Any professional who serves high-net-worth clients eventually comes face to face with a Mexican fideicomiso (pronounced fee-day-kah-mee-so) and has to decide how to advise the client on how the fideicomiso should be taxed and reported under U.S. tax law.
The Internal Revenue Service's representatives with whom my firm has spoken acknowledge that fideicomisos are not the types of tax-avoidance structures that are targeted by the onerous U.S. reporting requirements for foreign trusts. Nonetheless, because IRS agents also admit that the Service has no idea what a fideicomiso really is (and doesn't have the resources to figure it out), they recommend that foreign-trust reporting be done, just to be safe. After all, fideicomiso means “trust” in Spanish.
But this safe approach is incorrect and a waste of the client's money. Here's why.
La Constitución Politica
As a threshold matter, we first must determine whether a fideicomiso is, in fact, a trust for U.S. tax purposes. To answer this question, it's helpful to know a little history.
For national security purposes, the Mexican federal constitution prohibits non-Mexican persons from owning real property located within 60 miles of Mexico's border or within 30 miles 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
The entire Baja Peninsula (where Cabo San Lucas is located) and all of the other desirable coastal lands where foreigners would most want to purchase property are situated within the restricted zone. In the early 1970s, Mexico's government realized that allowing foreigners to purchase coastal property would greatly benefit Mexico's economy. Therefore, the government needed to find a way to balance Mexico's competing needs of maintaining secure borders while 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 this arrangement, the foreigner has unrestricted use of the property as if he owned the property outright, but the Mexican bank's legal ownership of the property technically satisfies the prohibitions in the Mexican federal constitution against foreign ownership of restricted-zone property.
When I first saw that a client didn't actually get the property, that some Mexican bank really owned it, I was appalled. But none of my clients has thought twice about plunking down millions on a residence just because of the fideicomiso. Apparently, other foreigners are equally undeterred. According to the Mexican Ministry of Foreign Affairs, 2008 saw 5,226 permits issued for fideicomisos, up from 1,970 in 2000.
The question wealth advisors have to answer is: What precisely are these people getting themselves into?
Is It a Common-law Trust?
A common-law trust is simply a relationship between a trustee and a beneficiary, under which the trustee is bound, by age-old principles of fiduciary duty, to hold and preserve property for the benefit of the beneficiary. There are no particular formalities for the creation of a common-law trust relationship, and, in the United States, the passage of state statutes that govern certain aspects of common-law trust relationships is relatively new in the long history of trusts.
But while fideicomiso is Spanish for “trust,” a fideicomiso is purely a creation of Mexico's statutory civil law. Mexican counsel has told us that fideicomisos are classified, primarily, as contractual arrangements (not relationships, as in the common-law trust context), under which the trustee and the beneficiary are both bound by the terms of the fideicomiso document and the applicable Mexican statutes.
Although fideicomisos are civil-law trusts, they have the three essential elements of common-law trusts:
- a trustee;
- property titled in the name of the trustee; and
- a beneficiary for whom the property is held.
But this is where the similarities between a fideicomiso and a common-law trust end.4
Under a common-law trust, the beneficiary's ability to use the trust property is typically within the trustee's complete discretion. The beneficiary has no legal rights to alienate the trust property, and the beneficiary's creditors cannot generally reach the beneficiary's interest in the trust to satisfy their claims. Although the beneficiary of a common-law trust cannot direct or control the trustee with regard to the trustee's management of the trust property, the trustee is bound by a strict fiduciary duty to invest, preserve and manage the property in the best interests of the beneficiaries. The beneficiary of a common-law trust is not liable for property taxes, maintenance expenses, or other charges attributable to the trust property — these are obligations of the trustee.
By contrast, the beneficiary of a fideicomiso (a civil-law trust) enjoys all of the rights of fee simple ownership of the property, and may sell, gift, lease, improve or encumber his beneficial rights in the property. The trustee of a fideicomiso has no involvement with the management or use of the property and is not required to ensure that the property is a good investment for the beneficiaries. In fact, the contract governing the fideicomiso relationship typically will prohibit the trustee from taking any action with respect to the property without the beneficiary's prior instruction. In many cases, the trustee's involvement is so minimal that the beneficiary never interacts with the trustee or even cares to remember who the trustee is. The beneficiary of a fideicomiso is responsible for all expenses and taxes attributable to the property. Clearly, the trustee's ownership of the restricted zone property is simply a legal sidestep.
