FOREIGN TRUSTS CREATED BY NRAs

Foreign Grantor Trusts: A foreign trust, like an NRA, generally is subject to U.S. income tax only with respect to U.S. source income (typically withheld at the source) and income effectively connected with a U.S. trade or business. However, distributions from the foreign trust to a U.S. person will carry out taxable income to that person, with adverse tax treatment of accumulated income, unless the trust qualifies as a “grantor trust” under U.S.

tax law. (IRC §§ 671-677) With a grantor trust, the person who funded the trust (the grantor) is treated as the owner of the income, even if distributions are made to someone else, and the beneficiaries are generally considered to receive tax-free gifts for income tax purposes. Therefore, a U.S. beneficiary of a foreign trust will greatly prefer that the trust be a grantor trust with an NRA individual as grantor.

Under the law in effect as of August 20, 1996, trusts settled by NRAs generally will not qualify as grantor trusts except under limited circumstances. (IRC § 672(f)(1)) If an NRA sets up a trust for the benefit of a U.S. person, the U.S. person will be taxed on the income received from the trust unless a grantor trust exception applies.

There are three relevant exceptions to the law, which permit the NRA to be the income tax grantor:

1. The grantor has the full power to revoke the trust without the consent of any person, or with the consent of a related or subordinate person who is subservient to the grantor. (IRC § 672(f)(2)(A)(i)) Upon the grantor’s incapacity, his or her guardian or another person previously designated by him for this purpose must possess the power to revoke on his behalf in order for the trust to continue to qualify as a grantor trust.
2. The grantor and/or the grantor’s spouse are the sole distributees of income or principal from the trust during the life of the grantor. (IRC § 672(f)(2)(A)(ii))
3. The trust was created on or before September 19, 1995, but only as to funds already in the trust as of that date, which must be separately accounted for, and only if the trust was a grantor trust pursuant to either IRC § 676 (concerning the grantor’s power to revoke) or IRC § 677 (concerning the grantor’s retained possibility of receiving income), but excluding IRC § 677(a)(3); income may be used to pay premiums on insurance policies on the grantor’s life.

Once the NRA grantor dies, a foreign trust that previously qualified as a grantor trust under one of the exceptions no longer will be a grantor trust, and all income accrued after the grantor’s death and distributed to the U.S. beneficiary will be taxed to him or her.

Foreign Nongrantor Trusts: Accumulations: One of the greatest disadvantages of a foreign nongrantor trust is the treatment of income that is accumulated in the trust and then distributed to a U.S. person in a subsequent year.

If a foreign trust falls into one of the above exceptions and so is a grantor trust, there is no accumulated income issue; any income accumulated in the trust may be added to the principal and distributed later without U.S. tax consequences.

If a foreign trust with U.S. beneficiaries does not fall within one of the exceptions and so is not a grantor trust, and if it distributes the current year’s income, including capital gains, to a U.S. beneficiary in the same calendar year, the income is taxed to the beneficiary and retains its character as ordinary income or capital gains. For foreign trusts, realized capital gains are included in distributable net income (DNI).

Any distribution from a discretionary nongrantor trust to a beneficiary carries out with it DNI to the extent that the trust has income. It makes no difference that the trustee characterizes the distribution as one of corpus or of capital gains. (U.S. tax law differs from the tax law of the United Kingdom and many other countries in this respect.) If two beneficiaries receive distributions from the trust in the same calendar year, each is treated as receiving a proportionate share of the trust’s DNI for that year. After all current income of the trust has been carried out to the beneficiaries, accumulated income will be carried out before further distributions are treated as distributions of corpus which are not taxed.

If a foreign trust accumulates income, the trust pays no U.S. income tax on that income other than withholding tax on U.S. source income paid to the trust or tax imposed on income effectively connected with a U.S. trade or business, and there is no U.S. in come tax currently payable by any potential beneficiary on that income. However, the trust is building up undistributed net income (UNI), which will have negative tax consequences if it is distributed to a U.S. beneficiary in a future year.

When a foreign trust has UNI from prior years and it distributes an amount not exceeding the greater of the current year’s DNI or fiduciary accounting income to the beneficiaries, including U.S. beneficiaries, the U.S. beneficiaries are taxed only on their share of the DNI. As previously noted, for foreign trusts (unlike domestic trusts), DNI includes realized capital gains, and the capital gains retain their character and are taxed at the lower capital gains rate, currently 20 percent.

When a foreign trust with UNI pays out to the beneficiaries in a calendar year an amount in excess of both the current year’s DNI and the current year’s fiduciary accounting income, UNI is carried out to the beneficiaries. Any amount distributed in excess of DNI in such case will carry out UNI. UNI paid to U.S. beneficiaries is fully subject to U.S. income tax and has the following additional negative consequences:

1. All capital gains realized by the trust in prior years that constituted part of the trust’s DNI are now ordinary income, taxed at rates up to 37 percent.
2. An interest charge is imposed on the tax due by the beneficiary on the UNI from the date the income was originally earned by the trust. From 1996 forward, the interest charge is pegged to the rate applicable to underpayment of tax and is compounded daily.
3. Finally, the “throwback” rules apply, so the income may be taxed at the beneficiary’s tax bracket for the years in which income was accumulated.

Use of Intermediaries: Because it is difficult for a foreign trust to qualify as a grantor trust, and because distributions of UNI from a foreign nongrantor trust to a U.S. beneficiary have such negative tax consequences, trustees will look for ways to “cleanse” accumulated income in a trust. One idea that has occurred to some is to distribute the accumulated income to a foreign intermediary (either an individual, a corporation or another trust), which can then later pay it to the U.S. beneficiary in the guise of current income, principal distribution or a gift.

