Transfers to Foreign Trusts: Treasury Proposes Regulations Under §§679 and 684
Introduction
Over the last several years, tax planning through the use of foreign trusts has attracted a great deal of attention. Certain practitioners have pointed out that employing foreign trusts as a means of deferring income from U.S. taxation has advantages when compared to controlled foreign corporations and passive foreign investment companies. Many nonresidents have also found foreign trusts to be a preferred vehicle for structuring U.S. real estate investments subject to FIRPTA,1 because foreign trusts are taxable as individuals and, as a result, are eligible for lower rates on capital gains.
Limitations on the use of foreign trusts by U.S. citizens and residents have been present in the Code for decades.2 In August, Treasury proposed regulations under Search7RHSearch7RH679 and 684, which provisions affect any creation of or transfer of assets to a foreign trust by a U.S. resident.3 The proposed regulations are extensive and cast an extremely broad net. They raise a number of interesting logistical issues for families with members spread across the globe, who may take up and later relinquish residence in different countries at different times. A U.S. resident in the senior generation of such a family who wishes to undertake gift and estate tax planning by making transfers in trust may find that his U.S. income tax liability with respect to the trust turns on the residence of his descendants (the beneficiaries), over which the trust settlor may have little information and even less control.
This article will review the most significant provisions of the proposed regulations under Search7RHSearch7RH679 and 684, and explore their impact on many common uses of trusts.
Taxation of Grantor Trusts and Foreign Trusts
In order to understand the impact of Search7RHSearch7RH679 and 684 and the proposed regulations, it is necessary to understand the basic principles of income, gift, and estate taxation of different types of trusts. A brief summary of the rules relevant to this discussion follows.
The Grantor Trust Rules
Under Search7RHSearch7RH671 through 678, a person who transfers property to a trust (a "grantor") and who retains an interest in or certain powers over the trust will be treated (for income tax purposes) as the owner of the portion of the trust to which such interest or powers relate. A trust the assets of which are deemed owned by the grantor (or other person) is known as a grantor trust. If the grantor is a U.S. citizen or resident, the grantor is subject to U.S. income tax on the worldwide income of the trust (or the portion of the trust deemed owned by the grantor). If the trust is not a grantor trust but is a U.S. trust, its worldwide income will be subject to U.S. income tax under the rules governing the income taxation of trusts and their beneficiaries. If the trust is not a grantor trust and is also not a U.S. person (a "foreign nongrantor trust"), the potential exists for some or all of the trust's income to escape U.S. taxation entirely. This is because a foreign trust, like a nonresident alien individual, is subject to U.S. income tax only on its U.S. source income (excluding non real estate capital gains) and any income effectively connected with a U.S. trade or business (or treated as such); it is not subject to U.S. income tax on its foreign source income, or on U.S. source income that is neither effectively connected income nor fixed or determinable annual or periodical ("FDAP") income.
Congress has long been concerned with the potential for the assets of a foreign nongrantor trust to accumulate income on a tax-deferred basis. Section 679, which was enacted in 1976 and amended in 1996, is one of the primary provisions intended to prevent this deferral.
The intent of Search7RH679 is to prevent the income tax deferral that might otherwise arise, as follows. Suppose a foreign trust, FT, invests in U.S. assets that generate the type of income that is not subject to U.S. tax (e.g., non real estate capital gains and portfolio interest) and invests in non-U.S. assets in countries that do not tax interest or dividends. If FT is formed and administered in a country that does not impose tax on such income derived by a resident trust, FT will pay no income tax anywhere in the world. Even though FT's ultimate distribution to its U.S. beneficiaries may be taxable, FT's income can accumulate completely free of tax until that time. Section 679 prevents this tax-free accumulation where there is a transfer of assets to FT by a U.S. person and where FT has one or more U.S. beneficiaries. In such a case, the trust is treated as a grantor trust and the U.S. transferor will be taxable on income attributable to the transferred assets, even if she retains no interest in and receives no distributions from the trust.
Transfers to Foreign Trusts
Section 684 was enacted in 1997. Sections 1491 through 1494, which were repealed at that time, had previously subjected all asset transfers by a U.S. person to a foreign trust to a 35% excise tax, whether or not the transfer was made with donative intent or was for fair market value.4 The foreign trust could not increase its basis in the assets received from the U.S. transferor by the amount of excise tax paid in connection with the transfer.
Under Search7RH684(a), a transfer to a foreign trust is treated as a taxable disposition (i.e., a sale of the assets transferred to the trust, at fair market value), except to the extent provided in the regulations. Thus, the general rule is that gain (but not loss) is recognized to the extent the fair market value of the asset exceeds its basis in the hands of the transferor at the time of the transfer. Since the trust is deemed to have purchased the asset at its fair market value, the trust's basis in the asset is equal to that value.
Section 684(b) provides that gain is not recognized under Search7RH684(a) to the extent the U.S. transferor is considered to be the owner of the trust under the grantor trust rules, including Search7RH679. Section 684(c) provides that if a U.S. trust becomes a foreign trust (for example, by the replacement of the U.S. trustee with a foreign trustee), the trust assets are considered to be transferred to a foreign trust and gain must be recognized under Search7RH684(a).
Estate and Gift Taxation of Residents and Nonresidents
U.S. citizens and those U.S. residents who are domiciled in the United States are subject to the same rules.5 All worldwide assets of U.S. citizens or domiciliaries are included in their estates and subject to full U.S. estate and gift tax. Similarly, the basis of any such asset in the hands of the person who acquires it from the decedent is determined under Search7RH1014. Section 1014 provides that the basis of property in the hands of a person acquiring it from a decedent, or to whom the property passed from a decedent, is the fair market value of the property at the date of the decedent's death.
Individuals who are not U.S. citizens or domiciliaries 6 (referred to herein as nonresidents) are subject to a different set of rules. Under Search7RHSearch7RH2101 and 2106, estate tax is imposed only on the portion of an alien nondomiciliary's gross estate that consists of property within the United States. This generally includes real and tangible personal property located in the United States as well as shares of domestic corporations and debt obligations of U.S. persons. Under Search7RH2501(a)(2), the gift tax applies even more narrowly to alien nondomiciliaries, because it does not apply to the transfer of intangible property at all.
