Reporting foreign trust and estate distributions to U.S. beneficiaries: Part 3

Part 3 contains a comprehensive analysis of the tax reporting of the net income distribution to a U.S. beneficiary of a foreign nongrantor trust. It also contains a comprehensive example illustrating various aspects of fiduciary accounting, applying tax treaty provisions and the corresponding DNI allocations that determine the net distribution amounts to the entity's U.S. and foreign beneficiaries.

Readers should be familiar with Parts 1 and 2 of this article to fully understand the analysis and discussion in Part 3. This article helps practitioners succeed in the challenges facing estate and trust administration in today's global environment. Having both U.S. and foreign beneficiaries can significantly complicate the procedures and responsibilities for foreign fiduciaries facing changing, complex laws.

To demonstrate the tax reporting of income distributions to the entity's U.S. beneficiary and foreign beneficiary, the practical aspects can better be understood with comprehensive illustrations of the entity's various income items under U.S. and a foreign jurisdiction's laws. The following example illustrates how proper estate plan drafting and a prudent fiduciary's actions can benefit both the U.S. and foreign beneficiaries. It also illustrates how the fiduciary can satisfy tax compliance responsibilities and benefit the beneficiaries economically. Understanding these complex reporting issues can better enable practitioners to assist fiduciaries to achieve administrative success.

Practical example: Foreign nongrantor trust with foreign and U.S. beneficiaries

A foreign nongrantor trust, the ABC Trust, is a complex trust created in Australia using English trust law principles. Australia is a common law jurisdiction comprising six states and two self-governing territories (each has a legislative, an executive, and a judicial branch of government and its own trustee act). Under Australian law, the ABC Trust is a "trading trust" (i.e., a trust conducting a business, with the profits distributed to the beneficiaries, also defined as the registered holder in listed public companies and, accordingly, has the right to receive any dividends paid)¹ and a "family trust" (all beneficiaries are family members)² for which the trustee manages its passive investments. It has a noncorporate foreign trustee, Mr. C, who resides and manages the trust and its assets in Sydney. Mr. C has made a "family trust election" under Australian law. The ABC Trust files Form 1040NR, U.S. Nonresident Alien Income Tax Return, in the United States on a calendar-year basis.

Its two foreign beneficiaries are citizens and residents of Australia (Mr. D and Ms. R), and its two U.S. beneficiaries, both of whom are U.S. citizens, live in Chicago (Mr. S and Ms. J). Each beneficiary is designated in the trust instrument as an income beneficiary with a 25% beneficial interest in the trust. The remainder beneficiaries of the ABC Trust are the children of the four income beneficiaries. For tax year 2015, the ABC Trust receives income from three sources:

1. Distributions as a limited partner from a U.S. domestic limited partnership, M Real Estate Management LP, which owns residential real property that rents 45 apartment units to tenants in Chicago. M Real Estate Management LP was formed under the state of Illinois's Uniform Limited Partnership Act and occupies an office in Chicago. The ABC Trust has a 50% interest in the partnership; the trust maintains a permanent establishment office in Chicago; and the trust receives quarterly distributions from the General Partner.
2. Dividend income from U.S. corporate stocks (U.S. source) managed by a branch brokerage office of U.S. Brokerage A in Chicago.
3. Dividend income from Australian corporate stocks managed by a branch brokerage office of Australian Brokerage B (foreign income) in Sydney.

Regarding the income distributions to the ABC Trust beneficiaries for 2015, the following tax results and tax reporting issues are analyzed:

Foreign beneficiaries of the ABC Trust: Mr. D and Ms. R, residents of Australia, would provide Form W-8ECI, Certificate of Foreign Person's Claim That Income Is Effectively Connected With the Conduct of a Trade or Business in the United States, as well as Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting (Individuals), to the payer (Mr. C, as trustee) to certify that each is a foreign person, as a result of their receiving their allocated income portion of the "net rental income" and dividend income, respectively, in their 2015 distributions. Each is a beneficial owner of the U.S.-source income that represents the effectively connected income (ECI) portion of the partnership income (from the rental operations). These forms would contain the individual taxpayer identification number (ITIN) for each beneficiary, after the IRS processed Form W-7, Application for IRS Individual Taxpayer Identification Number.