Is It Something Other Than a Trust?
Indeed, the rights and obligations of the trustee and the beneficiary of a fideicomiso are so vastly different from those of a common-law trust, that we were hesitant to conclude summarily that fideicomisos should be classified as trusts for U.S. tax purposes.
Because the trustee of a fideicomiso is essentially ignored for all practical purposes, we considered the possibility that a fideicomiso is really a nominee (or agency) arrangement. The benefit of classifying a fideicomiso as a nominee arrangement would be that the U.S. beneficiary is simply considered the direct owner of the underlying property for U.S. tax purposes, and therefore, none of the U.S. filing requirements for foreign trusts would be implicated. Under a nominee theory, the beneficiary would be the principal (the legal owner of the property), and the trustee would be the agent (the party acting on behalf of the principal). But the fundamental requirement under Mexican law is that the trustee hold legal title to the property, with the foreigner having only the beneficial rights in the property. In this regard, it could be said that the beneficiary of a fideicomiso is actually the agent of the trustee, not the other way around. In any event, the basic attributes of a nominee relationship, as outlined by the U.S. Supreme Court in Commissioner v. Bollinger, are not present in a fideicomiso arrangement.5 Therefore, we think that it would be difficult to take the position that a fideicomiso is a nominee arrangement.
We also considered the possibility that a fideicomiso, although organized as a trust in Mexico, should, in fact, be classified as a Mexican entity for U.S. tax purposes. The advantage of this classification would be that the U.S. tax and informational filings for foreign entities carry less punitive failure-to-file penalties than the filings for foreign trusts. For a trust to be classified as an entity, the trust must be a “device to carry on a profit-making business which normally would have been carried on through business organizations that are classified as corporations or partnerships” under U.S. tax law.6 It certainly can be said that investing in valuable real estate on the Mexico coast is a profit-making endeavor, but the Treasury Regulations and relevant case law envision a trust carrying on an active business in order for it to be classified as an entity.7Fideicomisos established to allow foreigners to purchase property in Mexico's restricted zone do not conduct an active business such that they could be considered business entities.8 Therefore, such fideicomisos should be considered trusts for U.S. tax purposes.
After determining that fideicomisos are more like trusts than nominee arrangements or entities, we considered whether, given the control exercised over the trustee by the U.S. beneficiary, fideicomisos could be classified as U.S. trusts, instead of foreign trusts, for U.S. tax purposes. If fideicomisos were classified as U.S. trusts, U.S. filing requirements for foreign trusts would not apply.
In order for a trust to be considered a U.S. trust, both of the following two tests must be met:
- one or more U.S. persons must control all substantial decisions of the trust, with no foreign person having the power to veto any of the substantial decisions;9 and
- a U.S. court must be able to exercise primary supervision over the trust's administration, which generally means that the U.S. court, upon petition by a proper party, can render orders or judgments resolving substantially all issues regarding the administration of the entire trust.10
Because of the significant control of a beneficiary and the limited powers of the trustee in a fideicomiso arrangement, it is likely that a fideicomiso could pass the first test. But it would be difficult to argue that a U.S. court would be able to exercise primary supervision over the administration of a fideicomiso given that all of the trust's activities are in Mexico and its sole asset is Mexican real estate. Thus, a fideicomiso would likely fail the second test. Accordingly, fideicomisos should be more properly classified as foreign trusts for U.S. tax purposes.
Having concluded that fideicomisos are foreign trusts for U.S. tax purposes, we next must determine whether the U.S. beneficiary or the Mexican trustee of a fideicomiso must comply with the U.S. information reporting requirements for foreign trusts.
In general, the U.S. beneficiary and/or the Mexican trustee are required to file U.S. informational returns (Form 3520 and Form 3520-A) in either of two situations:
if the U.S. person is considered the owner of all or any part of the fideicomiso under Internal Revenue Code Section 679;11 or
if a reportable event occurs with respect to the fideicomiso under IRC Section 6048.12
We conclude that the U.S. filing requirements for foreign trusts should not apply to U.S. beneficiaries or Mexican trustees of fideicomisos.
