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

AuthorMcNamara, Jr., Lawrence H.
PositionPart 3

This three-part article explains the computations and tax withholding and reporting requirements for foreign nongrantor trusts and foreign estates making income distributions to U.S. beneficiaries. Part 1, in the October issue, analyzed how to properly classify a foreign trust for U.S. tax purposes and what types of income are classified as U.S.-source income for U.S. tax withholding purposes. Part 2, in the November issue, explained the common law and civil law jurisdictional issues affecting foreign trusts and foreign estates, tax treaty issues, distributable net income (DNI) of a foreign nongrantor trust, the Foreign Account Tax Compliance Act (FATCA) requirements for trust and estate entities, and the coordination of FATCA with Chapter 3 withholding requirements for payments to foreign payees.

Part 3 contains a comprehensive analysis of the tax reporting of the net income distribution to a U.S. beneficiary of a foreign nongrantor trust. It also contains a comprehensive example illustrating various aspects of fiduciary accounting, applying tax treaty provisions and the corresponding DNI allocations that determine the net distribution amounts to the entity's U.S. and foreign beneficiaries.

Readers should be familiar with Parts 1 and 2 of this article to fully understand the analysis and discussion in Part 3. This article helps practitioners succeed in the challenges facing estate and trust administration in today's global environment. Having both U.S. and foreign beneficiaries can significantly complicate the procedures and responsibilities for foreign fiduciaries facing changing, complex laws.

Illustrating foreign nongrantor trust beneficiary distributions

To demonstrate the tax reporting of income distributions to the entity's U.S. beneficiary and foreign beneficiary, the practical aspects can better be understood with comprehensive illustrations of the entity's various income items under U.S. and a foreign jurisdiction's laws. The following example illustrates how proper estate plan drafting and a prudent fiduciary's actions can benefit both the U.S. and foreign beneficiaries. It also illustrates how the fiduciary can satisfy tax compliance responsibilities and benefit the beneficiaries economically. Understanding these complex reporting issues can better enable practitioners to assist fiduciaries to achieve administrative success.

Practical example: Foreign nongrantor trust with foreign and U.S. beneficiaries

A foreign nongrantor trust, the ABC Trust, is a complex trust created in Australia using English trust law principles. Australia is a common law jurisdiction comprising six states and two self-governing territories (each has a legislative, an executive, and a judicial branch of government and its own trustee act). Under Australian law, the ABC Trust is a "trading trust" (i.e., a trust conducting a business, with the profits distributed to the beneficiaries, also defined as the registered holder in listed public companies and, accordingly, has the right to receive any dividends paid) (1) and a "family trust" (all beneficiaries are family members) (2) for which the trustee manages its passive investments. It has a noncorporate foreign trustee, Mr. C, who resides and manages the trust and its assets in Sydney. Mr. C has made a "family trust election" under Australian law. The ABC Trust files Form 1040NR, U.S. Non-resident Alien Income Tax Return, in the United States on a calendar-year basis.

Its two foreign beneficiaries are citizens and residents of Australia (Mr. D and Ms. R), and its two U.S. beneficiaries, both of whom are U.S. citizens, live in Chicago (Mr. S and Ms. J). Each beneficiary is designated in the trust instrument as an income beneficiary with a 25% beneficial interest in the trust. The remainder beneficiaries of the ABC Trust are the children of the four income beneficiaries. For tax year 2015, the ABC Trust receives income from three sources:

  1. Distributions as a limited partner from a U.S. domestic limited partnership, M Real Estate Management LP, which owns residential real property that rents 45 apartment units to tenants in Chicago. M Real Estate Management LP was formed under the state of Illinois's Uniform Limited Partnership Act and occupies an office in Chicago. The ABC Trust has a 50% interest in the partnership; the trust maintains a permanent establishment office in Chicago; and the trust receives quarterly distributions from the General Partner.

  2. Dividend income from U.S. corporate stocks (U.S. source) managed by a branch brokerage office of U.S. Brokerage A in Chicago.

  3. Dividend income from Australian corporate stocks managed by a branch brokerage office of Australian Brokerage B (foreign income) in Sydney.

