Above is the Foreign Grantor Trust Beneficiary Statement from the 3520-A
If it’s a FNGT? The U.S. beneficiary should receive a Foreign Non Grantor Trust Beneficiary Statement which includes information about the taxability of distributions they have received and foreign trust income they must report.
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
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– 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 “ – ” 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
Prudent foreign trust and estate administration should consider a number of crucial factors,
In addition, as discussed in a previous article by this author,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
This 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 U.S. tax laws, which are analyzed in the author’s previous articles. In some cases these issues are – to the earlier articles. Determining the proper tax classification of the trust or estate entity for U.S. tax purposes is critical for the fiduciary and his or her– 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.
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
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
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 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), a trust is classified as a foreign trust unless both of the following conditions are
To allow a trust a “reasonable period of time” to take corrective actions, in the event of an inadvertent change in fiduciaries,Treasury regulations allow a – period for corrective action to maintain the entity’s domestic status. 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 – 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. – (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:
For these purposes, “court” includes federal as well as state and local courts within the 50 states and the District of Columbia.“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:
The control test
Regs. Sec. 301.– (d)(1) provides the following criteria to satisfy the control
As previously discussed, the IRS regulations give the trust 12 months to correct an inadvertent change in trustee that causes an unintended loss of U.S. tax status, such as a trustee’s resignation, disability, or death (but not removal) or the trustee ceasing to be a U.S. person (i.e., change of residency or expatriation). Thus, the trust is able to make whatever changes are necessary to give control over all substantial decisions of the trust to a U.S. person.A change of trustee due to removal or appointment is not inadvertent under the regulations. If corrective actions are successfully undertaken within the – period, the trust will be treated as having maintained its U.S. tax status for the entire period. This result would occur even if one or more substantial decisions were not controlled by a U.S. person during the –
Caution: If a change in the trust’s fiduciary causes a change in the trust’s residence from a U.S. domestic trust to a foreign trust (if no corrective actions were successful by the end of the– period), that change is treated for U.S. tax purposes as a transfer to a foreign trust. That transfer is subject to immediate tax (gain recognition) under Sec. 684. Thus, trust income tax returns would be required to be filed reporting the trust transactions before the change of residency (as a domestic trust) and for the remaining period of the tax year (as a foreign trust). The IRS district director having jurisdiction over the trust’s tax return filing has authority to grant the trust an extension of time to make the necessary corrective actions, if a written statement is sent setting forth the reasons for failure to meet the time requirements, under – standards.
Trust entity classifications based upon IRS regulations
A trust’s “tax status” classification is critical from the standpoint of both fulfilling its purpose and operations, as well as the proper tax treatment and reporting under the Code and regulations. Correctly confirming the tax status classification is imperative in properly reporting a foreign nongrantor trust’s transactions for U.S. tax purposes. In analyzing the classification, determining whether the trust qualifies under the regulations as an “ordinary trust” or as a “business trust” will dictate the proper tax treatment for the entity’s transactions. An entity qualifying as a “business trust” may not be treated as a trust under Subchapter J of the Code.
Ordinary trusts: Regs. Sec. 301.7701-4(a)
In general, the term “trust” as used in the Code refers to an arrangement created either by a will or by an inter vivos declaration, whereby a trustee takes title to property to protect or conserve it for the beneficiaries’ benefit under the ordinary rules applied in chancery or probate courts. The beneficiaries cannot share in the discharge of this responsibility, and therefore, are not associates in a joint enterprise for the conduct of business for profit.
Business trusts: Regs. Sec. 301.7701-4(b)
Business trusts (or commercial trusts) generally are created by the beneficiaries simply as a device to carry on a– business that normally would have been carried out through business organizations that are classified as corporations or partnerships under the Code. That type of organization is more properly classified as a business entity. The legal form of the organization will not, in itself, cause an organization to be treated as a trust for federal income tax
The fact that an organization is technically created in a trust formation by conveying title of property to trustees for the benefit of persons designated as beneficiaries will not convert the entity into a trust if the organization is more properly classified as a business entity under Regs. Sec. 301.– . For example, the absence of formal corporate attributes (e.g., officers, bylaws, certificates, or a seal) may provide little proof as to the taxpayer’s true character. Although the regulations refer to a business trust as being either a corporation or a partnership, a business trust may also be a disregarded entity.
Investment trusts: Regs. Sec. 301.7701-4(c)(1)
An investment trust will not be classified as a trust if the trust agreement permits varying of the certificate holders’ investment.An investment trust with a single class of ownership interests, representing undivided beneficial interests in the trust’s assets, will be classified as a trust if there is no power under the trust agreement to vary the investment of the certificate
Because of the complexity of laws in foreign jurisdictions where the trust might have been created, it can be more difficult to properly classify the trust entity and its operations. An investment trust with multiple classes of ownership interests ordinarily will be classified as a business trust.If the trust is properly classified as a business entity under Regs. Sec. 301. – , it can choose under the – – election whether to be taxed as a corporation or a partnership for federal income tax purposes. However, caution is needed as the – – regulations are different for foreign entitiesthan for domestic entities. The settlor’s intent, as expressed in the trust instrument, and the operations of the entity will most likely determine the applicable tax status classification under the guidelines analyzed
U.S. tax treatment of foreign nongrantor trusts
A nongrantor trust is treated as its own taxpayer, separate from the grantor or settlor. Generally, a foreign nongrantor trust determines its taxable income the same way an individual does. However, Secs. 642, 643, 651, and 661 provide for certain modifications. For U.S. tax purposes, a foreign nongrantor trust is treated as a nonresident alien (NRA) individual who is not present in the United States at any time. A 30% tax is imposed on the net capital gains of an NRA who is present in the United States for 183 or more days during a tax year if those gains are allocable to sources within the United States. As a result of the Sec. 641(b) amendment, a foreign nongrantor trust is not taxed on U.S.- capital gains (except for gains resulting from the sale of a U.S. real property interest, which is treated as effectively connected income (ECI) with a U.S. trade or business under Sec. 897(a)). Thus, even if the trustee(s) of a foreign nongrantor trust permanently resides in the United States (but the trust entity continues to qualify as a foreign trust, as previously discussed in this article), the trust will be treated for U.S. tax purposes as if the trustee(s) had never been present in the United States during the tax
Gross income of a foreign nongrantor trust for U.S. tax purposes
The gross income of a foreign nongrantor trust consists
Gross income from sources within the United States
Note: While foreign nongrantor trusts do not normally engage in a U.S. trade or business, they may invest in partnerships that engage in a U.S. trade or business, resulting in the trusts’ having ECI.For a foreign nongrantor trust to be subject to U.S. tax on ECI, the – entity must have a “permanent establishment” in the United States to operate or conduct that business. Permanent establishment is defined under U.S. international principles and/or an applicable income tax treaty provision. When a foreign nongrantor trust is a general or limited partner in a U.S. partnership that is engaged in a U.S. trade or business, the trust is deemed to be engaged in that trade or business.
Dispositions of U.S. real property interests
When a foreign nongrantor trust disposes of a U.S. real property interest (USRPI), the gain is treated as ECI.A USRPI is an interest in
For these purposes, “interests in real property” include fee ownership,– , and leaseholds of land, improvements thereon, any associated personal property, and options to acquire any of those interests. If a foreign nongrantor trust receives consideration for disposing of an interest in a partnership that holds USRPIs, that consideration will be treated as consideration for the disposition of a USRPI. The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) imposes a tax on the disposition of those USRPIs. A USRPI includes a U.S. real property holding company (USRPHC), which, under Sec. 897(c)(2), is defined as any corporation in which the fair market value (FMV) of its USRPI equals or exceeds 50% of the sum of the FMV of its (1) USRPIs; (2) interests in real property located outside of the United States; and (3) other assets used or held for use in a trade or business. Sec. 1445 provides that the tax withholding under Secs. 1445(a) and (c) applies to all foreign persons disposing of USRPIs.
Under Sec. 1445(c)(1)(A), the amount of tax required to be withheld cannot exceed the transferor’s maximum tax liability for the transfer of a USRPI, as determined by the IRS. A determination of the transferor’s maximum tax liability is initiated upon request by either the transferor or the transferee.The procedures require the filing of Form – , Application for Withholding Certificate for Dispositions by Foreign Persons of U.S. Real Property Interests, to apply for a withholding certificate to request reduced tax withholding on the disposition based upon the transferor’s maximum tax liability. The transferor’s maximum tax liability is the sum of the maximum amount of U.S. income tax that could be imposed on the disposition of a USRPI, plus the amount that the IRS determines to be the transferor’s unsatisfied tax withholding liability.
Transferees may request a maximum tax liability determination either before or after the transfer of a USRPI. However, those transferee determination requests can only be made to cure overwithholding errors. Transferees, nevertheless, have primary tax withholding responsibility before a transaction occurs. Factors such as time constraints and needing financial information from the transferor to establish the maximum tax liability make any possibility of reduction in withholding tax difficult to achieve before the disposition occurs.IRS officials are required to respond to a request for a determination of tax liability within 90 days after receiving the request.
An exception applies to the disposition of a personal residence when the gross amount realized is less than $300,000.For a USRPI disposition that is not a disposition under Sec. 1445(a), but instead is one under Sec. 1445(e)(1)(A), the tax withholding rules are different. A U.S. partnership, the trustee of a U.S. trust, or the executor of a U.S. estate is generally required to deduct and withhold tax equal to 35% of the gain realized on the disposition of a USRPI, to the extent that it is allocable to a partner or beneficiary who is a “foreign person.” (Sec. 1445(a), by contrast, requires tax withholding of 15% on the gross amount realized.) The distributive share allocable to each partner of the gain realized on the disposition of a USRPI is determined under Sec. 704 principles and rules. Tax withholding on the gain is feasible because the partnership, trustee, or executor is the withholding agent that computes the gain on the
Real property interest gains are subject to Sec. 1446 tax withholding (withholding on foreign partner’s ECI), not Sec. 1445 tax withholding (FIRPTA) when the partnership is a domestic partnership, otherwise subject to both tax withholding requirements (Secs. 1445 and 1446) on any gain from a USRPI disposition, provided the partnership fully complies with Sec. 1446 withholding and tax reporting requirements. If tax amounts are withheld under Sec. 1445 by the partnership at the time of the USRPI disposition, the amounts can be “credited against” the Sec. 1446 tax liability.
Election to treat income from real property as ECI
A foreign nongrantor trust that receives rental income from real property located in the United States may make a tax election under Regs. Sec. 1.– to treat all the income from real property located in the United States as ECI, if the property is held for the production of income. The election may be made only for U.S. real estate income that is not in facteffectively connected with the conduct of a trade or business within the United States (because it is held for investment for the production of income).
In contrast, net rental income received by an NRA (or a nongrantor foreign trust) as a partner in a U.S. partnership with U.S. real property rental income would be classified as ECI (and thus not subject to a Sec. 871(d) tax election). In the absence of the election, no operating expenses are deductible from the gross rents reported (i.e., treated and reported as income not effectively connected with the conduct of a U.S. trade or business under Sec. 871(a)(1)(A)).
U.S.-source fixed or determinable, annual or periodic income (FDAP)
U.S.-source FDAP income includes dividends, rents and royalties, annuities, and certain interest income from bonds and other debt obligations (taxable, unless qualified under the “portfolio interest exemption” (Sec. 871(h)) or a tax treaty provision), gains from certain dispositions of timber, coal, or domestic iron ore held for at least one year, income from certain original issue discount obligations, and gains from the disposition of certain intangible property where payments are contingent on productivity, use, or disposition of the property.
U.S. income tax will not be imposed on a foreign nongrantor trust’s receipt of interest income from the following
Tax deductions allowable for U.S. tax purposes
When determining how much of its taxable income is ECI for U.S. tax purposes, a foreign nongrantor trust reduces its effectively connected gross income (or gross income treated as effectively connected) by the deductions that are “connected” with the income.Regs. Sec. 1. – determines the apportionment and allocation of deductions for this purpose. Regs. Sec. 1. – (a)(1) stipulates that “the proper apportionment and allocation of the deductions with respect to sources of income within and without the United States shall be determined as provided in part I (section 861 and following), subchapter N, chapter 1 of the Code.” Further, “[t]he ratable part (portions of allowable deductions) shall be based upon the ratio of gross income from sources within the United States to the total gross income. See [Regs. Secs.] 1. – and 1. – .”
