Amendments to U.S. Tax Law Applicable to Foreign Trusts and Gifts and Loans from Foreign Persons

Taxation Advisory - October 1, 1996 Issue

On August 20, 1996, President Clinton signed bills enacting legislation which dramatically changed the rules pertaining to foreign trusts as well as the reporting requirements for both grantors and beneficiaries associated with such trusts.

The new measures target perceived abuses related to various types of foreign trusts. The changes affect so- called outbound grantor trusts (and more specifically asset protection trusts), in which U.S. persons create, or transfer property to, trusts located outside the United States, and inbound grantor trusts, created by non- resident aliens ("NRA's") of the United States which includes U.S. persons among their beneficiaries. The new laws are summarized below.

Notice to IRS of Gifts Received from Foreign Persons

New information reporting requirements are imposed on U.S. persons with respect to foreign gifts received after August 20, 1996. For purposes of the new requirements, the term "foreign gifts" means amounts received from persons, other than U.S. persons, which the recipient treats as gifts or bequests. However, such term does not include certain gifts made by a donor through certain qualified direct payments of the donee's medical or tuition bills.

If the total value of foreign gifts received by a U.S. person during any taxable year exceeds US$10,000, the person must furnish in the manner prescribed by regulations, any required information regarding each foreign gift received during the relevant taxable year. The reporting threshold will be subject to a cost-of-living adjustment.

If a U.S. person fails to furnish the required information with respect to a foreign gift within the prescribed time period the tax consequences of the receipt of the gift will be determined by the IRS, and the U.S. person must pay, upon demand and in the same manner as a tax, an amount equal to 5% of the amount of the foreign gift for each month during which the failure continues, not to exceed 25% of the amount of the gift in the aggregate. However, the penalty will not apply if the failure to report the foreign gift was due to reasonable cause and not willful neglect.

Foreign Trust Defined

The new measures modify the definition of a foreign trust (which under previous law was a facts and circumstances test) by expressly defining a foreign trust as any trust other than a domestic trust. To qualify as a domestic trust, a trust must meet two tests:

a court within the United States is able to exercise primary supervision over the administration of the trust; and
one or more U.S. fiduciaries have authority to control all substantial decisions of the trust.

Inbound Grantor Trusts (Foreign Grantor)

Under prior law, if an NRA grantor created a foreign grantor trust, the income from such a trust (other than U.S. source income) was not subject to U.S. income tax, moreover, distributions by such a trust to U.S. persons were not taxed to such persons. This planning technique had been used for a number of years and was sanctioned by the U.S. Treasury in Revenue Ruling 69-70 in 1970.

Under the new legislation:

Generally only U.S. persons will be treated as owning assets in a foreign trust for U.S. income tax purposes. However, the rules do provide exceptions for trusts which are revocable by an NRA grantor (or revocable with the consent of certain people who are related to the grantor) or, if the trust is not revocable, for trusts which may only make distributions to the grantor or the grantor's spouse during the grantor's lifetime. In addition to these exceptions, the new law also exempts foreign trusts in existence on September 19, 1995, provided that the grantor or the grantor's spouse were in the class of beneficiaries.
Any income from a foreign grantor trust which fails to meet one of these exceptions if paid to a U.S. person will be taxed to the recipient as income. Foreign trusts that do not fall into one of these exceptions will be treated as non-grantor trusts (i.e. those trusts in which the grantor is either deceased, or in which he no longer has any rights or possible interest). As a result, the United States will tax all income distributed to U.S. persons at ordinary rates until all income in the trust is distributed, and will impose interest at market rates on amount of income earned in prior years and accumulated in the trust when such accumulated income is deemed distributed.
If a U.S. beneficiary (or his or her relatives) receives a loan from a foreign trust, the value of such loan will be taxed as a constructive distribution to that beneficiary. Limited grandfathering is granted for loans of cash and marketable securities entered into prior to September 19, 1995. The provision specifically taxing the use of real property by U.S. beneficiaries has been omitted from the legislation. However, the Treasury is authorized to issue regulations for situations which may lead to tax avoidance.
The Treasury is authorized to recharacterize gifts (whether in trust or otherwise) from corporations and partnerships if such recharacterization would prevent the avoidance of tax.
The treatment of accumulation distributions from foreign trusts is modified to bring the interest charge imposed on such distributions into line with market rates.

