This three-part article explains the computations and tax withholding and reporting requirements for foreign nongrantor trusts and foreign estates making income distributions to U.S. beneficiaries. Part 1, in the October issue, analyzed how to properly classify a foreign trust for U.S. tax purposes and what types of income are classified as U.S.-source income for U.S. tax withholding purposes. Part 2, in the November issue, explained the common law and civil law jurisdictional issues affecting foreign trusts and foreign estates, tax treaty issues, distributable net income (DNI) of a foreign nongrantor trust, the Foreign Account Tax Compliance Act (FATCA) requirements for trust and estate entities, and the coordination of FATCA with Chapter 3 withholding requirements for payments to foreign payees.
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.Illustrating foreign nongrantor trust beneficiary distributions
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:
- 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.
- Dividend income from U.S. corporate stocks (U.S. source) managed by a branch brokerage office of U.S. Brokerage A in Chicago.
- 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.Complex trusts may be complex for both U.S. and foreign beneficiaries
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.Tax treatment for the beneficiaries of the complex trust
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.U.S. tax reporting and tax withholding for the ABC Trust as a foreign partner
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.Active trade or business under the U.S.-Australia tax treaty
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.Example (the ABC Trust): Financial information to be analyzed (2015)
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);
The trust had no "undistributed net income" (UNI) as of Dec. 31, 2014.
Analysis of Table 7
The DNI is apportioned between the fiduciary and the beneficiaries. Not all of the DNI, $621,612, was distributed. Thus, the income distributions will carry out only a portion of DNI to the beneficiaries (as shown in Table 7 above).
Analysis of Table 8
Income distributed by an estate or trust to its beneficiaries generally retains its character in the hands of the beneficiaries (Secs. 652(b) and 662(b)). Therefore, distributions carrying out DNI consist of a pro rata share of each type of income included in DNI, unless the governing instrument directs otherwise. The income distribution for each beneficiary above is "grossed-up" for the tax withholding allocated to each at the fiduciary's discretion.
The tax withholding rate, as required in Regs. Sec. 1.1441-3(f)(1), is the rate applicable to U.S.-source income as follows:
Partnership net rental income (Sec. 871(b)(1)) is taxed at the applicable graduated tax rate (under Sec. 1) of 25% (for a single or married-filing-separately NRA taxpayer) in the 2015 rate schedule of the instructions to Form 1040NR, based upon each beneficiary's share of the applicable portion of ECTI share. The trustee, as the withholding agent, has withheld tax at the marginal tax rate applicable to that income item.
FDAP (dividend income) (Sec. 1441(a) and 1441(b)) is the reduced tax treaty rate (U.S.-Australia) of 15%.
The trustee would provide each beneficiary with a "Foreign Nongrantor Trust Beneficiary Statement," reporting the information in Tables 8 and 9 as discussed in Part 1 of this article. In addition, he would provide a copy of Form 8805 to each beneficiary. Also, he would provide each beneficiary, including the foreign beneficiaries shown in Table 9, a "Statement of the Amount of Applicable Code Sec. 33 Credit Allocated" to each on their share of ECTI (net rental income). See Part 1 for details of information required to be reported in the statement.
Australia tax withholding allocation, $4,458: If a foreign nongrantor trust pays foreign taxes (the trustee paid the Australia tax for the U.S. beneficiaries in the ABC Trust), each U.S. beneficiary who received a distributive share of the Australia dividend income on which taxes were paid may elect to take a tax credit on his or her U.S. income tax return for the foreign tax attributable to his or her income share.36 The tax credit on the beneficiary's U.S. individual income tax return is limited to the proportion of tax against which the tax credit is taken as to the income from foreign sources bears to his or her entire taxable income.37 Neither the Code nor the regulations explain how to treat the amount of foreign taxes paid (as includible in gross income for the tax benefit, as U.S. tax withheld and allocated is treated in a grossed-up method). A similar method should be applied with respect to the foreign tax credit on the foreign income distributed to the beneficiary as the beneficial owner of that income.38
Table 8 uses the gross-up tax rate of 15% for the income tax consequences and tax reporting of the Australia tax credit for the U.S. beneficiaries.
Analysis of Table 9
The U.S. taxes associated with the net income distribution allocation to each foreign beneficiary has been withheld and paid by the trust's withholding agents. As discussed in Part 1, no tax refund could be claimed on the beneficiaries' respective 2015 Forms 1040NR, as the withholding rate was 15%, the same as their U.S. tax rate. However, regarding the ECI income (net rental income allocated to their distributable share), a possible income tax refund could be claimed on their Form 1040NR, as their applicable tax rate, filing as an NRA with ECI income, could be less than the graduated tax rate of 25% allocated to their share of the withholding tax.
