Tax professionals increasingly are providing advice for clients who are U.S. beneficiaries of foreign trusts. These clients may be subject to tax on income earned by, or from, controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs) whose shares are held in trust. Both of these regimes, also known as “anti-deferral regimes,” reduce the deferral (or the benefits of deferral) of U.S. income tax that generally exists for U.S. shareholders of domestic corporations.1
These anti-deferral regimes require that certain types of passive income of CFCs or PFICs be taxed to their U.S. shareholders, or impose punitive U.S. tax on income derived from disposing of shares in or receiving distributions from such corporations. It's incumbent on tax advisors to make their foreign trust clients aware of the CFC and PFIC rules whenever appropriate. Indeed, advisors may want to help such clients avoid the imposition of tax on their U.S. beneficiaries under these regimes altogether by restructuring the foreign trusts or the trusts' holdings of foreign corporations to the extent possible.2
But tax advisors and their clients are in a bit of a quandary: There's a lack of guidance about the application to foreign trusts of the indirect and constructive stock ownership rules under the CFC and PFIC regimes. (See “Ownership Rules,” p. 45.) This is less of a problem when a foreign trust is a grantor trust (See “Foreign Grantor Trusts,” p. 47), but a more significant problem for discretionary foreign non-grantor trusts. (See “Foreign Non-Grantor Trusts,” p. 48. Also see Amy P. Jetel's feature “When Foreign Trusts Are Non-Grantor,” p. 53 for a discussion of U.S. taxation of foreign non-grantor trusts, the throwback tax and reporting requirements.)
The simplest piece of advice for these clients is to avoid investments in foreign corporations that could be subject to the CFC or PFIC rules. But there are other options that permit foreign trusts to make investments in foreign companies while possibly reducing the likelihood that the CFC and PFIC regimes would subject the U.S. beneficiaries to U.S. income tax and reporting obligations. Let's take a look.
Foreign Operating Companies
One way for a foreign trust to avoid the application of the anti-deferral regimes is for it to invest only in foreign operating companies (that is to say, companies whose income is derived primarily from the operation of an active business abroad.) Companies that operate an ongoing business, rather than simply invest in passive investments, most likely will not generate significant Subpart F income. Even if, for example, a foreign company is classified as a CFC as a result of the application of the indirect stock ownership rules to the U.S. beneficiaries of the foreign trust, there will be minimal Subpart F income for the U.S. beneficiaries to include in their U.S. gross incomes (although the U.S. beneficiaries still may be subject to U.S. reporting obligations.)
If a foreign trust has sufficient control over the corporation, it could make a so-called “check-the-box” election with respect to the corporation. This election will result in the corporation being treated as a pass-through entity. A pass-through entity is an entity all of the income of which “passes through” to its equity owners for U.S. income tax purposes, such as a partnership or a disregarded entity. As a result of the check-the-box election, the foreign trust will not hold an interest in a foreign corporation to which the CFC or PFIC rules could apply.
This approach will be effective only if the corporation to which the check-the-box election is made does not own any interests in other corporations that are themselves either CFCs or PFICs that are not treated as pass-through entities. If it does own such interests, the result of the election will be to treat such other entities as being directly owned by the trust and indirectly by the beneficiaries.
This approach may be a costly one to pursue for a trust that already owns interests in CFCs or PFICs. For U.S. income tax purposes, the check-the-box election will be treated as if the corporation had liquidated then distributed all of its assets to the trust, and as if the trust then had contributed these assets to the pass-through entity. The result could be immediate and substantial tax liability for the trust's U.S. beneficiaries.3
If the foreign trust holds an interest in a PFIC, the U.S. beneficiaries (or grantor, in the case of a grantor trust) may want to make a qualified electing fund (QEF) election to avoid the PFIC regime's special tax on excess distributions. An “excess” distribution is the portion of a distribution from a PFIC that is more than 125 percent of the average distributions made to a shareholder with respect to his shares within the three preceding years included in his holding period. If a U.S. beneficiary makes this election, he would be taxed on his pro rata share of the PFIC's ordinary income and net capital gain from all sources on an annual basis — whether or not such income is distributed. A QEF election is possible only if the foreign company is willing to provide the U.S. taxpayer with the information necessary to calculate his tax, as provided in Treasury Regulations Section 1.1295-1(g).