Regs. Sec. 1.– (a)(1) provides that “the operative sections [as applied in this section in determining taxable income of the taxpayer] include . . . section[ ] 871(b) [i.e., ECI] . . . (relating to taxable income of a nonresident alien individual . . . which is effectively connected with the conduct of a trade or business in the United States).” Accordingly, a foreign nongrantor trust is allowed to use those procedures to determine its taxable income for the tax year with regard to
Expenses properly allocated to ECI
The tax treatment and tax reporting of a foreign nongrantor trust’s administrative expenses paid, such as professional fees (accounting, tax, and legal fees), which are directly attributable to calculating and reporting the trust’s ECI for the tax year, are not clear. Regs. Sec. 1.– does provide guidance on the tax treatment and reporting of the allocation and apportionment of expenses for determining taxable income from sources within and outside the United States by providing rules for that
A taxpayer to which this section applies is required to allocate deductions to a class of gross income and then apportion deductions within the class of gross income between the statutory grouping of gross income (or among the statutory groupings) and the residual grouping of items of gross income.Classes of gross income enumerated in Sec. 61 include “distributive share of partnership gross income” (ECI). Legal and accounting fees and expenses are ordinary and necessary, are definitely related and allocable to specific classes of gross income or to all of the taxpayer’s gross income, and are allocated as provided in Regs. Sec. 1. – (e)(5).
Therefore, the calculated deductible amount of professional fees paid by the foreign nongrantor trust is determined by allocation and apportionment procedures, allocated to the ECI for the tax year, following the guidance in Regs. Sec. 1.– , as discussed above. This amount is shown as a reduction of gross income for distributable net income (DNI) purposes. Unfortunately, reporting this amount on Form 1040NR, U.S. Nonresident Alien Income Tax Return, because of its inadequate reporting format for foreign estates and trusts, is difficult for all parties to comprehend (thus, the resulting tax preparation and IRS processing is complex and subject to confusion). However, the tax reporting and treatment of this deduction for U.S. tax purposes will be illustrated in Part 3 of this
The following tax deductions are allowable to the foreign nongrantor trust for U.S. tax purposes in determining its taxable income, regardless of whether it has
These deductions, as indicated above, are reported on Form 1040NR for the tax year. No deductions are allowable or allocable against U.S.-FDAP income, except to the extent the income is properly classified as
Application of a foreign tax credit
In some cases, a foreign nongrantor trust may pay a foreign income tax in the country of its residence in the tax year that it reported U.S. ECI on its U.S. fiduciary income tax return. For U.S. tax purposes, that foreign income, war profits, or excess profits tax paid on that income may, subject to certain limitations, be permitted as a tax credit (or tax deduction under Sec. 164(a)(3)) against the trust’s U.S. income tax liability.The total amount of the foreign tax credit, if applicable, is
U.S. tax rates imposed on income
ECI received and reported by the foreign nongrantor trust for the tax year is subject to the same U.S. tax rates that apply to domestic trusts under Sec. 1(e) or 55.Sec. 1(h) imposes tax rates between 15% and 28% on – capital gains, but only certain capital gains are taxable to the foreign nongrantor trust as previously
Withholding on U.S.-source income
Importance of the tax withholding certificate
A primary duty of the foreign fiduciary is to obtain signed withholding certificates from the beneficiaries and prepare one for the entity before U.S.-income is collected or reported by the withholding agents. Form – – , Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities), is used by foreign entities to document their tax status for purposes of Chapter 3 (withholding on payments to foreign persons) and Chapter 4 (FATCA) for FDAP payments, as well as for certain other Code
The form has 30 parts; however, Part I, “Identification of Beneficial Owner,” contains detailed tax information to profile the entity’s type, address, and individual taxpayer identification number (ITIN) or taxpayer identification number (TIN). Part XXVI, “Passive NFFE,” applies to most foreign trusts and estates. Part XXX, “Certification,” contains declarations that the preparer (or authorized agent) attests to by his or her signature. The form is provided to each withholding agent, not filed with the IRS, and is generally valid starting with the date signed and ending on the last day of the third succeeding calendar year after the year the form was signed (unless a change of circumstances makes the form incorrect).
The withholding agent or payer of income may rely on a properly completed Form– – to treat a payment as being associated to a foreign entity that beneficially owns the income amounts paid. In addition, by completing Part III, “Claim of Tax Treaty Benefits,” the agent can apply a reduced tax treaty rate, or exemption, to the tax withholding amount on the income payment. Failure to provide the form to the agent may require the agent to withhold tax at a 30% nonrefundable rate for each income payment.
If the foreign nongrantor trust or foreign estate is receiving income that is ECI allocated to the entity through a partnership, the fiduciary will provide Form– , Certificate of Foreign Person’s Claim That Income Is Effectively Connected With the Conduct of a Trade or Business in the United States, to an authorized representative of the partnership for Sec. 1446 withholding. The beneficial owner of income paid to a foreign partner that is a foreign complex trust or a foreign estate is the trust entity or estate itself.
Form– , Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting (Individuals), is to be signed and completed by the foreign beneficiaries of the nongrantor trust or foreign estate to document their requirements for Chapter 3 and 4 purposes. The form is valid for the same time period as Form – – , as indicated previously. Form – , Request for Taxpayer Identification Number and Certification, is provided to the U.S. beneficiary to sign and certify his or her filing status as a U.S. person. Additional information is provided in the author’s previous article.
The foreign beneficiaries can obtain ITINs by filing Form– , Application for IRS Individual Taxpayer Identification Number. The applicant mails the form and supporting identification documentation (Form – applicant package) to the IRS at an IRS Taxpayer Assistance Center or submits the package to a – certified acceptance agent or in person to the IRS at certain IRS Taxpayer Assistance Centers. Under the new provisions of Sec. 6109, as enacted by the PATH Act of 2015, ITINs issued after 2012 expire on Dec. 31 of the third consecutive tax year of nonuse. Those issued before 2012 expire on a rolling schedule based upon the date of issuance unless the ITIN has already expired due to nonuse for three consecutive
Application of U.S. tax withholding
In general, foreign nongrantor trusts are subject to U.S. tax withholding on certain items of income that are received from U.S. sources that are not ECI. That income, FDAP, as previously described, is subject to a flat 30% tax withholding (or lower tax treaty provision rate), which is the responsibility of the withholding agent to collect and remit to the U.S. Treasury. The withholding agent is generally the last person (or financial institution) who handles the U.S.-income item before the payment, net of withholding tax, is remitted to the foreign taxpayer or the entity’s foreign agent. Under these procedures, Chapter 3 of Subtitle A of the Code, “Withholding of Tax on Nonresident Aliens and Foreign Corporations,” applies. The withholding agent would provide Form – , Foreign Person’s U.S. Source Income Subject to Withholding, to the fiduciary to report the category of each income item and the tax withholding
If income (including FDAP income) is ECI, tax withholding is generally not required. A foreign entity can qualify for this exemption if it has a U.S. permanent establishment or place of business. However, U.S. partnerships that have taxable income that is ECI (or that is treated as ECI), do have a withholding obligation if the income is allocable to a foreign partner (i.e., the foreign nongrantor trust) under Sec. 704.The tax rate on that withholding is the highest rate of tax specified in Sec. 1(e) for the foreign nongrantor trust or foreign
A foreign partner may claim a Sec. 33 withholding tax credit for its share of any Sec. 1446 tax paid (as withheld on the foreign partner’s income allocation) by the partnership as computed and reported on the partner’s U.S. income tax return.The tax return would report the income items making up its allocable share of the partnership’s effectively connected taxable income (ECTI) for the tax year. A foreign partner may substantiate proof of payment (the amount of its tax paid under Sec. 1446) to be applied to its U.S. tax liability by attaching a copy of Form 8805, Foreign Partner’s Information Statement of Section 1446 Withholding Tax, with the Form 1040NR that the partnership provides to the partner for the tax
The foreign trust or foreign estate must provide a copy of the Form 8805, as provided by the partnership, to each of its beneficiaries. Each beneficiary may claim the tax credit by attaching the Form 8805 to the beneficiary’s U.S. income tax return. In addition the foreign estate or trust must provide a statement informing each beneficiary of the allocated amount of Sec. 33 credit for withholding tax that the fiduciary elects to allocate to the beneficiary on his allocable share of the income
No official IRS form is available for making this statement regarding Regs. Sec. 1.– (d) tax reporting. Until an official IRS form is available, the statement must contain the following information: (1) the name, address, and TIN or ITIN of the entity; (2) the name, address, and TIN of the partnership; (3) the amount of the partnership’s ECTI allocated to the entity for the partnership’s tax year, as shown on Form 8805; (4) the amount of Sec. 1446 tax the partnership paid on behalf of the entity; (5) the name, address, and TIN or ITIN of the beneficiary of the entity; (6) the amount of the partnership’s ECTI allocated to the entity for purposes of Sec. 1446 tax that is allocated to and included in the beneficiary’s gross income; and (7) the amount of Sec. 1446 tax paid by the partnership on behalf of the entity that the beneficiary is entitled to claim on the U.S. income tax return as a Sec. 33
The statement furnished to each beneficiary must be attached to the foreign trust’s or foreign estate’s U.S. income tax return for the tax year.Each beneficiary of the entity must attach the statement provided by the fiduciary, as well as a copy of the Form 8805, to the beneficiary’s U.S. income tax return for the tax year in which it claims a credit for the Sec. 1446 tax. Where the entity has multiple beneficiaries, each beneficiary may claim a portion of the Sec. 1446 tax that may be claimed by all beneficiaries as a tax credit in the same proportion as the amount of ECTI that is included in each beneficiary’s gross income bears to the total amount of ECTI included by all beneficiaries for the tax year.
Further information about specific guidance regarding tax withholding on foreign taxpayers in the case of trusts and estates is explained on pages 802 through 805 of the article “Reporting Trust and Estate Distributions to Foreign Beneficiaries: Part 1,” in the December 2012 issue of The Tax Adviser. Regs. Sec. 1.– provides specific guidance on tax withholding for trusts and estates with foreign beneficiaries. Similar procedures apply to foreign beneficiaries of foreign nongrantor trusts or foreign estates who receive distributions of U.S.- income from the entities. In general, tax withholding is required unless the payer has received appropriate documentation indicating that withholding is not required (or a lower withholding rate applies) and that person has no reason to believe that the documentation is inaccurate.
U.S. withholding taxes credited to the U.S. beneficiaries
If the foreign nongrantor trust had FDAP income, income from the disposition of a U.S. real property interest, or income distributions from a domestic partnership (ECI), the entity likely paid withholding taxes under Sec. 1441, 1445, or 1446. IRS regulations provide that a U.S. beneficiary who receives an income distribution from a foreign trust that includes U.S.-income from which U.S. tax has been withheld must include in his or her distributive income share the amount of the allocated tax withheld on those income items. As a result, the beneficiary’s distribution is “grossed up” for the allocable amount of withholding tax, which he or she can claim as a credit against his or her personal income tax liability. Where the investment is held in the name of a fiduciary for an estate or trust, and that fiduciary is an NRA, under Regs. Sec. 1. – (f), tax withholding is required on the U.S.- income even if the income beneficiaries are citizens or residents of the United States.
If income from sources within the United States has been transferred abroad, it is still treated as being from U.S. sources.So, for example, if U.S.- income is paid to the foreign trust’s trustee who then distributes that income to the U.S. beneficiaries, it is still treated as U.S.- income. If satisfaction of a tax liability of the beneficial owner by a withholding agent constitutes income to the beneficial owner and that income is of a type subject to tax withholding, the amount of the tax payment deemed made by the withholding agent for purposes of Regs. Sec. 1. – (f) is determined under the “ – formula” in Regs. Sec. 1. – (f)(1). The payment constitutes additional income to the beneficial owner based upon all the facts and circumstances, including any agreements between the parties and applicable law. The formula as described in the regulation is as follows: Payment [taxable] = Gross payment without withholding [1 – (tax rate)].