First, we determined that a U.S. person should not be considered the owner of the fideicomiso under IRC Section 679. Under this section, a U.S. person who transfers property to a foreign trust that has U.S. beneficiaries is treated as the owner of the portion of the trust that is attributable to the property transferred to the trust. But the U.S. person is not treated as the owner of the foreign trust if he makes a transfer to the trust “in exchange for consideration of at least the fair market value of the transferred property.”13 If the U.S. person transfers more to the trust than what he receives from the trust in return, then he will be treated as the owner of the portion of the trust attributable to the excess amount.14
In looking at the specific facts surrounding fideicomisos established to hold property in the restricted zone for non-Mexican citizens, two questions arise with respect to the application of Section 679 and its fair market value (FMV) exception.
- Has the U.S. person even made a transfer to a foreign trust within the meaning of Section 679?
- If so, is the amount transferred to the trust nonetheless an FMV price for the consideration the U.S. person receives in exchange from the trust?
We conclude that the U.S. person has likely not made a transfer to a foreign trust within the meaning of Section 679. Alternatively, if the U.S. person has made a transfer to the trust, we believe that the transfer is nonetheless for FMV. Under either analysis, therefore, the U.S. person should not be treated as the owner of the fideicomiso under Section 679.
No Transfer to a Foreign Trust
By its own terms, IRC Section 679 applies only to transfers made by a U.S. person to a foreign trust. When a U.S. person purchases real property through a fideicomiso, the U.S. person does not transfer assets to a foreign trust within the meaning of this section, either at the time of the initial purchase or when the U.S. person pays for improvements, repairs, or other ongoing costs of the property.
At the initial purchase, the U.S. person does not transfer funds to the trustee, but pays the purchase price directly to the person who previously held the beneficial rights in the fideicomiso (such as the real-estate developer or another individual or entity). In some cases, the U.S. person purchases shares in the U.S. company that is the beneficiary of the fideicomiso. In either scenario, the U.S. person does not pay the trustee for the right to use the trust property, but instead purchases the beneficial interests in the fideicomiso from a third party.
The transaction is akin to an individual purchasing stock in a corporation from a previous shareholder — which is wholly different from a situation in which a person purchases property, titles it in the name of the corporation, and receives shares from the corporation in exchange for his deemed contribution to the company. In the same way that no transfer is made to a corporation when a person buys stock in the company, a purchaser of beneficial interests in a fideicomiso has not made a transfer to the fideicomiso.15
Therefore, Section 679 should not apply to the U.S. person's initial purchase of beneficial rights in the fideicomiso.
How about the U.S. person's expenditures after the initial purchase to improve the property or to pay the ongoing property costs? One might argue that these are deemed payments to the fideicomiso because they're costs and expenses attributable to property owned by the trust. This argument is based on the premise that the legal owner of the property (the trustee) is responsible for the payment of costs associated with the property, and that the payment of those costs by another person (the beneficiary) fulfills the trustee's obligations.
But the document governing the fideicomiso places the obligation to pay property costs (including taxes, repairs, and improvements) on the holder of the beneficial interests — not the trustee. Therefore, the beneficiary's payment of these ongoing costs is in fulfillment of the beneficiary's own obligations, not the trustee's. As such, Section 679 should not apply to the beneficiary's expenditures after his original purchase of the beneficial interests in the fideicomiso.
In short, a plain reading of Section 679 reveals that it's reasonable to conclude that a U.S. person who purchases beneficial rights in a fideicomiso and pays ongoing costs associated with the fideicomiso property has never made a transfer to a foreign trust within the meaning of Section 679. Because Section 679 does not apply, the U.S. person should not be considered the owner of a foreign trust. Therefore, the U.S. filing requirements applicable to U.S. owners and foreign trustees of foreign trusts should not apply to fideicomisos.
For added safety, we conclude that even if the U.S. person did make a transfer to a foreign trust, that transfer was nonetheless for fair market value, and therefore falls within the FMV exception to IRC Section 679.