Alternatively, if the PFIC stock is stock that is regularly traded on a qualified stock exchange, to avoid the special tax on excess distributions, each U.S. beneficiary could make a mark-to-market election. This is an election to treat stock in the PFIC as if it were sold at the end of each year. If the stock increased in value since the prior year, the U.S. beneficiary includes the gain in his income as ordinary income. If the stock has decreased in value since the prior year, the U.S. beneficiary is permitted to deduct the resulting loss to the extent of the gains that he included in income in prior years.
Most foreign private equity funds and hedge funds are classified as PFICs for U.S. income tax purposes. If a foreign non-grantor trust with U.S. beneficiaries invests in these types of foreign investment funds, the indirect ownership provisions of the PFIC regime may treat such U.S. beneficiaries as the indirect owners of the trust's interests in the funds. The U.S. beneficiaries would be subject to U.S. income tax and an interest charge on the excess distributions from the fund.
Tax professionals can advise their foreign trust clients to avoid triggering tax for the U.S. beneficiaries under the PFIC regime by investing in a domestic equivalent of the foreign hedge fund or private equity fund. The PFIC rules do not apply to investments in U.S. entities. Because it may not be possible for a foreign trust to invest directly in a U.S. hedge fund or private equity fund (as U.S. funds tend to avoid admitting foreign owners), the foreign trust may need to establish a U.S. limited liability company or partnership that is classified as a partnership for U.S. income tax purposes to be the owner of any U.S. hedge fund or private equity fund interests.4
The trustees of a foreign discretionary non-grantor trust that holds interests in foreign corporations can start making income distributions to non-U.S. beneficiaries. A pattern of past income distributions to non-U.S. beneficiaries (but not to U.S. beneficiaries) could have an impact on how the PFIC or CFC rules apply to the U.S. beneficiaries of the trust.
In one recent private letter ruling, PLR 200733024, and an older PLR, 9024076, the Internal Revenue Service considered several factors in determining the actuarial interest of a beneficiary in a discretionary trust. As indicated in these rulings, the IRS might interpret a pattern of past distributions to non-U.S. beneficiaries to mean that the non-U.S. beneficiaries are deemed to own the majority of the trust's income and, as a result, the majority of the foreign company stock held in the trust.
Fixed Income Interests
It's often difficult to determine how to apply the indirect and constructive ownership rules in the context of a completely discretionary foreign non-grantor trust. Before drafting a trust agreement governing the trust, the drafters might want to consider the possibility that in the future, the trust could invest in assets that might be classified as CFCs or PFICs. The trust agreement could give non-U.S. beneficiaries fixed income interests in the trust rather than giving the trust complete discretion over all income and principal.
Let's consider a foreign trust (FT) that holds a 100 percent interest in a foreign company with significant amounts of Subpart F income each year. FT has six beneficiaries: three U.S. beneficiaries and three non-U.S. beneficiaries. The trust agreement provides that at least 50 percent of the trust's income is required to be distributed to non-U.S. beneficiaries each year. The trustees would have the discretion to distribute the remainder of the trust income and the trust principal among all of the beneficiaries.
Based on Treas. Regs. Section 1.958-1(c)(2) and FSA 199952014, the non-U.S. trust beneficiaries who are entitled to receive at least 50 percent of the current trust income should be treated as owning at least 50 percent of the stock owned by the trust. In that event, the company, the stock of which was held in the trust, probably would not be classified as a CFC.