Because the ABC Trust also collected U.S. dividend income, that income (under Sec. 871(a)(1)(A), which is income "not effectively connected with a U.S. trade or business") is subject to U.S. tax withholding (Sec. 1441(b); Regs. Sec. 1.1441-3(c)(1)) at 30% of the gross income amount (or reduced treaty amount as stipulated in the U.S.-Australia income tax treaty,³ Article 10(2)(b)). As indicated in the IRS Instructions for Forms W-8ECI and W-8BEN, if the "foreign person(s) or foreign entity" expects to receive income that is effectively connected income andincome that is not effectively connected income, the trustee would also provide Form W-8BEN-E, Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities), to each financial institution payer or withholding agent and Form W-8ECI (in the case of M Real Estate Management LP). Form W-8BEN-E would indicate the trust's ITIN, country of residence, Chapter 3 status (complex trust) and Chapter 4 status (passive nonfinancial foreign entity), and certification that the entity is the beneficial owner of all income and is not a U.S. person.

The U.S. financial institution payer of the dividend income payments to the ABC Trust would be responsible for withholding tax payments for 2015. The trustee would also complete Part III of Form W-8BEN-E to claim tax treaty benefits (i.e., a reduced treaty rate of 15% withholding tax on the dividend income payments) by indicating the "country of residence" and other information about the beneficial owner's status. The reduced tax rate is stipulated in Article 10(2)(b) of the U.S.-Australia Treaty.

U.S. Brokerage A would also prepare Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, to report the taxes withheld and pay them to the IRS, and provide Form 1042-S, Foreign Person's U.S. Source Income Subject to Withholding, to the payee (trustee of the ABC Trust) for 2015.

U.S. beneficiaries of the ABC Trust: For the two U.S. beneficiaries, Mr. C would request that each complete Form W-9, Request for Taxpayer Identification Number and Certification, certifying each's tax identification number and address, and that each is a U.S. person.

U.S. agent of the ABC Trust: Mr. C previously engaged a U.S. agent, L Esq., with S LLP, a law firm in Chicago that represents the ABC Trust in IRS matters. He maintains the entity's accounting records, tax information data, a copy of the trust instrument, other relevant legal documents, and copies of the entity's fiduciary income tax returns from the United States and Australia. Mr. L keeps Mr. C informed about financial information on the entity's U.S. investments and U.S. tax laws with periodic meetings and communications.

Tax reporting under Australian laws for the ABC Trust and its beneficiaries: Current trust laws in Australia stipulate that the beneficiary and not the trustee is regarded as the beneficial owner of the property where the trustee holds the trust property solely in trust for the beneficiary.⁴ Express trusts, which are most common for holding assets in Australia, are either fixed (a fixed amount is distributed periodically) or discretionary (the trustee has discretion to determine when and if the trust will make distributions) and are primarily used for family estate planning purposes.⁵

Australian residents are taxed on their worldwide income. Nonresidents of Australia are generally taxed only on their Australia-source income.⁶ In general, a trust's taxable income is calculated on its assessable income less its allowable deductions. Division 6 of Part III of the Commonwealth of Australia Income Tax Assessment Act 1936 (ITAA 1936) assesses income tax on the trust's net income, which requires the calculation of a trust's total assessable income, as though the trustee were a resident taxpayer.⁷

Dividend income paid to shareholders by Australia resident companies is taxed under a system known as "imputation," under which the income tax the Australian company paid may be imputed or attributed to the shareholders using "franking credits" (i.e., credits for taxes paid by the company that attach to the dividends the shareholders receive). Thus, if a company pays or credits a shareholder/payee with dividends that have been "fully franked," a 30% income tax has been deducted for Australian tax purposes. The payee is entitled to a franking credit (tax offset) for the tax that the company has paid on its income. The annual dividend distribution statement sent to the payee must disclose the amount of the franking credit, and the payee is entitled to reduce the income tax payable on the dividend income by this amount.⁸

