need to be provided with the original purchase date, the original cost, the date of sale and the amount of the proceeds.
Commissions and fees paid with respect to the purchase or sale of securities are generally included in the cost of the security purchased or they reduce the sales proceeds of a security sold.
Capital losses in excess of capital gains may be deducted only up to $3,000 per year. Any capital loss in excess of $3,000 may be carried over to offset capital gains in a future year. Special treatment may be required if the assets sold is stock in a PFIC or in a CFC.
Interest income is taxed at ordinary tax rates unless the interest income is tax-free municipal interest. Accrued interest on bonds that is included in the fair market value of the portfolio at year-end is not included in the US taxpayer’s income until the interest is actually (or constructively) received.
When bonds are purchased between interest payment dates, special treatment is required. For bond purchases, interest accrued at the date of purchase that is included in the purchase price does not affect the cost basis of the bond for purposes of determining the gain or loss on sale or maturity.
Rather, such interest should be reflected as an offset against the interest income received from that bond at the next interest payment date.
The purchase price should not be accounted for on a combined basis, inclusive of the accrued interest. Similarly, where a bond is sold between interest payment dates, the amount of interest accrued through the date of the sale should be accounted for as interest income and not included in the proceeds from the sale of the bond.
Alternative investments such as currency futures and forward contracts as well as transactions in commodities, including commodity-based exchange traded funds (ETFs) and unit trusts, also require special treatment. Gain from currency futures and forwards are treated as long-term in part and short-term in part.
Long-term gain from the sale of commodities or other collectibles is taxed as a special 28 per cent tax rate.
Transactions in currencies other than the US dollar must be converted into US dollars using the spot rate at the time the transaction took place. Thus, the foreign currency gain or loss inherent in the sale of an investment asset is included in the capital gain or loss from the transaction and, other than in the case of currency contracts as discussed above, is not separately stated as a gain or loss on currency fluctuation.
Liabilities and expenses
Loans by the trust to the US owner or to a US beneficiary are treated as distributions from the trust unless the loan satisfies the requirements of a “qualified obligation”. An obligation is a qualified obligation only if:
- the obligation is reduced to writing by an express written agreement,
- the term of the obligation does not exceed 5 years (including options to renew and rollovers) and it is repaid within the 5-year term,
- all payments on the obligation are denominated in US dollars,
- the yield to maturity of the obligation is not less than 100 per cent of the applicable federal rate for the day on which the obligation is issued and not greater than 130 per cent of the applicable federal rate8,
- the US person agrees to extend the period of limitations for assessment of any income or transfer tax attributable to the transfer for three years and
- the US person reports the status of the obligation, including principal and interest payments, on Form 3520 for each year that the obligation is outstanding.
Like items of income, expense items are reported on the cash basis with some exceptions, such as depreciation. While a US taxpayer is entitled to deduct some items in full, other items are deductible only to the extent the amount of the deductions in that category exceeds a percentage of the US taxpayer’s adjusted taxable income.
For example, certain investment advisory fees are grouped into a category of miscellaneous deductions that are deductible only to the extent the aggregate amount of all deductions in the miscellaneous deduction category exceeds 2 per cent of the US taxpayer’s adjusted gross income for the year. Trustee fees are ordinarily deductible in full.
Foreign grantor trust with a foreign grantor and a US beneficiary
A foreign grantor trust with a US beneficiary is subject to US taxation in the same manner as a non-resident individual and may be required to file Form 1040-NR, US Non-resident Alien Income Tax Return. It is subject to US taxation on income from a US business, including an interest in a partnership, and on certain passive income from US sources.
A US beneficiary who receives a distribution from a foreign grantor trust that does not have a US owner is considered to have received a non-taxable gift from the owner of the grantor trust. The amount of that gift must be reported by the US beneficiary on Form 3520 as a distribution from a foreign trust.
Foreign nongrantor trust with a US beneficiary
A foreign grantor trust with a foreign grantor and a US beneficiary shifts to a non-grantor foreign trust upon the death of the foreign grantor. From that point forward, any US beneficiary who receives a distribution from the foreign trust may be subject to US income tax on that distribution to the extent that the foreign trust had distributable net income for the year.
Further, to the extent such distribution includes income that was earned and accumulated in a prior year, the throwback rules may also apply. Under the throwback rules, in addition to the tax on the distribution, the US beneficiary is subject to an interest charge.
Because a foreign non-grantor trust is taxed like a non-resident alien individual, the financial institution in which the investment portfolio is held should treat the account as a “W-8” account (an account owned by a foreign taxpayer).
Establishing the account as a W-8 account will result in only items of US source income and US withholding taxes being reported to the foreign trust on Form 1042-S. Further reporting would be required for the account once FATCA becomes effective.
If the foreign grantor trust owned a foreign company, a check the box election may have been made effective at or around the time of the settlor’s death when the trust ceased being a grantor trust9.
The character of the items of income earned by the foreign non-grantor trust passes through to the US beneficiary receiving the distribution. To the extent the trust distribution includes long-term capital gain income or qualified dividend income, the beneficiary receives the benefit of the reduced rate of US income tax.