Definition of Resident and Nonresident
It is important to keep in mind that the definition of U.S. resident for estate and gift tax purposes, by including only U.S. citizens and domiciliaries, is far narrower than the definition of U.S. resident for income tax purposes. The income tax definition, which is incorporated into both Search7RHSearch7RH679 and 684, is contained in Search7RH7701(a)(30) and includes resident aliens under Search7RH7701(b). Resident aliens include lawful permanent residents (commonly referred to as "green card holders") and other non-U.S. citizens who are U.S. residents based on the number of days they are present in the United States in any particular year.7 Thus, many non-U.S. domiciliaries, not generally subject to U.S. estate and gift tax, are nevertheless U.S. residents for income tax purposes and therefore subject to the provisions of Search7RHSearch7RH679 and 684.
The Search7RH679 Regulations
Section 679 applies in the event of the following: (1) a U.S. transferor,8 (2) transfers property, (3) to a foreign trust,9 (4) that has one or more U.S. beneficiaries. The recently proposed regulations are expansive in their interpretation of Search7RH679, particularly with respect to the types of transfers that are included within its scope and the definition of "U.S. beneficiary."
Indirect Transfers
Under the proposed regulations, various situations are characterized as indirect transfers and are thereby brought within the scope of Search7RH679.
Prop. Regs. Search7RH1.679-3(c) provides that when a transfer by a U.S. person to a foreign person (an "intermediary") is followed by a transfer by the intermediary to a foreign trust, the transfer will be considered an indirect transfer by the U.S. person to the foreign trust "if such transfer is made pursuant to a plan one of the principal purposes of which is the avoidance of United States tax." The proposed regulation generally applies if the U.S. person is related 10 to a beneficiary of the foreign trust, unless the U.S. person can demonstrate to the satisfaction of the Commissioner that:
(A) The intermediary has a relationship with a beneficiary of the foreign trust that establishes a reasonable basis for concluding that the intermediary would make a transfer to the foreign trust;
(B) The intermediary acted independently of the U.S. person;
(C) The intermediary is not an agent of the U.S. person under generally applicable U.S. agency principles; and
(D) The intermediary timely complied with the reporting requirements of Search7RH6048, if applicable.
Absent satisfaction of all of the foregoing requirements, the intermediary will be treated as the agent of the U.S. transferor and the property in question will be treated, for purposes of Search7RH679, as having been transferred to the foreign trust by the U.S. transferor.
Two examples of this indirect transfer rule that are provided in the proposed Search7RH679 regulations are not very instructive. The first example involves an unidentified intermediary and a stated intention to avoid Search7RH679.11 The second example involves an intermediary who was an uncle of the beneficiary and concludes that the U.S. transferor could not establish that the intermediary acted independently.12 Because no other facts are provided, it is not clear under what circumstances it could be established that the uncle (or other intermediary) acted independently.
An interesting aspect of the indirect transfer rules of the proposed Search7RH679 regulations is that they are taken almost verbatim from Treasury regulations adopted in 1999 under Search7RH643. Regs. Search7RH1.643(h)-1 provides that, under certain circumstances, a distribution from a foreign trust to a foreign person who then makes a gratuitous transfer to a U.S. person will be recharacterized as a transfer by the foreign trust to the U.S. person.13 However, although the indirect transfer rules under the two sets of regulations are essentially the same, the examples illustrating the family member intermediary issue are quite different.
Two examples in the Search7RH643 regulations involve a grandparent and a child who are non-U.S. residents and a grandchild who is a U.S. resident. Under these examples, the grandparent creates and funds a foreign trust. The trust later transfers property to the child, who, in turn, transfers property to her child, the grandchild of the trust's creator. In one example, the regulation concludes that the U.S. person (i.e., the grandchild) is unable to demonstrate that her parent acted independently from her grandparent, with the effect that the U.S. grandchild is treated as receiving the property in question as a distribution from the trust.14 The other example, in which it was held that the parent acted independently, includes facts that the parent had previously made equivalent gifts to her child (the grandchild of the trust settlor) from her own assets and had income far in excess of the amounts given to the grandchild.15 It is not clear why the example in the Search7RH679 regulation involves an uncle and not grandparents, or why no example is provided under the Search7RH679 regulation (as examples are provided under the Search7RH643 regulation) with facts to indicate the types of circumstances under which an intermediary will be held to have acted independently.
Any difference in the application of the indirect transfer rules can be important because the provisions of Search7RHSearch7RH643(h) and 679 apply in similar situations and the form of the transaction will largely govern which rules apply. Thus, if a grandparent who is a U.S. person transfers property outright to his non-U.S. resident child, who then funds a foreign trust for her U.S. resident child (the grandchild of the U.S. transferor), Search7RH679 would apply. Alternatively, if the U.S. resident grandparent funds a trust for the benefit of his non-U.S. resident child, who then makes outright gifts to the grandchild, Search7RH643 would apply.