As a result, the fiduciary will charge the tax payment allocated to the U.S. beneficiary’s income distribution to income as a payment on behalf of that beneficiary. The U.S. beneficiary will be subject to U.S. tax on the– taxable payment and receive a corresponding tax credit for the tax withholding on his or her individual income tax return for that tax year. The entity reports (as an income distribution deduction) that amount without a deduction for the amount of withholding tax required to be withheld as reported on the “foreign nongrantor trust beneficiary statement,” as prepared and submitted by the trustee. The amount of the beneficiary’s share of allocated tax actually withheld is allowed as a tax credit against the total income tax for the year as computed in the U.S. beneficiary’s tax return.
The– rule described above also applies to Chapter 3 tax withholding on ECI, if a U.S. beneficiary is subject to taxes imposed on his or her allocable share of ECI paid to the foreign trust. The portion of tax withheld at the source that is allocable to the income share distributed to the U.S. beneficiary will be similarly allowed as a tax credit against the total income tax for the year as reported in the beneficiary’s tax return, and any excess can be refunded. Again, those amounts are required to be reported by the trustee on the beneficiary’s foreign nongrantor trust beneficiary statement to enable him or her to report the amounts
If the amount of the income item is subject to withholding tax that is paid in a currency other than the U.S. dollar, the amount of Sec. 1441 withholding tax is determined by applying the applicable rate of withholding in the foreign currency amount and converting the amount withheld into U.S. dollars on the date of payment at the spot rate (as defined in Regs. Sec. 1.– (d)(1)) in effect on that date. A withholding agent making payments in foreign currency may use a – spot rate or a monthly average spot rate. The agent may also use the spot rate on the date the taxes are deposited (as determined by Regs. Sec. 1. – (a)), provided that the deposit is made within seven days from the date of the income item payment subject to the withholding obligation. These procedures must be followed consistently from year to year.
Reporting U.S. beneficiary distributions from foreign nongrantor trusts
As previously discussed in this article, the trustee of the foreign nongrantor trust may be required to file Form 1040NR to report the U.S.- income and tax withholding for the tax year. Form – , Allocation of Estimated Tax Payments to Beneficiaries, is filed with the IRS by many U.S. domestic trusts and estates to report the allocation of estimated income tax payments paid by the trust or estate to its beneficiaries (by a timely tax election under Sec. 643(g)). Many practitioners also file Form – separately with the IRS, following the IRS instructions and due date, as well as attach a copy with Form 1040NR, to report the U.S. income tax withholding allocated to U.S. beneficiaries, as previously discussed above. Those procedures are intended to alleviate possible “matching errors” with IRS records to avoid correspondence to rectify those reporting
Unfortunately, the IRS has not provided specific guidance on the U.S. tax form to use as a mechanism to track the U.S. beneficiary’s Social Security number on Form 1040NR or Form– for the trust’s allocated share of tax withholding distributable to each beneficiary. As analyzed above, Regs. Sec. 1. – (f) provides guidance that the allocation and matching to each applicable beneficiary should be properly reported. In addition, Sec. 1462 clearly stipulates that the tax withheld at source should be included as income on the return of the income recipient. It further stipulates that any tax so withheld is credited against the amount of income tax as computed on the recipient’s individual income tax
By filing Form ITIN (on Forms 1042-S and 8804). This author recommends that a separate Form – be filed with the entity’s Form 1040NR (designating “Section 1441(b) Taxes” on the top of one, and “Section 1446(b) Taxes” on the top of the other). As discussed above, the U.S. beneficiary’s “foreign nongrantor trust beneficiary statement” will be attached to the Form 1040NR filed by the trustee. Submitting Form – directly to the IRS, within 65 days after the tax – date, and attaching it to the filed Form 1040NR, will more likely avoid matching discrepancies in IRS processing procedures. Until the IRS provides specific guidance on this tax reporting (i.e., a tax form with procedures to properly report the tax year’s allocation of tax withheld to U.S. and foreign beneficiaries by the trustee), filing Form – appears to be an effective method to safeguard these payment allocations under Sec. 1462 and Regs. Sec. 1. – (f).– to report the allocations of tax withheld to each applicable beneficiary, U.S. and foreign ones, practitioners will make a reasonable attempt to avoid matching problems with the tax payments that withholding agents collect and deposit with the IRS as reported under the foreign trust’s employer identification number (EIN) or
Foreign nongrantor trust beneficiary statement
Currently, no official IRS form exists for a foreign nongrantor trust beneficiary statement; however, Notice– and the IRS Instructions to Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, provide clarification of the information needed for the trustee to correctly report the tax information for the U.S. beneficiary for the tax year. The information should be reported by the fiduciary so that each U.S. beneficiary can determine the appropriate tax treatment of any applicable trust distribution(s) for the tax year. According to Notice – , information similar to the tax information required to prepare Schedule – (Form 1041), Beneficiary’s Share of Income, Deductions, Credits, etc., is adequate. The statement need not be filed as an attachment to Form 1040NR; however, attaching the statement might be prudent if questions are raised regarding the trust’s transactions because the statement pertains to each beneficiary for the tax year. Perhaps a more important reason for the trustee to prepare the statement in a diligent manner is to enable the beneficiary to accurately report the information on Form 3520, which requires that information on Part III. If the beneficiary lacks that information because the trustee did not prepare a statement, the beneficiary could be in the position of inadvertently electing the default method, resulting in being subject to the harsh tax consequences of the throwback rules, which are discussed below. These procedures are explained in Notice – and Form 3520
Under the throwback rules, any distribution from a foreign nongrantor trust, whether from principal or from income, will be treated for U.S. tax purposes as an accumulation distribution, which is includible in the beneficiary’s gross income (subject to ordinary income tax rates and an interest charge), unless the IRS was provided adequate records to determine the proper tax treatment of those distribution(s).By designating the current tax year distribution(s) as a “Current Year Income Distribution(s), on the Beneficiary’s Statement,” the beneficiary will be in a position to file an accurate income tax return for the tax year (assuming that the information on the statement is accurate and can be sufficiently substantiated).
Caution: Although certain types of U.S.-and – income items are not taxable to the foreign nongrantor trust, as discussed earlier in this article, those items are taxable to the U.S. beneficiary and, therefore, should be disclosed on the foreign nongrantor trust beneficiary statement. Some examples include U.S. bank deposit interest income, capital gains from security sales (not effectively connected with a U.S. trade or business), foreign dividends, foreign interest, and foreign rental
Form 3520 filed by the U.S. beneficiary
Form 3520 is required to be filed for any tax year by a U.S. person who received (directly or indirectly) a distribution from a foreign trust.Each distribution for the tax year is reported in Part III of the Form 3520, which is filed by the due date of the beneficiary’s U.S. income tax return or the extended due date, Oct. 15, if a timely extension is filed. On the form, the U.S. person is required to report the gross reportable amount, which includes the gross amount of the distributions from a foreign trust. Failure by the beneficiary to properly report a distribution(s) on his or her Form 3520 and/or individual income tax return for the applicable tax year could subject the the beneficiary to a tax penalty equal to the greater of $10,000 or 35% of the gross reportable amount.
The U.S. beneficiary can, in some cases, satisfy– requirements to avoid or reduce any penalties, in the event that a distribution is not correctly reported in a timely manner. However, the fact that a foreign jurisdiction would impose a civil (or criminal) penalty on the taxpayer (or any other person) for disclosing the required information is not acceptable as reasonable cause. In addition, the trustee’s refusal to provide information for any other reason, including difficulty in producing the required information or any provisions in the trust instrument that prevent the disclosure of required information, will not be considered reasonable cause. It is the beneficiary’s responsibility, rather than that of the entity’s fiduciary or U.S. agent, to report the correct tax information on Form 3520.
The HIRE Act of 2010provides that a taxable distribution occurs in a tax year that a trustee of a foreign trust permits the “uncompensated personal use” of any trust property directly or indirectly by a U.S. beneficiary or any related U.S. person. If such an event occurs, the FMV of the use of the property is treated as a taxable distribution to the U.S. beneficiary (or related party). A later return of the property (to the trustee) without timely payment for the use of the property would be disregarded and treated instead as a taxable distribution for tax purposes. This statutory provision does not apply to the extent that the trustee is paid the FMV for the use of the property within a reasonable period of time after the (personal) use. Any uncompensated use of trust property treated as a taxable distribution, as discussed above, would be reportable on Form 3520 and the taxpayer’s individual income tax return for the tax year. Neither the statute nor the committee reports provide specific guidance on issues of uncompensated use, such as defining a “reasonable period of time” after use for consideration to be paid or guidelines on measuring the FMV of the use. The IRS has yet to formulate regulations or guidance on these issues. Therefore, caution is advised to seek professional assistance in tax reporting when this issue arises. Other “Practice Tips” are specified in the author’s previous article.
Form 8938 filed by the U.S. beneficiary
U.S. beneficiaries may be required to file Form 8938, Statement of Specified Foreign Financial Assets, with their individual income tax return, for tax years ending after Dec. 19, 2011.The tax return filing requirements under the final regulations indicate that the form is required by a U.S. person holding an interest in foreign financial assets exceeding $50,000 at the end of the tax year or $75,000 during the tax year. The regulations further provide that an interest in a foreign trust or foreign estate does not have to be included on a statement of foreign financial assets (SFFA), unless the specified individual (SI) either knows or has reason to know of the existence of the interest based upon readily accessible information. Receipt of a distribution from the foreign trust or foreign estate constitutes actual knowledge of its existence for Sec. 6038D purposes. Simplified valuation rules apply that allow an SI to place a value of $0 on the SFFA in years that no distribution is received and the SI does not know the value of the interest based upon readily accessible information.
If readily accessible information is available to value the beneficiary’s interest, then the maximum value of that interest is the sum of (1) the FMV, determined on the last day of the applicable tax year, of all currency and other property distributed by the foreign trust or estate during the year to the SI as a beneficiary; and (2) the FMV, determined on the last day of the year, of the SI’s right as a beneficiary to receive mandatory distributions from the entity.To alleviate the burden of duplicative tax reporting, the IRS instructions provide exceptions for reporting SFFAs on Form 8938. The tax form, in Part IV, “Excepted Specified Foreign Financial Assets,” has a line to indicate the “Number of Forms 3520” filed for the corresponding tax year. The IRS regulations stipulate that the SI is not required to report an SFFA on Form 8938, provided that the SI already reports that SFFA on one of the designated international information returns that was timely filed with the IRS (Form 3520 being one of those designated).
Failure to comply with Sec. 6038D reporting requirements subjects the taxpayer to civil penalties. Failure to file Form 8938 in a timely manner can result in a penalty of $10,000.The penalty can increase if the taxpayer does not rectify the reporting and filing after being contacted by the IRS. The penalty will not apply if the SI can demonstrate that the violation was due to reasonable cause and not due to willful neglect. New Sec. 6501(e)(1)(A) created a longer – assessment period for certain foreign income omissions on taxpayer income tax returns. The new provision applies to omissions of income from SFFAs that exceed $5,000.
FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), must be filed if the U.S. beneficiary or U.S. trustee of a foreign nongrantor trust has a financial interest in or signature authority or other authority over any financial accounts, including bank, securities, or other types of financial accounts in a foreign country, if the value of those accounts exceeds $10,000 for the tax year. FinCEN Form 114 must be filed by April 15 of the calendar year, for years after 2015, but an extension to Oct. 15 is automatic and does not require an extension request. The form must be filed electronically through the BSA– System. For trusts, if a U.S. person beneficiary has a present beneficial interest in more than 50% of the entity’s assets or receives more than 50% of the current year’s income, the beneficiary reports the entity’s foreign financial accounts (subject to the $10,000 reporting threshold). However, if the trust, trustee of the trust, or agent of the trust is a United States person, the U.S. beneficiary does not have an FBAR reporting obligation.
Distributions from a foreign nongrantor trust to foreign beneficiaries
The NRA beneficiary of a foreign nongrantor trust is required to file Form 1040NR only if the full amount of federal U.S. withholding tax is not collected by the payers (withholding agents) for the U.S.-income allocable to the NRA’s share of the trust’s DNI for the tax year. However, he or she is required to file Form 1040NR if the NRA has an income distribution in the current tax year that represents an allocated share of ECTI as a beneficiary (as a result he or she is treated as being engaged in a U.S. trade or business, as previously discussed because of the trust’s income being classified accordingly under Sec. 875(1)).