If the client doesn't want to have significant amounts of trust income actually paid to the non-U.S. beneficiaries, the trustees could invest the trust's other assets so as to avoid producing trust accounting income.5 Alternatively, the trust agreement could provide that, rather than requiring the trustees to distribute 50 percent of the income to the non-U.S. beneficiaries each year, the non-U.S. beneficiaries could have the right to withdraw up to 50 percent of the trust income. The non-U.S. beneficiaries do not have to actually exercise these withdrawal rights every year.
It may be possible to avoid the classification of a foreign company as a CFC if ownership of its stock is split between several different trusts, some for the benefit of U.S. beneficiaries exclusively and some for the benefit of non-U.S. beneficiaries exclusively.
For example, assume X, a non-U.S. person, has four children, A, B, C and D. A and B are non-U.S. persons. C and D are U.S. persons. X has created four foreign non-grantor trusts, one for the exclusive benefit of each of his children. Each trust agreement provides that the trustees of the trust have complete discretion to distribute trust income and principal to the beneficiary at any time. The FTs have decided they will each purchase a 25 percent interest in a foreign corporation (FC) that generates significant Subpart F income each year. Even if each of A, B, C and D are deemed to own 25 percent of the FC stock owned by his foreign trust under the CFC indirect stock ownership rules, the FC will not be a CFC because A and B are not U.S. persons and will be deemed to own 50 percent of FC's stock. The FC stock deemed to be owned by each sibling is not treated as being constructively owned by the other siblings because, for purposes of IRC Section 318, the members of a shareholder's family include only his spouse, children, grandchildren and parents. The FC still will be a PFIC, however, and C and D may be subject to U.S. tax and/or reporting obligations under the PFIC regime.
Grantor Trust Status
If it can be anticipated that a proposed foreign trust, with U.S. beneficiaries but a non-U.S. grantor, might hold interests in corporate entities that throw off Subpart F income, it might make sense to draft the trust agreement so as to ensure grantor trust status. Under IRC Section 672(f), the only way to ensure grantor trust status with a non-U.S. grantor is to provide either that the trust is wholly revocable by the grantor without the consent of any adverse party or that all of the income of the trust is required to be paid to the grantor or his spouse during the grantor's lifetime. Under foreign tax law, these provisions may not be desirable for the non-U.S. grantor from an estate tax or inheritance tax perspective. If, however, grantor trust status is at all possible, it will definitely solve any possible PFIC or CFC problem that could arise for the U.S. beneficiaries during the grantor's life.
After the grantor's death, however, the trust will be re-classified as a foreign non-grantor trust. Because of the indirect and constructive ownership rules, the U.S. beneficiaries at that point may be deemed to own the CFC or PFIC shares held inside the trust. The foreign trust can avoid the application of the CFC rules altogether if the trust sells the shares of the company (presumably to a non-U.S. purchaser) within 30 days of the death of the non-U.S. grantor. The disposition will be timely if it prevents the corporation from having been a CFC in the hands of any U.S. beneficiary of the foreign trust for 30 days or more during the year of death of the non-U.S. grantor. For purposes of counting the 30 days, the date of death of the non-U.S. grantor is excluded and the date of the disposition is included. For example, if a non-U.S. grantor dies on September 1, a disposition of the stock of the corporation on or before September 30 would be timely.6 The disposition will not be a taxable transaction for U.S. income tax purposes, because: (1) foreign trusts are not taxed on the gains from the sale of non-U.S. company stock, and (2) no tax is imposed under the CFC regime for 30 days.7
If at the death of the non-U.S. grantor, the foreign trust instead held PFIC stock and disposed of the PFIC stock within 30 days of death, tax under the PFIC regime may not be avoided altogether. The U.S. beneficiary would be considered to have made an indirect disposition of the PFIC shares. Any gain on the sale would be treated as an “excess distribution” and would be taxed under the PFIC regime.8
- The American Jobs Creation Act of 2004, which was enacted on Oct. 22, 2004, Public Law Number 108-357, 118 United States Statutes at Large 1418 (the 2004 Act) repealed the foreign personal holding company rules under Internal Revenue Code Sections 551 through 558. The repeal is effective for taxable years of foreign corporations beginning after Dec. 31, 2004.
