Many clients think the foreign trust tax and reporting rules can be circumvented by using non-U.S. persons as nominees. But the United States has rules to prevent potential abuse of tax law by U.S. persons who receive indirect transfers from foreign trusts: the inbound intermediary rule of Internal Revenue Code Section 643(h).1 Indeed, even innocent clients can be caught in this rule's web. And the Internal Revenue Service is looking hard for culprits — because officials believe it's common in offshore financial secrecy jurisdictions to interpose entities, individuals or both as stated owners when the beneficial or true owner is contractually acknowledged in side agreements, statements or other devices.

Clearly, U.S. practitioners need to be aware of the nuances of the intermediary rule, that is, what triggers its application and what exceptions exist. Also, if a non-U.S. relative wants to give your U.S. client a gift and there is any cause to believe the money might somehow be attributed to a family foreign trust arrangement, be sure to know all the facts before counseling about potential tax obligations.

Basic Scenario

Here's a basic fact pattern that would implicate IRC Section 643(h):

Because of political instability in his home country, Xavier has immigrated to the United States and is applying for a green card. That will make him a U.S. resident for U.S. federal income tax purposes.2 Xavier and his brother, Yves (also a non-U.S. person) are both beneficiaries of a discretionary trust governed by Bahamian law with a Bahamian trust company as trustee. The trust was created by their now-deceased father, Gide, also a non-U.S. person.

Both Xavier and Yves have been receiving distributions from the Bahamian discretionary trust for years to support their living expenses. Xavier learns that getting his green card means his distributions will be taxed and comes up with a plan where these distributions are routed to Yves, who, in turn, can then gift the money to him.

If IRC Section 643(h) didn't exist, Xavier might have been able to convert an otherwise taxable distribution into a tax-free gift.3 But Section 643(h), enacted by the Small Business Job Protection Act of 1996 (the 1996 Act)4 says: “For purposes of this part, any amount paid to a United States person which is derived directly or indirectly from a foreign trust of which the payor is not the grantor shall be deemed in the year of payment to have been directly paid by the foreign trust to such United States person.”

Some key points about this statute:

  • It applies whether or not the U.S. person or the intermediary is a beneficiary of the foreign trust.

  • It applies whether or not the intermediary is a U.S. or non-U.S. person.

  • It applies whether or not the foreign trust is created by a U.S. or non-U.S. person.

  • It does, however, create an exception where the grantor is, himself, the intermediary.5

Suppose Xavier's father purposefully excluded Xavier as a beneficiary of the Bahamian trust, but Yves, out of a sense of moral obligation and because he is, in general, financially better off than his brother, has been making gifts all along to Xavier to compensate for the disparity in their net worths. Even though Xavier is not a beneficiary who can directly benefit from the trust, the broad language of the statute permits the IRS still to re-characterize the gifts Xavier receives from Yves as direct distributions from the trust.

But as will be seen, under Treasury regulations promulgated in 1999, Xavier might have an argument to avoid the intermediary rule's reach under these particular circumstances.

Grantor v. Nongrantor

IRC Section 643(h) was enacted along with other changes made by the 1996 Act, affecting U.S. taxpayers' tax and reporting obligations with respect to receipt of distributions from foreign trusts. Because the tax consequences turn on whether a trust is grantor or nongrantor, the foreign grantor trust rules also were revised to limit the instances in which a non-U.S. person could be treated as the owner of a foreign trust.

Before 1996, any trust in which a grantor (whether a U.S. person or not) retained one or more of the grantor trust powers enumerated in IRC Sections 673 to 677, or any trust in which a non-U.S. person was granted an IRC Section 678 power, was eligible for grantor trust status. This meant the trust was disregarded for income tax purposes, that is to say the grantor was treated as the “owner” of the trust and required to include its income, deductions, credits and capital gains in his income (a so-called “grantor trust”).6 If the grantor was a non-U.S. person and the trust was a foreign trust,7 neither the grantor nor the trust was subject to income tax (except withholding tax on U.S.-source income paid to the trust or tax on effectively connected income which could be avoided by investing in non-U.S. source income producing assets). Likewise, distributions from the trust to U.S. beneficiaries were treated as tax-free gifts from the grantor.8

But the 1996 Act provided that, effective after Aug. 20, 1996, a trust would not be treated as a grantor trust with respect to a non-U.S. person unless one of the following two exceptions applied:

  • the “revocable trust exception” — the grantor has power to revoke the trust and revest its assets in himself either alone or with the consent of a related or subordinate party subservient to the grantor9; or