An indirect transfer within the scope of Search7RH679 may also arise in the context of a loan to a foreign trust from a bank which also happens to hold deposits on behalf of the U.S. transferor. For example, a U.S. transferor's deposit of funds with a foreign bank followed by the bank's loan to the foreign trust will be treated as an indirect transfer by the U.S. transferor to the foreign trust, unless the transferor can demonstrate that the bank has a relationship with the trust that establishes a reasonable basis for concluding that the bank would make a loan to the trust and that the bank acted independently of the U.S. transferor in making the loan.16
Constructive Transfers
Under the proposed regulations, certain transactions are characterized as constructive transfers for purposes of applying Search7RH679. A constructive transfer includes any assumption or satisfaction of a foreign trust's obligation to a third party. For example, a U.S. person's payment of a foreign trust's debt that arose from services rendered by a third party to the trust constitutes a constructive transfer by the U.S. person to the trust, as would the U.S. person's assumption of that debt of the trust.17
A constructive transfer may also occur when a U.S. person guarantees a foreign trust's debt. Under Prop. Regs. Search7RH1.679-3(e), if a foreign trust borrows money or other property from an unrelated lender and a U.S. person related to the trust guarantees that debt, the U.S. guarantor is treated for purposes of Search7RH679 as a U.S. transferor who has made a transfer to the trust (and therefore is deemed to own the applicable portion of the trust). In such a case, a special rule applies to repayments of principal with respect to the guaranteed loan: "payments of principal to the lender by the foreign trust are taken into account on and after the date of the payment in determining the portion of the trust attributable to the property deemed transferred by the U.S. guarantor." 18 Some fairly elaborate accounting may be required in order for the trust and the U.S. guarantor to track the portion of the trust that is subject to Search7RH679 (and the income attributable to that portion, which must be reported by the U.S. guarantor).
Who is a U.S. Beneficiary?
A trust is treated as having a U.S. beneficiary for a taxable year unless (i) under the terms of the trust instrument, no part of the income or corpus of the trust may be paid or accumulated during the year to or for the benefit of a U.S. person, and (ii) if the trust were terminated at any time during the taxable year, no part of the income or corpus of the trust could be paid to or for the benefit of a U.S. person.19 The determination of whether a trust has a U.S. beneficiary is made on a year-by-year basis.
Possibility of a Distribution to a U.S. Person
The regulations take an extremely expansive view regarding the possibility that trust income or assets could be distributed to or accumulated for the benefit of a U.S. person. This determination is made without regard to whether income or principal of the trust is actually distributed to a U.S. person during the year and without regard to whether a U.S. person's interest in the trust is contingent on a future event. Thus, whenever the possibility exists for the distribution of a trust's current income, accumulated income, or principal to a U.S. resident, all assets of the trust that are attributable to property transferred to the trust by a U.S. transferor will be treated as owned by the U.S. transferor, notwithstanding the likelihood that all or most of the trust's income or principal will be distributed to non-U.S. resident beneficiaries.
This broad interpretation is made clear in examples provided in Prop. Regs. Search7RH1.679-2. Many of the examples use as the typical fact pattern a resident alien parent, A, with a resident alien son, B, and a nonresident alien daughter, C. In these examples, the possibility that all or any part of the income may be distributed to or accumulated for the benefit of B, or that all or any portion of the corpus of the trust may be distributed to B either before or after the death of A, is sufficient to cause the entire trust to be a grantor trust throughout A's lifetime.20 Examples also are provided that make it clear that the possibility that a U.S. resident may become a beneficiary, such as by inclusion in a class of potential beneficiaries or because someone has the power to name additional beneficiaries who could possibly include U.S. persons, will cause the trust to be a grantor trust under Search7RH679.21
Under the expansive scope of the regulations, it is not sufficient, to avoid the application of 679, for a trust instrument to provide that distributions will not be made to any U.S. person. Prop. Regs. Search7RH1.679-2(a)(2)(iii), Example 13, describes a trust for a potential beneficiary, B, who is a U.S. resident. The trust instrument prohibits distributions to B as long as he remains a U.S. resident. Even though B might never be entitled to receive distributions because he may never cease to be a U.S. resident, the possibility that B might later become a nonresident and then be entitled to receive distributions is sufficient to cause the trust to be treated as having a U.S. beneficiary. Thus, in order to escape the reach of Search7RH679, the trust instrument must permanently disqualify B and anyone else who is a U.S. resident from being entitled to receive distributions of trust income or corpus that accumulated during the period that such beneficiary was a U.S. resident.
Changes in Status of a Beneficiary
The regulations provide special rules addressing changes in the status of a beneficiary from a non-U.S. person to a U.S. person. The possibility that a non-U.S. person could become a U.S. person (e.g., take up U.S. residence) is not taken into account, for purposes of Search7RH679, until the year in which the beneficiary in fact becomes a U.S. person. However, if a beneficiary is not a U.S. person at the time the U.S. settlor transfers assets to the trust, but the beneficiary becomes a U.S. person within five years thereafter, the grantor will have an additional income inclusion in the year the beneficiary becomes a U.S. person.22 The amount of additional income is equal to the undistributed net income of the trust 23 and the grantor is also subject to an interest charge.24
These rules do not apply in the event a non-U.S. beneficiary first becomes a U.S. resident more than five years after the U.S. transferor's transfer to the trust. The five year exception is applied extremely narrowly, however. An example in the regulations indicates that the first time the U.S. beneficiary becomes a U.S. resident means the first time ever. If the beneficiary was previously a U.S. resident during any period, apparently without regard to how many years ago such prior U.S. residency occurred, the benefit of the five year rule is lost.
Changes in beneficiary status from that of a U.S. resident to that of a non-U.S. resident may take the trust outside the scope of Search7RH679, but with potential adverse tax consequences under Search7RH684, as discussed below.
Remote Contingencies
Some contingencies are considered sufficiently unlikely to occur that they are not counted for purposes of determining whether a trust has a U.S. beneficiary. A person who is not named as a beneficiary and who is not a member of a class of beneficiaries under the trust instrument is not taken into account if the U.S. transferor is able to demonstrate to the satisfaction of the Commissioner that the possibility of a U.S. person becoming a beneficiary "is so remote as to be negligible." 25 Two examples illustrating "negligible contingencies" are provided. In one example, the primary beneficiary of the trust is the settlor's uncle and the contingent beneficiaries are the settlor's children. The trust terminates on the death of the settlor and the children will receive trust assets at that time if the settlor's uncle does not survive.26 Given the generations of the various parties in this example, the example strongly implies that the settlor expects that the uncle will die before the settlor and the assets in the foreign trust will accumulate for the benefit of the settlor's children. Consequently, the finding that the contingency is not negligible is perhaps not surprising. The second example sets forth a situation involving intestate succession where the possible U.S. beneficiary is a cousin of the settlor who could only receive a trust distribution if the settlor's three nonresident grandchildren predecease their mother.27 Based on these examples, it is likely that a U.S. resident parent with both resident and nonresident children could not avoid Search7RH679 by establishing a separate foreign trust for his nonresident child, if the trust provides that upon the death of the nonresident child, the trust assets may be distributed to the remaining children of the settlor.