Whether a trustee or a beneficiary is taxed on that income, or a share of that income, will depend on whether the beneficiary is presently entitled to a share of that income. Under Australian law, the trust is not a taxpaying entity, even though the trust is required to file a tax return each year (unless it is a member of a consolidated group).⁹ A beneficiary will be presently entitled to the income if the beneficiary has an indefeasible and absolute vested interest in the trust or is deemed under a Division 6 provision to be entitled to that income.¹⁰

Regarding Australian taxation of foreign resident beneficiaries of an Australian trust (i.e., the U.S. beneficiaries, Mr. S and Ms. J), under Division 6 of Part III of the ITAA 1936, the trustee will be liable to pay the Australian tax on the foreign beneficiary's share of the net income of the trust entity for the tax year. However, the tax paid by the trustee in these circumstances is not a "final tax" because the foreign resident beneficiary will also be liable for tax on that share of net income but may claim a tax credit for the tax the trustee paid.¹¹

However, income (such as interest, dividends, and royalties) taxed under the "withholding tax rules" is not taxed again to the trustee or to a beneficiary under Division 6. A nonresident beneficiary is liable, under the withholding tax rules of Division IIA of Part III of the ITAA 1936 for tax on Australia-source unfranked dividends, interest, and royalties to which the beneficiary is entitled while nonresident.¹² The withholding tax is collected from the trustee under the "pay as you go" withholding rules (Taxation Administration Act 1953).

For a trust to be a family trust, the trustee must make a family trust election under Schedule 2F to the ITAA 1936. The "anti-franking trading measures," preventing franking credits for dividend income received as part of a "discretionary trust distribution" from passing through to the beneficiaries, do not apply to a family trust (i.e., the credits do pass through to the beneficiaries).¹³

Intergovernmental agreement in effect (Australia and the United States): Australia executed a Model I FATCA IGA with the United States, effective June 30, 2014. The U.S.-Australia Income Tax Treaty was signed on Aug. 6, 1982, and entered into force on Oct. 31, 1983. The tax treaty was modified by a protocol signed on Sept. 27, 2001, that became enforceable on May 12, 2003. The treaty is effective for:¹⁴

• U.S. and Australian withholding taxes for amounts paid or credited after June 30, 2003;
• Other U.S. taxes, for periods beginning after Dec. 31, 2003; and
• Other Australian taxes for any income tax year beginning after June 30, 2004.

Tax reporting under U.S. laws for the ABC Trust and its beneficiaries: With regard to the first category of income, "net rental income from a 50% interest in a U.S. limited partnership," the ABC Trust is treated and classified as a nonresident alien (NRA) for U.S. tax purposes (Sec. 641(b)). Because the net rental income is effectively connected income (ECI) with the conduct of a trade or business in the United States, the foreign nongrantor trust's taxable income is calculated by reducing its ECI by the deductions that are connected with that income (i.e., gross rents less allowable rental expenses) (Sec. 873(a)). The proper allocation of deductions is determined under Regs. Sec. 1.873-1.

However, neither the Code nor the regulations indicate whether the income distributions made to the foreign nongrantor trust (which is a complex trust) to the trust's beneficiaries that include income "effectively connected with the conduct of a trade or business within the U.S.," are deductible under Secs. 651 and 661. It is appropriate to allow a foreign nongrantor trust to deduct that portion of its distributions to its beneficiaries that consist of ECI for the tax year. In determining the portion of a distribution that consists of ECI, each distribution should be treated as consisting of the same portion of ECI as the total of the trust's ECI bears to the trust's total income for the period,¹⁵ which is consistent with IRS guidance on Sec. 875(1). A foreign nongrantor trust that is a general or limited partner in a partnership engaged in a U.S. trade or business is deemed to be engaged in that trade or business.¹⁶ Sec. 875(1) expressly provides that an NRA is considered engaged in a trade or business within the United States if the individual's partnership (i.e., the foreign trust's partnership) is so engaged.