The FMV exception applies to transfers to foreign trusts in consideration for the “right to use property of the trust.”16 Typically, when a person uses property owned by someone else, she makes periodic arm's length rental payments to the property owner. These rental payments are equal to what the user considers a fair price for her enjoyment of the property and the owner considers a fair price to cover the continued expenses and other burdens associated with property ownership. Indeed, the Treasury Regulations that were promulgated to provide guidance on Section 679 state that “rents … paid to a trust are transfers for fair market value … to the extent that the payments reflect an arm's length price for the use of the property of … the trust.”17
With a fideicomiso, the U.S. person does not pay periodic rental for residing in the trust property. Rather, she pays a large lump-sum amount that is equal to what fee simple title to the property itself is worth, followed by additional ongoing payments for property improvements and expenses. What the U.S. person receives in exchange for these payments is not simply the right to reside in the property, with the legal owner retaining all of the fee simple rights and obligations of the property (as in a typical rental arrangement).
Instead, the U.S. person:
- receives the right to use and improve the property without restriction;
- enjoys the upside (or suffers the downside) of value fluctuations of the property; and
- is burdened with all of the obligations of property ownership.
Therefore, the value of what the U.S. person receives should be closer to a fee simple title price than a rental price.
Furthermore, there exists an active arm's length market for objectively determining the true FMV price for using property held in a fideicomiso. In fact, the Treasury Regulations provide that FMV is the price at which property (or interests in property) “would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts.”18
With Mexican real property held through fideicomisos, there is a large and active market for the buying and selling of real property through fideicomisos among unrelated parties who have full knowledge of the fact that the property must be legally owned by a Mexican bank. Just like any other traditional real estate market, these sales and purchases are brokered by established real estate professionals, and the price that a buyer is willing to pay is subject to the same market forces of supply and demand as any other real estate market.19
Moreover, to the extent that a discount should be applied to the initial purchase price or the ongoing payments (to account for the fact that the purchaser does not actually get fee-simple title to the property), the existing market already should adjust for any such discount. Therefore, the amounts paid by purchasers in this arm's length market should already reflect any applicable discounts.20
Because we are able to observe an active market for the use of real property held in fideicomisos, we believe that it is reasonable to conclude that the purchase price and ongoing expenditures made by buyers in this market reflect a true arm's length price. Therefore, such payments by a U.S. person should qualify for the FMV exception to IRC Section 679.21
As a result, the U.S. person should not be considered the owner of a foreign trust for U.S. tax purposes, and the U.S. filing requirements applicable to U.S. owners and foreign trustees of foreign trusts should not apply to fideicomisos.
No Reportable Events
Regardless of whether a U.S. person is considered the owner of a fideicomiso under IRC Section 679, he nonetheless could be required to file a Form 3520 for any year in which a reportable event occurs with respect to the fideicomiso. These reportable events, set forth in IRC Section 6048, are:
- If a U.S. person transfers money or property to a foreign trust, he must report the transfer on Form 3520 for the year of the transfer.22
- If a U.S. person receives a distribution from a foreign trust, he must report the distribution on Form 3520 for the year of the distribution.23
We conclude that neither the initial purchase nor the ongoing payments made by the U.S. person should be considered reportable transfers to a foreign trust under Section 6048. Similarly, we also conclude the U.S. person's use of the fideicomiso property should not be deemed distributions that are reportable under Section 6048. Our thinking is:
A reportable event does not occur when the U.S. person makes the initial purchase or ongoing payments — Similar to the exception applicable to ownership of a foreign trust under IRC Section 679, a reportable event does not include any transfer of property to a foreign trust in exchange for consideration of at least the property's FMV.24
Notice 97-3425 is the primary authority issued by the IRS to provide guidance on the reporting obligations of IRC Section 6048. This notice explains that one of the main purposes of the reporting requirements of Section 6048 is to ensure that U.S. taxpayers comply with Section 679. Accordingly, if Section 679 does not apply to a particular situation, then reporting is not required under Section 6048.26 As we've said, in the context of fideicomisos established to allow non-Mexican citizens to purchase property in Mexico's restricted zone, the U.S. person should not be deemed to have made a transfer to a foreign trust within the meaning of Section 679. The result is that Section 679 does not apply to the U.S. person's purchase of beneficial interests in the fideicomiso or to the ongoing payment of property expenses. As such, these payments also are not subject to the reporting requirements of Section 6048.
