ABOUT THE AUTHOR: Michael Betley TEP is Managing
Director of Trust Corporation of the Channel Islands Ltd
I t is estimated that one in three European families have a US
citizen as an extended family member (through birth, immigration or
marriage). The taxation by the US of its citizens’ worldwide income
and gains regardless of residency is an inescapable shadow. There
is a growing sense that belonging to this group by association is
contagious and brings trouble. While this is not strictly true, the
reality is that there is often collateral risk that one could
reasonably avoid. With the arrival of Hiring Incentives to
Restore Employment Act (HIRE) last year, the Internal Revenue
Service (IRS) rash will become contagious. This article is meant to
provide some practical insight into some of the issues presented to
non-US trustees and fiduciaries (Foreign Trustees) representing US
persons or trust beneficiaries.
More than ever before, trustees must be aware of the
implications of straying into the US tax net. It is much easier to
fall into currently, particularly given the increasing intrusion of
the IRS overseas. Many Foreign Trustees are simply not aware, or
familiar with the required reporting and tax issues resulting from
exposure to the US either through US persons or holding US
assets.
As a Foreign Trustee you may commonly come across the following
scenarios:
1Foreign US trusts that may have within their
beneficial class named or unnamed US
beneficiaries2Beneficiaries of foreign trusts who immigrate to the
US or marry a US citizen3Subsequently
identifying that a settlor (grantor) or beneficiary is a dual
passport holder and you find that while you had assumed that
individual was a non-US person, you now find out that they
are.4Managing the onerous throwback rules where you have a
mix of beneficiaries including US beneficiaries where annual income
and gains have not been fully distributed each
year.5Transfer of assets back to the US in order to avoid
the new Report of Foreign Bank and Financial Accounts (FBAR)
rules.6Restructuring the ownership of US located property
such as works of art and real estate to allow US beneficiaries to
continue to enjoy their use rent free.7Establishing new or
inward migration of foreign trusts to the US including establishing
private trust companies for that purpose.
The enactment of HIRE has brought into play, for the first time,
various benefits that US individuals receive directly or indirectly
as beneficiaries of foreign trusts. These new provisions came into
force on 18 March 2010. Further, more wide-ranging sections will
not become effective until after 31 December 2012. It is
anticipated that there will be changes to the current provisions,
however whatever they finally look like, they will impose
significant changes to the way foreign trusts are likely to be
managed going forward.
I set out a number of areas that Foreign Trustees ought to be
aware of when considering how they and their beneficiaries may be
affected by the provisions of HIRE.
Foreign trusts: is there a US
beneficiary?
A foreign trust will be treated as having a US beneficiary if
any US person can be treated as receiving a current, future or
contingent beneficial entitlement to trust fund assets. HIRE
creates a ‘rebuttable presumption’, which will treat a foreign
trust as having US beneficiaries if there is any transfer of
property from a US person. In essence, any US person who directly
or indirectly transfers assets to a foreign trust is treated as the
owner of that portion of the trust property during any taxable year
in which there is a US beneficiary who is entitled to enjoy that
portion of a trust. The presumption applies unless the US
transferor submits sufficient information to the IRS to demonstrate
that no portion of the income or capital (corpus) of the trust has
been accumulated, paid to, or maintained for the benefit of a US
person.
Under HIRE, a US person who is treated as the owner of all or
any portion of the foreign trust has the obligation to provide such
information as the IRS may require, and ensure that the foreign
trust complies with the US reporting obligations. This provision of
the new law applies to taxable years from 1 January 2011.
Can you identify your US
beneficiaries?
It is not always obvious who falls under the definition of a ‘US
person’. The definition includes a US citizen, resident or Green
Card holder. It should be noted that this includes minor children
even if they have no reporting requirements of their own. A US
person is defined as; a citizen or resident of the United States; a
domestic partnership, a domestic corporation or an estate or trust
that is not a foreign estate or trust. A US citizen also includes
individuals born in the US who have not otherwise correctly
renounced their US citizenship rights. As a consequence, trustees
of foreign trusts need to be extra vigilant in identifying who
might fall within this category, as well as keeping regular contact
so that they can be alerted to when beneficiaries move to the US
and become so resident.
New reporting requirements
- Prior to HIRE, there was a penalty of 35 per cent on any
undisclosed sum that had not been previously returned by a tax
payer in respect of the creation of a foreign trust or indeed the
transfer of money or assets to that foreign trust. This was also
true if the executors or trustees did not notify the IRS following
the death of a US owner of a foreign trust.