Pre-immigration Trusts
A frequently used planning technique for the representation of a non-U.S. resident contemplating a change of residence to the United States was for the individual to transfer assets to a foreign trust before moving to the United States. In 1995, Search7RH679 was amended to provide that it applies if a non-U.S. resident has a residency starting date within five years after the transfer of property to a foreign trust. Prop. Regs. Search7RH1.679-5 expands the reach of the statute to some extent to include a non-U.S. resident who created a revocable foreign trust more than five years earlier but amended the trust to make it irrevocable within five years of the change of residency.28 When this provision applies, the property deemed transferred to the foreign trust on the residency starting date includes undistributed net income, attributable to the property deemed to be transferred.29
Some Common Fact Patterns
The proposed Search7RH679 regulations will have serious consequences for a common fact pattern involving families with U.S. residents in the senior generation and descendants that include both U.S. and non-U.S. residents. If a settlor (senior generation member resident in the United States) establishes a foreign trust, FT, for his descendants at a time when all of them are non-U.S. residents, Search7RH679 will not apply. (Section 684 may apply, however, to cause a gain recognition event, as discussed further below.) If one of FT's non-U.S. resident beneficiaries becomes a U.S. resident within five years of the creation of FT, Search7RH679 will apply from the year in which the beneficiary becomes a U.S. resident. An amount equal to the trust's undistributed net income will be taxable to the settlor in that year (and an interest charge will be imposed on such amount) and the entire income of the trust will thereafter be taxable to the settlor under Search7RH679.
A resident alien parent with resident and nonresident children may consider setting up two sets of trusts, one for the U.S. resident child and issue and the other for the non-U.S. resident child and issue. Ordinarily such trusts would provide that if a child dies without surviving issue, the sibling of the beneficiary will become a beneficiary. It would appear that such a provision would not satisfy the remote contingency exception described above. Providing for disposition to the settlor's heirs at law, in such event, may satisfy the remote contingency rule, although the example described above suggests that this result may depend on the age of the nonresident child and whether she has any descendants.
The proposed regulations make it advisable to set up a separate trust for each child or even for each grandchild. Under the proposed regulations, if a foreign trust is settled exclusively for nonresident beneficiaries and within five years thereafter one of the beneficiaries becomes U.S. resident, the U.S. transferor is taxable in that year on the trust's undistributed net income and is subject to an interest charge, as described above. The likelihood of such an event greatly increases with the number of potential beneficiaries, as does the amount of potential income, because a trust for multiple beneficiaries is likely to be larger than a trust for a single beneficiary. Separate trusts for each adult child and each adult or adolescent grandchild protect the settlor from the decision of any one descendant. Multiple separate trusts can be established under a single trust instrument. However, care must be taken to maintain separate records for each trust, particularly if some of the trusts will not file U.S. tax returns. In addition, all filings under Search7RH6048 must be clear that there are multiple trusts.
In addition to establishing separate trusts for separate beneficiaries, it may be advisable to provide for separate subtrusts to be created each time the U.S. transferor makes a transfer to the trust. Under the five-year rule, Search7RH679 does not apply if a non-U.S. beneficiary first becomes a U.S. resident more than five years after the U.S. transferor's transfer to the foreign trust. Because the five-year rule applies on a transfer-by-transfer basis, the fact that a beneficiary becomes a U.S. beneficiary within five years of one transfer should not taint an earlier transfer (i.e., made more than five years before the beneficiary becomes a U.S. person). However, as an administrative matter, separate trusts (or subtrusts) for each transfer may be preferable. This structure will avoid the complicated task of tracking, within a single trust, the assets attributable to multiple transfers and will minimize the risk that failing to account for such assets correctly may cause an otherwise exempt portion of a trust to become subject to Search7RH679.30
The proposed regulations make it more difficult to engage in multi-generational planning, because including grandchildren as potential beneficiaries subjects the trust to the risk of their change of residence. It may be preferable simply to name nonresident children as beneficiaries and to have those beneficiaries set up separate trusts for their children. It is possible that the proposed regulations may be read to conclude even in that case where separate trusts are established that the possibility of distributions to the U.S. resident grandchildren is sufficient to cause Search7RH679 to apply. Depending upon the age and health of the non-U.S. resident beneficiaries, it may be possible simply to provide that upon the death of the named non-U.S. beneficiaries all trust assets will be contributed to charity. Care can be taken to insure that all intended distributions to the nonresident beneficiaries are made prior to their deaths, with sufficient time for such beneficiaries to set up their own trusts for their descendants.
Fair Market Value Exception
An exception is provided underSearch7RH679 for certain transfers for fair market value. Under this exception, Search7RH679 does not apply to any transfer to a foreign trust to the extent of the value of property received from the trust in exchange. Similarly, a distribution by an entity, such as a partnership or a corporation, to a trust with respect to an interest in the entity held by the trust is characterized as a transfer for fair market value.31
Congress was concerned that taxpayers could use the fair market value exception to avoid the application of Search7RH679 by transferring property to a foreign trust in exchange for the trust's note, which the parties do not in fact intend to be repaid by the trust. Thus, one of the 1996 amendments to Search7RH679 provides that obligations issued by the trust, by any grantor or beneficiary, or by any person related to any grantor or beneficiary, are not taken into account in applying the fair market value exception, except as provided in regulations. Transfers to unrelated foreign trusts are not subject to the qualified obligation rules.
