The offshore trust industry has seen a great deal of recent changes. Larger trust companies have been acquiring new business by purchasing smaller trust companies. Some trust companies have bought the trust inventories of other trust companies which have chosen to exit a particular jurisdiction.
Moreover, as some trust companies have decided to shed trusts with U.S. connections given the looming and imminent onset of “FATCA”1, more U.S. friendly trust companies with an eye to developing a niche in this area have bought these same trust inventories.
Purchasers of trust inventories should be warned that many complicated tax issues may be lurking in these trust structures with U.S. settlors or beneficiaries, some not too far below the surface. These issues include identification of the real “grantor”, accurate classification of a grantor trust status of each trust and status as a foreign or domestic trust for U.S. tax purposes, correct and timely identification of U.S. beneficiaries and proper U.S. tax planning for foreign trusts with U.S. beneficiaries. Other issues include identification of U.S. anti-deferral regimes for foreign companies in which U.S. beneficiaries may have an attributed indirect interest through a foreign trust, and exit strategies to eliminate attributed ownership of these foreign companies.
To fully grasp these issues and the complexity of the analysis required, it is helpful to review some simple definitions under U.S. 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 U.S. 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 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 U.S. 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 U.S. grantor to qualify as a “grantor” trust for U.S. tax policy reasons.
- A foreign grantor will not be within the U.S. tax system with respect to the income generated by the trust unless the trust is, for example, deemed engaged in a U.S. trade or business or has U.S. source income. If the grantor is treated as the owner of the assets of a foreign trust for U.S. income tax purposes, no distribution from such trust made to the U.S. beneficiary would be taxable income to the U.S. beneficiary. The U.S. 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 U.S. income tax during the life of the foreign grantor, and the foreign grantor may be outside of the U.S. tax system as well.
- In addition, U.S. 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 U.S. beneficiaries of foreign trusts which are not foreign grantor trusts so that U.S. beneficiaries may not benefit from the deferral of tax that has occurred in the trust offshore when the beneficiary receives a distribution.
- If a U.S. 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 U.S. beneficiary may be subject to both an interest charge and the back tax of the “throwback rules”.
- These concepts are important to understand a number of “tax traps” that can create problems for trustees and U.S. beneficiaries of a foreign trust unless a qualified U.S. tax attorney has provided thorough and accurate advice concerning the foreign trust.
Tax Trap Number 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 favorable grantor trust status, only the person who actually contributed the assets to the trust may be treated as the “owner” of the assets for U.S. 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 company was the grantor and the trust was funded for a business reason of the company, the company 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 U.S. beneficiary cannot report distributions properly for U.S. tax purposes, and the foreign trustee cannot meet its obligation to provide the correct information to the U.S. beneficiary.
Tax Trap Number 2
An unanticipated U.S. beneficiary
For U.S. income tax purposes, a U.S. “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 United States, known as the “substantial presence test”.
There are exceptions to the substantial presence test if an individual was present in the United States 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 U.S. taxpayers even though they are in the United
States on a student visa. Alternatively, beneficiaries who are splitting their time with other countries may well be U.S. taxpayers if they are spending more than half the year in the United States 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 Internal Revenue Service so they are not treated as U.S. taxpayers.
If a beneficiary discovers that he is a U.S. taxpayer, the beneficiary and the trustee will have to coordinate to make sure that the beneficiary fulfills his U.S. tax compliance obligations. As of next year, the trustee will also have to make sure that it is fulfilling its obligations under FATCA.
Tax Trap Number 3
Foreign corporations with passive assets
There are two different anti-deferral income tax regimes in the United States which effectively operate to deny certain U.S. 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 percent of the foreign corporation is owned by vote or value by “U.S. shareholders”, who hold at least 10 percent 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 U.S. 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 percent or more of its income is from passive sources or 50 percent or more of its assets are held for the production of passive income. The PFIC regime applies regardless of the percentage ownership of the U.S. 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, U.S. tax laws may attribute ownership of shares of the foreign corporation to a U.S. beneficiary. The result may be that the U.S. beneficiary is subject to U.S. 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.
Tax Trap Number 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 United States 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.
Tax Trap Number 5
Failure to plan for the incapacity of the foreign grantor
Foreign grantor trust status is extremely valuable for any foreign trust with U.S. 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 an offshore trust company to address all of these issues when acquiring new trust inventory by having an experienced U.S. tax attorney review each trust in the inventory. In this review, the attorney should determine on a case by case basis the status for U.S. tax purposes of each trust, as well as highlighting any potential problems, pitfalls or ambiguities for U.S. tax purposes that should be addressed and resolved.
The attorney can also help the foreign trust company streamline its intake and compliance to make sure U.S. beneficiaries are identified, and to make sure that the trustee is coordinating with any U.S. beneficiary regarding U.S. tax compliance. Finally, the attorney can give the trust company advice concerning maintaining the trust and the entities owned by the trust in a tax efficient manner aimed at minimizing future tax and reporting consequences.
- “FATCA”, or the Foreign Account Tax Compliance Act, was enacted by the United States government in 2010. FATCA requires a 30 percent withholding tax to be deducted from certain payments made to a foreign financial institution unless that institution has entered into an agreement with the IRS to report information about U.S. accounts. Alternatively, the withholding tax may be avoided if the government of the jurisdiction of the foreign financial institution has entered into a certain type of information sharing agreement with the United States government.