  • the exception for “trusts that distribute only to grantor or grantor's spouse”10 — the only amounts distributable from the trust (whether income or principal) during the grantor's lifetime are to the grantor or the grantor's spouse.11

Because both of these exceptions are predicated on the non-U.S. person being a so-called “grantor,”12 an unexercised IRC Section 678 withdrawal power held by a non-U.S. person no longer results in grantor trust status.13

If a trust fails to qualify as a grantor trust under these narrow exceptions, it will be a foreign nongrantor trust. A foreign nongrantor trust computes its income as a non-U.S. person14 — but U.S. beneficiaries of a nongrantor trust are subject to income tax when they receive distributions15 to the extent of their share of the foreign nongrantor trust's distributable net income (DNI) earned in that year.16

DNI of a foreign trust includes certain items of U.S.-source income that are not otherwise taxable to the trust as well as non-U.S. source income and realized gains. DNI is pro-rated among distributions to non-U.S. and U.S. beneficiaries and a U.S. beneficiary's pro-rated share is subject to income tax (but the character is preserved).17

If a foreign nongrantor trust does not distribute all its DNI, it has undistributed net income (UNI). Generally a distribution that exceeds DNI is deemed to carry out UNI. A distribution of UNI to a U.S. beneficiary is treated as an “accumulation distribution” and has these consequences:18

  • All capital gains realized by the non-U.S. trust in prior years are carried out to the beneficiary, but at ordinary income tax rates (currently up to 35 percent) rather than the capital gains tax rate (which currently is 15 percent for long-term capital gains and up to 35 percent for short-term capital gains).

  • An interest charge is assessed on the deferred tax that is due on the accumulation distribution which, for tax years after Dec. 31, 1995, is the compounded floating rate applicable to underpayments of tax. For post-1995 years, the interest charge is computed based on a weighted average method.

  • A “throwback tax” applies to the accumulation distribution, so that the income is taxed at the beneficiary's tax rate over the years in which the distribution was deferred.

After all DNI and UNI has been exhausted, the distribution is deemed to come from principal and is not taxed.

Separately, the 1996 Act enacted independent reporting obligations for distributions received after Aug. 20, 1996. A U.S. beneficiary is required to report distributions on Form 3520, Part III and obtain a “Foreign Grantor Trust Beneficiary Statement” or “Foreign Nongrantor Trust Beneficiary Statement,” as the case may be, from the trustee.19 Unless a beneficiary statement is provided, any distribution from a foreign trust, whether of income or principal, to a U.S. beneficiary is treated as an accumulation distribution.20 There is a penalty of 35 percent of the gross value of the distribution for failing to comply with these reporting requirements.

Taking our example, if Xavier were to receive the distribution directly from the Bahamian trust, which is a foreign nongrantor trust, he would be subject to tax on his proportionate share of the trust's DNI. If the total distributions to Xavier and Yves exceeded the trust's DNI and the trust's fiduciary accounting income for that year,21 and the trust had UNI, Xavier also could be subject to tax on the UNI under the accumulation distribution rules. But, under these rules, the interest charge on the deferred tax would not apply to income attributed to a year in which Xavier was not a U.S. person.22

In addition, Xavier would have to report the distribution on Form 3520 and obtain a Foreign Nongrantor Trust Beneficiary Statement from the Bahamian trustee to avoid penalties and possible recharacterization of the entire distribution as an accumulation distribution.

If, instead, Yves were to receive the distribution and make a gift to Xavier, IRC Section 643(h) could recharacterize it as a direct distribution from the trust, and the same consequences would flow. This would be irrespective of Yves's motivations behind the gift or whether Xavier is a beneficiary of the trust.

Regs Narrow Statute's Scope

This result for all the real Xaviers out there may seem rather unfair. So, for post-1999 transfers, Treasury regulations require “a principal purpose of tax-avoidance” as a precursor to the application of the intermediary rule.23 But even this corrective is not as fair as it sounds, because the regulations presume a tax avoidance purpose, if all these three factors are present:

  1. The U.S. person is related24 to a grantor of the foreign trust or has another relationship with a grantor of the foreign trust that establishes a reasonable basis for concluding that the grantor of the foreign trust would make a gratuitous transfer to the U.S. person.

  2. The U.S. person receives from the intermediary, within the period beginning 24 months before and ending 24 months after the intermediary's receipt of property from the foreign trust, either the property the intermediary received from the foreign trust, proceeds from such property, or property in substitution for such property.

