Foreign Income & Taxpayers
As globalization shortens distances around the world and the prevalence of domestic-only organizations declines, a different statistic continues to grow: the number of globally mobile individuals subject to multijurisdictional taxation. Entrepreneurs, executives, project managers, recent graduates, and professionals alike are increasingly finding their next opportunity located outside the borders of their home country.
Often, these international opportunities create interactions with foreign trusts, either as parties to a transaction or as an investment. Whether these opportunity seekers are U.S. persons (defined below), or about to become U.S. persons, it is important to remember that the U.S. tax system casts a global net. Indeed, timely disclosures of international transactions and ownership of non-U.S. assets have in recent years been a primary focus of U.S. tax administrators. Further, both enacted and proposed legislation continues to increase the frequency and detail of this reporting.
Included among these ever-expanding requirements are numerous rules and mandatory filings for U.S. persons with ties to foreign trusts. Historically, trusts have served as powerful tools to manage and transfer wealth, shelter assets from creditors, and achieve myriad other goals. Recently, these benefits have only been amplified by favorable changes to the U.S. transfer-tax system. Given these uses and benefits, it is no wonder that trusts are commonly used both within the United States and throughout the world. However, despite the significant efforts of tax advisers to ensure their U.S. clients understand and comply with required tax and information-reporting forms on U.S. trust relationships, all too often transactions go unreported, even though penalties in these cases can be quite severe.
The process of determining which forms must be filed and what tax implications exist for a given fact pattern begins with identifying the individuals the rules apply to. For both U.S. tax and information-reporting purposes, the rules apply to "U.S. persons" who find themselves involved in some way with a "foreign trust." For natural persons, Sec. 7701(a)(30) provides that a "U.S. person" is anyone who possesses U.S. citizenship (even dual citizenship) or who is a resident of the United States. While it is typically a straightforward exercise to confirm a taxpayer's citizenship status, the rules governing U.S. tax residency require a bit more effort.
If the deviations from the standard residency rules (e.g., the "closer connection" exception, U.S. tax treaties, and certain elections) are not considered, a person is a U.S. tax resident if he or she either holds U.S. permanent resident status (i.e., a green card) or meets the substantial presence test. Under Sec. 7701(b)(3), the substantial presence test treats an individual as a U.S. tax resident if he or she is physically present in the United States for at least 31 days during the current year, and 183 days during the three-year period that includes the current year and the two years immediately preceding it. Note that the calculation counts all of the days present in the current year, one-third of the days present in the first year before the current year, and one-sixth of the days present in the second year before the current year. Finally, also consider that U.S. persons can include nonresident alien individuals making a Sec. 6013(g) election to voluntarily be treated as a U.S. resident for certain U.S. tax purposes.
Assuming a U.S. person is involved, the next determination is whether a particular trust is, under U.S. rules, a domestic or foreign trust. By default, Sec. 7701(a)(31)(B) treats a trust as a foreign trust unless (1) a court within the United States is able to exercise primary supervision over the administration of the trust (the court test) and (2) one or more U.S. persons have the authority to control all substantial decisions of the trust (the control test). Advisers assisting clients should refer to Regs. Sec. 301.7701-7 for detailed guidance in applying the court and control tests to their situation. Of important note, however, is that both tests must be met before a particular trust is treated as a domestic trust for U.S. tax purposes and that a trust's classification can shift from domestic to foreign through changes in administration or other circumstances.
Interestingly, in many cases, the issue may not necessarily be whether a particular trust is a foreign trust, but instead whether a trust arrangement even exists. Indeed, many U.S. persons have come to learn that they have created foreign trusts or have received distributions from foreign trusts, without ever having engaged in any sophisticated estate, financial, or tax planning. This can occur where U.S. persons open certain types of non-U.S. financial accounts or participate in certain foreign retirement or savings plans. For example, a number of common Canadian retirement and education savings plans are treated by the IRS as foreign trusts for U.S. purposes.
