Learning to live with the new foreign nongrantor trust rules.

• Author: McCaffrey, Carlyn S.
• Position: The Rise of the International Trust - Statistical Data Included

I. INTRODUCTION

The Small Business Job Protection Act of 1996 (the 1996 Act)(1) was intended to deal a heavy blow to the appeal of foreign trusts to U.S. persons. The results were mixed. On. the one hand, the 1996 Act imposes an array of reporting requirements, imposes harsh penalties on failures to comply with these requirements, increases the interest charge imposed on taxes paid on distributions of accumulated income from foreign trusts, treats loans of cash from foreign trusts as distributions, and expands the kinds of gifts that can be treated as indirect transfers from foreign trusts.(2) On the other hand, curiously, the 1996 Act encourages the creation of foreign trusts by its adoption of a set of criteria for foreignness that is both more objective than the criteria formerly used and more biased in favor of foreign status.(3)

This Article discusses how to create foreign trusts, examines their exposure and the exposure of their U.S. beneficiaries to U.S. income tax, and describes the reporting requirements imposed on their creators, their beneficiaries, and the trusts themselves. In addition to explaining the rules, this Article also considers the extent to which foreign trusts continue to be useful planning tools for U.S. persons.

II. How TO CREATE A FOREIGN TRUST

1. How to Determine Whether a Trust is a Foreign Trust

   1. Before the 1996 Act

      Before the 1996 Act there was no clear standard for determining a trust's nationality. The former statutory definition consisted only of a statement that a foreign trust is a trust "the income of which, from sources without the United States which is not effectively connected with the conduct of a trade or business within the United States, is not includible in gross income under subtitle A."(4) This statement is merely descriptive of the consequences of foreign trust status and gives no guidance on how to determine its existence.(5)

      Judicial and administrative authority partially filled the definitional void by establishing a test that required weighing the trust's foreign contacts against its U.S. contacts.(6) The guidance these authorities provided was of little help in determining the foreign or domestic status of trusts with both foreign and domestic contacts.

   2. After the 1996 Act

      New Code [subsections] 7701(a)(30)(E) and (31)(B) attempt to provide clarity, but do so in a way that creates a strong statutory bias in favor of foreignness. Under new Code [subsections] 7701(a) (30) (E) and (31)(B), a trust is a foreign trust unless both of the following conditions are satisfied:

      a. A court or courts within the U.S. must be able to exercise primary supervision over administration of the trust; and b. One or more U.S. persons have the authority to control all substantial decisions of the trust.(7) The Act's version of the definition referred to "fiduciaries" rather than persons. Section 160 l(i)(3)(A) of the Taxpayer Relief Act of 1997 changed the word "fiduciaries" to "persons".(8)

      Under this test, a trust may be a foreign trust even if it was created by a U.S. person, all of its assets are located in the United States, and all of its beneficiaries are U.S. persons. All it takes is one foreign person who has control over one "substantial" type of trust decision.

      Example: Jenny, a U.S. citizen and resident of New York, created a trust for the benefit of her children, all of whom are U.S. citizens and residents. She named the Gotham Trust Company, a New York corporation, and her brother Pat, a citizen and resident of Ireland, as co-trustees. The trust instrument gave Pat the right to determine the ages at which each of the children would receive his or her share of the trust fund. It directed that the trust funds be maintained in the United States in the custody of Gotham and that the laws of the State of New York were to govern the trust's administration. Despite its significant U.S. contacts, the new law will treat Jenny's trust as a foreign trust since an obviously substantial decision is controlled by a foreign fiduciary.(9)

      The new definition fulfills the Treasury Department's goal to

      increase the flexibility of settlors and trusts administrators to decide where to locate and in what assets to invest. For example, if the location of the administration of the trust were no longer a relevant criterion, settlors of foreign trusts would be able to choose whether to administer the trusts in the United States or abroad based on. non-tax considerations.(10) It is understood that one of the principal objectives the Treasury sought to achieve by implementing this new definition was to level the competitive playing field for trust business between U.S. and foreign institutions. Under the former definition, a foreign person who might have preferred to use a U.S. financial institution as trustee was generally reluctant to do so because of the likelihood that the trust would have been taxed as a U.S. domestic trust. Under the new law a foreign person can easily use a U.S. financial institution without creating a domestic trust.(11) Thus, the new definition may level the competitive playing field for trust business between U.S. and foreign institutions. But, although the new Code provision establishes a more objective method for determining whether a trust is domestic or foreign, it falls short of establishing the bright line test that was intended.