Outbound Grantor Trusts (U.S. Grantor)

Before the enactment of the new measures, U.S. grantors of a foreign trust with U.S. beneficiaries were taxed on the income of the foreign trust as if they owned the assets directly. Prior law provided an exception to this rule, such that U.S. persons who sold property at fair market value to a trust established by a related party would not be regarded as the grantor of such trust for income tax purposes. The new law, applicable to all property transfers after February 6, 1995, provides that, in determining whether a transfer qualifies for the fair market value sale exception, debt obligations of or guarantees by the trust or related parties will be disregarded and taxpayers will be deemed to be grantors of foreign trusts if they structure transfers to foreign trusts as sales in exchange for trust notes or other similar instruments. Grantor trust status can still be avoided if the trust pays the seller full market value for the property and the seller recognizes all the gain at the time of transfer.

If a U.S. trust (not otherwise a so-called "grantor trust") becomes a foreign trust after February 6, 1995, the U.S. grantor will thereafter be considered grantor of the trust and taxed as if the trust was a grantor trust. If a U.S. trust becomes a foreign trust after August 20, 1996, any property that was transferred by a U.S. grantor to the trust prior to the trust becoming a foreign trust will be subject to an excise tax in an amount to be determined by formula when the trust becomes a foreign trust.

The creation of a foreign trust by a U.S. person or the transfer of property to such a trust, or the receipt of a distribution by a U.S. person from any foreign trust whether created by a U.S. person or otherwise, gives rise to a series of reporting requirements on the part of transferors and of U.S. beneficiaries which are discussed in more detail below.

The new law provides that a trust settled by a U.S. person will not become a grantor trust because the trust has a U.S. beneficiary if no trust beneficiary becomes a U.S. person at any time during the five year period following the original transfer to the trust. Again, this provision applies to transfers of property after February 6, 1995.

The rules also provide that an NRA who becomes a U.S. resident within five years after directly or indirectly transferring property to a foreign trust will be treated as having transferred such property (and any undistributed income) to the foreign trust on the date he became a U.S. resident.

New Information Reporting Requirements as to Foreign Trusts

The new measures impose information reporting requirements, and attendant compliance penalties, on U.S. persons with respect to their transfers to, their ownership of, and their interests in, foreign trusts. Moreover, to the extent provided in regulations, these new requirements will also affect the obligations of U.S. persons to report their transfers to, their ownership of, and their interests in, domestic trusts that have substantial activities, or hold substantial property, outside of the United States. However, any of the new requirements may be suspended by the IRS if it is determined that the United States has no significant tax interests in obtaining the required information.

Reporting Requirements as to Certain Reportable Events Expanded information reporting requirements will apply to certain reportable events involving foreign trusts and charitable trusts, that occur after August 20, 1996:

A U.S. person who creates a foreign trust must report the creation of the trust to the IRS.
Upon the death of a U.S. citizen or resident, the decedent's executor must report the decedent's death to the IRS if: (I) the decedent was treated as an owner of part of a foreign trust under the grantor trust rules; or (ii) part of a foreign trust was included in the decedent's gross estate.
A U.S. person who transfers money or property, whether directly or indirectly, to a foreign trust must report the transfer to the IRS.

The preceding rule also applies to a transfer to a foreign trust by reason of death, in which case the reporting obligation falls upon the decedent's executor. Moreover, the fact that another U.S. person may be treated an owner of part of a foreign trust under the grantor trust rules is disregarded in determining whether a reportable transfer to the trust has occurred. However, no reporting obligation is imposed with respect to a transfer to a foreign trust by a U.S. person if the transfer was made in exchange for consideration with a value equal to, or greater than, the value of the transferred property, although such transfers may attract U.S. Federal capital gains tax.

The required written notice must be given on or before the ninetieth day after the occurrence of the reportable event or on such later day as prescribed by regulations. The notice must contain any information required by regulations, including the amount of any money or other property transferred in connection with the reportable event, the identity of the relevant trust, and each Trustee and beneficiary, or class of beneficiaries, of the relevant trust.

Reporting Requirements of U.S. Grantors of Foreign Trusts

If, at any time during any taxable year of a U.S. person that begins after December 31, 1995, the person is treated as the owner (i.e., "grantor") of any portion of a foreign trust under the grantor trust rules, the person shall be responsible for ensuring that the foreign trust files a return setting forth a full and complete accounting of the trust's activities and operations for the relevant taxable year, the name of the trust's U.S. agent, and any other information as prescribed by regulations. Moreover, the U.S. person must also ensure that the foreign trust furnishes the proper information, as prescribed by regulations, to each U.S. person who is treated as an owner of part of the trust or who receives, directly or indirectly, any distribution from the trust.