By filing Form 1040NR for 2015, each foreign beneficiary, Mr. D and Ms. R, would report the gross income from ECI income as $62,485 (grossed-up from $46,864 by the tax withholding allocation on the income distribution). In a similar manner, their U.S. dividend income gross taxable distribution would be $56,325 (grossed-up by the $8,449 allocated withholding tax). This author recommends that Mr. C also file a "Foreign Nongrantor Trust Beneficiary Statement" for each foreign beneficiary with Form 1040NR for the trust entity and provide a copy to each beneficiary. In addition, Form 8805 would be provided to each beneficiary, as well as the "Statement of the Amount of Applicable Code Sec. 33 Credit Allocated," as discussed in Part 1, for them to file and include those attachments with the U.S. Form 1040NR for the tax year.
Analysis of Table 10
The DNI for the ABC Trust for 2015, as reported in Table 6 on p. 880, is $621,612. However, the trust entity's allowable distribution deduction is not equal to the entire taxable portion of DNI because the total of the Tier 2 distributions ($480,000) is less than the total DNI. Thus, not all of the DNI was distributed for 2015 (Regs. Sec. 1.661(c)-2)). Thus, the distributions will carry out only a portion of the DNI to the four beneficiaries.
A foreign nongrantor trust is allowed an income distribution deduction for computing its U.S. income tax liability, similar to domestic trusts (Secs. 651(a) and 661(a)). When calculating the income distribution deduction, DNI is computed only with items of income and allowable deductions included in the trust's gross taxable income (Secs. 651(b) and 661(c)). If all income is not distributed to the beneficiaries (as illustrated for the ABC Trust for 2015), the portion retained by the entity consists of a pro rata share of each class of income included in DNI. This undistributed net income (UNI) will affect the reporting of distributions to U.S. beneficiaries in future tax years. If an accumulation distribution is made, each income item included in UNI that is distributed will lose its tax character (other than tax-exempt income) and be treated as ordinary income.
See Table 11 for how the income distribution deduction affects the U.S. income tax liability of the ABC Trust for 2015.
Analysis of Table 11
The DNI serves as a ceiling on the beneficiaries' income inclusion amounts. The income distribution deduction is limited to the trust entity's gross taxable income that is included in DNI. Because not all of the DNI was distributed, the distributions carry out only a portion of DNI to the beneficiaries (Regs. Sec. 1.661(c)-2).
Analysis of Table 12
The above analysis reports the trust's income effectively connected with a U.S. trade or business as analyzed in Parts 1 and 3. The IRS would probably verify that all beneficiaries filed their 2015 income tax returns before processing any refund. The U.S. agent may need to communicate with IRS officials and provide trust accounting and tax information statements to ensure that the IRS has all the information needed to process the entity's 2015 Form 1040NR.
The ABC Trust continues to be taxed (subject to the Sec. 1441 tax withholding), as reported on Form 1042-S by U.S. Brokerage A on its U.S.-source income not effectively connected with a U.S. trade or business (the U.S. dividend income), regardless of the income distribution deduction. The U.S. and foreign beneficiaries are subject to U.S. tax on their share of the net income distributions allocated to the U.S. dividend income (as reported in Table 8). Each will receive a U.S. tax credit for his or her allocable share of tax withholding reported in the trust's Form 1040NR and on Form 1042-S. Mr. C allocated and reported each beneficiary's share by filing Form 1041-T, Allocation of Estimated Tax Payments to Beneficiaries, and attached it to the trust's 2015 Form 1040NR.
The advantage of reporting the tax withholding allocation for each beneficiary on one tax form (Form 1041-T) with a "total amount" is that it will match the amount reported on the entity's Form 1040NR (as illustrated in Table 13). The IRS Instructions for Form 1040NR stipulate that for a foreign estate or foreign trust, Form 1040NR should be "changed as necessary to comply with provisions of Subchapter J of the IRC." Mr. C has chosen to follow those instructions to make the tax reporting more accurate and easier to follow.
The two foreign beneficiaries will not be eligible for a tax refund on their share of the U.S. dividend income, as their tax rate on that income is 15% (the same as the withholding rate). However, it is important for each foreign beneficiary to file Form 1040NR for 2015, as each will most likely report a tax refund due on his or her allocable share of ECI income because the 2015 tax table amount would most likely be less than the 25% allocated withholding amount that each will report, according to their "Foreign Nongrantor Trust Beneficiary Statement" provided by the trustee.