Regarding the income distributions to the ABC Trust beneficiaries for 2015, the following tax results and tax reporting issues are analyzed:

Foreign beneficiaries of the ABC Trust: Mr. D and Ms. R, residents of Australia, would provide Form W-8ECI, Certificate of Foreign Persons Claim That Income Is Effectively Connected With the Conduct of a Trade or Business in the United States, as well as Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting (Individuals), to the payer (Mr. C, as trustee) to certify that each is a foreign person, as a result of their receiving their allocated income portion of the "net rental income" and dividend income, respectively, in their 2015 distributions. Each is a beneficial owner of the U.S.-source income that represents the effectively connected income (ECI) portion of the partnership income (from the rental operations). These forms would contain the individual taxpayer identification number (ITIN) for each beneficiary, after the IRS processed Form W-7, Application for IRS Individual Taxpayer Identification Number.

Because the ABC Trust also collected U.S. dividend income, that income (under Sec. 871(a)(1)(A), which is income "not effectively connected with a U.S. trade or business") is subject to U.S. tax withholding (Sec. 1441(b); Regs. Sec. 1.1441-3(c)(1)) at 30% of the gross income amount (or reduced treaty amount as stipulated in the U.S.-Australia income tax treaty, (3) Article 10(2)(b)). As indicated in the IRS Instructions for Forms W-8ECI and W-8BEN, if the "foreign person(s) or foreign entity" expects to receive income that is effectively connected income and income that is not effectively connected income, the trustee would also provide Form W-8BEN-E, Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities), to each financial institution payer or withholding agent and Form W-8ECI (in the case of M Real Estate Management LP). Form W-8BEN-E would indicate the trust's ITIN, country of residence, Chapter 3 status (complex trust) and Chapter 4 status (passive non-financial foreign entity), and certification that the entity is the beneficial owner of all income and is not a U.S. person.

The U.S. financial institution payer of the dividend income payments to the ABC Trust would be responsible for withholding tax payments for 2015. The trustee would also complete Part III of Form W-8BEN-E to claim tax treaty benefits (i.e., a reduced treaty rate of 15% withholding tax on the dividend income payments) by indicating the "country of residence" and other information about the beneficial owner's status. The reduced tax rate is stipulated in Article 10(2)(b) of the U.S.-Australia Treaty.

U.S. Brokerage A would also prepare Form 1042, Annual Withholding Tax Return for U. S. Source Income of Foreign Persons, to report the taxes withheld and pay them to the IRS, and provide Form 1042-S, Foreign Person's U.S. Source Income Subject to Withholding, to the payee (trustee of the ABC Trust) for 2015.

U.S. beneficiaries of the ABC Trust: For the two U.S. beneficiaries, Mr. C would request that each complete Form W-9, Request for Taxpayer Identification Number and Certification, certifying each's tax identification number and address, and that each is a U.S. person.

U.S. agent of the ABC Trust: Mr. C previously engaged a U.S. agent, L Esq., with S LLP, a law firm in Chicago that represents the ABC Trust in IRS matters. He maintains the entity's accounting records, tax information data, a copy of the trust instrument, other relevant legal documents, and copies of the entity's fiduciary income tax returns from the United States and Australia. Mr. L keeps Mr. C informed about financial information on the entity's U.S. investments and U.S. tax laws with periodic meetings and communications.

Tax reporting under Australian laws for the ABC Trust and its beneficiaries: Current trust laws in Australia stipulate that the beneficiary and not the trustee is regarded as the beneficial owner of the property where the trustee holds the trust property solely in trust for the beneficiary. (4) Express trusts, which are most common for holding assets in Australia, are either fixed (a fixed amount is distributed periodically) or discretionary (the trustee has discretion to determine when and if the trust will make distributions) and are primarily used for family estate planning purposes. (5)

Australian residents are taxed on their worldwide income. Nonresidents of Australia are generally taxed only on their Australia-source income. (6) In general, a trust's taxable income is calculated on its assessable income less its allowable deductions. Division 6 of Part III of the Commonwealth of Australia Income Tax Assessment Act 1936 (ITAA 1936) assesses income tax on the trust's net income, which requires the calculation of a trust's total assessable income, as though the trustee were a resident taxpayer. (7)

Dividend income paid to shareholders by Australia resident companies is taxed under a system known as "imputation," under which the income tax the Australian company paid may be imputed or attributed to the shareholders using "franking credits" (i.e...

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