1996 TAX LAW CHANGES AFFECTING
Note: See IRS Notice 97-34 for the filing
and reporting requirements regarding Foreign Trusts.
FOREIGN NON-GRANTOR TRUSTS
INTEREST ON ACCUMULATION DISTRIBUTIONS.
- The interest rate applicable to the accumulations of income within these trusts was 6%
simple. This interest rate applied to accumulations through tax year 1995.
- The interest rate has now been changed to the compounding interest rate charged for
underpayments of tax under IRC Sec. 6621(a)(2).
Effective date: Distributions made after August 20, 1996
- Planning Note: If possible, use a foreign corporation to accumulate income tax-free,
then pay dividends to a foreign trust in the year in which distributions to beneficiaries
- The Treasury is directed to issue regulations to prevent abusive transactions in this
LOANS FROM FOREIGN TRUSTS
To prevent indirect distributions to a beneficiary, a loan of cash
(including foreign currency and cash equivalents) or marketable securities from a foreign
non-grantor trust to a U.S. grantor or beneficiary will be treated as a distribution that
- This rule applies to loans made to persons related to a U.S. grantor or beneficiary, but
will not apply to loans to a tax-exempt entity.
- This rule will not apply to arm's-length loan transactions.
- Note: Congress had considered treating any use of property, such as rent-free use of a
trust's condominium by a beneficiary, as a taxable distribution. The final legislation did
not contain this provision.
Effective Date: Loans made after September 19, 1996.
INBOUND FOREIGN GRANTOR TRUST
Non-applicability of the U.S. Grantor trust rules
To prevent foreign grantors from setting up foreign grantor trusts
(taxed to the foreign person) with U.S. beneficiaries receiving the income tax-free, the
grantor trust rules have been modified. IRC Sec. 6651(d)(2).
- Under the new law, the grantor trust rules will not apply if the grantor is a foreign
- The grantor trust rules will only apply when computing the income of a U.S. person or
- If this new law applies, then the foreign trust will be considered a non-grantor trust
and the U.S. beneficiaries will be taxed on their distributions and the new interest rules
on accumulated distributions will apply.
Under IRC Sec. 672(f), the old grantor trust rules will continue to
apply when -
- The grantor retains the power to revoke the trust and that power is not conditioned upon
the approval or consent of anyone else;
- Note: approval or consent by a non-adverse related party who is subservient to the
grantor under IRC Sec. 672(c) is permitted.
- If the consent of the grantor's child is necessary for the grantor's actions and the
child does not have beneficial interest in the trust, IRC Sec. 677 will usually treat the
grantor as the owner of the trust.
- Income or corpus during the grantor's lifetime is solely distributable to the grantor or
the grantor's spouse;
- A trust is established to pay compensation for services rendered; and
- Trusts owned by the grantor or another person under Code Sec. 676 or 677 [other than
Code Sec. 677(a)(3)] that are in existence on September 19, 1995.
Planning note: A foreign grantor trust naming a U.S. beneficiary
which is revocable by the grantor, or in which the income is distributable only to the
grantor or the grantor's spouse, will continue to be treated as a grantor trust.
- Under such an arrangement, the trust's income will continue to be taxable to the grantor
(or spouse) and distributions of that income to the U.S. beneficiary will be tax-free.
- The U.S. beneficiary will become taxable on the distributions of income only when the
grantor (or the grantor's spouse) dies.
- The grantor trust rules will apply to CFCs (controlled foreign corporations) which are
treated as grantors.
Under prior law, use of a foreign corporation as the grantor of a
revocable trust could have resulted in a perpetual grantor trust.
TRANSFERS BY U.S. BENEFICIARIES
- Under IRC Sec. 672(f)(5), when a U.S. beneficiary makes a gift to a foreign grantor and
the beneficiary retains an interest in the property, the trust is recast as a grantor
trust in which the U.S. person is the grantor as to the transferred property.