Note: The lines and descriptions designated in this table were determined by the tax return preparer, as the Form 1040NR instructions clearly state: “[C]hange the form [as needed] to reflect the provisions of Subchapter J, Chapter 1” of the Code.39
Analysis of Table 13
As noted, the Form 1040NR instructions tell the preparer to change the form to comply with Subchapter J (for a foreign estate or foreign trust), but Subchapter N, "Tax on Income From Sources Within or Without the United States," also applies because of the "U.S.-source income rules," which affect foreign trusts and estates as well as NRA beneficiaries.
The preparer can report the $33,796 in tax withheld online 58 (which is for reporting the transportation tax paid) by altering the form to indicate the type of tax paid or withheld. This withholding tax is allocable to all beneficiaries on their respective U.S. dividend income allocation to offset the total tax reported on Schedule NEC, Tax on Income Not Effectively Connected With a U.S. Trade or Business (line 54). The amounts are reported on a separate Form 1041-T and designated as "Sec. 1441(b) Taxes."
Line 62a ($96,280) represents the withholding taxes on U.S. dividends and ECI (Form 8805) to offset amounts on lines 62b and 62d. The respective amounts are reported in two separate Forms 1041-T, one designated on the form's top as "Sec. 1446(b) Taxes [Sec. 33 Credits]" and a second Form 1041-T as "Sec. 1441(b) Taxes."
Lines 61 and 71 represent the trust entity's net amounts after allocation of withholding taxes to the beneficiaries as reported on Forms 1041-T by the trustee (see Table 13).
Best practice guidelines
The following best practice strategies will facilitate sound foreign trust and foreign estate administration procedures for foreign fiduciaries making distributions to U.S. and foreign beneficiaries:
- Consider opportunities for reducing the Sec. 1441 withholding tax in coordination with withholding agents following IRS regulations, provided adequate documentation (i.e., withholding certificates) is obtained.
- Collect and keep all necessary tax forms (Forms W-8BEN, W-8ECI, W-8IMY, and W-9, if applicable) and other documentation from beneficiaries as needed to verify residency and compute the correct withholding amounts. Prepare Form W-8BEN-E to document the fiduciary's tax status and applicable tax treaty provisions for the entity.
- Review applicable U.S. tax treaty provisions with each applicable income item and beneficiary's tax status and residency. Seek professional advice to ensure a proper understanding of the provisions as they affect each tax year's withholding amounts.
- Review and verify the accuracy of the withholding agent's taxes withheld with each income payment to determine that the amount complies with tax laws.
- Verify that all applicable tax information forms are filed by each withholding agent for the tax year and verify their accuracy.
- Prepare each beneficiary's U.S. "Foreign Nongrantor Trust Beneficiary Statement" with assistance from knowledgeable professional practitioners. Clearly indicate how much of each current year's distribution to the applicable beneficiary is a "current-year income distribution" and how much is a current-year distribution of "accumulated net income" not distributed by the entity in a prior tax year ("undistributed net income").
- Prepare each beneficiary's "Statement of the Amount of Applicable Code Sec. 33 Credit Allocated." Provide a copy to each beneficiary as well as a copy of Form 8805 received from the partnership.
- Engage a qualified and reputable U.S. agent to represent the entity and its fiduciary, as well as the entity's beneficiaries in tax matters involving the United States and the IRS. Ensure that the agent keeps copies of accounting and tax records for each tax year.
- File timely and complete fiduciary tax returns for each tax year in the United States and the foreign jurisdictions, as applicable. Ensure that each beneficiary files his or her U.S. individual income tax return if withholding taxes are allocated on Form 1041-T, Allocation of Estimated Tax Payments to Beneficiaries.
- Maintain frequent communication between the fiduciary and the U.S. agent on the results of the entity's U.S. investments, as well as tax developments.
- Maintain frequent communication between the fiduciary and each of the entity's beneficiaries to ensure they are informed of financial and tax information as it affects them for each tax year.
Beware: With facts similar to the ABC Trust, where U.S. taxes are overpaid on ECI, all beneficiaries (including any NRA beneficiaries) should file Forms 1040 or 1040NR for the tax year to protect the entity's claim to a tax refund as reported in Table 13, as well as possibly claiming an individual tax refund on each's share of the income.