The proposed regulations detail the following specific rules.32 An obligation issued by a foreign trust that is a related person to the U.S. transferor is not taken into account for purposes of the fair market value exception unless it is a "qualified obligation." 33 This means an obligation that (i) is in writing, (ii) does not have a term in excess of five years, (iii) provides for payments denominated in U.S. dollars, and (iv) has a yield to maturity not less than 100% nor greater than 130% of the applicable federal rate (AFR) in effect under Search7RH1274(d) for the day on which the obligation is issued.34 The U.S. transferor must agree to extend the period for assessment of any income or gift or estate tax attributable to the transfer and any consequential income tax changes for each year that the trust's note is outstanding to a date that is at least three years beyond the maturity date of the note. The U.S. transferor must also report the status of the loan (including principal and interest payments) for each year the note is outstanding.35
Under the fair market value exception, if a U.S. transferor transfers property to a related foreign trust with a U.S. beneficiary in exchange for a note from the trust that complies with the qualified obligation rules, Search7RH679 does not apply and the trust's assets may grow on a tax-deferred basis.36 Of course, the transfer will be a sale transaction and any gain will be recognized by the transferor. In addition, accumulations inside the trust will be reduced by payments of interest on the note (which will be includible in the income of the U.S. transferor). If the trust's assets are likely to outperform the AFR, however, such a sale for a qualified obligation may be a worthwhile planning technique.
In the event that a trust issues a note to a related U.S. transferor and the note does not constitute a qualified obligation under the rules described above, the U.S. transferor's transfer to the trust will be subject to Search7RH679. In such a case, principal repayments under the nonqualified note will decrease the portion of the trust treated as owned by the U.S. transferor. The proposed regulations provide that each principal payment "is taken into account on and after the date of the payment in determining the portion of the trust attributable to the property transferred.37 This rule is similar to the rule discussed above under the constructive transfer rules. As noted in that discussion, some elaborate accounting may be required in order for a trust and the U.S. transferor that holds the note to be able to track the portion of the trust deemed owned by the note holder under Search7RH679.
The Search7RH684 Regulations
Like Search7RH679, Search7RH684 provides rules that significantly limit the use of foreign trusts by U.S. citizens and residents. Section 684 generally treats a transfer to a foreign trust as a taxable disposition of the transferred assets, unless the transferor is treated as the owner of the trust under the grantor trust rules, for example, because the foreign trust has one or more U.S. beneficiaries. Section 684 is also triggered by the change in status of a trust from a U.S. trust to a foreign trust, for example, because the beneficiary changes her status from U.S. resident to non-U.S. resident and, as a result, the trust ceases to be a grantor trust.
Definition of "Foreign Trust"
The definition of "foreign trust" is found in Search7RH7701(a)(31) and related regulations adopted in 1999. The definition is expansive. A trust is treated as a foreign trust (for U.S. income tax purposes) unless (i) a court within the U.S. is able to exercise primary supervision over the administration of the trust 38 and (ii) one or more U.S. persons have the authority to control all substantial decisions of the trust.39 Under this definition, for example, a trust with one U.S. trustee and one non-U.S. trustee who jointly make decisions on behalf of the trust will be treated as a foreign trust. This is true even if the trust is governed by U.S. law, all trust assets are in the U.S., and every other person connected with the trust (settlor, beneficiaries) is a U.S. person. The proposed Search7RH684 regulations provide, however, that if a U.S. trust without any U.S. beneficiaries inadvertently becomes a foreign trust, the trust may redomesticate under Regs. Search7RH301.7701-7(d)(2).40
Indirect and Constructive Transfers
Prop. Regs. Search7RH1.684-2 provides rules for determining whether a transfer to a foreign trust has occurred. Indirect and constructive transfers are included, under rules similar to those set forth in the proposed Search7RH679 regulations. Thus, when property is transferred by a U.S. person to a foreign person who subsequently transfers the property to a foreign trust, the transferor must demonstrate to the satisfaction of the Commissioner that the foreign person acted independently of the U.S. person in making the subsequent transfer.41
Under Prop. Regs. Search7RH1.684-2(d), if a trust is treated as owned by any person under the grantor trust rules, a transfer by that trust is treated as a transfer by the deemed owner. For example, if a U.S. transferor, A, transfers property to a U.S. trust, UST, that is revocable by A, UST's subsequent transfer of property to a foreign trust that is not a grantor trust (i.e., does not have a U.S. beneficiary and is not otherwise a grantor trust) is treated as a transfer by A (not UST) that is subject to tax under Search7RH684. Similarly, if A transfers property to a foreign trust, FT1, that is revocable by A, FT1's transfer of assets to a second foreign trust, FT2, that is not a grantor trust, is treated as a transfer by A to FT2 that is subject to tax under Search7RH684.42 (A's transfer to FT1 remains nontaxable, because FT1 is a grantor trust.)
Significantly, the proposed Search7RH684 regulations characterize any event which "de-grantorizes" a trust as a transfer subject to Search7RH684. Under Prop. Regs. Search7RH1.684-2(e), if a foreign trust (or any portion thereof) is treated as owned by a U.S. person under the grantor trust rules (for example, because it has a U.S. beneficiary), and then ceases to be treated as owned by such U.S. person under such rules, such U.S. person is treated as having transferred, immediately before the trust ceases to be a grantor trust, the assets of such trust (or portion thereof) to a foreign trust. Accordingly, if a foreign trust which was a grantor trust because of a U.S. resident beneficiary ceases to be a grantor trust because the beneficiary becomes a non-U.S. resident (or dies), gain will be recognized with respect to appreciated assets held by the trust at that time.