Similarly, to the extent US withholding tax was charged on dividends (or other income), the US beneficiary is entitled to claim their share of those taxes as a credit on their US income tax return. In order to communicate items such as these to the US beneficiary, the foreign trust would provide the US beneficiary with a Foreign Non-grantor Trust Beneficiary Statement.
This statement would provide the US beneficiary with all of the information that the beneficiary needs to properly account for the trust distribution on their US income tax return. Again, this places a significant burden on the trustee/management company either to properly understand US income tax rules or retain US tax counsel to assist them.
In order to properly prepare a beneficiary statement, the foreign trust must compute its distributable net income for the year. In determining its distributable net income for the year, the trust should take into account all of the adjustments described above with respect to grantor trusts.
One difference, however, is in the treatment of capital gains. If a trust distribution includes a distribution of long-term capital gain, the beneficiary is taxed on their share of the gain at the preferential 15 per cent rate.
If the long-term capital gain is not distributed in the year derived, that income becomes undistributed net income and does not receive the reduced capital gain tax rate when distributed in a future year.
Further, capital loss may only be utilised to the extent such capital loss offsets capital gain. No net capital loss benefit flows through to the US beneficiary.
Many foreign non-grantor trusts try to distribute all of their distributable net income on an annual basis in order to avoid the application of the throwback rule. Any amount of distributable net income that is not distributed currently becomes undistributed net income that may be subject to the throwback rules when distributed in a future year.
In order to provide the trust with sufficient time to determine its distributable net income for the year, the trust may elect to treat any distribution made within the first 65 days of the year as attributable to the prior year. For example, the trust may elect to treat a distribution made 1 March, 2012 as attributable to the 2011 tax year of the beneficiary.
Ownership of PFICs
Ownership of a PFIC by a foreign trust, whether grantor or non-grantor, creates significant tax complications to US owners and US beneficiaries. The potential rate of return on these investments must be substantial when weighed against the potentially negative income tax consequences that arise from holding such instruments.
Whenever possible, ownership of these assets should be avoided. A US owner of an interest in a PFIC, whether direct or indirect, is subject to US income tax and an interest charge to the extent the US owner receives an excess distribution from the PFIC or disposes of their interest in the PFIC.
These rules apply with respect to a direct or indirect interest in the PFIC. Certain elections may be available to mitigate the adverse consequences of PFIC ownership. Beginning with the 2011 tax year, a US owner of an interest in a PFIC is required to file an annual information statement disclosing their interest in the PFIC.
In order to compute the tax consequences of the ownership of the PFIC, the US tax preparer will need information regarding the original purchase price and date of the PFIC stock, the date of any sales of the PFIC stock, and the dates and amounts of any dividends received from the PFIC.
From our experience, most trusts which we encounter have financial statements prepared in a manner that is consistent with the fiduciary accounting rules of the jurisdiction of administration of the trust.
These accounting rules are quite different from those required in order to provide a US grantor trust owner or a US beneficiary with the type of information required to prepare their US income tax returns.
The burden continues to be on the trust administrators and the US tax preparers to work together to provide the US taxpayers with the information required to comply with US income tax laws. In recent years, this relationship has become more important and it will continue to do so into the future because of the IRS offshore initiative and the enactment of FATCA.
The financial institution or trust company that appreciates the complexity of the US tax and reporting issues presented and takes the proper steps to better address them will have achieved a great benefit for all involved.
- The rules for distinguishing between a grantor trust and a non-grantor trust are beyond the scope of this article. For now, we will assume that a grantor trust is foreign trust settled by a US taxpayer that has at least one US beneficiary. Under certain circumstances, a foreign trust with a non-US grantor may also be considered a grantor trust during the non-US grantor’s life.
- A check the box election is made by filing Form 8832, Entity Classification Election.
- Unless otherwise noted, all form references are to Internal Revenue Service or Department of the Treasury forms.
- A CFC is a foreign company more than 50% owned by vote or by value by US shareholders. A US shareholder for this purpose is a US person that owns at least 10% of the voting stock of the foreign company. For purposes of determining ownership, various constructive ownership or attribution rules apply.
- A PFIC is a company organised in a foreign country 75% of whose income is from passive sources (interest, dividends, rents, royalties, gains, etc.) or 50% of whose assets are assets that generate passive income or are held for the generation of passive income. The consequences of ownership of an interest in a PFIC are discussed further below.
- A dividend from a foreign company that is not organized in a country that has a treaty with the United States may also be a qualified dividend if the foreign company is traded on a US securities exchange (e.g., an American Depository Receipt, etc.).
- Mutual fund investments present further accounting complications as most mutual fund distributions made in January of a particular year(which were ex-dividend in the prior year) are taxable to the unit holders in the prior year. For example, for 2011 tax returns, an adjustment will be required to include in income most mutual fund dividends received in January 2012. Further, another adjustment will be required to exclude from income any mutual fund dividends received in January 2011 that were included in income in 2010.
- The US Department of the Treasury publishes the applicable federal rates on a monthly basis.
- If no check the box election was made, the foreign company will likely be considered a CFC or a PFIC. As discussed above, a US shareholder of a CFC is taxed annually on his or her pro rata share of the CFC’s subpart F income regardless of whether such income is actually distributed. The reduced tax rates applicable to long-term capital gains and qualified dividends do not apply.