Domesticating Foreign Trusts: the Trust, Tax, and Ethical Considerations in Bringing Foreign Trusts Home

• Jurisdiction: United States,Federal
• Author: By Brian P. Tsu, Esq.*
• Publication year: 2018
• Citation: Vol. 24 No. 4

DOMESTICATING FOREIGN TRUSTS: THE TRUST, TAX, AND ETHICAL CONSIDERATIONS IN BRINGING FOREIGN TRUSTS HOME

By Brian P. Tsu, Esq.*

I. INTRODUCTION

A. Scope

Trust domestication is the process by which the situs of a foreign trust is moved from a foreign jurisdiction to the United States. This article identifies reasons for domesticating a foreign trust from the perspective of a U.S. beneficiary or settlor.¹ In addition, this article examines the trust, tax, and ethical considerations and, where possible, offers potential solutions to problems encountered in a trust domestication. Although relevant to a trust domestication, this article will not examine the local laws of a foreign trust and instead will focus on the U.S. legal aspects of the transaction.

B. What is a Foreign Trust? 1. Generally

There are frequently questions as to whether wealth management and succession vehicles available in foreign jurisdictions are in fact trusts under state trust law and U.S. tax law. While there is no single definition, for purposes of this article, a trust is an arrangement recognized under applicable trust law, by which a trustee holds property contributed by the settlor for one or more beneficiaries. A foreign trust, then, is any trust that has a non-U.S. trustee and is administered outside of the United States. The definition of a foreign trust for U.S. tax purposes, however, is more nuanced.

2. What is a "Foreign Trust" for U.S. Tax Purposes?

For U.S. federal tax purposes, a "foreign trust" is any trust other than a trust² that is classified as a U.S. person (a "domestic trust").³ A domestic trust is any trust that satisfies both the "court test" and the "control test."⁴ For purposes of this article, and in a tax context, the terms "foreign trust" and "domestic trust" will refer to these definitions.

a. Court Test

Under the court test, a U.S. court must be able to exercise primary supervision over the administration of such trust.⁵A court is "able to exercise ... supervision" if it has "the authority under applicable law to render orders or judgments resolving issues concerning the administration of the trust."⁶ A U.S. court exercises primary supervision if the court has the authority to determine "substantially all issues regarding the administration of the entire trust."⁷ The Treasury Regulations offer a safe harbor for meeting the court test. The safe harbor provides that a trust satisfies the court test if (1) the trust instrument "does not direct that the trust be administered outside the United States;" (2) the trust is "in fact administered exclusively in the United States;" and (3) the trust instrument does not contain an automatic migration clause.⁸

b. Control Test

Under the control test, a trust may be characterized as a domestic trust only if U.S. persons have the authority to control all "substantial decisions" for the trust.⁹ A "substantial decision" is a decision made under the trust instrument and applicable law that is not "ministerial" in nature.¹⁰ Decisions regarding the timing or amount of a distribution, choice of beneficiary, removal and replacement of trustee, investments, allocation of receipts to income or principal, and resolution of claims against the trust are all examples of substantial decisions. Ministerial decisions include decisions regarding bookkeeping, collection of income, and execution of investment decisions made by others.¹¹

Generally speaking, a trust settled under the laws of a state and administered by a U.S. trustee is a domestic trust barring any other unusual facts (e.g., a foreign person acting as trust protector with the power to remove and replace the trustee). While domestic trusts are subject to U.S. income tax on their worldwide income, foreign trusts are taxed as nonresident aliens and, accordingly, are only subject to U.S. taxation on U.S. source income.¹²

C. Why Domesticate a Foreign Trust? 1. Avoidance of Onerous Tax Rules Applicable to a Foreign Trust

If the trust beneficiaries are U.S. persons, a domestic trust, rather than a foreign trust, would typically be preferable due to the complex and often onerous tax rules applicable to foreign trusts. Chief among these rules is the application of the throwback tax on accumulation distributions. Under these rules, when a foreign nongrantor trust has accumulated taxable income, subsequent distributions of such income to U.S. beneficiaries will be subject to both ordinary income tax rates (regardless of the original character of such income) and an interest charge. Depending on how long the foreign trust has accumulated such income, it is possible for the tax and interest charge to consume the entire distribution. The throwback tax and its potential impact on a trust domestication are discussed further below.