While the United States-Canada tax treaty does provide beneficial U.S. treatment for a few types of Canadian retirement plans, it does not include special provisions for Canadian tax-free savings accounts, nor does it carve out any exceptions for Canadian registered education savings plans. Given that these types of financial accounts are often organized in trust form (whether obvious or not), the IRS has argued that these arrangements constitute foreign trusts and that a U.S. person's involvement with them is subject to corresponding U.S. taxation and information reporting. As similar accounts and plans exist in many other countries, advisers must be able to assist their U.S. clients in identifying potential foreign trusts even where none are thought to exist.
Where a U.S. person is connected to a foreign trust, Sec. 6048 sets out the information that must be reported, the reporting due dates, and the events for which filings are required. Specifically, Sec. 6048(a) provides that a "responsible party"—which, depending on the circumstances, can be a grantor, transferor, or executor—must timely deliver certain information to the IRS after a "reportable event" occurs. Reportable events include the creation of a foreign trust by a U.S. person, a U.S. person's transfer of money or property (directly or indirectly) to a foreign trust, and the death of a U.S. person if (1) the decedent was the owner of any portion of a foreign trust or (2) any portion of a foreign trust was included in the decedent's U.S. gross estate. This reporting is completed on Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, and must be filed by the due date of the responsible party's U.S. income tax return.
If a U.S. person is considered the owner of a foreign trust (under the grantor trust rules of Secs. 671—679), Sec. 6048(b) requires the owner to annually supply detailed information to the IRS on Form 3520, while also ensuring that the trust files information returns and that recipients of trust distributions receive pertinent information to help them meet their compliance obligations. To accomplish the latter requirements, the IRS provides Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner. The trustee of the foreign trust should prepare Form 3520-A, as well as certain accompanying statements (Form 3520-A includes templates) to be provided to the trust's U.S. owner(s) and U.S. beneficiaries. These forms are due by the 15th day of the third month after the end of the trust's year (usually March 15). An extension of time to file Form 3520-A is available, but a separate extension form (Form 7004, Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns) must be timely filed.
In addition, Sec. 6048(c) requires that U.S. beneficiaries of foreign trusts provide to the IRS detailed information regarding their distributions, using Form 3520, to help the Service ensure proper income tax treatment. Civil penalties under Sec. 6677 for failure to file information returns for foreign trusts can be substantial. For example, the penalty imposed for failing to report a transfer of property to, or a distribution of property from, a foreign trust is the greater of $10,000 or 35% of the property's value (Sec. 6677(a)).
Certainly, through the magnitude of the penalties, U.S. lawmakers have made clear the importance of appropriately and timely reporting transactions with foreign trusts. However, the various information return requirements are only part of the U.S. taxpayer's considerations. Sec. 684 provides that where a U.S. person transfers (directly, indirectly, or constructively) property to a foreign trust (or estate), the transfer will be treated as a sale or exchange, and the transferor must recognize a gain equal to the excess of the fair market value (FMV) of the property transferred over the property's adjusted basis. The amount of gain recognized must be determined on an asset-by-asset basis, and, perhaps unsurprisingly, the rules prohibit the recognition of a loss on a transfer of an asset to a foreign trust (Regs. Sec. 1.684-1(a)). There are a limited number of exceptions to gain recognition under Sec. 684, with the most common including transfers to grantor trusts, transfers to charitable trusts, certain transfers at death, and transfers for FMV to unrelated trusts (Regs. Sec. 1.684-3).
Where a U.S. person is the settlor of a foreign trust, Sec. 679 provides that, generally, if the trust benefits (or could benefit) at least one U.S. beneficiary, the trust will be a grantor trust for U.S. tax purposes. The exceptions to the general rule include cases where (1) a U.S. person dies and, under a provision of the decedent's will, leaves assets to a foreign trust (i.e., a testamentary transfer); or (2) a U.S. person sells an asset to a foreign trust (with U.S. beneficiaries) for some type of consideration equal to (or greater than) its FMV (Sec. 679(a)(2)). Note, though, that special rules govern the determination of "consideration" for this purpose, which restrict the use of loans and other obligations (Sec. 679(a)(3)).
