Tax accounting issues for foreign trusts: this two-part article describes tax accounting and reporting consequences of foreign and domestic trusts. Part I defines these trusts and discusses some advantages and disadvantages of foreign trust status.

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

EXECUTIVE SUMMARY

* A foreign trust is any trust that fails to satisfy the court or control test for establishment of U.S. domestic trust status.

* The AJCA expatriation rules give tax advisers and fiduciaries more standards to measure the control test as a result of new, information return filing requirements.

* Foreign trusts created by a nonresident alien or U.S. person no longer living in the U.S. can provide deferral or avoidance of U.S. income tax.

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The Small Business Job Protection Act of 1996 (SBJPA) changed Sec. 7701(a)(30) and (31) to effectively allow a trust to have foreign status even if it was created by a U.S. person, all of its assets were in the U.S., and all of its beneficiaries were U.S. persons. The requirement of "one foreign person" having control over "one" substantial type of trust decision favors foreign residents. (1) The U.S. is attractive for international planners when their clients seek unique trust law advantages (i.e., no rule against perpetuities in certain states, protection from forced heirship and private trust company trusteeship) that the U.S. offers, without subjecting themselves to unnecessary tax costs. (2) In addition, many fiduciary accounting issues have become paramount with the passage of the American Jobs Creation Act of 2004 (AJCA) and affect trusts. The AJCA created new "expatriation" rules for both trustees and beneficiaries that further complicate the tax and accounting requirements, especially in recording tax payments and applying foreign tax credits.

This article compares domestic and foreign trust status for fiduciary, reporting and tax accounting purposes. Part I, below, points out the differences between foreign and domestic trusts and describes the advantages and disadvantages of foreign trust status. Part II, in the July 2006 issue, will illustrate some tax consequences of foreign and domestic trusts that fiduciaries and tax advisers need to understand to report trust transactions properly under local law and in accordance with the trust instrument.

Background

A recent $21 million judgment in New York against a foreign fiduciary for lack of prudent investor standards illustrates what can happen when the due diligence and care needed to understand trust transactions under international law are lacking. (3) For example, many states do not honor U.S. tax treaties with foreign countries. California does not conform to the Code as it relates to treaties that exempt certain income from Federal taxation. In support of California, as well as other states, the U.S. Supreme Court has ruled (4) tax treaties between the U.S. and foreign governments generally do not prohibit the taxing authority of subnational governments (such as states) to regulate in their own best interests.

Another recent Supreme Court decision (5) threatens attorneys with criminal prosecution when their advice "assists in deprivation of property of others, including depriving a foreign tax authority of tax revenue." The long-term effect of this decision remains to be determined. Regardless, advisers should hold themselves to the same standards of conduct as they do for U.S. tax matters. (6) Professionals who advise in structuring transactions that use foreign-source income on which taxes are evaded risk prosecution under Federal money laundering statutes.

What Is a Foreign Trust?

Under the SBJPA, a "foreign trust" is "any trust other than a domestic trust." Under Sec. 7701(a)(30(E), a trust is a domestic trust under U.S. income tax laws if it satisfies two conditions:

1. Court test: A court within the 50 states or the District of Columbia has primary jurisdiction over the administration of the trust.

2. Control test: One or more U.S. fiduciaries have the authority to control all substantial trust decisions. (7)

   The terms of the trust instrument and applicable law must be reviewed and analyzed to determine whether both tests are met. An analysis will also encompass the actions and residency of the fiduciary

   Court Test

   The court test covers any Federal, state or local court (within the U.S.) that has the authority or would have the right to render orders or judgments resolving administrative issues. Jurisdiction over a trustee, a beneficiary or trust property is not sufficient; primary supervision (jurisdiction) is required. (8) Regs. Sec. 301.7701-7(c)(4) sets forth some of the specific situations in which a trust satisfies the court test:

1. Uniform Probate Code: The standards of the court test are met if a fiduciary registers the trust in a court within the U.S. under a state statute that has provisions substantially similar to those contained in Article VII, Trust Administration, of the Uniform Probate Code.

2. Testamentary trust: The court test is satisfied flail fiduciaries of the trust have been qualified as trustees by a court within the U.S.

3. Inter vivos trusts: The court test is satisfied if the fiduciaries or beneficiaries take affirmative steps with a U.S. court, to subject trust administration to the primary supervision of the court.

4. Multiple court supervision: The court test is satisfied if both a U.S. court and a foreign court can exercise primary supervision over trust administration.

   The SBJPA has "automatic migration provisions." If the trust instrument provides that a U.S. court's attempt to assert jurisdiction or otherwise supervise the administration of the trust directly or indirectly would cause the trust to migrate from the U.S., a court within the U.S. is not considered to have primary jurisdiction over the trust. (9)

   Under a safe-harbor rule, a trust is a domestic trust if(1) the trust is administered exclusively in the U.S.; (2) U.S. persons control all substantial trust decisions; (3) the trust instrument does not direct the trust to be administered outside...