Sec. 875(2) expressly provides that an NRA who is a beneficiary of an estate or trust that is engaged in any trade or business within the United States shall be treated as being engaged in that trade or business within the United Sates.If a partnership is engaged in a trade or business within the United States, the estate or trust as a partner of that entity, is treated as so engaged.
The NRA would qualify as a U.S. person and, as a result, the foreign beneficiary would be required to file either Form 1040NR or 1040, under the following
As a result, unless one of the above exceptions applies to the NRA beneficiary, the trustee of the foreign trust would have no U.S. reporting responsibility for the NRA’s U.S. tax reporting, unless the IRS questions the foreign trust’s transactions or its trust instrument provisions, which might affect the U.S. tax reporting for the NRA
Certain U.S.-income, specifically ECI, received by the foreign nongrantor trust and distributed to the NRA beneficiary under Sec. 871(b), requires the foreign beneficiary to file Form 1040NR for the tax year to report his or her distributive share of ECTI in the trust’s DNI. As previously discussed in “Application of U.S. Tax Withholding,” on p. 719, a U.S. partnership with a foreign partner (i.e., foreign nongrantor trust) must withhold U.S. tax (under Sec. 1446(b)(2)(A)) and report the tax withheld on Form 8804, Annual Return for Partnership Withholding Tax (Section 1446), to the IRS, and on Form 8805, to the foreign partner. This tax withholding is required at the highest ordinary tax rate for the foreign partner (i.e., Sec. 1(e), or 39.6% for 2015 and 2016 for a foreign nongrantor trust). Part 3 of this article will discuss and illustrate the tax reporting of this income item in a comprehensive example for both the U.S. and NRA beneficiary, as well as the
For the reasons stated above, with regard to the distributive share of ECI income (partnership distributed income), the NRA beneficiary should request, and the trustee should respect the request, that he or she be provided with a foreign nongrantor trust beneficiary statement with the same tax information and format as described above for the U.S. beneficiary. The NRA beneficiary could then file a complete and accurate Form 1040NR with the tax information the foreign trust previously reported to the IRS for the tax
Consistency requirement for trust beneficiaries
Beneficiaries of a trust or estate must treat any reported item on their own individual income tax return consistent with the tax treatment of that item on the fiduciary income tax return. For this purpose, a “reported item” is any item for which the trust or estate must furnish information to the beneficiary. Exceptions to this rule apply
Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR), is the tax form that the beneficiary completes to attach to his or her income tax return to explain the inconsistency. A beneficiary is treated as having complied with these requirements for the reported item,
Obviously, in the case of a U.S. beneficiary of a foreign nongrantor trust, the beneficiary should use caution under those circumstances. Sound professional guidance would certainly be beneficial, considering the potential
Fiduciary income tax return reporting and tax year
Even though a foreign nongrantor trust may file a tax return in its resident tax jurisdiction on a – basis, calendar tax year reporting is required for Form 1040NR. Therefore, the foreign trust would be required to adopt a calendar tax year for U.S. filing purposes under Sec. 645(a). In addition, Sec. 6654(1) provides that any trust that is subject to federal income tax is required to pay estimated income tax
Form 1040NR is required to be filed by a nongrantor trust or foreign estate, as indicated in the Form 1040NR instructions, following the provisions of Subchapter J of the Code. Treasury regulations require a return to be filed in situations including
Under Regs. Sec. 1.– (b), the trustee of the foreign nongrantor trust is required to obtain a U.S. TIN for fiduciary tax return filing and tax withholding purposes. The due date of Form 1040NR is the 15th day of the sixth month following the close of the calendar tax year, unless the trust has a U.S. office or place of business (in that case, it is the fourth month after the tax year end).
The fiduciary of a foreign nongrantor trust is– to appoint a U.S. agent to act as the foreign trust’s limited agent to respond to any request by IRS officials to examine records or produce testimony or to respond to a summons for records or testimony. The format of the agreement to authorize the U.S. agent under Sec. 6048(b) is outlined in Notice – , Section IV.B., “Appointment of U.S. Agent.” The agent can also be beneficial in handling tax matters with the foreign trust’s or foreign beneficiary’s home country’s tax
In recent years, international regulatory and– 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
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.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
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.Families from the Gulf states tend to be – and give the – of the family group priority. 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.
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– 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
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 – law country’s own law(s) the legal effects that will result from the trust’s facts. 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,
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.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. The HCCH has 83 member states from around the world, and is attracting nonmember countries that are becoming parties to the Hague conventions.
Benefits of the Hague conventions
The Hague conventions and their articles create greater legal certainty in difficult– 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. 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
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.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
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.
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.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.
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
The challenges under the above circumstances will continue to confront professionals and fiduciaries. The quality of the local service providers, the professional team members, and the judiciary, if needed, often determines the final outcome. The jurisdictional rules and enforcing judgments are additional essential criteria for all parties to consider in this
Trust administration can often involve multiple jurisdictions. A trust, for example, can be created under the laws of Country A, but be administered by a trustee in Country B (and perhaps also Country C). At the same time, the trust can be a tax resident in Country D. These circumstances result in a legal dilemma and raise questions: What law applies to what issues? One question might be whether the trust property in the trust declaration was “alienable” (transferable from the settlor to the trustee’s control at the settlor’s death) “in some form” according to the law of situs. Subject to those qualifications, the “conflicts rules” in the Hague convention would determine the law governing the validity of the trust and its terms.
Some estate planning attorneys advise the testator to draft a supplemental will to cover only the property owned in a specific foreign jurisdiction (i.e., a foreign codicil to a domestic will). Care is recommended in preparing a codicil because of the risk of revocation of any portion of the original domiciliary will. A supplemental will usually designates the immovable property located in the foreign country, such as real property.
An alternative is to execute an “international will” to provide for the testator’s foreign ownership of the property. The international will, when drafted to meet the requirements of the International Institute for the Unification of Private Law (UNIDROIT), will be valid in any jurisdiction that has signed the Uniform International Wills Act. Treaty signatories include several foreign countries, as well as the United States, 23 states, and the District of Columbia.
However, owning foreign property in a civil law country might make such a codicil unnecessary to complete a bequest to a beneficiary, if the property vests in the decedent’s heirs immediately upon the testator’s death. Qualified and experienced legal advice is the best option before proceeding with international estate planning and drafting the necessary legal documents to safeguard foreign assets. Practitioners should exercise caution in coordinating the “situs” will with the nonresident’s primary will to be sure both are valid and enforceable. Mistakes can often result in the accidental revocation of either will.
One of the objectives of this article is to educate the reader on the nuances of estate and trust administration with a global perspective. The proper income tax reporting of the foreign trust or foreign estate is directly related to these legal issues previously discussed. Determination of the foreign estate’s or trust’s situsis critical. Multiple types of situs can exist simultaneously, including administrative situs, jurisdictional situs, tax situs, and locational
Administrative situs typically refers to the jurisdiction where the trust is principally administered and is considered by most professionals as the most significant type of situs when referring to the entity’s situs. Legal guidance provides rules to determine the administrative situs of a trust. For example, the Uniform Trust Code (adapted wholly or partially by 29 states and Washington, D.C.)provides that a trust instrument’s selection of administrative situs will control, if the trustee’s principal place of business is located in, or a trustee is a resident of, the designated jurisdiction (or at least part of the administration takes place in the designated jurisdiction). If these criteria are met, practitioners can be more confident that a trust’s administrative situs and its applicable benefits are legally satisfied by finding clear statutory and judicial law in the desired jurisdiction.
Jurisdictional, tax, and locational situs
Jurisdictional situs refers to the country whose courts have jurisdiction to hear matters regarding the trust. The location of a trust’s principal place of administration will ordinarily determine which court(s) have primary supervision, if not exclusive jurisdiction, over the trust, and all questions pertaining to the trust’s administration. The trust’s tax situs is the jurisdiction where the entity’s income is taxable. This determination often depends on how the jurisdiction’s tax laws classify a trust or estate as a resident entity. The locational situs of a trust holding intangible assets usually is considered to be the location of the trust’s administrative situs. Real property, however, usually is treated as located in the jurisdiction of the property’s physical location.
For U.S. tax purposes, assets treated as having a U.S. situs
However, ordinary U.S. bank accounts or– accounts are generally not treated as U.S. situs property (Sec. 2105).
While it is possible to have an administrative trustee perform his or her duties in a desired jurisdiction, in some foreign trust administrations, trustee powers such as investment and beneficiary distribution authority can be shared or delegated to a– or “trust protector” in another jurisdiction. In those cases, the fiduciaries share in the “control” function, as discussed in Part 1 of this
This author is familiar with some – cases where former U.S. residents retired from U.S. employers and returned to their foreign home countries, where they subsequently died. In most of these cases, the decedent did not formalize his or her estate plan properly before death. In these cases, some of the assets remained in the United States, and some were located in the home country. In addition, the will, which was drafted in the decedent’s home country, designated both U.S. and foreign beneficiaries of the estate, but it did not designate a U.S. executor to administer the U.S. assets. These circumstances presented many challenges for the beneficiaries and the decedent’s executor in the home
In these cases, the U.S. beneficiaries, with the executor’s approval, should seek a knowledgeable law firm to petition the U.S. probate court to establish an “ancillary estate administration” to administer these U.S. assets (and subsequent distributions to the beneficiaries after the probate court approves those distributions). An “ancillary administration” is an estate administration where the decedent has property, but where the decedent was not domiciled.
The probate court’s ancillary proceeding would include the appointment of a designated administrator (as no will existed to designate such a U.S. representative for the estate) who would manage the estate’s U.S. assets and liabilities (i.e., resulting in an estate inventory). These cases might also have an “administrator with will annexed,” which means an administrator appointed after the executor named in the will has refused or is unable to act.
Many challenges may face the accounting firm engaged to assist the administrator in these cases. A strong international tax and forensic accounting background would give the engagement members an advantage to assist in the inventory discovery process and formulation of a plan of action. A priority would be to determine whether the decedent had successfully expatriated under U.S. immigration and tax laws. The possibility that the decedent had not completed expatriation as required might result in possible tax and penalty assessments that would burden the estate’s liquid assets, expand the timetable of the estate’s administration, and diminish future beneficiary distributions. Two recent tax court cases involving the same taxpayerdemonstrate the importance of getting both the U.S. immigration and tax law aspects of an expatriation right. The first decision “firmly shuts the door on informal abandonment of U.S. residency.”
To demonstrate the complexities of administering an estate with assets located in a civil law and a common law jurisdiction, consider the common occurrence of Quebec residents who own property in the United States. Quebec, which adopted the French legal system of its origins, follows civil law, while the rest of Canada follows common law. In most civil law jurisdictions, the decedent’s property is automatically and immediately transferred to the heirs and legatees, with title transferred upon death, according to the will. This legal concept comes from the French customary law principle: le mort saisit le vif (the dead gives possession to the living).
When a Quebec decedent’s estate assets are located in a jurisdiction where the administrator must be appointed by the court, the Quebec liquidator (formerly referred to as the executor) will most likely encounter jurisdictional law problems.Under Quebec succession law, while the heirs have control and possession of the estate property from the moment of death, the liquidator exercises control and possession of the property for the period of administration to liquidate the estate and satisfy certain debts at the decedent’s death. The liquidator may face restrictions in the foreign jurisdiction with regard to status and capacity, often requiring a bond or surety on the liquidator’s behalf.
If, for example, the Quebec decedent’s estate included real property located in Florida, a probate proceeding would be commenced in Florida, and the Florida court would appoint a personal representative or administrator. Although the “notarial will” is the most common and widely used estate document in Quebec, it is not generally accepted in common law jurisdiction locations, such as Florida.(A notarial will avoids probate in civil law jurisdictions because notaries there are afforded – powers.) For a Quebec estate with a notarial will, to deal with property in Florida, the estate will have to obtain letters of verification from the Quebec court to release estate assets in a common law
Unfortunately, many decedents with assets located in multiple jurisdictions do not engage in proper estate planning with advice from qualified professionals before their death. In those cases, executors face fiduciary risks in administering the estate, given the divergence between the civil law and common law legal
Further examples of the challenges facing fiduciaries include being confronted with requirements to satisfy tax obligations in a common law jurisdiction as well as inheritance tax obligations owed by the beneficiaries in a civil law jurisdiction. In a U.K. probate administration, for example, where the inheritance tax (IHT) exceeds the value of the U.K. estate, but there are foreign assets under the control of the executor that are sufficient to cover the shortfall, should the executor remit funds from the foreign assets located in the foreign jurisdiction to cover the IHT obligations?