Alternatively, if the U.S. person has made a transfer to a foreign trust within the meaning of Section 679, we conclude that such transfers should nonetheless be considered for FMV. The FMV exception to Section 679 is the same as the FMV exception to Section 6048 (because Section 6408 is meant to enforce the provisions of Section 679).27 Therefore, because the transfers should satisfy the FMV exception to Section 679, then they also would not be reportable events under Section 6048.
In summary, neither the initial purchase nor the ongoing payments made by the U.S. person should be reportable events under Section 6048, either because the U.S. person has not made a transfer to a foreign trust or because the transfers are for FMV.
A reportable event does not occur when the U.S. person uses the fideicomiso property — We have previously concluded that the U.S. person does not make a transfer to a foreign trust under IRC Section 679 when he or she purchases the beneficial interest in the fideicomiso from a third party. Under this analysis, the beneficial interest that the U.S. person purchases carries with it the right to use the trust property without restriction, as well as the obligation to pay expenses attributable to the property. Because the ability to use the trust property is purchased as part of the bundle of rights and obligations attached to the beneficial interest in the fideicomiso, the U.S. person's exercise of those rights should not be considered a distribution from the fideicomiso that is subject to the reporting requirements of IRC Section 6048.
Also, under our alternative analysis (in which we assume that the U.S. person has made a transfer to the fideicomiso and conclude that it is for FMV), it follows that the U.S. person's use of the trust property should not be considered a distribution from the trust because the U.S. person has paid the trust for his use of the property. But, unlike the subsection of Section 6048 that requires reporting of transfers to foreign trusts (Section 6048(a)), the subsection of Section 6048 that requires reporting of distributions from foreign trusts (Section 6048(c)) does not have its own explicit FMV exception. Nonetheless, Notice 97-34 provides that only gratuitous transfers from a foreign trust are considered distributions that are reportable under Section 6048(c), and that a payment (or deemed payment) from a foreign trust to a U.S. person will be reportable on Form 3520 as a distribution only to the extent that it exceeds the FMV of what the U.S. person transferred to the trust in exchange.28 Therefore, under our FMV analysis, because we conclude that the U.S. person paid a fair market price for the use of the trust property, we can conclude that the value of the use of the trust property is equal to the price paid. As such, the U.S. person's use of the trust property should not be reportable as a distribution under Section 6048.Not a Tax-avoidance Device
Although fideicomisos can be exempted from the application of IRC Sections 679 and 6048 under a plain reading of the IRC, Treasury Regulations, and Notice 97-34, it is also important to mention that fideicomiso arrangements are simply not within the stated purpose of Sections 679 and 6048.
Prior to the enactment of Section 679 in 1976,29 U.S. persons were able to defer the payment of U.S. income tax by transferring income-generating assets to foreign trusts. In short, by simply placing otherwise taxable assets in a foreign trust, U.S. tax could be deferred until distributions were later made to U.S. persons. To negate this opportunity for tax deferral, Section 679 was added to the IRC to cause the income of nearly all foreign trusts created by U.S. persons to be taxed currently to the trust's U.S. grantor, regardless of whether the income is retained by the trust or distributed to U.S. persons.30 To enforce Section 679's goals of preventing tax avoidance by U.S. persons, Section 679 was amended, and the information reporting rules of Section 6048 were expanded, in 1996.31 These changes to Sections 679 and 6048 closed the various loopholes that had been revealed in the intervening 20 years since Section 679 was passed, the result being that any transfer to a foreign trust that is structured in a way that could thwart the purposes of Section 679 will be considered a disguised contribution that is subject to Section 679. (For example, loans to foreign trusts will be deemed to be gratuitous contributions unless certain specific requirements are met.)
Unlike the foreign-trust arrangements targeted by Sections 679 and 6048, fideicomisos are not tax-avoidance devices. Under Mexican law, any income derived from the trust property is attributed directly to the beneficiary, and therefore, the U.S. beneficiaries always report the income on their U.S. tax returns, claiming any available foreign-tax credits for the tax paid in Mexico on such income. Furthermore, residential real estate is not the type of asset that is typically placed in a structure designed to avoid U.S. tax.