The same rule applies to beneficiaries of a trust or estate that is engaged in a U.S. trade or business (Sec. 875(2)). Rev. Rul. 91-32acknowledges that this principle has been extended to the treaty context where (despite any express treaty authority) the courts have held that a partnership's U.S. permanent establishment is attributable to its foreign partners.¹⁷ From this holding, the IRS concludes that a partnership's "fixed place of business" is attributable to its foreign partners. Accordingly, any "undistributed net income" from that ECI, for the tax year, would be subject to U.S. domestic trusts' graduated tax rates.¹⁸

In analyzing Rev. Rul. 85-60, the IRS explained that it involved a simple foreign nongrantor trust with a limited partner interest in a U.S. partnership, which had a permanent establishment in the United States. The IRS ruled that the rental income from the partnership's activities was not exempt from U.S. income taxes under a U.S. income tax treaty provision where the trust was considered to be in receipt of business profits attributable to that partnership's permanent establishment. The foreign trust's distribution of that income to its sole beneficiary would be included in the beneficiary's gross income under Sec. 871(b). Further facts included that the trust instrument required that the trustee distribute all of its income each tax year to A, the beneficiary, which the trustee did annually. The foreign trust, TR, became a limited partner in PRS, a limited partnership formed in the United States under the State S Uniform Limited Partnership Act. PRS was engaged in the real estate development business in State S and maintained a business office there.

Further, the particular income tax treaty's intent is to allow the source country to tax business profits if the economic contact or activities are sufficient to constitute a permanent establishment, despite the trust's foreign residence. When a limited partnership conducts business activities in the United States through a fixed place of business (such as an office), the office of the limited partnership is a permanent establishment in the United States for each limited partner.¹⁹ As such, the IRS held that PRS's office was a permanent establishment for each partner, includingTR.

Further, Sec. 702(b) provides that the "character of income" included in a partner's distributive share, and accounted for separately under Sec. 702(a), is determined as if the income were realized directly from the source from which it was realized by the partnership, or incurred in the same manner as incurred by the partnership. Because the commercial profits (i.e., net income) will affect the income tax liability of the foreign trust or A, the foreign trust must take this income item into account separately from any other income items.²⁰ As a result, the net rental income generated by PRS's rental activities maintains its character as "commercial profits" for the foreign trust.

As for the foreign trust's U.S. tax ­liability, it will not owe any federal income tax, because it is allowed an income distribution deduction in computing its taxable income, under Sec. 651(a), in the amount of the income required to be distributed (all income, as stipulated in the trust instrument's terms) to the NRA income beneficiary, A.²¹ Sec. 875(2) provides that an NRA who is a beneficiary of a trust or estate that is engaged in any trade or business in the United States is treated as being engaged in that trade or business. In interpreting Sec. 875(2)'s legislative intent in Rev. Rul. 85-60, the IRS explained that A, the foreign beneficiary of the foreign trust, would be treated as engaged in the real estate development business in the United States because, for purposes of Sec. 875(2), the foreign trust is treated as engaged in that business through its limited partnership interest in PRS. Further, Sec. 652(b) provides that income distributed from a trust described in Sec. 651 has the same character in the beneficiary's hands as in the trust's hands.

Under the U.S. Model Income Tax Treaty, a common provision, Article VI(1), as incorporated into tax treaties with other countries, A would not be subject to U.S. taxes on industrial and commercial profits unless A is engaged in industrial or commercial activities in the United States through a permanent establishment. These two factors (as analyzed in Rev. Rul. 85-60) must be satisfied to tax the income as U.S.-source income for U.S. tax purposes under the treaty provisions (such is the holding in Rev. Rul. 85-60). As a result, the income will be included in A's gross income under Sec. 871(b). The applicable U.S. income tax treaty will be interpreted consistently with the Code and the intent of the treaty provisions. Even though Rev. Rul. 85-60 addresses U.S. tax reporting for a simple foreign nongrantor trust, similar tax treatment and reporting should be allowable for complex foreign nongrantor trusts with similar facts, including the payment of income distributions to their beneficiaries. However, some form of authoritative guidance would be helpful.