- This 35 per cent penalty on the undisclosed sum still remains,
however, HIRE imposes a further penalty for failure to file the
requisite information. The minimum additional penalty for each
failure to disclose is USD10,000 and applies to filings after 31
December 2009.
- Foreign Trustees must be aware of this reporting but the
primary obligation falls on the US person or US grantor. There are
further penalties which apply as part of the enhanced FBAR rules.
Foreign Trustees will need to be geared up to provide the relevant
information to allow relevant individuals to complete their own
domestic reporting obligations.
Foreign withholding tax
The most dramatic change for Foreign Trustees is the extent to
which they will be treated as one of a number of new reporting
categories such as foreign financial institutions (FFIs). Each
trust company is going to need to determine its own policy on
whether to sign up to the new reporting requirements, but any trust
company not entering into an FFI agreement with the IRS (which
essentially puts the onus on the FFI to report whether its trusts,
settlors and/or beneficiaries are US persons) will suffer a 30 per
cent withholding of income and gains on all US investments. There
is concern that, as drafted, the regulations imply that each
individual trust (and not just the trust company itself) will be
treated as an FFI. As such, for payments made after 31 December
2012, a US withholding agent will need to withhold tax of 30 per
cent on payments made to an FFI if that FFI (i.e. each separate
trust) does not have an appropriate agreement with the IRS.
Use of foreign trust property by US
beneficiaries
Foreign Trustees should be aware that these provisions will
apply to existing trusts even if there was no earlier reporting
requirement. HIRE means that some trusts will be caught unless
steps are taken in order to mitigate the position. Any new trusts
being created will be treated as having a US person associated with
it (as noted above) unless the settlor or transferor provides
relevant information to clearly demonstrate that there is no US
beneficiary in the tax year in question. It is not just the payment
and receipt of cash or in specie distributions that are taxable,
HIRE now also brings into play indirect benefits such as those
noted below:
- Cash loans – qualified obligations: Any loan of cash or
marketable securities made by a Foreign Trustee will be treated as
a distribution unless it fulfils the criteria as a ‘qualifying
obligation’. As such, a loan from a foreign non-grantor trust made
to a US beneficiary is likely to be treated as comprising a
distribution of distributable net income (income and gains arising
in the current year (DNI)) and possibly undistributed net income
(accumulated or undistributed income and gains (UNI)). This is
unlikely to be the case where the loan fulfils the criteria of a
qualified obligation and where the recipient beneficiary files the
requisite form 3520 (this sets out the transactions undertaken with
foreign trusts and the receipt of foreign gifts).
- Use of non-cash trust assets: The HIRE Act changed the
treatment of a US beneficiary’s use of non-cash loans and assets.
Previously, for example, works of art could be lent to US
beneficiaries for them to use without that ‘use’ being treated as a
taxable benefit or distribution. From March 2010, however, HIRE
imposes a charge such that US beneficiaries are deemed to be
treated as having received a distribution equal to the fair market
value of the asset in use. This applies to art work and other items
of tangible personal property. Unhelpfully, the new provisions give
no assistance in determining how to value the ‘use’ of this
property, but Foreign Trustees should obtain evidence of market
value. It appears as though the IRS will apply a reasonableness
test when assessing appropriate market value.
- Use of rent-free trust property: As with works of art, it had
been possible for US beneficiaries to use US real estate and
property, owned by a foreign trust, rent free. Following the
introduction of HIRE, if a foreign non-grantor trust has current
DNI or accumulated income UNI, the ‘use’ of such property will
become taxable on the US beneficiary. As noted above, the use will
be taxed as a distribution equal to the fair market value of the
rent of that property. The fact that the property remains vacant
for large periods of time appears to be irrelevant as it may still
be treated as a benefit if it is generally available to the US
beneficiary.
As a consequence, Foreign Trustees will now need to consider
either imposing a fair market rental charge on the use of a
property by the US beneficiaries or restructure the
arrangements.
One option that has been put into practice is to transfer the US
real estate into a domestic US trust structure. This may not be
suitable in all cases, but the initial advantages are that the US
beneficiaries will no longer be subject to the deemed market rental
charge for the use of the trust property and if settled from a
foreign non-grantor trust, the new US domestic trust will have
continuing succession planning advantages and escape estate
duties.
Trustees beware
The introduction of HIRE together with FBAR and other
pre-existing regulations, such as the Foreign Account Tax
Compliance Act, will have a dramatic effect on the way
business is conducted by Foreign Trustees going forward. The
penalties and costs for non-compliance are encouraging many Foreign
Trustees to abandon their US beneficiaries and settlors. For those
who wish to continue to act for US persons, there will be
significant changes that will need to be embraced over the next 12
to 18 months.