These circumstances create a number of legal and accounting issues to resolve in both jurisdictions. Should the U.K. executor expect the executor administering assets in the other jurisdiction to remit funds to pay the IHT? Should the foreign executor who has tax withholding responsibilities for the foreign beneficiaries do so? Doing so could subject the foreign executor to a claim of a “breach of trust” to pay tax that cannot be enforced against him or her.
The general rule is that a will should be construed in accordance with the system or laws the testator intended, which presumes that the law of the testator’s domicile when the will was executed applies. However, the will may stipulate that a specific jurisdiction and its laws should apply to settle the estate. The executors may need to demonstrate their fiduciary responsibilities by carefully communicating with the beneficiaries, including various calculations of different scenarios affecting their beneficial interests.Careful drafting of the estate documents is prudent and generally aids the executor; however, it can be difficult to anticipate what challenges will
As explained in Part 1 of this article, U.S. tax laws presume that trusts are foreign trusts unless both the “control test” and the “court test” are met. In many cases, a settlor has established a foreign trust under Delaware law (because of the state’s favorable trust laws and court system) by entrusting – powers to a – .S. person, usually designated as the trust protector. In those cases, the trust fails the control test because the designated Delaware administrative trustee does not control all the trust’s substantial
Although, before 1997, the statutefor determining whether a trust is domestic or foreign referred to “fiduciaries,” if the “person” (a – .S. person such as a trust protector) has the power to control substantial decisions, the person is treated as a fiduciary for purposes of the current statute (as referred to in Part 1). Substantial decisions
Having a trust protector can be advantageous because of the greater oversight and coordination of the trust’s fiduciaries. In addition, the protector will have more flexibility to handle future situations, better monitor trust administration according to the settlor’s original intent, and promote privacy and confidentiality of the entity’s
At first glance, it would appear that a Sec. 2056A qualified domestic trust (QDOT) would not qualify as a foreign trust because of its strict statutory requirements. Generally, a surviving spouse must be a U.S. citizen for property transferred to the surviving spouse from a decedent spouse’s estate to be eligible for the marital deduction. This requirement was enacted to prevent a noncitizen surviving spouse from transferring the inherited assets out of the United States, thereby avoiding a U.S. estate tax liability. An exception allows the deferral of estate tax for property transferred to a surviving spouse who is a – .S. citizen, if the property passes to a QDOT, which the executor has timely elected to treat as a QDOT.
The QDOT tax rules do not prohibit the– .S. citizen spouse from serving as a – of the QDOT. However, the other – must be a U.S. person (or U.S. institution) who is responsible for withholding the estate tax imposed upon QDOT distributions to the surviving spouse. If the – .S. citizen spouse is a – who has the authority to control some or all substantial decisions concerning the trust and becomes a – .S. resident, the QDOT may be classified as a foreign trust. Distributions of income from the QDOT to the surviving spouse are not subject to the U.S. deferred estate tax. However, a more immediate concern would be two income tax
The U.S. trustee is responsible, and may be personally liable, as a withholding agent for withholding taxes on that income and the tax reporting to the IRS on trust distributions to the nonresident noncitizen surviving spouse.Obviously, care must be exercised in those
While this article’s purpose is to explain U.S. laws on distributions to U.S. beneficiaries from foreign trusts and foreign estates (i.e., understanding the tax concepts), fiduciary accounting income is an accounting and economic concept that has been incorporated into Subchapter J of the Code. In most jurisdictions, including foreign ones, a body of laws has been enacted that frames the substance of the drafting of the testamentary trust instrument’s terms. Typically, a body of case law exists in each jurisdiction that defines the rights and responsibilities of each party. The fiduciary’s primary responsibility is to maintain accurate records and prepare regular fiduciary accountings, which enable the fiduciary to plan future transactions and prepare tax returns for the entity and its
Fiduciary accounting income (FAI) is the trust or estate income determined using the governing instrument (i.e., in a will or trust instrument) and applicable local jurisdictional law. Thus, the economic interests of the income and remainder beneficiaries are determined by providing a means of allocating receipts and disbursements between the entity’s income, which may be accumulated or distributed currently to the income beneficiaries, and principal, which will subsequently be distributed to the remainder beneficiaries. FAI is not a tax concept like “taxable income,” “gross income,” and “distributable net income.”
Subchapter J and Subchapter N of the Code determine the proper tax treatment of U.S.-income for foreign trusts and foreign estates. Although FAI is not a tax concept, domestic complex trusts must disclose it on Schedule B, Income Distribution Deduction, of Form 1041, U.S. Income Tax Return for Trusts and Estates. However, FAI becomes more important for a foreign trust that does not distribute all of each current year’s distributable net income (DNI) to its U.S. income beneficiaries. Any resulting undistributed net income, when distributed to the U.S. income beneficiaries in a subsequent tax year, becomes subject to the “throwback rules” and “interest charge rules” discussed in Parts 1 and 3 of this FAI, as determined under the instrument and local law, provides documentary evidence of each tax year’s current net income. Distributions to the U.S. beneficiaries are measured with the calculated net income share to each beneficiary to determine whether all of the net income has been distributed for the tax
Under U.S. tax laws DNI governs the tax treatment for trusts and estates (including foreign trusts and foreign estates) on key tax
Under the U.S. tax rules, the limitation on the entity’s income distribution deduction applies even if a trust or estate distributes an amount greater than DNI to the beneficiaries. For example, a simple trust could distribute an amount greater than DNI in a tax year if FAI is greater than DNI (e.g., if– trustee fees are allocated to principal, not income, under the terms of the trust instrument for FAI purposes). Estates or complex trusts could make distributions in excess of DNI because these entities are classified as ones that can make distributions of principal (corpus). However, the entity’s income distribution deduction is limited to the DNI
The amount included in the income beneficiary’s gross income may be less, but never more, than his or her allocated portion of DNI, even if all income is required to be distributed in the current tax year. Gross income distributed by an estate or trust to its income beneficiaries generally retains the “same character” in the beneficiary’s hands, as it was accounted for to the estate or trust.Therefore, DNI must be reported by “class of income,” net of expenses, before the net income can be allocated to the beneficiaries. Deductions directly attributable to one class of income are allocated to that income. If the direct expenses exceed the related income, they can be allocated to other classes of income. Indirect expenses may be allocated to any item of income included in DNI, if a reasonable portion is allocated to nontaxable income.
The proper computation of DNI for foreign trusts differs from domestic trusts under Sec. 643(a). Generally, the DNI of a U.S. domestic nongrantor trust for a tax year is equal to its taxable income for that tax year, adjusted by adding to taxable
A foreign nongrantor trust’s DNI includes capital gains, however,and
Note: The special DNI calculation rules applicable to foreign nongrantor trusts do not apply to foreign estates. Capital gains and– income are not included in a foreign estate’s DNI for U.S. tax
The trust instrument or local law may require that specific classes of trust income be allocated to specific beneficiaries. If those requirements have economic substance, independent of the tax consequences, the amounts the beneficiaries received retain their character for income allocation purposes.
As explained in the Tax Adviser article, “Reporting Trust and Estate Distributions to Foreign Beneficiaries: Part 1,” the typical beneficiary wants a cash distribution to be paid in his or her functional currency. To enhance the benefits of the currency exchange, a prudent fiduciary needs to know the tax reporting issues. Executing these conversion procedures successfully can maximize potential gains and minimize potential losses in currency conversion amounts. The – article provides more detailed guidance in these
In 2010, FATCA added Chapter 4 of Subtitle A (comprising Secs. 1471 to 1474) to the Code. FATCA established a new tax withholding and – regime that supplements the Chapter 3 rules under Secs. 1441 through 1446. FATCA requires foreign financial institutions (FFIs) and nonfinancial foreign entities (NFFEs) to identify and disclose their U.S. accounts and substantial U.S. owners, or be subject to a 30% withholding tax on certain U.S.- income payments to them. The 30% withholding is required on “withholdable payments” made after June 30, 2014, to foreign entities, which includes foreign trusts, unless the payee qualifies for an exemption.
Payments to accounts owned by foreign estates are not subject to FATCA.However, fiduciaries of foreign estates have FATCA tax reporting responsibilities to identify and disclose information, like foreign trust fiduciaries. The author recommends that readers review the article, “FATCA: A New World of Terminology and Compliance,” for a detailed list of withholdable payments and exceptions from those
Final regulations in T.D. 9610 impose significant– and – requirements on fiduciaries
A foreign trust can be classified as an FFI if the trust’s income is primarily from passive investments and is professionally managed,as illustrated in Regs. Sec. 1. – (e)(4)(v). Professional management includes a trust company or a – company trustee that hires a professional investment manager. If the trust is an FFI, any tax overwithholding is generally not refundable.
An NFFE foreign trust is not professionally managed and has primarily passive investment income. Most NFFEs can avoid FATCA withholding by
Unlike an FFI, an NFFE can file for a tax refund for any overwithheld tax. However, an NFFE nongrantor trust may have difficulty in obtaining refunds.Electing to be treated as a “direct reporting NFFE” (i.e., registering with the IRS and filing annual FATCA reports, but not entering into an FFI agreement) will improve the likelihood of obtaining tax refunds. An NFFE beneficial interest owner can claim a tax refund by crediting tax amounts withheld under FATCA against his or her U.S. tax liability by filing a U.S. income tax return with all the required information for the tax year.
The United States has entered into IGAs or reached agreement with more than 50 other countries. Several FFIs had difficulties complying with FATCA reporting requirements because of the complexities of bank secrecy laws, sovereignty issues, and local – – issues. The resulting IGAs contain provisions enabling easier FATCA compliance for those
Model 1 and Model 2 IGAs implement FATCA tax information gathering differently. FFIs in Model 1 jurisdictions report directly to tax authorities in the FATCA/IGA jurisdiction, which is then shared with IRS officials.This tax information is exchanged under existing tax treaties or tax information exchange agreements with the IRS. As a result, the FFI in those jurisdictions is generally not required to withhold tax on payments made to nonparticipating FFIs (i.e., the FFI has no FATCA agreement with the IRS) or recalcitrant account holders, if the tax information is reported as required under the IGA terms. A trust resident in a Model 1 IGA jurisdiction is not obligated to assume withholding responsibilities on withholdable payments made to nonparticipating FFIs or recalcitrant account holders. The entity, however, is required to report tax information to the payer of the U.S.- income payment to facilitate tax withholding if the need
With Model 2 IGAs, FFIs report directly to the IRS. Each registers with the IRS as a participating FFI, but the agreement with the IRS enables the FFI to not withhold on payments to recalcitrant account holders if the FFI complies with the IGA.The Model 2 FFI is required to file IRS Form 8966, FATCA Report, containing information about any nonconsenting or noncompliant U.S. account holders. The form is filed on a – basis and is due March 31 of each tax year. A trust is deemed compliant if it complies with the IGA
Application of U.S. tax treaties
The– rules have a direct correlation with the tax withholding requirements under FATCA and IGA tax reporting compliance. In general, – rules (as stipulated in each treaty’s provisions with each U.S. tax treaty partner) serve as the basic element of international taxation. First, the – rules establish a tax jurisdiction’s authoritative right to tax specific income derived within the jurisdiction by a taxpayer that may otherwise not have a taxable nexus with the jurisdiction. Second, – rules were established with the objective of protecting taxpayers from double taxation on the same income item in both the United States and the foreign jurisdiction. In addition to mismatches or lack of clarity between the U.S. statutory source rules and related tax treaty provisions (or lack thereof), complexity abounds, as the United States is not the only jurisdiction to tax its residents on their worldwide
With regard to the taxation for foreign nongrantor trusts and foreign estates, as well as nonresident beneficiaries, under U.S. statutory source rules (specifically Secs. 861 through 875 and related Treasury regulations), certain U.S.-FDAP income, ECI, and gains on dispositions of U.S. real property interests are taxable for U.S. tax purposes (as analyzed in Part 1 of this article). The specific provisions of each tax treaty should be carefully interpreted in its own context because tax laws vary from country to country. The tax benefits derived from each tax treaty (such as a reduced withholding tax rate or full tax exemption) are generally available to taxpayers who are residents of one or both “Contracting States” named in the treaty. A “resident of a Contracting State” refers to a taxpayer who is liable for taxation under that country’s laws by reason of residence, domicile, citizenship, or place of management (Article 4 of the U.S. Model Income Tax Convention). In the case of estates and nongrantor trusts, the tax status of the person or entity who is taxable on the income (e.g., the beneficiary or the entity) determines who is eligible for the treaty benefits, such as a reduced withholding tax
With regard to criminal mutual legal assistance treaties (MLATs), the United States is more receptive to enforcing foreign tax jurisdiction judgments in criminal cases under its obligations in those treaties.Despite these treaties, it remains difficult for foreign tax authorities to recover their taxpayers’ assets located in the United States in civil law cases. Thus, even if FATCA partner countries obtained tax information regarding their residents’ U.S. financial assets, seizing those assets to satisfy domestic civil law judgment liabilities would be difficult. Generally, the United States currently has treaty obligations to enforce foreign civil law judgments with five countries: Canada, Denmark, France, the Netherlands, and Sweden. Essentially a common law rule, the “revenue rule,” which prohibits enforcing foreign tax judgments in the United States, prevents U.S. courts from enforcing foreign civil law tax judgments.