- IRC Sec. 672(f)(5)(A) provides that the U.S. person will be considered the grantor of
the trust even if the foreign grantor would otherwise be considered the grantor of the
- Transfers by family members of property to a foreign grantor will not cause the U.S.
beneficiary to become the grantor of a U.S. grantor trust.
FOREIGN TAX CREDITS
The Secretary of Treasury may devise regulations to account for any
taxes paid by the foreign grantor on the income from the trust and allow a credit under
the foreign tax credit limitations.
- These rules will take effect on August 20, 1996.
- If a domestic trust becomes a foreign trust or assets are transferred to a foreign trust
before January 1, 1997, then no tax will be imposed under IRC Sec. 1491.
OUTBOUND FOREIGN GRANTOR TRUSTS
If a U.S. person transferred property to a foreign trust, he was treated as the owner
of the property in any year in which the trust had U.S. beneficiaries ("ownership
rule"). Also, sales to a trust for fair market value were exempted from IRC Sec.
679(a)(1), even when the trust paid for the property with an obligation.
CHANGES TO THE LAW
- If the trust pays fair market value for the property transferred by a U.S. beneficiary,
then the beneficiary will not be treated as the owner of the trust. IRC Sec. 679(a)(2).
- Obligations issued by the trust, grantor or beneficiaries or parties related thereto,
containing arm's-length terms and conditions will qualify for this exception to the
ownership rule as well.
- Transfers to charitable trusts are exempted from the ownership rule.
- A foreign grantor who transfers property to a trust who then becomes a U.S. resident
within 5 years of the transfer is now brought within the ownership rule. IRC Sec.
- The ownership rule will apply retroactive to the first date the person became a U.S.
Note: This ownership rule applies when residency is acquired under IRC Sec.
7701(b)(2)(A), the physical presence test (as modified by the closer connection test).
The amount transferred includes the non-distributed income arising between the time of
the property transfer to the trust and the date of residency.
If a foreign person becomes a U.S. resident more than 5 years after the transfer, the
ownership rules will not apply.
OUTBOUND TRUST MIGRATIONS
A transfer of property by a U.S. person to a domestic trust, which subsequently becomes
a foreign trust while the beneficiary is still alive, will be considered a transfer to a
foreign trust on the date of migration.
- The transferor, under IRC Sec. 679(a)(1), is treated as the grantor to the portion
previously transferred to the trust and the reporting requirements will apply.
DISTRIBUTIONS BY FOREIGN TRUSTS
Amounts paid or derived from a foreign trust, directly or indirectly, to a U.S.
beneficiary will be considered a direct payment to a U.S. beneficiary. Intermediaries or
nominees interposed between the foreign trust and the U.S. beneficiary are disregarded.
These rules do not apply to a withdrawal from a foreign trust by its grantor, with a
subsequent gift or other payment to a U.S. person.
- Planning point: If a foreign grantor has children living in the U.S. and other
countries, the grantor should withdraw the income from the trust and make a gift to the
U.S. beneficiary, rather than causing a trust distribution.
- Also, consider not making the U.S. children beneficiaries of the foreign trust. Gifts
can be made to the U.S. children from the grantor or children living in other countries
who are the beneficiaries of the trust.
The ownership rules will apply to transfers of property after February 6, 1995.
RESIDENCE OF FOREIGN TRUSTS
Under prior law, there was not an objective test to determine whether a trust was
domestic or foreign.
CHANGES IN THE LAW
Under IRC Sec. 7701(a)(30) and (31), there is a two-part objective test to determine
the residency of a trust. A trust is considered domestic if -
- A U.S. court can exercise primary supervision over the administration of the estate or
- One or more U.S. fiduciaries have the authority to control all substantial decisions of
- A trustee may elect the application of these objective tests for the trust's tax year
after the date of enactment.