- This article focuses on U.S. beneficiaries of foreign trusts, but U.S. beneficiaries of domestic trusts that invest in controlled foreign corporations (CFCs) or passive foreign investment companies (PFICs) also might be subject to the anti-deferral regimes
- See Treasury Regulations Section 301.7701-3(g)(1)(iii). Any gain recognized on the deemed liquidation under IRC Section 311 will be taxed to the U.S. beneficiaries of the trust under the CFC or PFIC regimes.
- The new U.S. entity may have certain tax withholding obligations when it distributes its investment income to the foreign trust. IRC Section 1441(a) requires any payor of any of the items of income listed in IRC Section 1441(b) to withhold a 30 percent tax (or lower treaty rate) to the extent such income constitutes gross income from U.S. sources of any nonresident alien individual or of any foreign partnership, unless such income is effectively connected with the conduct of a U.S. trade or business. The income items listed in IRC Section 1441(b) are the various kinds of fixed or determinable annual or periodic income (such as interest, dividends, rents, annuities and the like.) The Treasury regulations state that income paid to a foreign trust is subject to the withholding requirements of IRC Section 1441. In general, withholding will be required unless the payor has received appropriate documentation indicating that withholding is not required (or that a lower rate of withholding applies) and the payor does not have any reason to believe that the documentation is inaccurate.
- The term “trust accounting income” generally is used for local law purposes to describe the amount required or permitted to be distributed to current trust beneficiaries when the terms of the trust instrument require or permit trust income, but not trust principal, to be distributed to such beneficiaries. The items that are included in the term “income” or “trust accounting income” vary from jurisdiction to jurisdiction. There is no standard federal definition. The term generally includes items such as dividends and similar distributions made with respect to investments in business or investment entities, interest and rent. It generally excludes gains from the disposition of property. See Treas. Regs. Section 1.643(b)-1.
- Treas. Regs. Section 1.951-1(a) and (f).
- If the CFC is also a PFIC, it may not be possible to avoid some tax under the PFIC regime upon the disposition of the shares.
- The size of this gain depends on certain factors. Generally, IRC Section 1014 provides that a taxpayer who receives property from a decedent will have a basis in the property equal to the fair market value of the property on the decedent's date of death. However, under IRC Section 1291(e), a shareholder's basis in the PFIC shares received from a decedent is decreased by the difference between the new basis under IRC Section 1014 and the decedent's adjusted basis in the PFIC shares before the decedent's death. This basis reduction rule does not apply to a decedent who was a nonresident alien during his entire holding period. See M. Read Moore, “Thinking Outside the Box: U.S. Federal Income Tax Issues for Trusts and Estates That Own Shares in Foreign Corporations,” Second Annual International Estate Planning Institute, March 16, 2006.
Elyse G. Kirschner is counsel at Weil, Gotshal & Manges, LLP in New York
They're complicated and potentially costly — as they determine whether a U.S. beneficiary will be taxed on a foreign trust's income
Both the controlled foreign corporation (CFC) and passive foreign investment company (PFIC) regimes contain indirect ownership rules. The CFC regime also contains constructive ownership rules. In the CFC context, these rules are used to determine both whether a corporation is a CFC and the extent to which U.S. persons will be taxed on its income. In the PFIC context, these rules are used to determine the extent to which U.S. persons will be taxed on PFIC distributions and stock dispositions.
The indirect and constructive ownership rules applicable to CFCs and PFICs could result in the attribution of ownership of the shares of a CFC or PFIC held by a foreign trust to one or more of the foreign trust's U.S. beneficiaries. Unfortunately, it's often difficult to determine how these rules apply to a particular foreign trust.