A trust may be classified as a simple trust (all current-year income being distributed to the income beneficiaries) in one tax year and a complex trust (with not all income being currently distributed) in another tax year. In the example above, the ABC Trust was a simple trust in prior tax years, but a complex trust in 2015. The income tax rules that apply to complex trusts also generally apply to estates (exceptions for some specific tax reporting treatments were discussed in Part 2 of this article) for U.S. tax purposes. The income distribution deduction for a complex trust (which is illustrated by the tables in this article) is determined for the tax year as follows:

First, fiduciary accounting income (FAI) that the trustee, under the trust's governing instrument, is required to distribute currentlyis added to all amounts that are properly paid or credited, or required to be distributed, for that tax year.²² The trustee can elect under Sec. 663(b) to treat an amount properly paid or credited within the first 65 days of a tax year as if it were paid or credited on the last day of the previous tax year, an election that is also available to an estate.

Next, (1) that sum, reduced by the amount of tax-exempt income (i.e., particularly "foreign income," in the case of a foreign nongrantor trust or foreign estate) that the trust distributed (or was deemed to have distributed) is compared to (2) the trust's DNI (which includes any capital gains under Sec. 643(a)(6)(C)), reduced by the amount of tax-exempt interest income (i.e., including any foreign income) that the trust earned. The lesser of those two amounts ((1) or (2)) is the trust's "income distribution deduction" for the tax year.

The distribution's tax-exempt portion for each beneficiary is determined by the "character rule," under which its character is determined first by following the "specific provisions" of the trust instrument.²³ Thus, if the instrument provides that no distribution is to be made out of tax-exempt income, the fiduciary need not reduce the income distribution by those amounts unless the distributions actually exceed the income subject to income tax. In the absence of a specific trust provision, or if local law requires an allocation of different classes of income, the amount deductible by reason of distribution to the beneficiaries under Sec. 661(a) is treated as containing the same portion of each class of income items entering into the total DNI computation as the total of each class bears to the total DNI.²⁴ The gross amount of tax-exempt income (i.e., foreign income less allocated direct expenses (Sec. 643(a)(6)(A))) must for this purpose be reduced to "net," since DNI, also, is a net amount.²⁵

For a foreign nongrantor trust, its tax-exempt interest and foreign income does not involve a new computation. It merely means that the same amount of tax-exempt interest and foreign income that has previously been added to taxable income to determine its DNI under Sec. 643(a)(6) must be taken out again of both the allocable beneficiary distributions and the DNI of the entity to arrive at the proper income distribution deduction amount.

Although earlier IRS regulations already required that a specific provision of a governing instrument must have "economic effect independent of income tax consequences," they did not refer to "a provision of local law."²⁶ To clarify this position, the IRS added the principle of economic effect to provide that a provision under local law must have economic effect independent of income tax consequences for the specific provision to be respected for tax purposes.²⁷ This clarification could be more significant for income tax reporting for foreign nongrantor trusts because of unique local law provisions.

Under Sec. 662(c), both the U.S. and foreign beneficiaries of the foreign nongrantor trust are treated as receiving their allocable distributed share of DNI on the last day of the trust's tax year. Thus, each beneficiary must include his or her taxable portions of DNI in gross income for that tax year for U.S. tax purposes. A complex trust with multiple beneficiaries may be classified under a "tier system" or as "a separate share trust," under the trust's terms or local law. In the example in this article, the ABC Trust is classified as a "separate share" complex trust. Under the separate share rule for tax years ending after Dec. 31, 1999, if separate economic interests exist for a beneficiary or class of beneficiaries, and the interests neither affect nor are affected by interests accruing to another beneficiary, or class of them, then each beneficiary's interest or class's interests must be treated as a "separate share" for purposes of computing DNI.²⁸

Note: This comprehensive example does notaddress the tax rules of Illinois or Chicago or of the State of New South Wales or any local Australian government. Although these state and local government authorities have laws requiring tax reporting in these cases, this comprehensive example is intended to illustrate only U.S. and Australian federal tax laws.

