In the last few years, there’s been much confusion and debate in the international tax world regarding the U.S. taxation and reporting of Mexican fideicomisos that own U.S. persons’ coastal Mexico real estate.
The debate centers on the fact that fideicomiso means “trust” in Spanish. To play it safe, many professionals have advised their clients to fulfill the onerous foreign trust reporting requirements of the Internal Revenue Code for their fideicomisos. Other professionals looked to the nature of this so-called “trust” and concluded that foreign trust reporting wasn’t required. I’ve always been in this no-reporting camp, and in the April 2009 issue of this magazine, I wrote an extensive article on the subject. Since that time, I’ve revised my analysis, but have come to the same conclusion—no foreign trust reporting is required.
Earlier this year, a client asked me to obtain a private letter ruling from the Internal Revenue Service for his fideicomiso, and the IRS ruled that the fideicomiso wasn’t a “trust” for U.S. tax purposes. The PLR can’t be cited as legal precedent; therefore, this article will outline the legal analysis that I provided to the IRS in obtaining the PLR, so that you can evaluate your own clients’ fideicomisos to determine whether foreign trust reporting is required.
For national security purposes, the Mexican constitution prohibits non-Mexican persons from owning real property located within 100 kilometers of Mexico’s inland borders or within 50 kilometers of its coastline.1 These areas are referred to as the “restricted zone,” and only Mexican citizens (or Mexican corporations whose bylaws forbid the ownership of stock by non-Mexican citizens) are allowed to directly own real estate within the restricted zone.2
All of the desirable coastal lands where foreigners would most want to purchase property are within this area. In the early 1970s, Mexico’s government realized that allowing foreigners to purchase real property in these coastal areas would greatly benefit Mexico’s economy. Therefore, the government looked for a way to balance Mexico’s competing needs of maintaining secure borders and encouraging foreign investment.
The solution was to allow foreign persons to purchase the “beneficial interests” in a fideicomiso, under which legal title to the restricted-zone property is held in the name of a Mexican bank.3 Under such an arrangement, the foreigner could have unrestricted use of the property, as if he owned it outright, but the Mexican bank’s legal ownership of the property would technically satisfy the prohibitions in the Mexican constitution against foreign ownership of restricted-zone property.
In my original article, I concluded that fideicomisos were considered trusts for U.S. tax purposes, but that they could be excepted from the U.S. reporting requirements applicable to foreign trusts. However, since that time, I’ve revised my original analysis and concluded that they aren’t trusts after all.4
Common Law Trusts
To understand whether an arrangement should be considered a trust for U.S. tax purposes, it’s necessary to first understand the elements of a trust under the common law.
Unlike an entity, a trust has no legal personality, but is instead a unique relationship between the trustee and the beneficiary with respect to property. The defining aspect of a trust relationship is the fact that the trustee has a strict duty—a fiduciary duty—to deal with the property solely for the benefit of another. According to Section 2 of the Restatement (Third) of Trusts, a trust is a:
. . . fiduciary relationship with respect to property, arising from a manifestation of intention to create that relationship and subjecting the person who holds title to the property to duties to deal with it . . . for one or more persons.
In simpler terms, a trust is a relationship in which the trustee holds legal title to property, while the beneficiary holds only a passive beneficial interest in the property. A trustee occupies a position of confidence, trust and good faith towards a beneficiary and must fulfill a duty of loyalty to act in the beneficiary’s best interests, not its own.
As the holder of legal title to the property and being bound by its fiduciary duties, the trustee of a common-law trust is required to protect and conserve the trust property, and the trustee has the power to manage the property as it deems appropriate, regardless of the beneficiary’s desires.5 Likewise, the beneficiary has no responsibilities and can’t control the trustee’s actions with respect to the property. The beneficiary may force the trustee to act only if the trustee doesn’t perform consistently with its fiduciary duty.6
Furthermore, as the legal owner of the property, the trustee of a common law trust is responsible for paying all taxes and liabilities related to the property. Also, the trustee is entitled to receive any income and proceeds from the property, which can either be distributed to the beneficiary or reinvested in the trust, at the trustee’s discretion.
Federal Tax Law
Federal tax law follows these common law trust principles and will classify an arrangement as a trust for federal tax purposes only when property is transferred to a trustee who’s responsible for protecting and conserving that property for the benefit of a beneficiary.
Under Treasury Regulations Section 301.7701-4(a), a trust:
. . . refers to an arrangement created either by a will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts.