CFC INDIRECT OWNERSHIP
Internal Revenue Code Section 958(a)(1) provides that, for purposes of the CFC rules, stock ownership means either: (1) stock owned directly, or (2) stock owned indirectly through foreign entities. IRC Section 958(a)(2) provides that stock owned indirectly by a foreign trust will be considered to be owned proportionately by its beneficiaries. If a U.S. beneficiary of a foreign trust is treated as the indirect owner of a portion of the stock in a CFC owned by a trust, he'll be required to include in gross income for each year his pro rata share of the CFC's Subpart F income, whether or not the CFC has distributed any income to the trust and whether or not the trust, if it has received income from the CFC, distributed that income to the beneficiary.1
Unfortunately, neither the IRC nor the Treasury regulations describe how to determine a beneficiary's proportionate interest in a foreign trust. The Treasury regs state that the determination of a person's proportionate interest in a foreign trust will be made on the basis of all of the facts and circumstances in each case.2 The regs also provide that when the purpose of the determination is to attribute income of the CFC to a particular U.S. shareholder, then such person's interest in the income of the corporation held by the foreign trust is the most relevant factor.3 The regs have only one very simple example of how to apply the facts and circumstances test.4
CFC CONSTRUCTIVE OWNERSHIP
In addition to the indirect ownership rules of IRC Section 958(a)(2), IRC Section 958(b) provides constructive ownership rules the Internal Revenue Service uses to determine whether a U.S. beneficiary of a foreign trust constructively owns a portion of the trust's shares of a foreign company. The section applies for purposes of determining whether a person is a U.S. shareholder and whether a corporation is a CFC in the first place — and not whether a U.S. shareholder is subject to tax on the CFC's income. It incorporates the constructive ownership rules of IRC Section 318(a) and states that stock owned directly or indirectly by a trust will be considered as owned by its beneficiaries in proportion to the actuarial interests of such beneficiaries in the trust.5 This reliance on actuarial values makes these rules relatively simple to apply to foreign trusts that require mandatory income distributions and have fixed remainder interests. But these rules are more difficult to apply in the context of certain discretionary trusts.
PFIC INDIRECT OWNERSHIP
The PFIC regime also contains indirect ownership rules that apply to determine the extent to which U.S. persons will be treated as owning stock of a PFIC held by a foreign trust.6 IRC Section 1298(a)(3) provides that stock owned directly or indirectly by or for a trust will be considered as being owned proportionately by its beneficiaries.7 Except to the extent provided by regulations, this rule will not apply to treat stock owned by one U.S. taxpayer as owned by another U.S. taxpayer. As with the IRC provisions regarding CFCs, there is no description in the Code about how to determine a beneficiary's proportionate interest in a trust.
In 1992, the IRS issued proposed regulations that provide a trust beneficiary will be deemed to own a proportionate amount of the stock of a PFIC held by the trust, whether the trust is a foreign or domestic trust.8 The proposed regulations also provide that “the determination of a person's indirect ownership is made on the basis of all the facts and circumstances in each case; the substance rather than the form of ownership is controlling, taking into account the purpose of section 1291.”9 Unlike the CFC regulations, there is no indication that any particular weight be given to the fact that a beneficiary owns an income rather than a remainder interest. The regulations, which are still in proposed form after 16 years, do not indicate how to apply this proportionate ownership rule to the U.S. beneficiaries of trusts. Therefore, as in the CFC context, tax professionals are at a significant disadvantage in advising foreign trust clients about the application of PFIC rules to U.S. beneficiaries, especially in the case of certain types of discretionary trusts.
Unfortunately, neither the IRC nor the Treasury regulations tell us exactly how to determine a beneficiary's proportionate interest in foreign company stock held in a foreign trust for purposes of the CFC and PFIC regimes. Furthermore, there is very little relevant authority in the form of IRS rulings, either published or private. The ease with which the CFC and PFIC indirect and constructive ownership rules can be correctly applied to foreign trusts depends on: (1) whether the trust is a grantor trust or a non-grantor trust, and (2) whether, in the case of a non-grantor trust, the beneficiaries have fixed interests in the trust or whether the trustees have complete discretion to sprinkle distributions among one or more beneficiaries.