  3. The U.S. person cannot demonstrate to the satisfaction of the IRS that: (a) the intermediary has a relationship with the U.S. person that establishes a reasonable basis for concluding the intermediary would make a gratuitous transfer to the U.S. person; (b) the intermediary acted independently of the grantor and the trustee; (c) the intermediary is not an agent of the U.S. person under generally applicable U.S. agency principles; and (d) the U.S. person timely complied with the reporting requirement of Section 6039(f), if applicable, if the intermediary is a non-U.S. person.25

Some key points about the presumption:

  • Even if the U.S. person is a descendant of the intermediary and thus the natural object of his bounty, this fact, by itself, may not be sufficient to rebut the presumption absent other facts showing that the gift was independent of the transfer, for example if the intermediary has an established pattern of making gifts to the U.S. person from his own resources and this transfer is no different in nature, timing or amount from prior gifts.26

  • Even though the presumption is limited to a 24-month period, transfers taking place thereafter still may be challenged on their individual merits because the preamble to the final regulations indicate that the IRS commissioner may find that a transfer was made pursuant to a tax-avoidance purpose, whether or not any of the specified factors are present. As a consequence, the 24 months should not be viewed as a safe-harbor.27

Exceptions

Three exceptions exist, both in the statute and the Treasury regulations:

  • Fair market value exception — The intermediary rules don't apply to the extent that the transfer from the foreign trust to the intermediary or from the intermediary to the U.S. person is not a gratuitous transfer. For this purpose, a gratuitous transfer means a transfer other than for fair market value in the form of cash, property or services rendered in exchange.28

    There is an example in the Treasury regulations in which a foreign trust deposited funds with a bank which lent money to the U.S. beneficiary against the deposited collateral, the intermediary rules were triggered, and the U.S. beneficiary was considered to have received a distribution from the foreign trust.29 The example has its basis in current law, which says that a loan from a foreign trust to a U.S. beneficiary must satisfy certain requirements to avoid being characterized as a distribution. Among other things:

    1. it must be in writing;

    2. it must not extend beyond a five-year term;

    3. it must bear interest at the applicable federal rate (AFR); and

    4. it must be reported annually on Form 3520 while it remains outstanding and the U.S. beneficiary must agree to extend the period on assessment of tax.

    But there's a gray area. In our example, suppose that Yves loans funds to Xavier on an arm's length basis in connection with Xavier's start-up business venture, that is to say, with annual interest payments at the AFR and full expectation of repayment, but the loan takes place within 24 months of Yves receiving a distribution from the Bahamian trust. Here, it may be argued that Xavier received an indirect loan from the Bahamian trust, which is not a “qualified obligation” and hence, it's a distribution. However, Xavier may have an argument that the qualified obligation rules do not apply to loans between individuals.

  • Grantor exception — Both the statute and the Treasury regulations provide that the intermediary rules do not apply if the grantor is the intermediary. There's a gray area here as well: The term “grantor” includes a nominal grantor and an accommodation grantor, that is to say someone who creates a trust but makes no gratuitous transfers to it or someone who makes a gratuitous transfer for which he is reimbursed. It's clear these types of grantors may not be treated as “owners” for purposes of the grantor trust rules but not so clear whether distributions through them will fall within the grantor exception to the intermediary rules. But, routing distributions through nominal or accommodation grantors who are clearly nominees, was not intended to, and therefore probably does not, fall within the grantor exception.

    On the other hand, suppose that in our example, Yves was given a general power of appointment over the Bahamian trust, which he exercised to appoint to a new trust over which he reserved the power to revoke, naming himself and other family members, including Xavier, as beneficiaries. Such a trust would qualify as a grantor trust status with respect to Yves,30 and distributions which are made through him to Xavier should qualify for the grantor exception.

    Again, there's a gray area: Instead of Yves being given such a general power, suppose instead the Bahamian trustee exercised its discretion to distribute the trust to Yves. Of his own free will and not as part of a prearranged plan, Yves decides to transfer part of the assets to a new revocable trust naming himself and other family members, including Xavier, as beneficiaries. Does the grantor exception apply? Here, it may be argued that Yves is not the true grantor, depending on how long he held the assets in his individual name. However, assuming the beneficial owner is the one that receives or has the right to receive proceeds or other advantages as a result of the ownership, Xavier may have an argument that despite the trust, Yves continues to have unfettered dominion and control over the transferred assets since they are subject to his power to revoke and therefore, the grantor exception applies.