This mention of the “ordinary rules applied in chancery or probate courts” refers to the fact that, under the English common law (which we adopted in the United States), trusts were historically enforced by courts of equity in accordance with principles of equity, rather than under strict rules of law. A judgment under an action at law would declare the plaintiff’s rights against the defendant, whereas a decree in equity imposed duties upon the defendant. Modern day chancery and probate courts in the United States still exercise jurisdiction over trusts and enforce fiduciary duties against trustees. The Treasury regulations’ reference to these courts is simply a short-hand way to say that only a true common law trust arrangement, under which the trustee is subject to enforceable fiduciary duties, will be treated as a trust under federal tax law.
The regulation continues, stating that:
. . . an arrangement will be treated as a trust under the Internal Revenue Code if it can be shown that the purpose of the arrangement is to vest in
trustees responsibility for the protection and conservation of property for the beneficiaries who cannot share in the discharge of this responsibility.
In short, an arrangement will be considered a trust only when the so-called “trustee” has a real fiduciary duty to protect and conserve the property for a beneficiary. If the “trustee” has no such duty, and if the “beneficiary” is, in fact, responsible for the protection and conservation of the property, then, for purposes of federal tax law, a trust hasn’t been created.
Under Revenue Ruling 92-105,7 which deals with Illinois land trusts, the IRS ruled that a trust wasn’t created for federal tax purposes when the trustee’s only role was to hold legal title to real property, with no other powers or responsibilities with respect to the property, and when the beneficiary had the exclusive right to direct the trustee’s actions with respect to the property, to control the property’s management and to directly receive the earnings and proceeds derived from the property. In addition, the beneficiary described in this revenue ruling was personally obligated to pay any taxes and liabilities relating to the property. As a result, the IRS ruled that, for purposes of federal tax law, no trust was established.
Fideicomisos Aren’t Trusts
Under the guidance provided by Treas. Regs. Section 301.7701-4(a) and Rev. Rul. 92-105, it’s clear that simply calling something a “trust” doesn’t create a trust for federal tax purposes if:
(1) the trustee only holds legal title to property and isn’t subject to a fiduciary duty to protect and conserve the property;
(2) the beneficiary has the exclusive right to control the trustee’s actions with respect to the property; and
(3) the beneficiary has the exclusive right to the earnings and proceeds derived from the property and is personally obligated to pay all taxes and liabilities related to the property.
As described below, fideicomisos aren’t trusts, because they meet all three of these requirements.
No Fiduciary Duty
In a true trust arrangement, the trustee holds legal title to all property held in the trust and is bound by a fiduciary duty to protect and conserve that property. The beneficiary enjoys only the use of the property and can’t be responsible for its protection and conservation.
In contrast, the “trustee” of a fideicomiso serves only to satisfy a technicality of the Mexican constitution, which prevents non-Mexican citizens from owning real property in the restricted zone. In exchange for a small annual fee, the trustee does nothing but allow its name to be listed in the deed records as owner of the real property. Beyond that, the trustee has no responsibilities with respect to the property. Unlike a true trust arrangement, the trustee could allow the property to be taken without defending it and could allow it to fall into complete disrepair, and the beneficiary would have no recourse against the trustee for the resulting loss or decline in the property’s value. In fact, every fideicomiso deed that I’ve seen specifically states that the trustee has no duty to defend or maintain the property. Thus, without the beneficiary’s own obligation to protect and conserve the property, it would fall into disrepair or could be lost completely because the trustee does absolutely nothing.
Beneficiary Has Control
In a true trust arrangement, the beneficiary can’t control the trustee’s actions with respect to the property. The trustee is bound by its fiduciary duty to take whatever actions it deems necessary to manage the property, even if the beneficiary doesn’t agree with those actions. Absent the failure of the trustee to perform consistently with its fiduciary duty, the beneficiary has no power to affect the trustee’s actions with respect to the property.
But, in the case of a fideicomiso, the trustee has no ability to act independently of the beneficiary’s instructions. Instead, the beneficiary has exclusive control of the property’s management and can direct the trustee’s actions with regard to the property. The trustee, after taking title to the property, doesn’t take any independent actions with respect to the property, but merely waits to receive instructions from the beneficiary whenever he wishes to transfer title to a new owner. The trustee has no interaction with the property other than to participate in a transfer, at the beneficiary’s direction, and the fideicomiso deed itself typically gives the beneficiary complete control over the transfer and mortgaging of the property and absolves the trustee of any obligations with respect to those actions. In short, the beneficiary has the exclusive right to control the trustee with respect to the property.
Beneficiary Benefits and Obligations
In a true trust arrangement, the trustee, not the beneficiary, is entitled to receive all of the earnings and proceeds derived from the trust property, which the trustee can then elect to distribute to the beneficiary or retain and reinvest. Even if the terms of the trust direct the trustee to distribute all income to the beneficiary, the trustee must first receive the income on behalf of the trust before it can be distributed to the beneficiary. In addition, a true trustee, as the legal owner of the property, is obligated to pay all taxes and liabilities associated with the property.