A foreign trust's U.S. agent is a U.S. person authorized to act as the trust's limited agent solely for purposes of the application of certain provisions of U.S. tax law pertaining to:

requests by the IRS to examine records or produce testimony related to the proper treatment of amounts required to be taken into income by a U.S. person under the grantor trust rules; or
summonses issued by the IRS for such records or testimony.

If a foreign trust does not appoint a U.S. agent, the IRS may determine, in its discretion, the proper amount to be taken into income by a U.S. person under the grantor trust rules with respect to the trust. However, if the trustee agrees, in the prescribed manner and subject to any applicable conditions, to appoint a U.S. agent, the IRS will not have discretionary authority to determine the amount of income to be taken into account by a U.S. person under the grantor trust rules with respect to the trust.

The relevant provisions also state that the appearance of persons or the production of records by reason of a U.S. person being a foreign trust's U.S. agent, as described above, will not subject such persons or records to legal process for any purpose other than determining the correct treatment of amounts required to be taken into account by a U.S. person under the grantor trust rules. Also, it is explicitly stated that a foreign trust will not be deemed to have a U.S. office or permanent establishment, or to be engaged in a U.S. trade or business, solely by reason of having a U.S. person acting as the trust's U.S. agent as described above. This leaves open the question of whether such an agent will be a sufficient contact in the U.S. to allow creditors to attack the trust in the U.S.

Reporting Requirements of U.S. Beneficiaries of Foreign Trusts

If a U.S. person receives, after August 20, 1996, directly or indirectly, during any taxable year of the person, any distribution from a foreign trust, the person must file an information return regarding the trust for the relevant taxable year. The fact that another U.S. person may be treated as an owner of part of the trust under the grantor trust rules is disregarded in determining whether a reportable distribution from the trust has occurred. The return must include:

the name of the trust;
the aggregate amount of distributions the person received from the trust during the taxable year; and
any other information prescribed by regulations.

NOTE: If adequate records are not provided to the IRS to determine the proper tax treatment of a distribution to a U.S. person from a foreign trust, the distribution will be treated a taxable accumulation distribution.

To the extent provided by regulations, this characterization rule will not apply to a trust if the trust elects to appoint a U.S. agent to act as the trust's limited agent solely for purposes of the application of certain investigative provisions of U.S. tax law.

Applicable Penalties

In addition to any criminal penalty under U.S. law, if any return or notice required to be filed with respect to a foreign trust is not filed on or before the appointed time, or does not include the required information or includes incorrect information, the person required to file, or to ensure the filing of the return or notice must pay a penalty equal to 35% (5% in the case of failure to file a general information return) of the gross reportable amount. The term "gross reportable amount" means:

with respect to a so-called reportable event (e.g., the creation of a foreign trust by a U.S. person), the gross value of the property involved in the reportable event determined as of the date of such event;
with respect to a U.S. person required as the owner of a portion of a foreign trust under the grantor trust rules to ensure the filing of a return or notice by the trust, the gross value of the portion of the trust's assets, as of the close of the relevant taxable year, treated as being owned by such person; and
with respect to a U.S. person receiving distributions from a foreign trust, the gross amount of the reportable distributions.

If any failure continues for more than 90 days after the day on which a notice of the failure is mailed to the person required to pay a penalty as described above, the person must pay an additional US$10,000 penalty for each 30 day period, or fraction thereof, during which the failure continues after the expiration of the 90 day period. This additional penalty amount may not, with respect to any failure, exceed the gross reportable amount at issue.

No penalty is imposed if the failure was due to reasonable cause and not willful neglect. However, the fact that a foreign jurisdiction would impose a civil or criminal penalty on the relevant taxpayer, or any other person, for disclosing the required information is not reasonable cause for the failure. Accordingly, bank secrecy laws will not excuse a failure to satisfy the relevant requirements.

Moreover, the coverage of these penalty provisions is extended to any case of a failure to file a required return to report U.S. excise tax due upon a taxable transfer of appreciated property by a U.S. citizen, resident, corporation, partnership, estate or trustee to a foreign trust, estate, partnership or corporation.

For more information, contact Robert H. Goldie via phone at: 212-818-9200.