- What happens if the income of the controlled foreign corporation (CFC) is actually distributed to the foreign trust (and to the U.S. beneficiaries) in a later year? Internal Revenue Code Section 959(a)(1) generally provides an exclusion from the gross income of a U.S. shareholder for distributions of earnings and profits of a foreign corporation attributable to amounts which are, or have been, included in a U.S. shareholder's gross income under IRC Section 951(a).
- Treasury Regulations Section 1.958-1(c)(2).
- Treas. Regs. Section 1.958-1(d), Example 3.
- Treas. Regs. Section 1.958-2(c)(1)(ii)(a).
- Unlike the CFC regime, the passive foreign investment company (PFIC) regime does not rely on constructive ownership principles to attribute PFIC stock from one person to another. See Private Letter Ruling 200733024 (Aug. 17, 2007), which explains why the constructive stock ownership rules don't apply in the PFIC regime.
- See also IRC Section 1298(b)(5).
- Proposed Treas. Regs. Section 1.1291-1(b)(8)(iii)(C).
- Proposed Treas. Regs. Section 1.1291-1(b)(8)(i). PLR 200733024 (Aug. 17, 2007) provides an example of how the Internal Revenue Service makes this fact-specific determination.
— Elyse G. Kirschner
Foreign Grantor Trusts
Who “owns” the CFC or PFIC stock held in trust?
The application of the controlled foreign corporation (CFC) and passive foreign investment company (PFIC) indirect stock ownership rules to foreign grantor trusts is relatively straightforward. For U.S. income tax purposes, the grantor of a grantor trust (or other person treated as the owner of any portion of the trust) is treated as owning all (or a part) of the trust's assets, including any CFC or PFIC stock held in the trust.1
CONSIDER THESE SCENARIOS:
Scenario 1: FT is a foreign trust with U.S. beneficiaries created by Sam, a U.S. citizen. FT is a grantor trust for U.S. income tax purposes under Internal Revenue Code Section 679, treated as owned by Sam. FT holds 75 percent of the voting stock of FC, a foreign corporation whose 2007 income is comprised entirely of foreign personal holding company income (FPHCI). FC has only one class of stock outstanding. Because Sam is treated as the owner of FT's assets, including the FC stock, FC will be treated as a CFC due to the attribution rules of IRC Section 958. FC also will be classified as a PFIC due to the amount of its passive income, but Sam will be taxed only under the CFC regime.
Scenario 2: FT is a foreign trust with U.S. beneficiaries created by Boris, a non-U.S. citizen. FT is a grantor trust under IRC Section 672(f) because Boris has the right to revoke the trust without the consent of any adverse person. FT holds 75 percent of the voting stock of FC, a foreign corporation whose 2007 income is comprised entirely of FPHCI. FC has only one class of stock outstanding. Because Boris is treated as the owner of FT's assets, including the FC stock, FC will not be treated as a CFC regardless of the fact that FT has numerous U.S. beneficiaries. FC will be classified as a PFIC, but the U.S. beneficiaries will not be taxed under the PFIC regime because they will not be treated as owning the stock in FC.
Scenario 3: FT is a foreign trust with U.S. beneficiaries created by George and Martha, both U.S. citizens. George and Martha, who are unrelated, funded FT with $1 million. George transferred $900,000 to FT and Martha transferred $100,000 to it.
FT is a grantor trust for U.S. income tax purposes under IRC Section 679. FT also holds 75 percent of the voting stock of FC, a foreign corporation whose 2007 income is comprised entirely of FPHCI. FC has only one class of stock outstanding.
Because George is treated as the owner of 90 percent of FT's assets and Martha is treated as the owner of 10 percent of FT's assets, George is treated as indirectly owning 90 percent of the FC stock held in the trust (66.5 percent of all of FC's stock) and Martha is treated as indirectly owning 10 percent of the FC stock held in the trust (7.5 percent of FC's total outstanding stock.)