Simply put, fideicomisos should not be subject to Sections 679 and 6048 because they are not the types of tax-avoidance structures that these statutes were meant to target. This conclusion is supported by the fact that fideicomisos can be excepted from the application of Sections 679 and 6048 under a plain reading of the IRC, the Treasury Regulations, and Notice 97-34.U.S. Tax Consequences
We have concluded that a fideicomiso is a foreign trust and that it is either: (1) not subject to IRC Section 679 at all; or (2) qualifies for the fair-market-value exception to IRC Section 679. This conclusion means that the U.S. reporting requirements of IRC Section 6048 do not apply to fideicomiso structures.
But, in addition to the U.S. reporting issues, there also are U.S. tax consequences arising from fideicomisos.
Income tax — As mentioned, Section 679 causes the U.S. person who transfers assets to a foreign trust to be considered the owner of the foreign trust for U.S. tax purposes. A trust with an owner is called a grantor trust under U.S. tax law. The tax effect of a grantor trust is that the owner is taxed on all of the trust's income each year, regardless of whether such income is retained by the trust or distributed to the beneficiaries. By contrast, a trust that does not have an owner is a non-grantor trust. The tax effect of a non-grantor trust is that the trust itself is taxed on income that it retains in a given year, while the beneficiaries are taxed on income that is distributed to them during the year.
If Section 679 does not apply to fideicomisos, then fideicomisos are considered foreign non-grantor trusts for U.S. tax purposes.
Domestic non-grantor trusts are taxed in the U.S. on all income, whether it is U.S.-sourced or foreign-sourced. But foreign non-grantor trusts are subject to U.S. tax only on U.S.-source income. U.S. tax is imposed on a foreign non-grantor trust's income only when it is distributed to beneficiaries who are U.S. taxpayers. Hence, there exists an incentive for U.S. taxpayers to accumulate income within a foreign non-grantor trust (where it will escape U.S. taxation and be added to trust corpus), then distribute the accumulated income in a later year (when it will be treated as a distribution of non-taxable corpus). To prevent this tax avoidance, a special set of tax rules apply to distributions from foreign non-grantor trusts to the U.S. beneficiaries of such trusts.
If a foreign non-grantor trust does not distribute its distributable net income (DNI) to the trust's beneficiaries in the year in which the DNI was earned, it becomes undistributed net income (UNI) in the following year. If this UNI is later distributed to U.S. beneficiaries, those beneficiaries must pay regular income tax on the UNI, plus an interest charge on top of the tax. This interest charge is compounded daily over the period of time that the UNI was retained by the trust, and can therefore consume the entire distribution if the trust retained the UNI long enough. This taxation regime applicable to distributions of UNI from foreign non-grantor trusts is referred to as the throwback tax.
The goal of the throwback tax is to capture the incremental amount of U.S. tax that would have been paid if income accumulated by the trust had instead been distributed (and taxed) in the years in which it was earned (hence, the interest charge is imposed over the number of years of accumulation).
Although fideicomisos are considered foreign non-grantor trusts for U.S. tax purposes and are technically subject to the throwback tax rules, there should, in fact, be no practical U.S. tax effect to the U.S. beneficiaries of a fideicomiso. This is because all of the income derived from the trust property is attributed directly to the U.S. beneficiaries under Mexican law, and the U.S. beneficiaries will report such income on their U.S. tax returns in the year in which it was earned. (Although this is not required for U.S. tax purposes, we have yet to come across a situation in which the U.S. persons do not pass the fideicomiso's income through to their U.S. tax returns.)
In short, because all of the fideicomiso's income is subjected to U.S. tax on a current basis each year, there is, effectively, no UNI that accumulates untaxed at the trust level. Therefore, the throwback tax is not necessary to capture untaxed trust income because the trust income has been taxed as it was earned.
Gift tax — Under U.S. gift-tax rules, transfers by U.S. persons to trusts for less than full and adequate consideration are generally subject to gift tax.32 But if we conclude that the U.S. person has simply purchased a beneficial interest in the fideicomiso from a third party, then no transfer has been made to the trust that would be subject to U.S. gift tax. Alternatively, if we assume that the U.S. person did make an FMV transfer to the fideicomiso in exchange for using the trust property, U.S. gift tax should not apply because the transfer was for full and adequate consideration.33
Estate tax — A U.S. person's gross estate for federal estate tax purposes includes all property, and certain interests in property, owned at the time of his or her death.34
Under our conclusion that the U.S. person purchases the beneficial interest in the fideicomiso from a third party, there is no statute or Treasury Regulation exactly on point that would cause the value of the beneficial interest to be included in the U.S. person's gross estate, because U.S. tax law does not envision the concept of ownership of beneficial interests in trusts. But we think that the correct position is that the value of the beneficial interests should be included in the U.S. person's gross estate for estate tax purposes, primarily because the broad powers held by the owner of the beneficial interests amount to something close to outright ownership. Furthermore, it would be aggressive to take a position that a U.S. person can reduce his or her U.S. estate-tax liability, without any corresponding gift-tax consequence, by simply purchasing interests in fideicomisos.