A foreign estate or foreign trust fiduciary may have justification when reporting a particular income source item to take a tax position that any U.S. tax does not apply or is reduced by a U.S. treaty provision (a “ – position”) that is in force. That position should be disclosed on Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b), and attached to the entity’s U.S. fiduciary income tax return. Filing Form 8833 is not required to report a reduced rate of tax withholding for – connected income (i.e., FDAP income).
Withholding agents with Chapter 3 tax withholding responsibilities and FFIs with Chapter 4 withholding responsibilities are required to obtain certain documentation and tax information forms to determine the beneficial owner of specific income item payments that come under their control and supervision. For Chapter 3 requirements, a foreign complex trust or foreign estate is generally considered to be the beneficial owner of the income payments to it. An income payment made to a foreign complex trust or foreign estate may be treated as such if the withholding agent can reliably associate the payment with a withholding certificate or documentary evidence that establishes the foreign entity as the beneficial
Form– – , Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities), is required to be completed by foreign estate and trust entities to document their tax status for both Chapter 3 and Chapter 4 purposes for FDAP payments, as well as certain other Code provisions. A passive NFFE must list all substantial U.S. owners on the Form – – that is provided to the withholding agent (or certify on the document that it has no such U.S. owners). Form – , Certificate of Foreign Person’s Claim That Income Is Effectively Connected With the Conduct of a Trade or Business in the United States, is a certificate provided by the foreign entity to the applicable withholding agent who controls ECI payments in the event that the foreign entity is the beneficial owner of income effectively connected with a U.S. trade or business. These withholding certificates also serve as documentary evidence to establish evidence of residence for claiming any applicable tax treaty
The IRS has issued final regulations regarding tax withholding on certain U.S.-income payments to foreign persons, information reporting, and portfolio interest income paid to NRAs. A withholding agent may treat a payment as if it was made to a foreign complex trust or foreign estate, if the agent can reliably associate the payment with a withholding information certificate or documentary evidence that establishes that entity as the beneficial owner. However, for Chapter 3 tax purposes, a foreign simple trust is not treated as the beneficial owner or payee of the income payment. Under these circumstances (as properly verified with documentary evidence), the withholding agent can reliably associate a payment with a valid Form – , Request for Taxpayer Identification Number and Certification, from a U.S. beneficiary payee or Form – , Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting (Individuals), if an NRA beneficiary, if applicable, as the payee. Beneficial ownership of income is determined under Sec. 7701(l) and other U.S. tax principles, including those governing whether a transaction is a conduit transaction.
Fiduciaries, beneficiaries, and practitioners who are engaged in international estate or trust administrative activities achieve best results by staying informed of these tax reporting responsibilities and tax withholding requirements and acting accordingly. Maintaining accurate and timely documentation as facts and circumstances change is imperative. Potential risks of penalties for Chapter 3 and Chapter 4 noncompliance should be motivation for active communication and stewardship by all
With regard to foreign estate and trust administration and its tax reporting obligations, the ultimate responsibility falls on the fiduciaries who are faced with complying with laws in more than one tax jurisdiction. Because these laws may change without notice, fiduciaries face added pressure to seek knowledge and professional advice to formulate best practices and respond
If the fiduciary resides in a foreign jurisdiction and/or the foreign trust does not have an office or permanent establishment in the United States, it would be prudent for the fiduciary to authorize a U.S. agent to act on all U.S. tax matters needing attention. A U.S. agent is a U.S. person that has a binding contract with the foreign trust (i.e., trustee) that allows the U.S. person to act as the trust’s authorized U.S. agent in complying with Sec. 7602 (examination of books, records, and witnesses), Sec. 7604 (enforcement of summons), and Sec. 7603 (service of summons). The authorization applies to any request to examine records or produce testimony that may be relevant to the U.S. income tax treatment of any transaction with the reporting trust entity or with respect to any summons for those records or testimony.The agency relationship must be established by the time that the trust’s fiduciary income tax return is filed for the relevant tax year. Also, the authorization must remain valid during the – – period for each relevant tax
In the past few years, practitioners and fiduciaries have witnessed a new age of tax transparency, initiated with the FATCA tax regime, with a globally coordinated approach. Recently European Union countries have led the Organisation for Economic – and Development (OECD) and Global Forum on Transparency and Exchange of Information for Tax Purposes, with the objective of eliminating aggressive tax avoidance, as well as illegal tax evasion. The terms “tax evasion” and “tax avoidance” are considered by some jurisdictions to be the same, distorting what has historically been a clear distinction.
In conjunction with the coordination of global tax compliance, professional conduct and ethical standards are being developed, particularly in the United Kingdom, with its Professional Conduct in Relation to Taxation (PCRT).The PCRT contains fundamental ethical principles produced jointly by seven professional bodies. It was formulated to provide guidance for members who are engaged in U.K. tax planning and tax compliance work. Tax consultation has become more complex, not only because of more complex tax laws, but because professionals must exercise sound judgment regarding the implications of their advice.
Jointly developed by the OECD and– countries, the Common Reporting Standard (CRS) is a component of the Standard for Automatic Exchange of Financial Account Information in Tax Matters (AEOI standard). Although the CRS is modeled on FATCA, there are substantial differences. Specifically, with regard to trusts, FATCA procedures follow U.S. tax legislation and tax information exchange in circumstances where a tax obligation is due. In contrast, the existence of a tax obligation has no bearing on the amount of information that is required to be exchanged under the CRS procedures. Rather, the CRS’s focus is on whether an individual is a “controlling person of a trust” that satisfies the definition of “passive nonfinancial institution” for holding financial asset accounts. Tax authorities in EU countries, particularly France, the Netherlands, and Luxembourg, have recently questioned the tax treatment of trusts and their beneficiaries with regard to their tax residences.
As of Jan. 1, 2016, certain financial asset information then in existence became– for – countries. The United States is not a CRS signatory; however, IRS Commissioner John Koskinen has called on Congress to amend the FATCA statutory provisions to allow the United States to participate in the CRS. The CRS rules reflect a clear policy focus on “control,” apart from entity “ownership.” FATCA seeks to identify U.S. taxpayers’ beneficial ownership in – .S. assets, with the conviction that tax liabilities are derived from income associated with that ownership. The FATCA regime seeks the “specified U.S. person” with regard to – .S. FFIs and the “substantial U.S. owner” for passive NFFEs, which are “ – ” concepts. In defining “equity interest” for a trust entity, a key determiner of the account holder, the CRS rules encompass the trustee (including a professional trustee), the settlor, beneficiaries, protectors, and any other person exercising ultimate control over the entity.
The CRS, like FATCA, adopts a residency test in determining which tax jurisdiction’s laws govern a specific entity’s FATCA/CRS due diligence and tax reporting requirements. For a trust, this test means the residency of the trustee(s).Unlike FATCA, the CRS’s rules require that the entire value of underlying assets be disclosed in association with the trust’s fiduciary. Many practitioners are concerned that this global transparency movement may result in many difficult repercussions for their fiduciary clients, including – litigation and risk of confidential information disclosures to government agencies.
In conjunction with the CRS, after January 2017, a “legal entity identifier” (LEI) is required of all investors in global financial markets, including trust entities.The Financial Stability Board, set up by the – countries and organized by the central bankers, is the body that issues the LEI. As part of the process of issuing an LEI, detailed information for each applicant is verified with public sources, through the Global Legal Entity Identifier Foundation (GLEIF) in Switzerland. The unique identification number will be required before the applicant can trade in security purchases and sales on financial markets, even by a – fund manager or broker. Because many trusts do not have information that is publicly available to allow this verification, obtaining an LEI may be difficult, if not impossible. Unless regulations or procedures are developed soon to accommodate trust entities, fiduciaries may effectively be “ – ” of participation in the financial markets.
Another development in transparency occurred on Feb. 28, 2017, when members of the EU Parliament voted to adopt an amended– – directive that will provide for public access to registers of beneficial owners of companies and trusts. Trusts were previously excluded from the directive on privacy grounds. The new requirements include full transparency, including revealing the identity of beneficial owners.
With these global developments confronting fiduciaries in mind, the future will necessitate experienced and knowledgeable practitioners to guide fiduciaries with their fiduciary duties and responsibilities. Today’s responsibilities are likely to lead to increased challenges for existing trust structures in the future, and informed communication with beneficiaries will become more important for fiduciaries. History has demonstrated that trusts are resilient, and their flexibility makes them an excellent structure to benefit families with complex governance and succession issues. However, these recent developments should motivate fiduciaries to analyze their– structure in light of these new disclosure and registration
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
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– 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) and a “family trust” (all beneficiaries are family members) 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. Nonresident Alien Income Tax Return, in the United States on a –
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
Regarding the income distributions to the ABC Trust beneficiaries for 2015, the following tax results and tax reporting issues are
Foreign beneficiaries of the ABC Trust: Mr. D and Ms. R, residents of Australia, would provide Form– , Certificate of Foreign Person’s Claim That Income Is Effectively Connected With the Conduct of a Trade or Business in the United States, as well as Form – , 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.- 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 – , 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.– (c)(1)) at 30% of the gross income amount (or reduced treaty amount as stipulated in the U.S.-Australia income tax treaty, Article 10(2)(b)). As indicated in the IRS Instructions for Forms – and – , if the “foreign person(s) or foreign entity” expects to receive income that is effectively connected income andincome that is not effectively connected income, the trustee would also provide Form – – , Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities), to each financial institution payer or withholding agent and Form – (in the case of M Real Estate Management LP). Form – – would indicate the trust’s ITIN, country of residence, Chapter 3 status (complex trust) and Chapter 4 status (passive nonfinancial foreign entity), and certification that the entity is the beneficial owner of all income and is not a U.S.
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– – 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
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– , Foreign Person’s U.S. Source Income Subject to Withholding, to the payee (trustee of the ABC Trust) for
U.S. beneficiaries of the ABC Trust: For the two U.S. beneficiaries, Mr. C would request that each complete Form– , Request for Taxpayer Identification Number and Certification, certifying each’s tax identification number and address, and that each is a U.S.
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
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.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.
Australian residents are taxed on their worldwide income. Nonresidents of Australia are generally taxed only on their– income. 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.
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., credits for taxes paid by the company that attach to the dividends the shareholders receive). Thus, if a company pays or credits a shareholder/payee with dividends that have been “fully franked,” a 30% income tax has been deducted for Australian tax purposes. The payee is entitled to a franking credit (tax offset) for the tax that the company has paid on its income. The annual dividend distribution statement sent to the payee must disclose the amount of the franking credit, and the payee is entitled to reduce the income tax payable on the dividend income by this amount.
Whether a trustee or a beneficiary is taxed on that income, or a share of that income, will depend on whether the beneficiary is presently entitled to a share of that income. Under Australian law, the trust is not a taxpaying entity, even though the trust is required to file a tax return each year (unless it is a member of a consolidated group).A beneficiary will be presently entitled to the income if the beneficiary has an indefeasible and absolute vested interest in the trust or is deemed under a Division 6 provision to be entitled to that income.