FC will be treated as a CFC due to the application of the attribution rules of IRC Section 958. FC also will be classified as a PFIC due to the amount of its passive income, but George will be taxed only under the CFC regime. Martha, on the other hand, will be taxed only under the PFIC regime. This is because Martha is not a U.S. shareholder for purposes of the CFC regime.
- Internal Revenue Code Section 671.
— Elyse G. Kirschner
Foreign Non-Grantor Trusts
Applying indirect stock ownership rules turns on the beneficiary's interest and the extent of the trustee's discretion
The application of the controlled foreign corporation (CFC) and passive foreign investment company (PFIC) indirect stock ownership rules in the non-grantor trust context can be more complicated than when applied to grantor trusts. Let's consider an example.
Assume FT is a foreign non-grantor trust with three beneficiaries, Xavier, Yuri and Zoe. Each beneficiary is entitled to one-third of FT's income each year. At the end of FT's 10-year term, the trust fund will be distributed equally among the three beneficiaries. Xavier and Yuri are U.S. persons; Zoe is not. FT holds 100 percent of the voting stock of a FC, a foreign corporation whose 2007 income is comprised entirely of foreign personal holding company income (FPHCI). FC has only one class of stock. Under the attribution rules, Xavier, Yuri and Zoe will each be considered as owning 33⅓ percent of the shares of FC. As a result, in 2007, FC will be classified as a CFC.1 FC also will be a PFIC because of its percentage of passive income, and Xavier, Yuri and Zoe should be treated as each owning 33⅓ percent of such PFIC shares. Xavier and Yuri, however, will be taxed only under the CFC regime, which takes precedence over the PFIC regime.
Now let's see how the CFC and PFIC rules are applied when the size of a beneficiary's fixed interest in a trust is not as clear cut. Apply the same facts as in the previous example, except that on the death of the first of Xavier, Yuri and Zoe to die, FT will terminate and all of its property will be distributed to Adelle, a non-U.S. person. Suppose further that the actuarial value of the income interests in FT are equal to 30 percent of the overall value of the trust, and that the actuarial value of the remainder interest are equal to 70 percent of the overall value of the trust. Do Xavier and Yuri, the two U.S. persons, indirectly own 33⅓ percent of the shares of FC, as was the case in the prior example, or now do they each own only 10 percent of FC? The answer will determine whether FC is a CFC and the extent to which Xavier and Yuri will be taxed under the CFC or regime or the PFIC regime.
One could argue that the facts and circumstances show that Xavier and Yuri own 33⅓ percent of FC's stock at the current time because they each have a right to one-third of FC's income each year and because principal will not be distributed until the death of the first to die of Xavier, Yuri and Zoe. On the other hand, because 70 percent of the total actuarial value of the trust fund is allocated to the remainder, Xavier, Yuri and Zoe each should be treated as indirectly owning no more than 10 percent of the FC stock. In 1999, the Internal Revenue Service provided some guidance on this issue in Field Service Advice 199952014.2 The IRS determined that, for purposes of IRC Section 958(a), the trust beneficiaries who were entitled to receive all current trust income should be treated as owning all of the stock owned by the trust.3 The remainder beneficiaries were treated as owning no stock.
