The long arm of the US tax man

  • Author : Michael Betley
  • Date : May 2011
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.


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