OUTBOUND MIGRATION OF DOMESTIC
If a domestic trust changes its situs and becomes a foreign trust, there will be a
deemed outbound transfer of assets which occurs on the date of migration. IRC Sec.
- The 35% excise tax under IRC Sec. 1491 will apply to the deemed transfer, unless one of
the exceptions to IRC Sec. 1491 apply.
- The U.S. grantor is required to report the transaction under the newly-enacted reporting
- If a trustee, through an election, changes a domestic trust's situs to foreign, the
deemed outbound transfer will occur on the date of election.
- The residency provisions are applicable to tax years beginning after December 31, 1996.
A trust may make an irrevocable election to apply the provision to tax years ending after
August 20, 1996.
- The imposition of IRC Sec. 1491 to transfers to foreign trusts is effective on or after
August 20, 1996.
A "responsible party" must file certain information reports when the
following reportable events under IRC Sec. 6048(a)(3) occur -
- The creation of a foreign trust by a U.S. person;
- The transfer of money or property (either directly or indirectly) to a foreign trust by
a U.S. person; and
- The death of a U.S. citizen or resident if the decedent was treated as the owner of any
portion of a foreign trust under the grantor trust rules, or a portion of the foreign
trust was includable in the decedent's gross estate.
Reportable events do not include transfers of assets to foreign trusts for fair market
value, transfers involving deferred compensation or transfers to charitable trusts.
- A responsible party includes the grantor of an inter vivos trust, the transferor of
money or property (except at death) and the executor of the decedent's estate.
- Written notice of a reportable event must be given on or before the 90th date
after the event.
- The notice will probably contain the amount of money or value of the property
transferred to the trust, the identity of the trust, trustee and beneficiary, but the
Secretary of the Treasury will prescribe what information is needed.
GRANTOR TRUST REPORTING
A U.S. person treated as the grantor of a foreign trust under the ownership rules is
responsible under IRC Sec. 6048(b) for ensuring that the trust -
- Files a return containing a full and complete accounting of trust activities, the name
of the U.S. agent for the trust, and any other information the Secretary prescribes, and
- Furnishes other information that the Secretary of the Treasury may require regarding
U.S. grantors or beneficiaries.
A U.S. agent needs to be appointed for accepting service of process for IRS summonses
- If a U.S. agent is not appointed, then the Secretary of the Treasury, at his sole
discretion, may determine the amounts of income under the grantor trust rules.
- The judicial review standard of the Secretary's discretion is "arbitrary and
capricious," which gives the Secretary great latitude in exercising his discretion.
- Beneficiaries must report any distributions received from a foreign trust and the name
of the trust.
Penalties for failure to file the appropriate returns.
- The penalty for failing to provide the required notice or return in cases involving the
transfer of property to a foreign trust or the distribution from a foreign trust to a U.S.
beneficiary is 35% of the gross reportable income.
- If this information is not filed within 90 days of notice to file from the Secretary, an
additional $10,000 penalty for each 30-day period is imposed.
- This penalty applies to the failure to report transfers subject to the 35% excise tax
under IRC Sec. 1491.
NOTE: The reporting requirements under IRC Sec. 1491 encompass all transaction
under that statute, not just foreign trust transfers. Therefore, penalties could be
imposed for the non-reporting of cash or property transfers to foreign entities, whether
or not the underlying transaction is taxable.
Under prior law, there were no penalties for the failure to report a non-taxable
transfer under IRC Sec. 1491.
- If a U.S. grantor fails to ensure proper trust reporting, the penalty is 5% of the gross
- There is a reasonable cause exception to these penalties. Reasonable efforts to comply
with the reporting requirements will constitute reasonable cause.
- In no event will the total penalty amount exceed the gross reportable income.
- The reportable events provision is effective for events occurring after August 20, 1996.
- The grantor reporting provisions applies to tax years after December 31, 1995.
- The beneficiary reporting provision applies to distributions received after August 20,
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