Many foreign trusts, however, are discretionary trusts in which the beneficiaries have no fixed interests and are not entitled to receive any portion of the trust fund. The trustees have complete discretion to make trust distributions among the beneficiaries in any manner they wish. In these cases, it becomes very difficult to determine how to correctly apply the CFC/PFIC indirect ownership rules. For example, consider FT, a foreign non-grantor trust created by Greta. The trust is a discretionary trust for the benefit of Greta's issue. Greta has six children and grandchildren. Three of them are U.S. persons. Three of them are non-U.S. persons. There are no mandatory distributions of trust income or principal under the trust agreement. The trust agreement provides for distributions of income and principal among the beneficiaries solely in the discretion of the independent trustees. FT holds 100 percent of the voting stock of a foreign corporation (FC), which has only one class of stock. In 2007, 80 percent of FC's gross income is FPHCI. Both the CFC and the PFIC regimes could impose additional taxes and reporting obligations on the U.S. beneficiaries if the requirements are deemed to apply as a result of the indirect stock ownership rules. The beneficiaries of FT don't have any fixed interests in FT that can be easily calculated. The Code and the Treasury regulations don't give any guidance as to how to determine whether any of the U.S. persons should be treated as indirectly owning FC shares.
On March 21, 1990, the Internal Revenue Service issued Private Letter Ruling 9024076, dealing with calculating the actuarial interests of a trust's beneficiaries. However, the PLR dealt with a personal holding company; it was not in the context of a CFC or PFIC. The IRS identified several facts and circumstances that could be considered in determining the actuarial interest of a beneficiary in a discretionary trust for purposes of the personal holding company rules. These facts include:
the pattern of past distributions;
appropriate mortality assumptions;
the trustee's fiduciary duties; and
the relationships among the trustees and the beneficiaries.
According to the IRS, if it is possible to discern a pattern of past distributions, each beneficiary receiving distributions under such pattern will be deemed to own an income interest in the trust in the same proportion that the amount of distributions he receives bears to the total amount of the distribution. Each beneficiary's income interest can then be determined on an actuarial basis with reference to the mortality tables as if the trustees were required to distribute the income to such beneficiary over the remainder of his life. If, however, the trust has never made distributions in the past and if the beneficiaries are roughly the same age, this methodology might not be very helpful.4
The IRS recently issued a PLR that explored the application of the PFIC indirect ownership rules to foreign trusts with both U.S. beneficiaries and non-U.S. beneficiaries. In PLR 200733024 (Aug. 17, 2007), Fund B, a discretionary foreign non-grantor trust, owned shares of a foreign corporation (Corp J). At issue was whether Corp J was a PFIC, whether the gain from the liquidation of Corp. J was an excess distribution, and whether the U.S. beneficiaries of Fund B should be subject to the PFIC tax and an interest charge under IRC Section 1291. The IRS decided against the taxpayers on each of these issues, and in the process provided some insight regarding the IRS' view of how the PFIC indirect ownership rules should work.5
- See Treasury Regulations Section 1.958-1(d), Example 3.
- Field Service Advice 199952014 (Sept. 23, 1999). A similar result was reached in Private Letter Ruling 8748043 (Sept. 1, 1987).
- Compare Treas. Regs. Section 1.958-1(c)(2).
- One commentator has argued that the beneficiaries of a foreign trust should not be considered “U.S. shareholders” with respect to any foreign company held inside the trust unless the beneficiaries can control or influence the voting of the shares. See M. Read Moore, “Thinking Outside the Box: U.S. Federal Income Tax Issues for Trusts and Estates That Own Shares in Foreign Corporations,” Second Annual International Estate Planning Institute, New York (March 16, 2006). It is not at all clear that the Internal Revenue Code or the Treasury regulations support this argument.
- The Internal Revenue Service issued several findings in PLR 200733024 (Aug. 17, 2007). First, the Service said that Corp. J was a passive foreign investment company (PFIC) and the constructive ownership rules of Internal Revenue Code Section 318 do not apply in the context of a PFIC regime. The Service next found that the gain from the liquidation of Corp. J was an excess distribution for purposes of IRC Section 1291, even though Corp. J was not originally established for the purpose of deferring U.S. income tax. Third, the IRS said that the beneficiaries of Fund B should be treated as themselves having received an excess distribution equal to their pro rata share of the gain recognized by Fund B upon receipt of the liquidating distribution from Corp. J. In the process of making its ruling, the IRS focused on the pattern of distributions that had been made from Fund B to its beneficiaries.
— Elyse G. Kirschner