U.S. FOREIGN GRANTOR TRUST TAX AMENDMENTS
By:
Eduardo A. Cukier
New York
The Small Business Job Protection Act of 1996 (the "Act"), signed into law on August 20, 1996, amended the tax treatment of both inbound and outbound foreign grantor trusts and added new information reporting requirements. Many of the provisions are effective as of the date of enactment.
The Act establishes a two-part test for determining whether a trust is foreign or domestic, thereby providing an objective test for an area of law that was ambiguous prior to the Act. If both parts of the test are satisfied, the trust is treated as domestic. Under the first part of the test (the "Supervision Test"), in order for a trust to be treated as domestic, a U.S. court (Federal, State, or local) must be able to exercise primary supervision over the administration of the trust. The Supervision Test will generally be satisfied by any trust instrument that specifies that it is to be governed by the laws of any State. Under the second part of the test (the "U.S. Fiduciary Test"), in order for a trust to be treated as domestic, one or more U.S. fiduciaries must have the authority to control all substantial decisions of the trust. The U.S. Fiduciary Test will generally be satisfied if (i) fiduciaries that are U.S. persons hold a majority of the fiduciary power and (ii) if no foreign fiduciary, such as a "trust protector" or other trust advisor, has the power to veto important decisions of the U.S. fiduciaries.
A foreign trust is, in general, a trust other than a trust that is determined to be domestic. If a domestic trust changes its situs and becomes a foreign trust, the trust is treated as having made a transfer of its assets to a foreign trust and is subject to the 35 percent excise tax. In addition, the U.S. grantor would be required to report the transfer under certain reporting requirements.
With respect to inbound foreign trusts, the Act modifies the treatment of grantor trusts where the grantor is a foreign person. By way of background, a grantor that retains certain rights or powers over the grantor's trust is generally treated as the owner of the trust assets. Where the grantor is foreign, U.S. trust beneficiaries are not subject to U.S. tax on distributions from the trust. If, however, a U.S. beneficiary transfers property to the foreign grantor by gift, the beneficiary is treated as the grantor to the extent of the transfer.
Under the Act, the grantor trust provisions apply only to the extent that application results in income being currently taken into account in computing the income of a U.S. citizen or resident or a domestic corporation. Thus, the grantor trust rules generally do not apply to any portion of a trust where their effect is to treat a foreign person as owner of that portion. The Act provides that the grantor trust rules continue to apply to, among others: (i) revocable trusts (or any portion thereof) where the power to revoke is, in general, exercisable by the grantor without approval of another person; (ii) trusts (or any portion thereof) where distributions of income or corpus during the grantor's lifetime are only distributable to the grantor or the grantor's spouse; (iii) certain trusts (or a portion thereof) established to pay compensation for services rendered; and (iv) certain trusts owned by the grantor or another person that were in existence on September 19, 1995.
The Act retains the general rule that treats the U.S. beneficiary of a foreign grantor trust as a grantor of the portion of such trust to the extent of the property transferred by the U.S. beneficiary to the foreign grantor. The rule does not apply, however, if the transfer is a sale of the property for full and adequate consideration or a gift that qualifies for the annual exclusion under applicable rules. The Act also contains a transition rule providing that if a foreign grantor of a domestic trust ceases to be treated as the owner of the trust, and that trust becomes a foreign trust, or the assets of such trust are transferred to a foreign trust before January 1, 1997, such trust is exempt from the excise tax otherwise imposed on the transfer of assets to a foreign trust.
With respect to outbound foreign trusts, a U.S. person who directly or indirectly transfers property to a foreign trust, other than by sale at fair market value (the "Arm's Length Exception"), generally is treated as the owner of such trust property for the purposes of any year in which the trust has U.S. beneficiaries. The Act extends application of this rule to (i) foreign persons who, within five years of having transferred property to a foreign trust, become U.S. persons, and (ii) U.S. persons who have transferred property to a domestic trust that later becomes a foreign trust while the persons are alive. In applying the rule with respect to any transfer of property to a foreign trust, the Act does not treat a beneficiary as a U.S. beneficiary if the beneficiary first became a U.S. person more than five years after the date of the transfer. The Act also exempts transfers to a charitable trust from application of the rule.
With respect to the Arm's Length Exception, the Act provides, in general, that obligations (i.e., debt) issued by a trust, any grantor, or beneficiary of the trust, or by any person related to any such grantor or beneficiary, will not be taken into account in determining whether the trust paid fair market value to the transferor of the property. According to the legislative history to the Act, an exception to this general rule may be included in Regulations to be published by the Treasury Department for loans that provide for arm's length terms, taking into consideration whether there is a reasonable expectation that the loan will be repaid.
The Act also expands the information filing requirements and penalties where there is a U.S. grantor of a foreign trust or a distribution from a foreign trust to a U.S. person. Additionally, certain "responsible parties" are required to file designated information reports with the Internal Revenue Service upon the occurrence of certain events.
