Reporting foreign trust and estate distributions to U.S. beneficiaries.

Author:McNamara, Lawrence H., Jr.
Position:Part 2


* Trusts are common law creations; civil law jurisdictions generally do not recognize the trust concept.

* Trusts can have more than one situs, including administrative situs, jurisdictional situs, tax situs, and locational situs.

* The Foreign Account Tax Compliance Act (FATCA) may subject foreign trusts and estates to extensive information-gathering and information-reporting requirements.

This three-part article explains the U.S. tax reporting responsibilities, including determining the proper tax classification of the entity, reporting for income distribution payments, and reporting requirements under the Foreign Account Tax Compliance Act (FATCA), for foreign nongrantor trusts and foreign estates with U.S. beneficiaries. Part 1, in the October issue, explained how to classify a foreign nongrantor trust for the proper U.S. tax treatment, and the tax withholding rules for various income items received from U.S. sources.

Part 2 analyzes legal and beneficial ownership concepts as applied to a trust or estate created and administered in a foreign common law jurisdiction in contrast to a civil law jurisdiction, which generally does not recognize the trust entity concept. Part 2 also discusses the income tax treaty provisions and how they affect the entity's income reporting, as well as the impact of the FATCA tax regime provisions on the fiduciary's tax reporting responsibilities. Part 3, in the December issue, will analyze the "net income distribution" payment calculations for U.S. and foreign income beneficiaries, as well as offer a comprehensive example to illustrate the U.S. tax reporting for the foreign entity and its beneficiaries.

Readers should understand the content of Part 1 of this article to fully comprehend the analysis and discussion in Part 2. Estate and trust administration can be complex and challenging, with cross-border transactions requiring tax reporting under various jurisdictional laws and regulations. Having both U.S. and foreign income beneficiaries can significantly complicate the administrative responsibilities for fiduciaries. Part 2 will expand and broaden the fiduciary's global understanding of today's foreign trust and foreign estate tax reporting responsibilities in a changing legal and economic environment.

In recent years, international regulatory and tax-compliance global initiatives have raised awareness of and attention to the tax obligations affecting mobile owners of wealth and international financial institutions that operate in multiple jurisdictions. Traditionally, the fiduciary's duties and responsibility have been to protect the beneficiary's interest, being charged with legal responsibilities involving prudent care, astute guardianship, and stewardship. Today's fiduciary is also expected to have and to exercise the ability to process volumes of complex information, while balancing different sources of professional tax and financial advice. Simultaneously, a successful fiduciary respects the dynamics within multiple generations of family members, while considering the nuances that are often deeply embedded within each member's culture.

Straightforward wills are becoming commoditized so that they are now widely available at low cost, while estate planning is becoming increasingly complex, with a significantly more sophisticated entity structure that requires greater collaboration among professional advisers. (1) The issues confronting today's fiduciaries are not only ones of tax, residence, and domicile. The major legal systems dominate global fiduciary administrations: common law, civil law, and religious law.

People in the Persian Gulf states generally follow Islamic law or Sharia, a religious law that is not tied to a physical location, except in Saudi Arabia, where it is the law of the land. (2) Families from the Gulf states tend to be close-knit and give the well-being of the family group priority. (3) In contrast, the culture in countries using the common law legal system, including the United Kingdom, the United States, Canada, and Australia, tends to be more focused on the individual. Common law legal systems depend on judicial decisions to interpret and, in many cases, create law. Civil law countries, which follow statutory or codified systems, make up most of the other countries in the world. Countries with civil codes tend to have cultures that follow the laws like a rulebook rather than a guide. (4)

Inheritance laws in civil law jurisdictions are very different from those in common law jurisdictions. For example, common law principles allow older generations to disinherit younger generations or give them unequal shares of property in their trust instrument and/or will. In contrast, civil law countries follow forced-heirship principles, which guarantee that younger generations will inherit a certain share of a parent's assets. As a consequence, today's mobile society, which sometimes includes marriages that mix different cultures, complicates traditional estate and trust administration.

Advising clients in 'private international law'

Difficulties can develop when a trust is administered in a different jurisdiction from where it was created or established. The trust is a legal entity, which can only succeed administratively in a judicial environment where the jurisdiction recognizes the trust under common law principles. In countries where those legal principles are not recognized, the court will not find a rule for conflict of laws according to which it can determine the laws that apply to the trust. For example, even if a judge concludes that a common law country's law applies, it may be difficult to determine how to translate into the non-common law country's own law(s) the legal effects that will result from the trust's facts. (5) With these problems confronting fiduciaries and beneficiaries, the Hague Conference on Private International Law (HCCH) developed an international convention on the laws that apply to trusts and whether they are recognized, in 1982. The Hague trust convention ("Convention on the Law Applicable to Trusts and on Their Recognition") was adopted on July 1, 1985.

Application of the Hague conventions

The HCCH is a global intergovernmental organization that has as its mission the progressive unification of the rules that various countries have adopted to resolve differences among their legal systems. (6) Its objectives involve developing international approaches to court jurisdiction, jurisdictional law, and the recognition and enforcement of foreign judgments in a range of areas from banking laws to matters of marriage and personal status. (7) The HCCH has 83 member states from around the world, and is attracting nonmember countries that are becoming parties to the Hague conventions. (8)

Benefits of the Hague conventions

The Hague conventions and their articles create greater legal certainty in difficult cross-border circumstances. For example, under the conventions, a will executed by a testator in accordance with Swedish law will not be deemed invalid in Japan just because it is in a different form. (9) To meet its objectives for greater global legal certainty, the HCCH's Hague conventions must be more widely adopted by additional foreign jurisdictions. Some progress has been made in this ratification process over the last several years.

In terms of specific articles in the convention on trusts, for example, Article 6 stipulates that the legal system that applies to the trust is that which the settlor chose. The settlor's choice of legal system must be made either expressly or by implication in the terms of the trust instrument. (10) If not, Article 7 provides that the trust is governed by the legal system with which it is most closely connected. Under those circumstances, the following facts must be analyzed to ascertain the legal jurisdiction that applies to the trust:

* The location of the trust administration as designated by the settlor;

* The location(s) of the trust's assets;

* The trustee's place of residence or business location;

* The objectives or purposes of the trust; and

* The tax jurisdictional laws that apply where each asset is located. (11)

However, all questions concerning the law of succession must be dealt with according to the law of the state (country of jurisdiction) to which the testator or settlor belonged (his or her domicile) at death. (12)

Nevertheless, the recognition of a trust's valid legal establishment according to a foreign jurisdiction's laws has its limits. According to Article 15 of the convention, a trust's legal status is not recognized insofar as mandatory provisions of the legal order, as designated by the conflict of rules of the forum, would be violated. (13) For example, if assets located in Japan or Germany (civil law jurisdictions) were alleged to have become property of the trust, a Japanese or German judge must apply mandatory provisions of Japanese or German property law to determine that fact of law. (14)

Guarded optimism in applying the Hague convention

Recently more success stories have occurred in some civil law jurisdictions, and even in other common law jurisdictions, in recognizing the trust and its legal system applications. Two primary reasons point to these successful results:

  1. The Hague trust convention creates a "common framework" for civil law countries that desire to formally recognize the trust and its legal applications, thus avoiding the question of how the trust will be characterized under local law, an issue that can require complex analysis and legal rulings. (15)

  2. The convention provides a "term of reference" for the courts in countries that do not formally recognize trusts, but are presented with the responsibility to determine the application of the local jurisdictional laws, to make judicial decisions about a trust. (16) The challenges under the above circumstances will continue to confront professionals and fiduciaries. The quality...

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