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

• Author: McNamara, Lawrence H., Jr.
• Position: Part 1

This three-part article explains the procedures and tax compliance issues that fiduciaries face with foreign trusts and estates that pay and allocate distributions to U.S. beneficiaries. Part 1 explains the classification criteria of a foreign nongrantor trust or foreign estate for U.S. tax purposes and the proper information reporting to the IRS and the entity's beneficiaries after U.S. taxes are withheld based upon the "source-income requirements." Part 2, to appear in the November issue of The Tax Adviser, will analyze the trust or estate administration issues concerning the Foreign Account Tax Compliance Act (FATCA) (1) and laws in foreign jurisdictions, under common law or civil law, and their relevance to the trust's or estate's interested parties. Part 3, to appear in the December issue of The Tax Adviser, will contain a comprehensive example of calculating and reporting the net income distribution and corresponding withholding tax allocated to the income beneficiary (both U.S. and foreign) as well as the application of certain beneficial tax treaty provisions.

The evolution of the world economy and the increasingly mobile society present challenges for successfully administering foreign trusts and estates for fiduciaries, beneficiaries, and practitioners. The trust concept has expanded into foreign jurisdictions, even civil law jurisdictions. Administering a foreign trust or estate with U.S. beneficiaries entails additional fiduciary responsibilities that call for the fiduciary to seek knowledgeable and experienced professionals to guide the fiduciary in his or her administrative duties and tax compliance requirements under current U.S. laws and regulations.

That standard of prudence is even more profound today because of tax information exchange agreements between foreign governments and the United States. The standards for transparency and exchange of tax information were developed by Treasury's FATCA implementation, including Intergovernmental Agreements (IGAs), and by the Organisation for Economic Co-operation and Development (OECD) implementation of its Common Reporting Standard. The challenges of administering a foreign trust or estate are complex because each of the various tax jurisdictions has its own "source-income" rules and tax reporting requirements, which might affect the entity and its beneficiaries. The potential complexity and risks of penalties for noncompliance necessitate coordination and communication between practitioners and fiduciaries to carefully administer and monitor the execution of the payment of distributions and the resulting tax reporting before transactions are finalized.

Prudent foreign trust and estate administration should consider a number of crucial factors, including:

* Determing each beneficiary's proper income tax filing status and supporting it with documentation, including signed tax information statements;

* Analyzing the relevance of pertinent tax treaty provisions, depending upon the source-income rules and tax jurisdictional laws;

* Proper allocation of receipts and disbursements between income and principal under local law and the trust's or estate's governing instruments; (2)

* Engaging knowledgeable and experienced professionals in each tax jurisdiction to ensure that tax compliance is maintained;

* Following an informed, careful, and planned course of action before procedures are implemented.

In addition, as discussed in a previous article by this author, (3) the settlor's decision in designating a fiduciary and successor is critical when the future estate will include foreign beneficiaries (and the same care is advised for foreign trusts and estates with U.S. beneficiaries). That article also contains additional comments regarding the exercise of prudent care and due diligence in the entity's administration.

This three-part article will focus on the U.S. tax reporting and classification of "foreign nongrantor trusts" and "foreign estates," with both U.S. and foreign beneficiaries. Thus, this article does not address a foreign grantor trust (i.e., Sec. 672(f)) or a U.S. grantor trust created by a U.S. person who transferred assets to a foreign trust (i.e., Sec. 679). This article mentions some specific tax reporting issues under US. tax laws, which are analyzed in the author's previous articles. (4) In some cases these issues are cross-referenced to the earlier articles.

Determining the proper tax classification of the trust or estate entity for US. tax purposes is critical for the fiduciary and his or her advisers.

Evolution of the discretionary trust concept

Global jurisdictional tax laws and the corresponding tax reporting requirements change frequently, directly affecting the trust entity and its beneficiaries. These global trends have evolved into greater transparency and exchange of tax information ushered in by FATCA and the OECD's Common Reporting Standard. The discretionary trust has adapted to these changes, which afford flexibility in terms of the tax obligations allocated to the trust's global beneficiaries and the trust itself.