[Page 31]

Similarly, if the trust is invested primarily in U.S. situs property, a domestic trust, rather than a foreign trust, would be preferable as foreign nongrantor trusts are generally subject to U.S. withholding tax not applicable to domestic trusts and other U.S. persons. For example, foreign trusts are generally subject to withholding under the Foreign Investment in Real Property Tax Act when investing in, disposing of, or otherwise transferring U.S. real property.¹³ Foreign trusts are also subject to a 30% withholding tax on other types of U.S. source investment income.¹⁴

2. Onerous Tax Reporting Requirements for Foreign Trusts

U.S. settlors and beneficiaries are subject to reporting requirements for their interest in a foreign trust. To ensure compliance, the Internal Revenue Code imposes significant penalties for noncompliance, which generally start at $10,000.¹⁵

While U.S. trustees are accustomed to the tax reporting requirements for trusts under the Internal Revenue Code, a foreign trustee may or may not be as familiar with those requirements—especially as they relate to foreign trusts. The unfamiliarity of a foreign trustee can cause delays or otherwise hamper the U.S. settlor or beneficiary in satisfying their own reporting requirements. For example, the trustee of a foreign grantor trust with a U.S. owner (typically, the settlor) is required to file a Form 3520-A with the IRS and to provide the U.S. owner with a Foreign Grantor Trust Owner Statement so that the U.S. tax owner can meet his or her own Form 3520 reporting requirement. If the U.S. owner fails to file the Form 3520, he or she is subject to a penalty equal to the greater of $10,000 or 5% of the trust assets.¹⁶ Foreign trustees who are unfamiliar with U.S. foreign trust reporting requirements occasionally refuse or are unable to complete the Form 3520-A or provide the Foreign Grantor Trust Owner Statement.¹⁷ This problem is compounded by the fact that the failure of the foreign trustee to timely file the Form 3520-A results in a separate penalty, over and above the penalty applicable for failing to file a Form 3520, to the U.S. owner equal to the greater of $10,000 or 5% of the trust assets.

Additionally, U.S. beneficiaries of a foreign trust are required to report distributions from a foreign trust on a Form 3520. By default, distributions from a foreign nongrantor trust are treated as accumulation distributions, subjecting the U.S. beneficiary to the throwback tax and an interest charge, unless the foreign trustee establishes otherwise by furnishing a Foreign Nongrantor Trust Beneficiary Statement.¹⁸ Accordingly, it is critical to a U.S. beneficiary that the foreign trustee properly prepares, and timely furnishes, this statement.

3. Remote Administration

Foreign trusts necessarily require trust administration outside of the United States. A U.S. beneficiary may be uncomfortable with this arrangement especially when there are well-developed domestic trust jurisdictions with established laws, competent trustees, and sophisticated counsel. Further, time zone differences may make it difficult or inconvenient as a practical matter for a U.S. beneficiary to interact with a foreign trustee. Moreover, the U.S. settlor who established the foreign trust may now view the arrangement as unnecessarily complex, especially in light of the current regulatory environment, and no longer justifiable by the original purpose for the trust. In addition to remote administration, the fees charged by foreign trustees are often higher than those charged by U.S. trustees.

4. Difficulty Accessing U.S. Markets

For a variety of reasons, a foreign trustee may not be able to access certain U.S. investments, including the securities market.

5. Poor Trust Terms and Changed Circumstances

Although poor trust terms are not unique to foreign trusts, they nevertheless are a frequent motivation for domesticating a foreign trust. Further, the circumstances under which the foreign trust was created may have changed. For example, many foreign trusts were established for creditor protection reasons. If the settlor no longer needs creditor protection, the foreign trust may no longer be appropriate.

D. Strategies for Domesticating a Foreign Trust

There are two primary strategies for domesticating a foreign trust, namely (i) replacing a foreign trustee with a U.S. trustee and (ii) trust decanting. The optimal means will depend on, among other factors, the qualities of the foreign and domesticated trust, such as their respective terms, the identity of the beneficiaries and settlor, as well as any fiduciary and tax implications.

[Page 32]

1. Replacement of Foreign Trustee/Protector with U.S. Persons

Under this strategy, the foreign trustee or trust protector either resigns or is removed under the terms of the trust instrument (or local law) and each is replaced with U.S. persons.

2. Decanting

Under this strategy, the trustee of a foreign trust may hold the power to "decant," either under the terms of the trust instrument or local law. Decanting is the distribution of trust property from one trust to another trust. In the context of a trust domestication, this involves the distribution of property from the...