Under our alternate analysis, in which we assume that the U.S. person has made a FMV transfer to the fideicomiso, U.S. tax law does contain a statute on point. IRC Section 2036 provides that a decedent's gross estate includes “the value of all property to the extent of any interest therein of which the decedent has made a transfer (except in the case of a bona fide sale for an adequate and full consideration in money or money's worth), by trust or otherwise under which he has retained for his life … the possession or enjoyment of, or the right to the income from, the property.”35 A reading of this statute might imply that, because the transfer to the fideicomiso was a bona fide sale for adequate and full consideration (that is to say, FMV), that the value of the fideicomiso property would not be included in the U.S. person's estate. Nonetheless, our initial reaction is that it might be aggressive to conclude that a U.S. person can use fideicomisos to escape U.S. estate taxation on the cash used to purchase the use of the trust property (which cash would have been subject to estate tax if the U.S. person had retained it).
In short, we think that the most conservative position is that the value of the fideicomiso property should be included in the U.S. person's gross estate for federal estate tax purposes.36
Based on our extensive analysis of the statutes, the applicable Treasury Regulations, Notice 97-34, and relevant legislative history, we are comfortable advising our clients that the U.S. reporting requirements of IRC Section 6048 do not apply to fideicomisos. Of course, the only way to achieve certainty would be to obtain a private letter ruling from the Internal Revenue Service, which is a costly endeavor that most clients are not willing to undertake.
Therefore, we would like to see the Treasury issue guidance to taxpayers rather than leave them with the choice between taking the safe (but, in our view, wrong and costly) approach of filing foreign trust returns for fideicomisos, or stepping out on a limb and (rightly) taking the position that the foreign trust filings do not apply.
Constitución Politica de los Estados Unidos Mexicanos, Article 27, Section 1.
Ley de Inversion Extranjera, Art. 2, Section IV; Art. 10.
Ley de Inversion Extranjera, Art. 11.
There are some inheritance types of fideicomisos that operate very similarly to common-law trusts and do not allow the beneficiaries to have the unrestricted use and alienation of the trust property. There are also business types of fideicomisos that are more appropriately classified as business entities for U.S. tax purposes. Our 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.
Commissioner v. Bollinger, 108 S.Ct. 1173 (1988) (factors include whether: (1) a written agency agreement exists; (2) the nominee holds itself out as an agent to third parties; and (3) the nominee functions as an agent with respect to an asset).
Treasury Regulations Section 301.7701-4(b).
See, for example, Morrissey v. Comm'r, 296 U.S. 344 (1935); Estate of Scofield v. Comm'r, 266 F.2d 154 (6th Cir. 1959); Porter v. Comm'r, 130 F.2d 276 (9th Cir. 1942); Internal Revenue Service Private Letter Ruling 8552010 (Sep. 25, 1985).
Some types of fideicomisos would easily be classified as entities, rather than trusts. But we are analyzing only those used to hold Mexican real estate for non-Mexican citizens, supra note 4.
Treas. Regs. Section 301.7701-7(d)(1)(ii).
Treas. Regs. Sections 301.7701-7(c)(3)(iii) and (iv).
Internal Revenue Code Sections 6048(a) through (c).
IRC Section 6048(a)(3)(A)(ii).
IRC Section 679(a)(2)(B).
Treas. Regs. Section 1.679-4(b)(2).
In many cases, a new trust document is executed at the time of the purchase and it names the purchaser as both the trustor and the beneficiary of the fideicomiso. But this does not change the fact that the U.S. person is simply purchasing a beneficial interest in the trust from the prior holder of the beneficial interests.
Treas. Regs. Section 1.679-4(b)(1).