Navigate complexity with expert guidance
Fiduciaries of foreign nongrantor trusts and foreign estates are best advised to seek knowledgeable practitioners to assist them in administering the estate or trust that has U.S.-source income to report and distribute to U.S. or foreign beneficiaries. Experienced practitioners can guide fiduciaries in many complex administrative responsibilities involving multiple jurisdictions. Each tax year can present different complexities to resolve to achieve success. Planning the timing of each income distribution beforehand can enhance each beneficiary's net distribution amounts.
1Australia Income Tax Assessment Act 1997, §960.220(1).
2Australia Income Tax Assessment Act 1936, Schedule 2F, §§272-75, 272-87.
3Convention Between the Government of the United States of America and the Government of Australia for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion With Respect to Taxes on Income (1982).
4See Blaikie, Hickman, and Utz, "Australia," in Kaplan and Hauser, eds., Trusts in Prime Jurisdictions, p. 47 (Globe Business Publishing Ltd., 4th ed., 2016).
5Id., p. 48.
7Id., p. 51.
8See Australian Tax Office, You and Your Shares, p. 5 (June 2017), available at www.ato.gov.au.
9Blaikie, Hickman, and Utz, "Australia," in Kaplan and Hauser, eds., Trusts in Prime Jurisdictions, pp. 50, 53 (Globe Business Publishing Ltd., 4th ed., 2016)
10Id., p. 51.
11Id., p. 55.
12Id., p. 56.
13Id., p. 59.
14Protocol Amending the Convention Between the Government of the United States of America and the Government of Australia for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion With Respect to Taxes on Income, Art. 13(2).
15See, e.g., Rev. Rul. 85-60; Sec. 875.
16See Rev. Rul. 91-32; Sec. 864.
17Rev. Rul. 91-32, citing Unger, T.C. Memo. 1990-15, et al.
18See Sec. 871(b)(1).
19See Donroy, Ltd., 301 F.2d 200 (9th Cir. 1962); Johnston, 24 T.C. 920 (1955).
20See Regs. Sec. 1.702-1(a)(8)(ii).
21See Rev. Rul. 85-60.
23Sec. 661(b); Regs. Sec. 1.661(b)-1.
26Regs. Sec. 1.643(a)-5(b); before being amended by T.D. 9582 (April 13, 2012).
27Preamble to T.D. 9582.
28Regs. Sec. 1.663(c)-1. See the author's previous article, "Reporting Trust and Estate Distributions to Foreign Beneficiaries: Part 2," 44 The Tax Adviser 42, 45 (January 2013), for additional information on reporting trust and estate distributions to the beneficiaries.
29Section C, REG-108524-00 finalized by T.D. 9200, effective May 13, 2005.
30See Regs. Sec. 1.1446-3(d)(1)(i).
31Treasury Dep't, Technical Explanation of the Protocol Between the Government of the United States of America and the Government of Australia, Art. 10.
33U.S.-Australia Income Tax Treaty, Art. 16(3)(a), as amended by Art. 10 of the Protocol.
34U.S.-Australia Income Tax Treaty, Art. 16(2)(d)(ii), as amended by Art. 10 of the Protocol.
35U.S.-Australia Income Tax Treaty, Art. 7(2).
38The "gross-up method" tax treatment is recommended in Zaritsky and Rosen, BNA Tax Management Estates, Gifts, and Trusts Portfolios 854-4th, U.S. Taxation of Foreign Estates, Trusts and Beneficiaries, A-32 (2014).
39Instructions for Form 1040NR, p. 7 (2016).
AICPA recommends Form 1041NR tailored to foreign trusts
|In 2008, the AICPA submitted a draft Form 1041NR, U.S. Nonresident Alien Income Tax Return, tailored for use by foreign trusts, to the IRS for consideration. The draft form and schedules were developed by the AICPA Foreign Trust Task Force. The draft form, if adopted by the IRS, would allow for calculation of distributable net income and the distribution deduction and would include a Schedule K-1 for beneficiaries. However, the IRS has not adopted the suggested changes.
As a result, fiduciaries have little choice but to follow the IRS instructions to Form 1040NR to "[c]hange the form to reflect the provisions of Subchapter J, Chapter 1" of the Code, even though they may not feel comfortable doing so. In fact, fiduciaries must exercise their own due-diligence procedures by also changing the Form 1040NR to comply with Subchapter N and its regulations.
|Lawrence H. McNamara Jr. is a sole practitioner in North Bethesda, Md. He has been a member of the AICPA Trust, Estate and Gift Tax Technical Resource Panel, its Foreign Trust Task Force, and its Trust Accounting Income Task Force—Technical Issues Working Group. For more information about this article, contact email@example.com.