    Would the result change if Yves did not establish the trust for 24 months or if having established it, Xavier did not receive a distribution for 24 months? Certainly, as the transfer would fall outside the presumption, but as noted above, it could still be challenged on the merits.

  • De minimis exception — The Treasury regulations create a de minimis exception for transfers to a U.S. person in a taxable year that, in the aggregate, do not exceed $10,000 in value from all foreign trusts, either directly or through one or more intermediaries.31

Paying the Piper

The tax consequences depend on whether the intermediary is treated as an agent of the foreign trust or the U.S. person, under generally accepted agency principles. If the intermediary is an agent of the foreign trust, the property is deemed paid by the foreign trust to the U.S. person in the year it's paid by the intermediary to the U.S. person. As a consequence, the value is taken into account as of that date and increases or decreases in value from the date it was paid to the intermediary from the foreign trust but before it was paid to the U.S. person, are disregarded for tax purposes.

On the other hand, if the intermediary is an agent of the U.S. person, the property is deemed paid to the U.S. person in the year it's paid by the foreign trust to the intermediary and changes in value thereafter must be taken into account by the U.S. person. Generally, however, the intermediary is an agent of the foreign trust unless the IRS commissioner determines, or the U.S. person can demonstrate, that the intermediary is an agent of the U.S. person.32

Just Be Careful

Twelve years have elapsed since the enactment of IRC Section 643(h), and nine years since regulations were promulgated. Yet it still is difficult to establish operating guidelines because, invariably, each case comes down to its own facts and circumstances. It is incumbent on U.S. practitioners to fully familiarize themselves with their clients' individual facts and circumstance before rendering advice on the application of the intermediary rules. The IRS is watching — and watching closely.

Endnotes

  1. This article is based on materials presented at the Fourth Annual International Estate Planning Institute on May 27 to 28, 2008, co-sponsored by the Trusts and Estates Law Section and Committee on Continuing Legal Education of the New York State Bar Association and the Society of Trusts & Estates Practitioners. There are also outbound intermediary rules in the Internal Revenue Code applicable to U.S. persons who make transfers to foreign trusts through nominees, for example, IRC Sections 679 and 672(f)(5). But a discussion of them is beyond the scope of this article.

  2. The term “U.S. person” includes individuals who are U.S. citizens or otherwise meet the substantial presence or green card tests, U.S. partnerships, U.S. corporations and estates and trusts (other than foreign estates and trusts). See IRC Section 7701(a)(30). A non-U.S. person is someone who is not a “U.S. person.”

  3. Other principles, such as the step transaction doctrine, also may be used to recharacterize the transaction.

  4. PL 104-188, 110 Stat. 1755 (Aug. 20, 1996). Section 643(h) replaced former Section 665(c), which had been in existence since 1962 and contained similar language, but applied only to foreign trusts created by U.S. persons.

  5. A grantor is any person to the extent he (1) creates a trust or (2) directly or indirectly makes a gratuitous transfer to the trust. Treasury Regulations Section 1.671-2(e). A gratuitous transfer means a transfer other than for fair market value (FMV). A transfer is for FMV only to the extent of the value of property received, services rendered or the right to use property of the transferee. A transfer may be gratuitous even if it's not considered a gift for gift tax purposes (donative intent is immaterial) and regardless of whether the transferor recognizes gain on the transfer.

  6. IRC Section 671.

  7. Effective for trust tax years after Dec. 31, 1996, a trust is a treated as a U.S. trust if: (1) a court within the United States is able to exercise primary supervision over the administration of the trust (the “court test”) and (2) one or more U.S. persons have authority to control all substantial decisions of the trust (the “control test”). All other trusts are treated as foreign (non-U.S.) trusts for U.S. tax purposes. Thus, if a non-U.S. protector possesses a substantial decision (such as the power to replace the trustee or veto certain trustee decisions), a trust defaults to foreign status.

  8. Revenue Ruling 69-70, 1969-1 C.B. 182.

  9. A “related or subordinate party” is defined as a non-adverse party who is either the grantor's spouse who is living with the grantor, or the grantor's father, mother, issue, brother or sister; an employee of the grantor; a corporation or an employee of a corporation in which the stock holdings of the grantor and the trust are significant from the viewpoint of voting control; or a subordinate employee of a corporation in which the grantor is an executive. A non-adverse party means any person who does not have a substantial beneficial interest in the trust that would be adversely affected by the exercise or nonexercise of the power which he possesses respecting the trust.