Multiple Assets Deemed Transferred
Section 684 treats a transfer of property by a U.S. person to a foreign trust as a taxable disposition of the property. Under Prop. Regs. Search7RH1.684-1(a)(2), gain but not loss will be recognized on such a transfer. If multiple assets are transferred, losses on some assets may not be used to offset gains on other assets.43 Furthermore, the examples in this section require the recognition of all gain on a transfer to a foreign trust, even though the transferor might otherwise have been allowed to defer recognition of gain under another provision of the Code.44
Except for transfers at death (discussed below), the proposed regulations contain only a handful of exceptions to gain recognition that are sensible but will affect relatively few transactions, including a transfer for fair market value to an unrelated foreign trust, a transfer to a charitable trust that has received a determination letter, a distribution by an entity to a trust with respect to an interest in the entity held by such trust.45
Transfers by Death
Some of the most significant provisions of the proposed Search7RH684 regulations are contained in Prop. Regs. Search7RH1.684-3(c), which addresses transfers at death. The effect of Search7RH684 is particularly significant when planning for the disposition of assets upon the death of a person who is a U.S. resident for income tax purposes but not for estate tax purposes. As noted above, the estates of U.S. citizens and non-U.S. citizens who are U.S. residents for estate tax purposes (i.e., who are U.S. domiciliaries) include the decedents' worldwide assets. The basis of such assets in the hands of the person acquiring them from the decedent is stepped-up under Search7RH1014. By contrast, the estate of a foreign decedent who was not a U.S. domiciliary at the date of death includes only the decedent's U.S. assets.
Although non-U.S. assets held by a non-U.S. citizen who is a non-U.S. domiciliary are exempt from U.S. estate tax, issues arise concerning the basis of the decedent's property in the hands of his heirs and the application of Search7RH684 to the transfer of these assets. Under a longstanding revenue ruling, all assets held by a non-U.S. resident at death receive a basis step-up under Search7RH1014, including property which is not subject to U.S. estate tax.46 Under Search7RH1014(b)(1) through (4), the basis step-up applies to all assets owned by the nonresident directly, through a revocable trust, or through a trust with respect to which the nonresident possessed a general power of appointment which he exercised by Will. Nevertheless, as with decedents who are U.S. citizens and domiciliaries, the basis step-up does not apply to assets that were transferred, within the meaning of the estate tax rules, prior to the decedent's death. Thus, for example, if property is transferred before death to an irrevocable trust with respect to which the decedent does not possess a general power of appointment, the assets do not receive a basis step-up at death.
Since the enactment of Search7RH684, the most significant questions raised concern the impact of that section on transfers upon the death of a person who is a U.S. resident for income tax purposes but not for estate tax purposes. Questions arise in connection with transfers of property to the decedent's estate, transfers to testamentary trusts created under the decedent's Will, and the deemed transfer that occurs upon the death of the deemed owner of assets held in a grantor trust. Resolution of these questions turns upon the interplay between Search7RH684 and the basis step-up rules of Search7RH1014.
For income tax purposes, the termination of grantor trust status is treated as a transfer of the trust's assets by the deemed owner.47 This is the explicit rule in Prop. Regs. Search7RH1.684-2(e). Under this proposed regulation, the death of the U.S. transferor of a Search7RH679 grantor trust results in a deemed transfer by the U.S. transferor (the decedent), immediately before death, to the nongrantor foreign trust that results from the termination of grantor trust status. As confirmed by an example under this provision, the general rule is that the U.S. transferor recognizes gain at the time of the deemed transfer. Because the transfer is deemed to occur before death, Search7RH1014 does not apply; the gain recognized is the excess of fair market value immediately before death over the trust's basis in the assets without benefit of a step-up.48 The example notes that an exception for certain transfers at death may apply under Prop. Regs. Search7RH1.684-3(c) to prevent the gain recognition that otherwise would apply.
Prop. Regs. Search7RH1.684-3(c) states, in its entirety:
(c) Certain transfers at death. The general rule of gain recognition under Search7RH1.684-1 shall not apply to any transfer of property by reason of death of the U.S. transferor if such property is included in the gross estate of the U.S. transferor for Federal estate tax purposes and the basis of the property in the hands of the foreign trust is determined under Search7RH1014(a).
The preamble to the proposed regulations explains that this exception is intended to apply with respect to trusts over which the decedent retained sufficient powers to cause the trust to be included in the decedent's gross estate for estate tax purposes. This would include, for example, a trust that was revocable by the decedent or a trust over which the decedent possessed a general power of appointment. This would not include a trust that was treated as a grantor trust under Search7RH679 because of the presence of one or more U.S. beneficiaries, but was not otherwise a grantor trust.
The proposed regulations provide two examples interpreting the exception for transfers at death. In the first example, property was transferred to a foreign trust that was revocable by the grantor and, consequently, was treated as a grantor trust during the transferor's lifetime. Because the transferor was a U.S. citizen and retained the power to revoke the trust, the value of the trust's assets was included in his estate. Under the exception provided in Prop. Regs. Search7RH1.684-3(c) (quoted above), the transferor did not recognize gain under Search7RH684.49 The other example involved a transfer by a U.S. citizen to a foreign trust over which the U.S. transferor did not have a general power of appointment. Because it had a U.S. beneficiary, however, the trust was a grantor trust under Search7RH679 during the lifetime of the U.S. transferor. The example notes that, upon the death of the transferor, the assets in the foreign trust are not required to be included in the transferor's gross estate. As a result, the conversion of the trust from grantor to nongrantor status by reason of the death of the grantor is not eligible for the exception for transfers at death and gain is required to be recognized under Search7RH684. The gain is computed by reference to the historic basis of the assets in the hands of the trust (without a step-up under Search7RH1014).50
It is noteworthy that the exception for transfers at death refers to the "U.S. transferor" and requires inclusion of trust assets in the U.S. transferor's gross estate as well as a basis determined under Search7RH1014. U.S. transferors, under these regulations, include persons who are U.S. residents for income tax purposes, but who are non-U.S. domiciliaries, and therefore not U.S. residents for estate tax purposes. The gross estate of the deemed owner of a trust who is a U.S. resident for income tax purposes but not for estate tax purposes will not include any non-U.S. assets held by the trust at his death. Thus, even though Rev. Rul. 84-139 accords the benefit of a basis step-up to such assets under Search7RH1014, gain will be recognized under Search7RH684 if the assets deemed transferred are not included in the deemed transferor's gross estate. Apparently, the drafters of the proposed regulations intend that either assets are subject to estate tax or gain is recognized for income tax purposes.
It is far from clear, however, whether this rule applies to the wide variety of ways that assets may be transferred at death. Significantly, Prop. Regs. Search7RH1.684-1(a) provides for recognition of gain to any U.S. person (U.S. citizen or resident for income tax purposes) who transfers property to a foreign trust "or foreign estate." It is possible to read the proposed regulation as causing a non-U.S. citizen who is a resident for income tax purposes, but not a U.S. domiciliary, to recognize gain under Search7RH684 on all appreciated non-U.S. assets held directly at her death, on the theory that all such assets are transferred at death to a foreign estate. The issue is further complicated because assets need not necessarily end up in an estate. In fact, many civil law countries do not recognize the concept of an estate. The heirs of a decedent are considered to receive the assets directly from the decedent upon her death. Even in countries such as the United States that provide for the creation of an estate on death, the decedent can, by Will, make a specific bequest of assets directly to a named beneficiary. As a result, the application of Search7RH684 to non-U.S. assets held directly by a non-U.S. citizen, non-U.S. domiciliary might differ depending upon whether the assets are located in a civil law country or whether the decedent makes specific bequests in her Will.
Estate Planning Techniques to Avoid Search7RHSearch7RH679 and 684
The provisions of the Search7RHSearch7RH679 and 684 regulations addressing indirect transfers create substantial uncertainty when attempting to create a rational estate plan for families headed by persons who are resident in the U.S. for income tax purposes and who maintain investments and business interests both inside and outside the United States. For example, assume that a U.S. resident, non-U.S. domiciliary, A, has two children, B and C. B is a U.S. resident who manages the family's U.S. businesses and investments; C lives in country X and manages the family's businesses and investments in that country. Even disregarding tax consequences, a logical estate planning option would involve leaving the U.S. assets to B and the assets in X to C. Ordinarily, however, the relative values of the assets do not correspond to the location of the descendants and it is often the case that the non-U.S. assets represent a larger portion of the family's wealth. Thus, the owner of these assets would likely want the non-U.S. resident child to share the non-U.S. wealth with his U.S. resident sibling. If the settlor wished to equalize the inheritance between the two children, some of the foreign assets would need to be transferred to the U.S. resident child.
A transfer of non-U.S. assets to a foreign trust in which B is a potential beneficiary would be a grantor trust under Search7RH679 during A's lifetime. Upon the death of A, the trust would no longer be a grantor trust. Since non-U.S. assets are not includible in the U.S. estate of a U.S. resident who is not a U.S. citizen or domiciliary, gain would be recognized under the proposed Search7RH684 regulations at that time.
If A instead, were to divide his assets and place some of the non-U.S. assets in a separate foreign trust for C to which B is not a potential beneficiary, that trust would not be a grantor trust under Search7RH679 but the transfer would be taxable under Search7RH684.
Assuming that A is willing during his lifetime to be taxable on all the income from his assets, another possibility is for A to transfer non-U.S. assets to a revocable U.S. trust and provide by Will that the trust is not to be included in the decedent's estate. Upon A's death, Search7RH684 would not apply since there has been no transfer to a foreign trust or to a foreign estate and the assets should receive a basis step-up under Rev. Rul. 84-139. After A's death, because there is no longer any unrecognized gain (because of the basis step-up) in the assets held in the U.S. trust, the trust could then migrate outside the U.S. without any gain recognition, notwithstanding Search7RH684.
If A transfers non-U.S. assets outright to C (the non-U.S. resident child) during his lifetime or by specific bequest in his Will (including by operation of law in civil law countries), Search7RH684 would not apply. If, thereafter, C transfers certain assets to a foreign trust for the benefit of his sibling B (the U.S. resident child) or B's descendants, the IRS may seek to argue that the transfer by C to a trust for B is an indirect transfer from A to B. It would appear that the greater the length of time between A's transfer to C and C's transfer to the trust for B, the better the defense against this argument. Other distinctions between the assets transferred would also be helpful in countering this argument. It also appears that the indirect transfer argument would be more difficult if the transfer occurs after A's death.
Conclusion
In many respects, the proposed regulations appear to overreach and are likely to be subject to substantial commentary and criticism. Nevertheless, it will be impossible to prepare an estate plan for a U.S. resident nondomiciliary without careful consideration of their effects.
FOOTNOTES____________________
1
The Foreign Investment in Real Property Tax Act ("FIRPTA") enacted Search7RH897, which treats gain or loss realized by a nonresident alien individual or foreign corporation from the disposition of a U.S. real property interest as if it were realized in connection with a trade or business in the United States.2
In addition to Search7RHSearch7RH679 and 684, Search7RH668 provides for an interest charge on accumulation distributions received from foreign trusts, Search7RH643(h) provides rules for indirect distributions by foreign trusts, and Search7RH643(i) provides that certain loans from foreign trusts may be recharacterized as distributions. In addition Search7RH6048 requires extensive reporting requirements for foreign trusts as well as U.S. persons who make transfers to or receive transfers from foreign trusts.3
REG-209038-89, 65 Fed. Reg. 48185 (8/7/00), and REG-108522-00, 65 Fed. Reg. 48198 (8/7/00). The regulations are proposed to be effective generally with respect to transfers after August 7, 2000. Prop. Regs. Search7RH1.679-7.4
Section 1057, which was also repealed in 1997, permitted the taxpayer, in lieu of paying the excise tax, to treat the transfer to a foreign trust as a sale for fair market value.5
Search7RH2001(a). A person acquires a U.S. domicile, for this purpose, by living in the U.S., for even a brief period of time, with no definite intention of later removing therefrom. Regs. Search7RH20.01(b)(1).6
Although the Code refers to decedents who are not citizens of the United States, Regs. Search7RH20.0-1(b)(2) defines a "resident" decedent to include a decedent "who, at the time of his death, had his domicile in the United States."7
Under the "substantial presence" test, an individual is a U.S. resident in a particular calendar year if (i) the individual is present during such year on at least 31 days and (ii) the sum of the number of days the individual was present in the U.S. in the current year and the two preceding calendar years equals or exceeds 183 days, counting each day in the current year as one day, each day in the first preceding year as 1/3 of one day, and each day in the second preceding year as 1/6 of one day. Search7RH7701(b)(3).8
This includes U.S. citizens, non-U.S. citizens who are U.S. residents, domestic corporations and partnerships, estates other than foreign estates, and U.S. trusts.9
As noted under the discussion of the Search7RH684 regulations below, the definition of "foreign trust" is extremely broad and can include a trust with neither a foreign grantor nor a foreign beneficiary.10
Persons "related" to the U.S. transferor for this purpose include his or her brothers and sisters, ancestors, lineal descendants, and the spouses of any of the foregoing persons. Also "related" are corporations and partnerships in which the U.S. transferor (or one or more family members) owns at least 10%, and other trusts of which the U.S. transferor is the settlor. Prop. Regs. Search7RH1.679-3(c)(4) which incorporates, with certain modifications, Search7RHSearch7RH267 and 707(b).11
Prop. Regs Search7RH1.679-3(c)(5), Ex. 1.12
Prop. Regs. Search7RH1.679-3(c)(5), Ex. 2.13
Such recharacterization will cause the U.S. person to be taxable on the receipt of the distribution to the extent the distribution is made from current or accumulated income of the trust. Search7RHSearch7RH662, 665, and 668.14
Regs. Search7RH1.643(h)-1(g), Ex. 2.15
Regs. Search7RH1.643(h)-1(g), Ex. 3.16
Prop. Regs. Search7RH1.679-3(c)(5), Exs. 3, 4.17
Prop. Regs. Search7RH1.679-3(d)(2), Exs. 1, 2.18
Prop. Regs. Search7RH1.679-3(e)(3).19
Under certain attribution rules, amounts paid to or accumulated for the benefit of a controlled foreign corporation, a foreign partnership with a U.S. partner, or a foreign trust or estate which has a U.S. beneficiary are treated as paid to or accumulated for the benefit of a U.S. person. Prop. Regs. Search7RH1.679-2(b)(1).20
Prop. Regs. Search7RH1.679-2(a)(2)(iii), Exs. 2, 3, 4, 5.21
Id. Exs. 9, 10, 11.22
Prop. Regs. Search7RH1.679-2(a)(3).23
Very generally, this is the trust's "distributable net income" in excess of amounts distributed to beneficiaries. Section 665(a) provides detailed rules regarding the computation of undistributed net income.24
Section 668 imposes an interest equivalent charge on accumulation distributions from foreign trusts.25
Prop. Regs. Search7RH1.679-2(a)(2)(ii).26
Prop. Regs. Search7RH1.679-2(a)(2)(iii), Ex. 8.27
Prop. Regs. Search7RH1.679-2(a)(2)(iii), Ex. 7.28
Prop. Regs. Search7RH1.679-5(c), Ex. 2.29
Prop. Regs. Search7RH1.679-5(b)(2).30
As noted above, separate trusts and subtrusts can be created under a single trust instrument.31
Prop. Regs. Search7RH1.679-4(b).32
These rules were originally set forth in Notice 97-34, 1997-2 C.B. 422.33
Prop. Regs. Search7RH1.679-4(c).34
For example, the AFR for a five-year obligation issued in December 2000 is 5.87%, compounded annually.35
Prop. Regs. Search7RH1.679-4(d). The annual report on the status of the note is to be made on Form 3520.36
Special rules apply in the event an obligation that initially constitutes a qualified obligation ceases to qualify, or is renegotiated. Prop. Regs. Search7RH1.679-4(d)(3), (4), (5).37
Prop. Regs. Search7RH1.679-4(d)(6).38
This test is referred to as the "court test." Regs. Search7RH301.7701-7(c) provides a safe harbor under which the court test will be deemed to be satisfied if (i) the trust instrument does not direct that the trust be administered outside the United States; (ii) the trust is in fact administered exclusively in the United States; and (iii) the trust is not subject to an automatic migration provision (a provision which purports to cause the trust to migrate from the United States if a U.S. court attempts to assert jurisdiction or otherwise supervise the administration of the trust).39
This test is referred to as the "control test." Under Regs. Search7RH301.7701-7(d), "substantial decisions" means those decisions that persons are authorized or required to make under the trust instrument and applicable law and that are not ministerial. Examples of substantial decisions include whether or when to distribute income or corpus, the amount of any distributions, the selection of any beneficiary, whether a receipt is allocable to income or principal, and whether to remove, add, or replace a trustee.40
Prop. Regs. Search7RH1.684-4(c). Under Regs. Search7RH301.7701-7(d)(2), an inadvertent change in the trust's status that is caused by the death, incapacity, resignation, change in residency or other change with respect to a person who has the power to make a substantial decision of the trust, if corrected within 12 months (or extended period with permission of the IRS) will not cause the trust to be treated as a foreign trust.41
Prop. Regs. Search7RH1.684-2(b), regarding indirect transfers, imports the rules of Prop. Regs. Search7RH1.679-3(c). Prop. Regs. Search7RH1.684-2(c), regarding constructive transfers, imports the rules of Prop. Regs. Search7RH1.679-3(d).42
Prop. Regs. Search7RH1.684-2(d)(2), Exs. 1, 2.43
Prop. Regs. Search7RH1.684-1(d), Ex. 2.44
Prop. Regs. Search7RH1.684-1(d), Exs. 4, 5. These provisions, if they become final, will be interesting to taxpayers with expiring net operating losses.45
Prop. Regs. Search7RH1.684-3(b), (d), (e).46
Rev. Rul. 84-139, 1984-2 C.B. 168.47
Regs. Search7RH1.1001-2(c), Ex. 5.48
Prop. Regs. Search7RH1.684-2(e), Ex. 2.49
Prop. Regs. Search7RH1.684-3(f), Ex. 2.50
Prop. Regs. Search7RH1.684-3(f), Ex. 3.1 Except as otherwise noted, all section references are to the Internal Revenue Code of 1986, as amended (the "Code"), and the regulations thereunder."Except as otherwise noted, all section references are to the Internal Revenue Code of 1986, as amended (the "Code"), and the regulations thereunder.