The value of sound professional advice to fiduciaries in their pursuit of successful trust administration has also increased. For example, fiduciaries are advised to exercise their discretionary powers to allocate a portion of the U.S. tax liability to the beneficiaries and elect to allocate an applicable share of the tax withholding to each beneficiary. The remaining tax liability is reported by the trust after the fiduciaries have analyzed the resulting tax burdens to both the entity and its beneficiaries to determine the optimum economic consequences.

How to determine whether a trust is a foreign trust

The U.S. tax consequences and tax reporting requirements for a trust or estate are determined by the residence and classification of the entity and its fiduciary. After 1996, the Small Business Job Protection Act of 1996 (5) provides specific tax classification criteria to differentiate the foreign or domestic tax status of trusts with both foreign and domestic participants. Under Secs. 7701(a)(30) (E) and (31)(B), (6) a trust is classified as a foreign trust unless both of the following conditions are satisfied:

* A U.S. court must be able to exercise primary supervision over administration of the trust; and

* One or more U.S. persons must have authority to control all substantial decisions of the trust.

To allow a trust a "reasonable period of time" to take corrective actions, in the event of an inadvertent change in fiduciaries, (7) Treasury regulations allow a 12-month period for corrective action to maintain the entity's domestic status. (8) For example, if a U.S. trustee dies or abruptly resigns, and the trust now has a foreign fiduciary to replace the former U.S. trustee or the foreign fiduciary acts as a co-trustee with a new U.S. trustee, the trust would be classified as a foreign trust. Using these criteria, a trust can be classified as a "foreign trust," even if it was created by a settlor who is a U.S. person, all of its assets are located in the United States, and all of its beneficiaries are U.S. persons. Thus, if one foreign person, such as a "trust protector," has control over one "substantial" power to control decisions affecting the trust, that trust is classified as a foreign trust. Regardless of the Code provisions above, the two legal requirements fall short of establishing the "bright line test" that lawmakers intended. Treasury provided some clarity in Regs. Sec. 301.7701-7(d)(2).The regulations stipulate that a trust is a U.S. person (i.e., a domestic trust) on any day that the trust meets both the "court test" and the "control test."

The court test

A trust satisfies the court test if the following three requirements are met: (9)

* The terms of the trust instrument do not direct that the trust be administered outside of the United States;

* The trust is in fact administered exclusively in the United States (i.e., a U.S. court has "primary supervision"); and

* The trust is not subject to an automatic migration provision as described in Regs. Sec. 301.7701-7(c) (4)(ii), which means the trust instrument contains a provision under which the trust will automatically be relocated to another country if a U.S. court attempts to assert jurisdiction over the trust.

For these purposes, "court" includes federal as well as state and local courts within the 50 states and the District of Columbia. (10) "Primary supervision" under the regulations 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." The regulations provide a nonexclusive list of four types of trusts that satisfy the court test: (11)

* Trusts that are registered in a U.S. court by an authorized fiduciary under a state statute similar to the Uniform Probate Code, Article VII, "Trust Administration"; (12)

* Testamentary trusts, if all the fiduciaries have been qualified as trustees by a U.S. court;

* Inter vivos trusts, if the fiduciaries and/or beneficiaries take action in the event of the settlor's death in a U.S. court to cause the administration of the trust to be subject to the court's primary supervision; and

* Trusts that are subject to primary supervision for administration by a U.S. court and a foreign court.

The control test

Regs. Sec. 301.7701-7(d)(1) provides the following criteria to satisfy the control test:

* A "U.S. person" means a person qualifying within the meaning of Sec. 7701(a)(30).

* "Substantial decisions" mean all decisions other than ministerial decisions that any person, whether or not acting in a fiduciary capacity, is authorized or required to make, either under applicable law or the trust instrument. Those decisions include the primary powers assigned to a fiduciary such as making distributions, designating beneficiaries...