Sec. 1446 applies only to partnerships with effectively connected taxable income (ECTI) allocable under Sec. 704 to one or more foreign partners.²⁹ The U.S. tax reporting requirements of partnerships with foreign partners (in this example, M Real Estate Management LP, with the ABC Trust as a foreign partner) include making quarterly installment payments of Sec. 1446 tax payments with a voucher, Form 8813, Partnership Withholding Tax Payment Voucher (Section 1446). The amount of the Sec. 1446 tax payment is based upon each foreign partner's annualized ECI estimated to be allocated to the foreign partner. The U.S. partner, M Real Estate Management LP, would pay the quarterly tax payments on behalf of the foreign partner for each tax year of the partnership.³⁰

Each partnership (except a publicly traded partnership, which is subject to separate rules) that has ECI for the partnership's tax year, allocable to one or more of its foreign partners, must file an annual return (Form 8804, Annual Return for Partnership Withholding Tax (Section 1446)) with the IRS. Accordingly, each partnership must file an information statement (Form 8805, Foreign Partner's Information Statement of Section 1446 Withholding Tax), which contains the information on Form 8804 filed with the IRS. Form 8805, which also must be filed with the IRS, is provided to each foreign partner for his or her tax and filing information. For each noncorporate foreign partner, the applicable Sec. 1446 tax rate for 2015 is generally 39.6% (unless the partner is entitled to a preferential rate under Regs. Secs. 1.1446-3(a)(2) and 1.1446-6). A foreign nongrantor trust that is treated as an NRA for tax purposes may, in some cases, be subject to U.S. income tax under Sec. 871(b) on its "undistributed net income" that is ECI.

Important: BecausePart 1 of this article discusses in detail additional U.S. tax reporting for a foreign trust and its beneficiaries of ECTI, the reader should analyze this example with reference to Part 1 to achieve a more comprehensive understanding of the tax reporting responsibilities of the fiduciary and the beneficiaries.

Under the U.S.-Australia tax treaty, the limitation on benefits applies to all limitations on source-based taxation and treaty-based relief from double taxation only if the person (or entity) is a qualified person.³¹ A qualified person includes an individual, unless he or she receives income as a nominee on behalf of a third-party state resident, in which case benefits may be denied under those treaty provisions requiring that the income's beneficial owner be a resident of a state.³²

Under the treaty, a resident of a state who is not a qualified person is nevertheless entitled to treaty benefits for an item of income derived from the other state if the resident is engaged in the active conduct of a trade or business in the state of residency, and the income derived from the other state is connected with or incidental to that trade or business.³³ Activities conducted by persons "connected" to a resident, as well as activities conducted by a partnership in which that person is a partner, will be deemed to be conducted by the resident for purposes of the active trade or business test.

A person is connected to another if one possesses at least "50% of the beneficial interest" in the other party.³⁴ Under the treaty, where an enterprise of one state carries on business in the other state through a permanent establishment, the business profits that are attributable to that permanent establishment are those that the enterprise might be expected to make, if it were a distinct and independent enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment or with other enterprises with which it deals.³⁵

Under the above U.S.-Australia treaty provisions, the Australian trustee of the ABC Trust, Mr. C, would be treated in accordance with the analysis explained previously and in "Tax Reporting Under U.S. Laws for the ABC Trust and Its Beneficiaries," on p. 876 and as illustrated in the following example and tables.

The financial information for the ABC Trust for tax year 2015 is summarized in the following tables:

• Table 1: Gross Income With Australian and U.S. Tax Withholdings (below);