Contrary to a true trust arrangement, the beneficiary of a fideicomiso has an exclusive right to the earnings and proceeds derived from the property held in it. If any revenue is generated from the property or if the property is sold, the beneficiary will directly receive the revenue and sales proceeds without any involvement of the trustee. Thus, while the trustee’s name is placed in the deed records as the property’s legal owner, the beneficiary, not the trustee, has an exclusive right to the earnings and proceeds derived from the property. Furthermore, the beneficiary is directly responsible for paying all taxes and liabilities related to the property.
Foreign Trust Filings
Under IRC Section 6048 (entitled “Information with respect to certain foreign trusts”), information reporting obligations must be fulfilled with respect to certain types of foreign trusts. These reporting obligations are met by filing Form 3520 (“Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts”) and Form 3520-A (“Annual Information Return of Foreign Trust With a U.S. Owner”).
If an arrangement isn’t considered a “trust” for purposes of applying the IRC (that is, if it’s not a trust under Treas. Regs. Section 301.7701-4(a)), then IRC Section 6048 doesn’t apply, and neither Form 3520 nor Form 3520-A need be filed.
It’s also worth mentioning that real estate fideicomisos that are established solely to allow non-Mexicans to purchase property in the restricted zone are outside the stated purpose of the IRC provisions underlying the Form 3520 and Form 3520-A reporting regime. Specifically, the reporting rules of IRC Section 6048 were expanded in 19968 to enforce IRC Section 679, which was enacted in 19769 to prevent U.S. persons from deferring the payment of U.S. income tax by transferring income-generating assets to foreign trusts.10 Unlike the foreign trusts that were targeted by IRC Sections 679 and 6048, real estate fideicomisos aren’t tax avoidance devices. As discussed above, all income derived from the fideicomiso property is received directly by the beneficiaries (making it impossible for them to conceal such income in the first place), and they report the income on their U.S. income tax returns, claiming any foreign tax credits allowable for Mexican taxes paid. Furthermore, residential real estate—especially real estate purchased for the taxpayer’s own personal use—isn’t the type of asset that’s typically placed in a structure designed to avoid U.S. tax.
In January, I requested a PLR on behalf a client who holds residential real estate through a fideicomiso. The ruling request explained the law substantially as I’ve explained it in this article, and it applied the law to the specific facts of my client’s fideicomiso arrangement (which are nearly identical to every other client’s fideicomiso that I’ve encountered). The IRS issued the PLR on July 30, 2012,11 finding that my client’s fideicomiso wasn’t a trust for federal tax purposes. Instead, the IRS viewed my client as holding an interest in the residence directly. In short, my client’s fideicomiso is a “nothing” for U.S. tax purposes. Therefore, no foreign trust filings are required.
Although the PLR can’t be cited as precedent, it’s a good indication of how the IRS will view similar arrangements. In any case, the PLR doesn’t need to be cited at all if you can apply Treas. Regs. Section 301.7701-4(a) and Rev. Rul. 92-105 to your client’s facts and come to the same result.
1. Constitución Politica de los Estados Unidos Mexicanos (Political Constitution of the United Mexican States), Art. 27, Section 1.
2. Ley de Inversion Extranjera (Foreign Investment Law), Art. 2, Section IV;
3. Ley de Inversion Extranjera (Foreign Investment Law), Art. 11.
4. There are some inheritance types of fideicomisos that operate very similarly to common law trusts (and should be classified as trusts for U.S. tax purposes), and there are some business types of fideicomisos that operate like business entities (and should be classified as entities for U.S. tax purposes). This analysis is limited to the types of fideicomisos that are established for the sole purpose of allowing non-Mexican citizens to purchase property in the restricted zone.
5. Austin Wakeman Scott, William Franklin Fratcher, and Mark L. Ascher, Scott and Ascher on Trusts, Vol. 1, Section 2.1.5, 37-38 (5th ed. Aspen 2005).
6. Ibid., at Section 2.1.7., 39.
7. Revenue Ruling 92-105, 1992-2 C.B. 204.
8. P.L. 104-188 (Small Business Job Protection Act of 1996).
9. P.L. 94-455 (Tax Reform Act of 1976).
10. See Committee Report on P.L. 94-55; see also Notice 97-34, 1997-1 C.B. 422 (“One of the purposes of the reporting requirements in section 6048(a) is to ensure that U.S. transferors comply with section 679”).
11. The private letter ruling won’t be published until mid-November, which is after the publication date of this article. If you would like to receive a redacted advance copy of the PLR, feel free to contact me.