Treas. Regs. Section 25.2512-1. We think that this gift-tax definition of fair market value (FMV) is appropriate in the context of IRC Section 679 because IRC Section 679 is aimed at gratuitous transfers (See Part I, Schedule B of Form 3520). A gratuitous transfer is one that is less than FMV and is therefore wholly or partly in the nature of a gift.
For example, the third quarter of 2008 was a buyer's market. As a result, certain of our clients were able to negotiate a low price for the purchase of a new villa located in Cabo San Lucas. In the same vein, other clients elected to take their villas off the market until the market recovers.
Given the wide powers of the beneficiary and the limited involvement of the trustee, any applicable discount would likely be negligible.
Treas. Regs. Section 1.679-4(b)(1) states that the FMV exception does not apply to transfers to a trust in exchange for “an interest in the trust.” In our first analysis, we concluded that the U.S. person does not make a transfer to a trust, but instead purchases interests in the trust from a third party. In that situation, IRC Section 679 does not apply under its own terms, and therefore, its exception also does not apply. By contrast, in this discussion of the FMV exception, we have assumed that the U.S. person has made a transfer to the fideicomiso, making Section 679 applicable. In this scenario, although the U.S. person is named as the beneficiary of the trust after the purchase, we do not think it's appropriate to say that he has purchased the beneficial interest from the trustee because the U.S. person's primary goal in the transaction is not to become a beneficiary of a trust, but to have the unfettered right to use the real property held in trust.
IRC Section 6048(a)(3)(A)(ii).
IRC Section 6048(c)(1).
IRC Section 6048(a)(3)(B)(i).
Internal Revenue Service Notice 97-34, 1997-1 C.B. 422.
IRS Notice 97-34, Sections III.A. and III.B. Reporting is nonetheless required for FMV loans (qualified obligations) to foreign trusts. IRC Sections 679(a)(3) and 6048(a)(3)(B).
IRS Notice 97-34, Section III.B. uses the same FMV language for IRC Section 6048 as the language found in Treas. Regs. Section 1.679-4(b)(1).
IRS Notice 97-34, Section V.
P.L. 94-455 (Tax Reform Act of 1976).
See Committee Report on P.L. 94-455.
P.L. 104-188 (Small Business Job Protection Act of 1996).
See Treas. Regs. Section 25.2511-2.
If the beneficial interests in the fideicomiso are purchased through a limited partnership structure and the U.S. person makes gifts of limited partnership interests, then these gifts of limited partnership interests would be subject to gift tax. The value of the gifted limited partnership interests would be based on the FMV of the partnership property, which consists of beneficial interests in the fideicomiso.
IRC Section 2031 et seq.
IRC Section 2036(a).
If the beneficial interests in the fideicomiso are purchased through a limited partnership structure, then the asset included in the U.S. person's gross estate would be his limited partnership interest. The value of this limited partnership interest would be based on the FMV of the partnership property, which consists of beneficial interests in the fideicomiso.
Amy P. Jetel is a partner in the Austin, Texas, law firm, Schurig Jetel Beckett & Tackett, LLP
What we feel comfortable telling clients about fideicomisos
Fideicomisos should not be subject to the reporting requirements of IRC Sections 679 and 6048, because they're not the types of tax-avoidance structures targeted by these statutes, and because they can be excepted from the application of IRC Sections 679 and 6048 under a plain reading of the Internal Revenue Code, the Treasury Regulations, and Internal Revenue Service Notice 97-34.
Fideicomisos are considered foreign non-grantor trusts for U.S. tax purposes. As long as all of the fideicomiso's income is subjected to U.S. tax on a current basis each year, there is no income that accumulates untaxed at the trust level, and so the throwback tax does not apply.
Because a U.S. person simply purchases a beneficial interest in a fideicomiso from a third party, no transfer is made to the trust that would be subject to U.S. gift tax. Alternatively, if we assume that the U.S. person does make a fair-market-value transfer to the fideicomiso in exchange for using the trust property, U.S. gift tax should not apply because the transfer was for full and adequate consideration.
The value of the beneficial interest in a fideicomiso owned by a U.S. person at death should be included in the U.S. person's gross estate for estate tax purposes. That's primarily because the broad powers held by the owner of the beneficial interests amount to something close to outright ownership.
— Amy P. Jetel