  10. See generally IRC Section 672(f). An exception also exists for compensatory trusts. Some trusts in existence on Sept. 19, 1995 that qualified under prior law as grantor trusts because (1) the grantor or a non-adverse party or both had power to revoke the trust or revest title to the assets in the grantor (Section 676) or (2) the income, without the approval or consent of any adverse party, or both, may be distributed or could be accumulated for future distribution to the grantor or the grantor's spouse (Section 677), may continue to so qualify. But — they qualify only with respect to transfers made on or before Sept. 19, 1995, provided a separate accounting is kept for pre- and post-Sept. 19, 1995 transfers.

  11. Certain amounts that are distributable to discharge a legal obligation of the grantor or the grantor's spouse to an unrelated party (or to a related party but for bona fide, adequate and full consideration or in other limited circumstances) are treated as if distributed to them.

  12. See supra note 5.

  13. IRC Section 672(f)(1) trumps other provisions in Subpart E, which includes Section 678. The only exceptions to Section 672(f)(1) are set out in Section 672(f)(2).

  14. IRC Section 641(b) (providing that a foreign trust is treated as a nonresident alien individual who is not present in the United States at any time).

  15. A loan of cash or marketable securities is treated as a constructive distribution unless it is structured as a so-called “qualified obligation.” IRC Section 643(i) and Notice 97-34, 1997-1 C.B. 422.

  16. This is the rule applicable to distributions from a “complex trust,” which is any nongrantor trust that is not a “simple trust.” A simple trust is a nongrantor trust that is required to distribute all its income currently and makes no principal distributions in that year. IRC Section 651(a). A simple trust can become a complex trust if the trustee exercises its discretion to distribute principal in that year. In such case, distributable net income (DNI) is first carried to the income beneficiary who receives or is required to receive all of the income of the trust. IRC Section 662(a).

  17. Unless the trust or local law requires allocating different classes of income to different beneficiaries and the allocation has economic effect, independent of income tax consequences. IRC Sections 652(b) and 662(b); Treas. Regs. Sections 1.652(b)-2(a) and 1.662(b)-2(a).

  18. These rules are contained in IRC Sections 665-668.

  19. See IRC Section 6048(c) and Notice 97-34.

  20. An exception to this rule allows the U.S. beneficiary to avoid treating the entire amount received as an accumulation distribution if the U.S. beneficiary can provide certain information regarding actual distributions from the trust for the prior three years under a so-called “default method.”

  21. A distribution that does not exceed trust accounting income in a particular year is not treated as a distribution of undistributed net income (UNI). IRC Section 665(b).

  22. IRC Section 668(a)(2). Some have argued that Xavier should not be taxed under the accumulation distribution rules on the income attributed to a year in which Xavier was not a U.S. person. See Jose L. Nunez and Andrea L. Mirabito, “Just Off the Boat, Trust Fund in Hand,” Trusts & Estates, December 2005 at p. 57.

  23. Treas. Regs. Section 1.643(h)-1, applicable to transfers made to U.S. persons after Aug. 10, 1999.

  24. For these purposes, a U.S. person is related to a grantor of a foreign trust if the U.S. person and the grantor are related for purposes of Section 643(i)(2)(B), with these modifications: (1) for purposes of applying Section 267 (other than Section 267(f) and Section 707(b)(1)), “at least 10 percent” is used instead of “more than 50 percent” in each place it appears and (2) the principles of IRC Section 267(b)(10), using “at least 10 percent” instead of “more than 50 percent” apply to determine whether two corporations are related. Treas. Regs. Section 1.643(h)-1(e).

  25. Treas. Regs. Section 1.643(h)-1(a)(2).

  26. Compare Treas. Regs. Section 1.643(h)-1(g), Ex. 2 and Ex. 3.

  27. T.D. 8831.

  28. See supra note 5.

  29. Treas. Regs. Section 1.643(h)-1(g), Ex. 6.

  30. With respect to gratuitous transfers made by one trust to another, the grantor remains unchanged unless a person with a general power of appointment over the transferor trust exercises it in favor of another trust, in which case such person is the grantor of the transferee trust. See Treas. Regs. Section 1.671-2(e)(5).

  31. Treas. Regs. Section 1.643(h)-1(d).

  32. Treas. Regs. Section 1.643(h)-1(c).

Dina Kapur Sanna is a partner in the New York office of Day Pitney LLP