To address this, Treas. Reg. § 1.643(h)-1 sets out the treatment of structures that employ intermediaries and the circumstances under which such intermediaries will be

disregarded. Essentially, when property is transferred to a U.S. person by another person (the intermediary) who has received property from a foreign trust, the U.S. person will be treated as having received the property directly from the foreign trust if the intermediary received the property from the foreign trust pursuant to a plan in which one of the principal purposes was the avoidance of U.S. tax. Such a principal plan of avoidance will be deemed to exist if:

1. the intermediary is “related” to the grantor of the foreign trust or has a relationship to the grantor that establishes a reasonable basis for concluding that the grantor of the foreign trust would make a gratuitous transfer to the U.S. person;
2. the U.S. person receives from the intermediary, within the period beginning 24 months before and ending 24 months after the intermediary’s receipt of property from the foreign trust, either the property the intermediary received from the foreign trust, proceeds from such property or property in substitution for such property; or
3. the U.S. person cannot establish that the intermediary acted independently, had a reason for making gratuitous transfers to the U.S. person, and was not the agent of the U.S. person, even if the U.S. person properly reported the gift.

If the intermediary can be viewed as an agent of the foreign trust, a distribution will be deemed to take place from the foreign trust to the U.S. beneficiary at the time the intermediary makes the distribution to the U.S. beneficiary. If the intermediary can be viewed as an agent of the U.S. beneficiary, a distribution will be deemed to have been made to the U.S. beneficiary when the foreign trust makes the distribution to the intermediary.

A foreign trust with a large pool of UNI may be able to clear out the UNI in advance of a distribution to the U.S. beneficiary. If the foreign trust distributes all of its UNI to a non-U.S. person or a distinguishable foreign trust, the original trust becomes cleansed and can make a large principal distribution to a U.S. beneficiary in the next calendar year without carrying out accumulated income. The question remains of what to do with the “tainted” funds if they are added to a new trust; they can remain with the foreign beneficiaries or trusts or can go to charities, but it will be difficult for those funds to find their way to the

U.S. beneficiaries without running afoul of the intermediary rules.

Loans From Foreign Trusts: Under IRC § 643(i), if a non-U.S. settlor creates a foreign nongrantor trust that then loans cash or marketable securities to a U.S. beneficiary (including certain related U.S. persons even if they are not named in the trust instrument), the loan will be treated as a distribution to the U.S. person receiving it and will be taxed accordingly, even if the loan is later repaid.

In Notice 97-34, the Treasury carved out an exception to this rule. This exception permits a foreign trust to lend money to a U.S. beneficiary without having it treated as a distribution if it is a “qualified obligation.” An obligation is a qualified obligation only if it meets the following requirements:

1. The obligation is set forth in a written agreement.
2. The term of the obligation does not exceed five years.
3. All payments on the obligation are denominated in U.S. dollars.
4. The yield to maturity of the obligation is not less than 100 percent and not greater than 130 percent of the applicable federal rate (IRC § 1274(d)) for the day on which the obligation is issued.
5. The U.S. borrower extends the period for assessment by the IRS of any income tax attributable to the loan and any consequential income tax changes for each year that the obligation is outstanding to a date not earlier than three years after the maturity date of the obligation.
6. The U.S. borrower reports the status of the obligation, including principal and interest payments, on Form 3520 for each year that the obligation is outstanding.

A loan cannot be rolled over at the end of five years, and a new loan from the trust to the same U.S. beneficiary raises the issue of whether it constitutes a rollover.

The IRS is particularly focused on this area of the law. In fact, on May 8, 2024, Proposed Regulations were issued under Section 643(i) relating to loans from a foreign trust and below market use of property of a foreign trust by a US beneficiary, addressed in the following section. The Proposed Regulations largely track the current guidance of Notice 97-34. With respect to loans, the Regulations go beyond current law and would subject a nonresident who becomes a U.S. person within two years of receiving a non-qualified obligation as having received a distribution on his or her residency start date.

Uncompensated Use of Trust Property: Under Section 643(i), uncompensated use of trust property by a U.S. beneficiary of a foreign nongrantor trust is treated as a constructive distribution to the beneficiary to the extent of the fair rental value of the beneficiary’s use of the property. If there is DNI or UNI in the trust, the deemed distribution can carry out taxable income. However, if the trust’s only asset is residential property used by the beneficiary and the property is not rented out, there may not be any income to carry out, in which case the constructive distribution would be reportable by the U.S. beneficiary but not taxable. It is not a foregone conclusion, however, that having a U.S. trust is preferable instead. While U.S. trusts are not subject to this deemed distribution rule, gains on the sale of property owned by a U.S. trust are subject to an additional 3.8% net investment income tax that does not apply to foreign trusts.

It is notable that the Proposed Regulations under Section 643(i) mentioned previously also cover uncompensated use of trust property by a U.S. beneficiary. While there is a proposed “de minimis” rule whereby below market use of trust property for 14 days or less is disregarded, this is unlikely to provide significant relief in most cases. Interestingly, a deemed distribution of marketable securities under this rule could create significant tax consequences for the beneficiary. In those cases, built-in gain will be triggered (under Section 643(e)) and thus carried out to the beneficiary. There is also a 60 day cure period for paying fair market value rent for use of trust property and avoiding the deemed distribution.