   3. The Treasury Regulations

      Some clarity is provided by Treasury Regulation [sections] 301.77017, which is applicable to trusts for taxable years ending after February 2, 1999.(12) The regulations provide that a trust is a U.S. person on any day that the trust meets both the "court test" and the "control test."(13)

      a. The Court Test

      The "court test" is the regulatory explanation of the statutory requirement that "[a] court within the United States is able to exercise primary supervision over the administration of the trust.(14) The final regulations provide a safe harbor for the court test.(15) The safe harbor provides that a trust satisfies the court test if the following three requirements are met:

      (1) The trust instrument does not direct that the trust be administered outside of the United States; (2) The trust in fact is administered exclusively in the United States; and (3) The trust is not subject to an automatic migration provision described in (c)(4)(ii) of [sections] 301.7701-7.(16) According to the preamble to the regulations, the Internal Revenue Service (the Service) included the court test safe harbor in the final regulations because it recognized "the difficulty in determining whether the courts of a particular state would assert primary supervision over the administration of a trust if that trust had never appeared before a court" in that state.(17)

      Treasury Regulation [sections] 301.7701-7(c)(3) provides the following definitions critical to the application of the court test:

      (1) "Court" includes federal as well as state and local courts. (2) "United States" means the fifty states and the District of Columbia. (3) "Is able to exercise" means "that a court has or would have the authority under applicable law to render orders or judgments resolving issues concerning administration of the trust." (4) "Primary supervision" means the judicial "authority to determine substantially all issues regarding the administration of the entire trust . . . notwithstanding the fact that another court has jurisdiction over a trustee, a beneficiary, or trust property." (5) "Administration" means "the carrying out of the duties imposed by the terms of the trust instrument and applicable law, including maintaining the books and records of the trust, filing tax returns, managing and investing the assets of the trust, defending the trust from suits by creditors, and determining the amount and timing of distributions."(18) Treasury Regulation [sections] 301.7701-7(c)(4) describes four types of trusts that satisfy the court test and one that does not. The four types of trusts which satisfy the court test are:

      (1) Trusts that are registered in a court within the United States by an authorized fiduciary under a state statute substantially similar to the Uniform Probate Code, Article VII, Trust Administration.(19) (2) Testamentary trusts if all fiduciaries of the trust have been qualified as trustees by a court within the United States. (3) Inter vivos trusts if the fiduciaries and/or beneficiaries take steps with a court in the United States to cause the administration of the trust to be subject to the primary supervision of such court. (4) Trusts that are subject to primary supervision with respect to their administration by a U.S. court and a foreign court.(20) This list of trusts that satisfy the court test is not intended to be an exclusive list.(21) Thus, other types of trust may also satisfy the test.

      The type of trust that does not satisfy the court test is a trust whose trust instrument contains a provision that would cause the trust to migrate from the United States if a U.S. court attempted to assert jurisdiction over it or otherwise attempted to supervise its administration, either directly or indirectly.(22) However, a trust will not fail the court test solely because "the trust instrument provides that the trust will migrate from the United States only in the case of foreign invasion of the United States or widespread confiscation or nationalization of property in the United States."(23)

      b. The Control Test

      The "control test" is the regulatory explanation of the statutory requirement that "[o]ne or more United States persons have the authority to control all substantial decisions of the trust."(24) Treasury Regulation [sections] 301.7701-7(d)(1) provides the following critical definitions:

      (1) "United States person" means a U.S. person within the meaning of Code [sections] 7701(a)(30).(25) (2) "Substantial decisions" means all decisions other than ministerial decisions that any person is authorized or required to...