Regarding Australian taxation of foreign resident beneficiaries of an Australian trust (i.e., the U.S. beneficiaries, Mr. S and Ms. J), under Division 6 of Part III of the ITAA 1936, the trustee will be liable to pay the Australian tax on the foreign beneficiary’s share of the net income of the trust entity for the tax year. However, the tax paid by the trustee in these circumstances is not a “final tax” because the foreign resident beneficiary will also be liable for tax on that share of net income but may claim a tax credit for the tax the trustee paid.
However, income (such as interest, dividends, and royalties) taxed under the “withholding tax rules” is not taxed again to the trustee or to a beneficiary under Division 6. A nonresident beneficiary is liable, under the withholding tax rules of Division IIA of Part III of the ITAA 1936 for tax on– unfranked dividends, interest, and royalties to which the beneficiary is entitled while nonresident. The withholding tax is collected from the trustee under the “pay as you go” withholding rules (Taxation Administration Act 1953).
For a trust to be a family trust, the trustee must make a family trust election under Schedule 2F to the ITAA 1936. The “– trading measures,” preventing franking credits for dividend income received as part of a “discretionary trust distribution” from passing through to the beneficiaries, do not apply to a family trust (i.e., the credits do pass through to the beneficiaries).
Intergovernmental agreement in effect (Australia and the United States): Australia executed a Model I FATCA IGA with the United States, effective June 30, 2014. The U.S.-Australia Income Tax Treaty was signed on Aug. 6, 1982, and entered into force on Oct. 31, 1983. The tax treaty was modified by a protocol signed on Sept. 27, 2001, that became enforceable on May 12, 2003. The treaty is effective for:
Tax reporting under U.S. laws for the ABC Trust and its beneficiaries: With regard to the first category of income, “net rental income from a 50% interest in a U.S. limited partnership,” the ABC Trust is treated and classified as a nonresident alien (NRA) for U.S. tax purposes (Sec. 641(b)). Because the net rental income is effectively connected income (ECI) with the conduct of a trade or business in the United States, the foreign nongrantor trust’s taxable income is calculated by reducing its ECI by the deductions that are connected with that income (i.e., gross rents less allowable rental expenses) (Sec. 873(a)). The proper allocation of deductions is determined under Regs. Sec. 1.– .
However, neither the Code nor the regulations indicate whether the income distributions made to the foreign nongrantor trust (which is a complex trust) to the trust’s beneficiaries that include income “effectively connected with the conduct of a trade or business within the U.S.,” are deductible under Secs. 651 and 661. It is appropriate to allow a foreign nongrantor trust to deduct that portion of its distributions to its beneficiaries that consist of ECI for the tax year. In determining the portion of a distribution that consists of ECI, each distribution should be treated as consisting of the same portion of ECI as the total of the trust’s ECI bears to the trust’s total income for the period,which is consistent with IRS guidance on Sec. 875(1). A foreign nongrantor trust that is a general or limited partner in a partnership engaged in a U.S. trade or business is deemed to be engaged in that trade or business. Sec. 875(1) expressly provides that an NRA is considered engaged in a trade or business within the United States if the individual’s partnership (i.e., the foreign trust’s partnership) is so
The same rule applies to beneficiaries of a trust or estate that is engaged in a U.S. trade or business (Sec. 875(2)). Rev. Rul.– acknowledges that this principle has been extended to the treaty context where (despite any express treaty authority) the courts have held that a partnership’s U.S. permanent establishment is attributable to its foreign partners. From this holding, the IRS concludes that a partnership’s “fixed place of business” is attributable to its foreign partners. Accordingly, any “undistributed net income” from that ECI, for the tax year, would be subject to U.S. domestic trusts’ graduated tax rates.
In analyzing Rev. Rul.– , the IRS explained that it involved a simple foreign nongrantor trust with a limited partner interest in a U.S. partnership, which had a permanent establishment in the United States. The IRS ruled that the rental income from the partnership’s activities was not exempt from U.S. income taxes under a U.S. income tax treaty provision where the trust was considered to be in receipt of business profits attributable to that partnership’s permanent establishment. The foreign trust’s distribution of that income to its sole beneficiary would be included in the beneficiary’s gross income under Sec. 871(b). Further facts included that the trust instrument required that the trustee distribute all of its income each tax year to A, the beneficiary, which the trustee did annually. The foreign trust, TR, became a limited partner in PRS, a limited partnership formed in the United States under the State S Uniform Limited Partnership Act. PRS was engaged in the real estate development business in State S and maintained a business office
Further, the particular income tax treaty’s intent is to allow the source country to tax business profits if the economic contact or activities are sufficient to constitute a permanent establishment, despite the trust’s foreign residence. When a limited partnership conducts business activities in the United States through a fixed place of business (such as an office), the office of the limited partnership is a permanent establishment in the United States for each limited partner. As such, the IRS held that PRS’s office was a permanent establishment for each partner, includingTR
Further, Sec. 702(b) provides that the “character of income” included in a partner’s distributive share, and accounted for separately under Sec. 702(a), is determined as if the income were realized directly from the source from which it was realized by the partnership, or incurred in the same manner as incurred by the partnership. Because the commercial profits (i.e., net income) will affect the income tax liability of the foreign trust or A, the foreign trust must take this income item into account separately from any other income items.As a result, the net rental income generated by PRS’s rental activities maintains its character as “commercial profits” for the foreign
As for the foreign trust’s U.S. taxliability, it will not owe any federal income tax, because it is allowed an income distribution deduction in computing its taxable income, under Sec. 651(a), in the amount of the income required to be distributed (all income, as stipulated in the trust instrument’s terms) to the NRA income beneficiary, A. Sec. 875(2) provides that an NRA who is a beneficiary of a trust or estate that is engaged in any trade or business in the United States is treated as being engaged in that trade or business. In interpreting Sec. 875(2)’s legislative intent in Rev. Rul. – , the IRS explained that A, the foreign beneficiary of the foreign trust, would be treated as engaged in the real estate development business in the United States because, for purposes of Sec. 875(2), the foreign trust is treated as engaged in that business through its limited partnership interest in PRS. Further, Sec. 652(b) provides that income distributed from a trust described in Sec. 651 has the same character in the beneficiary’s hands as in the trust’s
Under the U.S. Model Income Tax Treaty, a common provision, Article VI(1), as incorporated into tax treaties with other countries, A would not be subject to U.S. taxes on industrial and commercial profits unless A is engaged in industrial or commercial activities in the United States through a permanent establishment. These two factors (as analyzed in Rev. Rul.– ) must be satisfied to tax the income as U.S.- income for U.S. tax purposes under the treaty provisions (such is the holding in Rev. Rul. – ). As a result, the income will be included in A’s gross income under Sec. 871(b). The applicable U.S. income tax treaty will be interpreted consistently with the Code and the intent of the treaty provisions. Even though Rev. Rul. – addresses U.S. tax reporting for a simple foreign nongrantor trust, similar tax treatment and reporting should be allowable for complex foreign nongrantor trusts with similar facts, including the payment of income distributions to their beneficiaries. However, some form of authoritative guidance would be
Complex trusts may be complex for both U.S. and foreign beneficiaries
A trust may be classified as a simple trust (all – income being distributed to the income beneficiaries) in one tax year and a complex trust (with not all income being currently distributed) in another tax year. In the example above, the ABC Trust was a simple trust in prior tax years, but a complex trust in 2015. The income tax rules that apply to complex trusts also generally apply to estates (exceptions for some specific tax reporting treatments were discussed in Part 2 of this article) for U.S. tax purposes. The income distribution deduction for a complex trust (which is illustrated by the tables in this article) is determined for the tax year as
First, fiduciary accounting income (FAI) that the trustee, under the trust’s governing instrument, is required to distribute currentlyis added to all amounts that are properly paid or credited, or required to be distributed, for that tax year.The trustee can elect under Sec. 663(b) to treat an amount properly paid or credited within the first 65 days of a tax year as if it were paid or credited on the last day of the previous tax year, an election that is also available to an
Next, (1) that sum, reduced by the amount of– income (i.e., particularly “foreign income,” in the case of a foreign nongrantor trust or foreign estate) that the trust distributed (or was deemed to have distributed) is compared to (2) the trust’s DNI (which includes any capital gains under Sec. 643(a)(6)(C)), reduced by the amount of – interest income (i.e., including any foreign income) that the trust earned. The lesser of those two amounts ((1) or (2)) is the trust’s “income distribution deduction” for the tax
The distribution’s– portion for each beneficiary is determined by the “character rule,” under which its character is determined first by following the “specific provisions” of the trust instrument. Thus, if the instrument provides that no distribution is to be made out of – income, the fiduciary need not reduce the income distribution by those amounts unless the distributions actually exceed the income subject to income tax. In the absence of a specific trust provision, or if local law requires an allocation of different classes of income, the amount deductible by reason of distribution to the beneficiaries under Sec. 661(a) is treated as containing the same portion of each class of income items entering into the total DNI computation as the total of each class bears to the total DNI. The gross amount of – income (i.e., foreign income less allocated direct expenses (Sec. 643(a)(6)(A))) must for this purpose be reduced to “net,” since DNI, also, is a net amount.
For a foreign nongrantor trust, its– interest and foreign income does not involve a new computation. It merely means that the same amount of – interest and foreign income that has previously been added to taxable income to determine its DNI under Sec. 643(a)(6) must be taken out again of both the allocable beneficiary distributions and the DNI of the entity to arrive at the proper income distribution deduction
Although earlier IRS regulations already required that a specific provision of a governing instrument must have “economic effect independent of income tax consequences,” they did not refer to “a provision of local law.”To clarify this position, the IRS added the principle of economic effect to provide that a provision under local law must have economic effect independent of income tax consequences for the specific provision to be respected for tax purposes. This clarification could be more significant for income tax reporting for foreign nongrantor trusts because of unique local law
Tax treatment for the beneficiaries of the complex trust
Under Sec. 662(c), both the U.S. and foreign beneficiaries of the foreign nongrantor trust are treated as receiving their allocable distributed share of DNI on the last day of the trust’s tax year. Thus, each beneficiary must include his or her taxable portions of DNI in gross income for that tax year for U.S. tax purposes. A complex trust with multiple beneficiaries may be classified under a “tier system” or as “a separate share trust,” under the trust’s terms or local law. In the example in this article, the ABC Trust is classified as a “separate share” complex trust. Under the separate share rule for tax years ending after Dec. 31, 1999, if separate economic interests exist for a beneficiary or class of beneficiaries, and the interests neither affect nor are affected by interests accruing to another beneficiary, or class of them, then each beneficiary’s interest or class’s interests must be treated as a “separate share” for purposes of computing DNI.
Note: This comprehensive example does notaddress the tax rules of Illinois or Chicago or of the State of New South Wales or any local Australian government. Although these state and local government authorities have laws requiring tax reporting in these cases, this comprehensive example is intended to illustrate only U.S. and Australian federal tax
U.S. tax reporting and tax withholding for the ABC Trust as a foreign partner
Sec. 1446 applies only to partnerships with effectively connected taxable income (ECTI) allocable under Sec. 704 to one or more foreign partners. The U.S. tax reporting requirements of partnerships with foreign partners (in this example, M Real Estate Management LP, with the ABC Trust as a foreign partner) include making quarterly installment payments of Sec. 1446 tax payments with a voucher, Form 8813, Partnership Withholding Tax Payment Voucher (Section 1446). The amount of the Sec. 1446 tax payment is based upon each foreign partner’s annualized ECI estimated to be allocated to the foreign partner. The U.S. partner, M Real Estate Management LP, would pay the quarterly tax payments on behalf of the foreign partner for each tax year of the partnership.