In cases where a U.S. person is treated as the owner of a foreign trust, traditional U.S. income tax rules apply, and the global income of the trust will be subject to annual U.S. taxation via inclusion in the grantor's U.S. individual income tax, irrespective of whether amounts are distributed from the trust. However, because of potential adverse income tax consequences that can occur with foreign nongrantor trusts, often cross-border estate plans are intentionally designed to trigger grantor trust classification to avoid onerous U.S. tax rules on distributions of accumulated trust income.
Under the "foreign grantor ownership" rules of Sec. 672(f), the traditional grantor trust rules do not apply to foreign trusts created by non-U.S. persons. Instead, a foreign trust created by a non-U.S. person is generally treated as a grantor trust only if (1) the trust is a revocable trust or (2) the only amounts distributable from the trust (whether income or corpus) during the lifetime of the grantor are amounts distributable to the grantor or his or her spouse. Where a U.S. person is a beneficiary of a foreign grantor trust, he or she will generally receive distributions free of U.S. income tax. Under Notice 97-34, the beneficiary should treat the distribution as a tax-free gift from the owner of the trust. To ensure this treatment, while preparing Form 3520-A, the trustee must also prepare a "foreign grantor trust beneficiary statement," and provide copies to the IRS and the beneficiary. Such a statement provides the IRS with the information required by Sec. 6048(c)(2) to avoid default U.S. income taxation of distributions in the hands of the U.S. beneficiary. However, while distributions from foreign grantor trusts may not be subject to U.S. income taxation, the U.S. beneficiary will still need to report any distributions by filing his or her own Form 3520.
Where U.S. beneficiaries receive distributions from foreign nongrantor trusts, the U.S. income tax considerations can be quite complex. U.S. rules require the beneficiary to determine the portion of each distributed amount that is (1) current-year income, which includes realized capital gains; (2) accumulated trust income (i.e., undistributed net income from prior years); and (3) a residual portion commonly known as principal or corpus. Note that Sec. 643(a)(6) specifically includes capital gains in distributable income, which is in contrast to traditional U.S. fiduciary principles.
If the U.S. beneficiary does not receive sufficient information to properly determine the categorization of a distribution, the IRS provides a "default method" for making the determination, described in Notice 97-34. To the extent any part of a distribution is treated as an accumulation distribution, the beneficiary must perform a "throwback" calculation under Secs. 665—667 to compute any additional tax. In addition, Sec. 668 imposes an interest charge on the deferred tax amount. This process effectively eliminates the benefit of U.S. tax deferral for years in which amounts were permitted to accumulate within the trust, and, as mentioned earlier, is a reason to either design a foreign trust to be treated as a grantor trust, or carefully monitor trust income and distributions each year to avoid the disadvantageous tax treatment of accumulation distributions.
Finally, it is important to consider whether additional information reporting may be required. Filers of both the U.S. Treasury's Financial Crimes Enforcement Network (FinCEN) Form 114 (formerly TD F 90-22.1), Report of Foreign Bank and Financial Accounts (FBAR), and Form 8938, Statement of Specified Foreign Financial Assets, may need to report certain information about foreign trusts. While a review of all the reasons a person may need to file an FBAR or Form 8938 is beyond the scope of this item, U.S. persons who are considered to own portions of foreign trusts, and U.S. beneficiaries with interests in foreign trusts, should carefully review the requirements for the FBAR and Form 8938, and be sure to timely file these forms, as appropriate.
Increasingly, U.S. persons are finding themselves interacting with foreign trusts, whether because of traditional estate and tax planning, or simply as a result of transactions with certain non-U.S. financial accounts. The United States imposes a complex system of taxation and information reporting on all U.S. persons involved in these interactions. Often, these requirements are misunderstood, and the necessary reporting and filings go uncompleted, even though the penalties for these failures are significant. As U.S. lawmakers and tax administrators continue to increase their scrutiny of international transactions and U.S. ownership of offshore assets, it has never been more important to understand the reporting requirements and appropriately advise U.S. clients in both planning and compliance.
Alan Wong is a senior manager–tax with Baker Tilly Virchow Krause LLP in New York City.
For additional information about these items, contact Mr. Wong at 212-792-4986 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP