In 1997, Mexico led the charge — blacklisting such traditional tax havens as the Cayman, Channel and Cook islands. Suddenly Mexicans were forced to disclose to their government when they placed assets in financial structures (trusts, companies, partnerships, etc.) in “outlaw” countries. Venezuela quickly followed Mexico's example, prompting others, including Argentina and Brazil, to enact similar lists. One rather ironic result of these Latin American countries' maneuvers has been to make the United States increasingly attractive to their wealthy citizens interested in financial privacy. Specifically, the asset-protection havens of Alaska, Delaware and North Dakota are most congenial for foreign settlors' purposes. And one of the best tools for these settlors to use on U.S. soil is the oxymoronically named “foreign-domestic trust.”
While U.S. settlors may find the foreign-domestic trust appealing for, say, alimony payments, it is really settlors residing in nations that have blacklists who will find it particularly useful, as the United States is currently absent from such lists.
The foreign-domestic trust allows foreign settlors to establish a trust in a non-blacklisted jurisdiction without attracting any more tax than if the trust had been set up in a traditional tax haven. Consider the foreign settlors seeking to create a revocable trust for the benefit of their spouses and descendants. Typically, these individuals would establish offshore trusts for many reasons, including estate planning, concern over forced-heirship rules, confidentiality and anonymity. But with many foreigners now facing blacklists, most of the traditional tax havens no longer suit their families' needs.
Moreover, compared to the English common law jurisdictions frequently thought of as offshore havens, the United States offers similar, perhaps even superior, infrastructure for trusts. Most U.S. states have developed bodies of trust law that should give settlors assurance about how a particular trust will be administered and interpreted, and their estate-planning objectives achieved regarding forced-heirship claims and other concerns. The United States also is, for the most part, better positioned to address political or military issues that at times could cause a trust to flee under force majeure provisions commonly found in offshore trusts. Foreign settlors considering the foreign-domestic trust can take comfort in the fact that the trust will be “foreign” for U.S. federal tax purposes, resulting in the same taxation of trust income and distributions even though it has a U.S. trustee.
The foreign-domestic trust also may be advantageous to those U.S. settlors attempting to guarantee net after-tax income to a beneficiary. This type of trust can pay income, free of U.S. income tax, to a separated or divorcing spouse, in situations in which the U.S. settlor relinquishes all control. U.S. settlors also may consider the foreign-domestic trust as an additional feature of asset-protection planning. Indeed, the trust may present opportunities to U.S. settlors already planning defective grantor trusts, but uncomfortable giving others the power to add beneficiaries.1
There are significant differences between how the U.S. government taxes domestic and foreign entities. Generally, U.S. domestic taxpayers report and pay federal taxes on worldwide income voluntarily — with cross-check disclosures to the Internal Revenue Service. Foreign taxpayers typically pay U.S. income tax on U.S.-source income only, and that tax is normally collected on a withholding basis. With taxation of trusts, the differences between foreign and domestic trusts generally relate to whether all trust income will be taxed on a current basis or only U.S.-source income (excluding capital gains) will be currently taxed. Key disclosure issues arise from the classification of a foreign trust as a grantor trust, and as a simple or complex trust.2
Generally, the U.S. income taxation of non-grantor trusts turns on whether the trust or the beneficiaries are in possession of trust income. U.S. resident trusts (U.S. trusts) are currently taxed on worldwide income and gains while non-resident trusts (foreign trusts) are subject to current U.S. income tax only on U.S.-source income.3 Of course, distributions from foreign non-grantor trusts to U.S. beneficiaries also will attract U.S. income tax and possibly the throwback tax on accumulated income.
Both U.S. and foreign settlors of a foreign-domestic trust need to ensure that the trust is classified as a foreign trust for U.S. federal tax purposes. This feat is typically accomplished by ensuring that either there is offshore involvement in the administration of the trust (perhaps very slight foreign involvement and/or veto powers) or the trust contains anti-jurisdiction provisions that attempt to prevent U.S. courts from obtaining jurisdiction over it. In many other respects, such a trust still may be administered in a particular state and have access to that state's courts to interpret the trust and/or to provide redress for trustee conduct. Typically, U.S. and non-U.S. settlors achieve foreign trust classification by simply appointing a foreign trust protector with the right to change trustees. Usually a non-U.S. settlor's ability to change trustees also would render the trust foreign. The ability to remove and replace trustees is but one of many trust powers that, when held by non-U.S. individuals, classifies a trust as foreign.
The ability to cause a trust that otherwise seems domestic to be classified as foreign stems from changes made to U.S. law in 1996. For years the tax residence of trusts was determined by a facts-and-circumstances test that looked at a number of factors. But if the trust had any U.S. resident trustee it was likely to be classified as domestic.4 President Bill Clinton proposed sweeping changes applicable to offshore trusts. By adopting a bright-line rule to determine whether trusts were foreign or domestic, Congress wanted to avoid the uncertainty of the former facts-and-circumstances approach.5 Now the law requires domestic trusts to have two elements: A U.S. court must be able to exercise primary supervision over the trust's administration (the court test); and one or more U.S. citizens must have authority to control all the trust's substantial decisions (the control test).6 A trust missing either element will be considered foreign.
The court test is normally satisfied when a U.S. resident serves as a trustee, because then it is likely a U.S. court can exercise primary supervision over the trust's administration.8 Indeed, when a trust has both U.S. resident and non-U.S. trustees, U.S. Treasury regulations recognize that the court test would be satisfied even if both a U.S. court and a foreign court could exercise primary supervision over the trust's administration. Scriveners wishing to flunk the court test include a trust provision providing that any attempt by a U.S. court to assert jurisdiction or otherwise supervise the trust's administration would cause the trust to migrate out of the United States.8 In most situations, particularly those in which U.S. court jurisdiction and a particular state's laws are desirable (to defend against forced-heirship claims, for example), such an automatic migration provision is counter-productive.
The control test can be difficult to satisfy if a trust grants non-resident alien (NRA) trustees or protectors the ability to make substantial decisions, but allows any non-U.S. individual to control or veto such decisions. The regulations9 define substantial decisions as:
- the amount of any distribution;
- the designation of a beneficiary;
- whether and when to distribute income or a corpus;
- whether a receipt is allocated to income or principal for trust-accounting purposes;
- whether to terminate a trust;
- whether to compromise, arbitrate or abandon claims of the trust;
- whether to sue on behalf of the trust or defend suits against the trust;
- whether to remove, add or replace a trustee; and
- certain investment decisions and the filling of trustee vacancies.
A simple way to cause a trust to be classified as foreign is to give an NRA the ability to make one or more substantial decisions. Indeed, even a veto power held by an NRA causes the trust to fail the control test.10 The NRA holding such power does not need to be a trustee, but could be a protector, settlor or any individual. Treasury regulations recognize that there may be inadvertent changes in the personnel possessing powers to make substantial decisions, and allow a 12-month transition period in which to maintain the status of a trust as either domestic or foreign.11
COMPLIANCE AND DISCLOSURE
Because foreign trust classification forces additional disclosures, U.S. settlors often choose domestic trusts — a reasonable choice. Non-U.S. settlors, however, tend to believe that settling a trust with a U.S. trustee leads to U.S. disclosures identifying their involvement with the trust. This perception is unwarranted.
While U.S. settlors of a foreign-domestic trust need to comply with a number of additional U.S. disclosures, non-U.S. settlors remain subject to the disclosure regime applicable to offshore trusts in general; they often are surprised at how little information is automatically available to be shared with the taxing authorities in their home countries. Granted, U.S. trustees would be wise to request a great deal of information from any settlor of a trust, particularly a foreign-domestic trust. But the disclosure of such due diligence information to governmental authorities (U.S. and foreign) is not automatic.
What U.S. tax and Treasury disclosures are automatically required of U.S. and foreign settlors of foreign-domestic trusts? And what tax information is readily available to foreign governments upon request?
U.S. settlors have obligations regarding these forms:
3520A — The feature common to most foreign-domestic trusts established by U.S. settlors is that they are irrevocable — whether the trust was set up for asset-protection, income, gift or estate tax reasons as well as other purposes. Because the trust is foreign, however, its U.S. settlor must ensure that the trustee files a Form 3520A by March 15 of the calendar year following each calendar year that the trust is in existence. U.S. settlors also are required to submit a Form 3520 when they file their U.S. income tax returns reporting the trust's income for each year that it exists.12 (To the extent U.S. beneficiaries receive distributions from a foreign-domestic trust, they likewise must report their receipt of distributions on Form 3520, filed with their income tax returns for the year in which they receive the trust distributions.)
TDF 90-22.1 — U.S. settlors also may have to file Form TDF 90-22.1 reporting the existence of their financial interest in a foreign trust account — although the need to file this form is less clear with a foreign-domestic trust that has no foreign accounts.
W9 — U.S. settlors also may file applicable W9 statements when the trust opens U.S. bank and brokerage accounts — if the foreign-domestic trust was classified as a grantor trust for U.S. tax purposes.
Typically, non-U.S. settlors create revocable trusts and conduct the majority of their investing through non-U.S. corporate holding companies (commonly referred to as private investment companies). In such cases, non-U.S. settlors have very little U.S. reporting requirements for their foreign-domestic trusts. Of course, the investment company likely would have to file a W8 (usually W-8BEN) if the company opens U.S. investment accounts. The W-8BEN form does reveal the beneficial owner of investments held by the company. But such ownership disclosures need not identify the settlor under current U.S. law regarding W-8BEN reporting of the private investment company, which defines the private investment company (not the trust) as the beneficial owner of the account.13 However, the settlor's identity is disclosed if the accounts are opened not through a private investment company but directly by a grantor trust (as most revocable trusts would be classified).
Less typically, non-U.S. settlors choose to establish an irrevocable trust and may, or may not, employ a private investment company to conduct that trust's investing. With irrevocable foreign-domestic trusts established by foreign settlors, W8 disclosures hinge on whether the trust is classified as grantor or not. When the foreign-domestic trust is classified as a grantor trust for U.S. tax purposes, the identity of the settlor is disclosed — unless a private investment company opened the investment account.14 But as long as the trust is classified as a non-grantor trust, current U.S. law does not require tax disclosure of the settlor's identity.15
Under grantor trust rules, the trustee of a foreign-domestic trust typically reports the trust's income to its U.S. owners using Form 1099 or other permissible methods.16 It also is possible that the U.S. trustee could disclose distributions to beneficiaries of the trust if the trustee thinks a 1040NR filing is appropriate and/or if the other methods described in IRC Section 1.671-4 are unavailable to the trust, because its situs is outside of the United States or it's owned by a foreign settlor.17 Additionally, if a foreign-domestic trust makes distributions to U.S. beneficiaries, the trustee would need to provide those beneficiaries either with a foreign grantor trust beneficiary statement or a foreign non-grantor trust beneficiary statement — informing them of the distributions they'd received during the prior calendar year as well as whether those distributions consisted of income that attracted U.S. income taxes.
The U.S. tax rules for domestic and foreign trusts leave a number of unanswered questions, particularly where a trust resides if an NRA, or several NRAs in various jurisdictions, have substantial control over the trust, or if the trust can automatically migrate from the United States. Despite such questions, the foreign-domestic trust is a significant tool for estate planners.
- The foreign-domestic trust falls within a general grantor trust rule applicable to foreign trusts that classifies any foreign trust created by a U.S. settlor that can benefit a U.S. beneficiary as a grantor trust under Internal Revenue Code Section 679.
- Treas. Regs. Section 1.1441-5(e)(2), (3).
- Foreign trusts may attract current U.S. income tax on U.S.-source capital gains if the trustee is present in the United States more than 183 days during the calendar year. IRC Section 871(a)(2). It is unclear whether an intentionally created U.S. foreign-domestic trust would ever meet this presence test, because the trust is deemed to be foreign under the U.S. rules.
- Rofus van Tholen Rhodes and Marshall J. Langer, U.S. International Taxation and Tax Treaties (2003), Section 32.02[c], Matthew Bender (1971).
- IRC Section 7701(a)(30), (31).
- Treas. Regs. Section 301.7701-7(a)(2).
- Treas. Regs. Section 7701-7(c)(4)(D).
- See, for example, Treas. Regs. Section 301.7701-7(c)(4)(ii).
- Treas. Regs. Section 301.7701-7(d)(1)(iii).
- Treas. Regs. Section 301.7701-7(d)(1)(iii).
- Treas. Regs. Section 301.7701-7(d)(2).
- Both 3520A and 3520 filings assume the trust will be regarded as a grantor trust for U.S. tax purposes.
- For example, Treas. Regs. Section 1.144-1(b)(2)(iii)(B); see also instructions to Form W-8BEN.
- For example, Treas. Regs. Section 1.1441-5(e)(3)(i) deems a settlor of a foreign grantor trust as the “beneficial owner” of trust income.
- Treas. Regs. Section 1.1441-5(e)(2).
- For example, Treas. Regs. Section 1.671-4.
- See Treas. Regs. Section 1.671-4(b)(6).