Each partnership (except a publicly traded partnership, which is subject to separate rules) that has ECI for the partnership’s tax year, allocable to one or more of its foreign partners, must file an annual return (Form 8804, Annual Return for Partnership Withholding Tax (Section 1446)) with the IRS. Accordingly, each partnership must file an information statement (Form 8805, Foreign Partner’s Information Statement of Section 1446 Withholding Tax), which contains the information on Form 8804 filed with the IRS. Form 8805, which also must be filed with the IRS, is provided to each foreign partner for his or her tax and filing information. For each noncorporate foreign partner, the applicable Sec. 1446 tax rate for 2015 is generally 39.6% (unless the partner is entitled to a preferential rate under Regs. Secs. 1.– (a)(2) and 1. – ). A foreign nongrantor trust that is treated as an NRA for tax purposes may, in some cases, be subject to U.S. income tax under Sec. 871(b) on its “undistributed net income” that is
Important: BecausePart 1 of this article discusses in detail additional U.S. tax reporting for a foreign trust and its beneficiaries of ECTI, the reader should analyze this example with reference to Part 1 to achieve a more comprehensive understanding of the tax reporting responsibilities of the fiduciary and the
Active trade or business under the U.S.-Australia tax treaty
Under the U.S.-Australia tax treaty, the limitation on benefits applies to all limitations on – taxation and – relief from double taxation only if the person (or entity) is a qualified person. A qualified person includes an individual, unless he or she receives income as a nominee on behalf of a – state resident, in which case benefits may be denied under those treaty provisions requiring that the income’s beneficial owner be a resident of a state.
Under the treaty, a resident of a state who is not a qualified person is nevertheless entitled to treaty benefits for an item of income derived from the other state if the resident is engaged in the active conduct of a trade or business in the state of residency, and the income derived from the other state is connected with or incidental to that trade or business.Activities conducted by persons “connected” to a resident, as well as activities conducted by a partnership in which that person is a partner, will be deemed to be conducted by the resident for purposes of the active trade or business
A person is connected to another if one possesses at least “50% of the beneficial interest” in the other party.Under the treaty, where an enterprise of one state carries on business in the other state through a permanent establishment, the business profits that are attributable to that permanent establishment are those that the enterprise might be expected to make, if it were a distinct and independent enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment or with other enterprises with which it deals.
Under the above U.S.-Australia treaty provisions, the Australian trustee of the ABC Trust, Mr. C, would be treated in accordance with the analysis explained previously and in “Tax Reporting Under U.S. Laws for the ABC Trust and Its Beneficiaries,” on p. 876 and as illustrated in the following example and
Example (the ABC Trust): Financial information to be analyzed (2015)
The financial information for the ABC Trust for tax year 2015 is summarized in the following
The trust had no “undistributed net income” (UNI) as of Dec. 31,2014.
Analysis of Table 7
The DNI is apportioned between the fiduciary and the beneficiaries. Not all of the DNI, $621,612, was distributed. Thus, the income distributions will carry out only a portion of DNI to the beneficiaries (as shown in Table 7 above).
Analysis of Table 8
Income distributed by an estate or trust to its beneficiaries generally retains its character in the hands of the beneficiaries (Secs. 652(b) and 662(b)). Therefore, distributions carrying out DNI consist of a pro rata share of each type of income included in DNI, unless the governing instrument directs otherwise. The income distribution for each beneficiary above is “grossed–up” for the tax withholding allocated to each at the fiduciary’sdiscretion.
The tax withholding rate, as required in Regs. Sec. 1.1441–3(f)(1), is the rate applicable to U.S.-sourceincome asfollows:
Partnership net rental income (Sec. 871(b)(1)) is taxed at the applicable graduated tax rate (under Sec. 1) of 25% (for a single ormarried–filing–separatelyNRA taxpayer) in the 2015 rate schedule of the instructions to Form 1040NR, based upon each beneficiary’s share of the applicable portion of ECTI share. The trustee, as the withholding agent, has withheld tax at the marginal tax rate applicable to that incomeitem.
FDAP (dividend income) (Sec. 1441(a) and 1441(b)) is the reduced tax treaty rate (U.S.-Australia) of 15%.
The trustee would provide each beneficiary with a “Foreign Nongrantor Trust Beneficiary Statement,” reporting the information in Tables 8 and 9 as discussed in Part 1 of this article. In addition, he would provide a copy of Form 8805 to each beneficiary. Also, he would provide each beneficiary, including the foreign beneficiaries shown in Table 9, a “Statement of the Amount of Applicable Code Sec. 33 Credit Allocated” to each on their share of ECTI (net rental income). See Part 1 for details of information required to be reported in thestatement.
Australia tax withholding allocation, $4,458: If a foreign nongrantor trust pays foreign taxes (the trustee paid the Australia tax for the U.S. beneficiaries in the ABC Trust), each U.S. beneficiary who received a distributive share of the Australia dividend income on which taxes were paid may elect to take a tax credit on his or her U.S. income tax return for the foreign tax attributable to his or her income share.grossed–upmethod). A similar method should be applied with respect to the foreign tax credit on the foreign income distributed to the beneficiary as the beneficial owner of that income.The tax credit on the beneficiary’s U.S. individual income tax return is limited to the proportion of tax against which the tax credit is taken as to the income from foreign sources bears to his or her entire taxable income. Neither the Code nor the regulations explain how to treat the amount of foreign taxes paid (as includible in gross income for the tax benefit, as U.S. tax withheld and allocated is treated in a
Table 8 uses thegross–uptax rate of 15% for the income tax consequences and tax reporting of the Australia tax credit for the U.S.beneficiaries.
Analysis of Table 9
The U.S. taxes associated with the net income distribution allocation to each foreign beneficiary has been withheld and paid by the trust’s withholding agents. As discussed in Part 1, no tax refund could be claimed on the beneficiaries’ respective 2015 Forms 1040NR, as the withholding rate was 15%, the same as their U.S. tax rate. However, regarding the ECI income (net rental income allocated to their distributable share), a possible income tax refund could be claimed on their Form 1040NR, as their applicable tax rate, filing as an NRA with ECI income, could be less than the graduated tax rate of 25% allocated to their share of the withholdingtax.
By filing Form 1040NR for 2015, each foreign beneficiary, Mr. D and Ms. R, would report the gross income from ECI income as $62,485 (grossed–upfrom $46,864 by the tax withholding allocation on the income distribution). In a similar manner, their U.S. dividend income gross taxable distribution would be $56,325 (grossed–upby the $8,449 allocated withholding tax). This author recommends that Mr. C also file a “Foreign Nongrantor Trust Beneficiary Statement” for each foreign beneficiary with Form 1040NR for the trust entity and provide a copy to each beneficiary. In addition, Form 8805 would be provided to each beneficiary, as well as the “Statement of the Amount of Applicable Code Sec. 33 Credit Allocated,” as discussed in Part 1, for them to file and include those attachments with the U.S. Form 1040NR for the taxyear.
Analysis of Table 10
The DNI for the ABC Trust for 2015, as reported in Table 6 on p. 880, is $621,612. However, the trust entity’s allowable distribution deduction is not equal to the entire taxable portion of DNI because the total of the Tier 2 distributions ($480,000) is less than the total DNI. Thus, not all of the DNI was distributed for 2015 (Regs. Sec. 1.661(c)-2)). Thus, the distributions will carry out only a portion of the DNI to the fourbeneficiaries.
A foreign nongrantor trust is allowed an income distribution deduction for computing its U.S. income tax liability, similar to domestic trusts (Secs. 651(a) and 661(a)). When calculating the income distribution deduction, DNI is computed only with items of income and allowable deductions included in the trust’s gross taxable income (Secs. 651(b) and 661(c)). If all income is not distributed to the beneficiaries (as illustrated for the ABC Trust for 2015), the portion retained by the entity consists of a pro rata share of each class of income included in DNI. This undistributed net income (UNI) will affect the reporting of distributions to U.S. beneficiaries in future tax years. If an accumulation distribution is made, each income item included in UNI that is distributed will lose its tax character (other thantax–exemptincome) and be treated as ordinaryincome.
See Table 11 for how the income distribution deduction affects the U.S. income tax liability of the ABC Trust for2015.
Analysis of Table 11
The DNI serves as a ceiling on the beneficiaries’ income inclusion amounts. The income distribution deduction is limited to the trust entity’s gross taxable income that is included in DNI. Because not all of the DNI was distributed, the distributions carry out only a portion of DNI to the beneficiaries (Regs. Sec. 1.661(c)-2).
Analysis of Table 12
The above analysis reports the trust’s income effectively connected with a U.S. trade or business as analyzed in Parts 1 and 3. The IRS would probably verify that all beneficiaries filed their 2015 income tax returns before processing any refund. The U.S. agent may need to communicate with IRS officials and provide trust accounting and tax information statements to ensure that the IRS has all the information needed to process the entity’s 2015 Form1040NR.
The ABC Trust continues to be taxed (subject to the Sec. 1441 tax withholding), as reported on Form1042–Sby U.S. Brokerage A on its U.S.-sourceincome not effectively connected with a U.S. trade or business (the U.S. dividend income), regardless of the income distribution deduction. The U.S. and foreign beneficiaries are subject to U.S. tax on their share of the net income distributions allocated to the U.S. dividend income (as reported in Table 8). Each will receive a U.S. tax credit for his or her allocable share of tax withholding reported in the trust’s Form 1040NR and on Form1042–S. Mr. C allocated and reported each beneficiary’s share by filing Form1041–T, Allocation of Estimated Tax Payments to Beneficiaries, and attached it to the trust’s 2015 Form1040NR.
The advantage of reporting the tax withholding allocation for each beneficiary on one tax form (Form1041–T) with a “total amount” is that it will match the amount reported on the entity’s Form 1040NR (as illustrated in Table 13). The IRS Instructions for Form 1040NR stipulate that for a foreign estate or foreign trust, Form 1040NR should be “changed as necessary to comply with provisions of Subchapter J of the IRC.” Mr. C has chosen to follow those instructions to make the tax reporting more accurate and easier tofollow.
The two foreign beneficiaries will not be eligible for a tax refund on their share of the U.S. dividend income, as their tax rate on that income is 15% (the same as the withholding rate). However, it is important for each foreign beneficiary to file Form 1040NR for 2015, as each will most likely report a tax refund due on his or her allocable share of ECI income because the 2015 tax table amount would most likely be less than the 25% allocated withholding amount that each will report, according to their “Foreign Nongrantor Trust Beneficiary Statement” provided by thetrustee.
Note: The lines and descriptions designated in this table were determined by the tax return preparer, as the Form 1040NR instructions clearly state: “[C]hange the form [as needed] to reflect the provisions of Subchapter J, Chapter 1” of the Code.
Analysis of Table 13
As noted, the Form 1040NR instructions tell the preparer to change the form to comply with Subchapter J (for a foreign estate or foreign trust), but Subchapter N, “Tax on Income From Sources Within or Without the United States,” also applies because of the “U.S.-sourceincome rules,” which affect foreign trusts and estates as well as NRAbeneficiaries.
The preparer can report the $33,796 in tax withheld online 58 (which is for reporting the transportation tax paid) by altering the form to indicate the type of tax paid or withheld. This withholding tax is allocable to all beneficiaries on their respective U.S. dividend income allocation to offset the total tax reported on Schedule NEC, Tax on Income Not Effectively Connected With a U.S. Trade or Business (line 54). The amounts are reported on a separate Form1041–Tand designated as “Sec. 1441(b) Taxes.”
Line 62a ($96,280) represents the withholding taxes on U.S. dividends and ECI (Form 8805) to offset amounts on lines 62b and 62d. The respective amounts are reported in two separate Forms1041–T, one designated on the form’s top as “Sec. 1446(b) Taxes [Sec. 33 Credits]” and a second Form1041–Tas “Sec. 1441(b) Taxes.”
Lines 61 and 71 represent the trust entity’s net amounts after allocation of withholding taxes to the beneficiaries as reported on Forms1041–Tby the trustee (see Table 13).
Best practice guidelines
The following best practice strategies will facilitate sound foreign trust and foreign estate administration procedures for foreign fiduciaries making distributions to U.S. and foreignbeneficiaries:
Beware: With facts similar to the ABC Trust, where U.S. taxes are overpaid on ECI, all beneficiaries (including any NRA beneficiaries) should file Forms 1040 or 1040NR for the tax year to protect the entity’s claim to a tax refund as reported in Table 13, as well as possibly claiming an individual tax refund on each’s share of theincome.
Navigate complexity with expert guidance
Fiduciaries of foreign nongrantor trusts and foreign estates are best advised to seek knowledgeable practitioners to assist them in administering the estate or trust that has U.S.-sourceincome to report and distribute to U.S. or foreign beneficiaries. Experienced practitioners can guide fiduciaries in many complex administrative responsibilities involving multiple jurisdictions. Each tax year can present different complexities to resolve to achieve success. Planning the timing of each income distribution beforehand can enhance each beneficiary’s net distribution amounts.