United States: FATCA’s Impact On Preparing Trusts With Offshore Business or Investment Activities

The Foreign Account Tax Compliance Act (FATCA) was enacted into law as part of the Hiring Incentives to Restore Employment (HIRE) Act of 2010. Its purpose was designed to prevent U.S. taxpayers from “hiding” under the cover of a foreign based entity or trust in evading U.S. income tax and possiblly evading U.S. transfer tax. For U.S. expatriates forming foreign trusts, consideration of the impact of Section 2801 must also be taken into account. FATCA is set forth in Chapter 4 of the Code and is more particularly set out in Sections 1471 to 1474. The FATCA withholding and disclosure rules are an “add-on” to the U.S. withholding and infromation reporting rules under Sections 1441 to 1446. In general, FATCA requires ‘foreign financial institutions’ (FFIs) and ‘non-financial foreign entities’ (NFFEs) to identify and disclose their U.S. accounts and substantial U.S. owners. Where the applicable disclosure and identification rules are not followed, a U.S. withholding agent will be required to withold 30% on all payments to be made to the FFI or NFFE as the case may be.

FACTA added Section 6038D which requires any individual who, during the taxable year, holds any interest in a “specified foreign financial asset” to attach a report (Form 8938) to his or her income tax return providing certain information regarding such financial assets when the aggregate value of all such assets exceeds $50,000 on the last day of the taxable year or $75,000 at any time during the taxable year. The dollar thresholds are doubled for married individuals filing a joint return.

A specified foreign financial asset is any financial account maintained at a foreign financial institution and also includes “any stock or security issued by any person other than a U.S. person,” “any financial istrument or contract held for investment that has an issuer or counterparty that is not a U.S. person”, and “any interest in a foreign entity”(per Section 1473). See Section 6038D(b). FATCA is viewed by some commentators and foreign tax authorities and financial institutions as imposing severe due diligence and disclosure requirements on foreign entities over which the U.S. would, in general, not have jurisdiction over, including foreign trusts and estates. In negotiations that were undertaken by the Treasury and IRS with many foreign governments, a set of intergovermental agreements were entered into with foreign governments which would require FFIs and NFFEs to report their disclosure information directly to the taxing authority of their home country instead of directly to the IRS as FATCA would otherwise require. All intergovernmental agreements (IGAs) contempate that a partner government will require all FFIs located in its jurisdiction that are not otherwise exempt will identify U.S. accounts and report information about U.S. accounts. In Announce. 2014-17, the Service posted on its website that the United States has signed IGAs with 26 jurisdictions and has reached agreements with many others. The final regulations provide that the IRS will publish a list identifying all countries that are treated as having a Model 1 or Model 2 IGA in effect. See Treas. Regs. Sections 1.1471-1(b)(78) and (79). Notice 2013-4, 2013-31 I.R.B.

The final regulations generally provide that, in order for the 30% FATCA withholding not to apply, a withholding agent must obtain an FFI’s GIIN (number) for payments made after June 30, 2014, and must confirm that the GIIN appears on the IRS FFI List. A special rule, however, provides that a withholding agent does not need to obtain a reporting Model 1 FFI’s GIIN for payments made before January 1, 2015. See Treas. Reg. Section 1.1471–3(d)(4)(iv)(A). Notice 2013–43 and Announcement 2014–1, 2014–2 I.R.B. 393, indicate that FFIs must register on the FATCA registration website by April 25, 2014 (GMT -5), to ensure they are included on the first IRS FFI List, which is expected to be electronically available on June 2, 2014 .

Last year the Service issued a set of final regulations under FATCA. TD 9610, 1/17/2013. The Final Regulations impose significant information-gathering and reporting requirements on fiduciaries of trusts and estates. As to trusts, FATCA is implicated where U.S. tax residents and citizens hold assets ouside of the United States and non-residents holding assets inside of the United States provided that they are tax residents of a country subject to a Model Intergovernmental Agreement to Improve Tax Compliance and Implement FATCA (a ‘Model IGA’).

Individuals who are beneficiaries of trusts, U.S. and non-U.S. banks and individuals who are trustees of trusts, banks that custody trust assets, executors and beneficiaries of estates, and single- or multiple-family investment offices are all potentially affected by FATCA. For the most part a foreign trust will, by definition, be considered to be an FFI under FATCA unless a specific applicable IGA states otherwise.

The CTB regulations under Section 7701 provide a definition of a trust, both domestic and foreign. Under Treas. Reg. Section 301.7701-7, a trust is a U.S. person provided: (i) a court within the United States is able to exercise primary supervision over the administration of the trust (court test); and (ii) one or more United States persons have the authority to control all substantial decisions of the trust (control test). A trust is a United States person for purposes of the Internal Revenue Code on any day that the trust meets both the court test and the control test. For purposes of the regulations in this chapter, the term domestic trust means a trust that is a United States person. The term foreign trust means any trust other than a domestic trust. Therefore, a foreign trust is a trust that is: (i) not subject to the primary jurisdiction of the U.S. courts; or (ii) is subject to the authority of a non-U.S. person who can control substantial decisions of the trust.

Now to the FATCA part. A foreign trust will be treated as an FFI where the trust’s income is primarily derived from investments and the trust is professionally managed. See Treas. Reg. Section 1.1471-5(e)(4)(i). This will be the case of course if the trustee of a foreign trust is a trust company. The same standard will presumably be met where a non-trust company trustee hires a professional investment manager. See Treas. Reg. Section 1.1471-5(e)(4)(i)(A). The FFI outcome may still apply where a professional advisor or other person serving as “trustee” is a professional with respect to investments and management of a trust. If a foreign trust does not fall within the definition of an FFI, it is to be treated as a NFFE. An an NFFE, the foreign trust may be able to side-step withholding and disclosure in non-Model 1 IGA jurisidictions.

For FATCA to apply, an FFI must have one or more substantial U.S. owners. See Treas. Reg. Section 1.1471-5(a)(2). Ownership tests are set forth under the regulations which may seem awkward in applying such tests to trusts, particularly with respect to discretionary or accumulation trusts. For a foreign trust that is not an FFI but an NFFE, the application of the ownership tests may also be difficult and are different than the ownership tests used for the FFI. In addition, the provisions of an applicable IGA may preempt the ownership tests set forth in the regulations.

As to the FFI ownership rules, a foreign trust is treated as an FFI trust (and has a substantial U.S. owner) where: (i) a U.S. person is treated as the owner of a portion of the trust for federal income tax purposes under the grantor trust rules; (ii) a U.S. person is entitled to receive a mandatory distribution from the trust; or (iii) a U.S. person may receive a discretionary distribution from the foreign trust and does receive such a distribution in the applicable calendar year. Treas. Reg. Section 1.1471-5(b)(3)(iii)(B) .

As concerns the NFFE rules, a U.S. owner is present where: (i) a U.S grantor is treated as the owner of the property under the grantor trust rules; or (ii) a U.S. owner owns more than 10% of the trust. A U.S. owner is treated as owning 10% or more of the trust where such U.S. person: (i) received distributions of more than 10% of either all distributions made during the year or the total value of the trust; or (ii) has a mandatory distribution right that exceeds 10% of the trust value; or (iii) the sum of (i) and (ii) exceeds either 10% of all distributions made during the year or the total value of the trust. Treas. Reg. Section 1.1473-1(b)(3)(ii).

The FACTA rules if applicable to foreign trusts do impose some burdens and potentially few benefits. Unless an IGA applies to the contrary, an FFI that is deemed to have a substantial U.S. owner under FATCA must comply with the relevant registration and disclosure information. There also is Chapter 3 withholding rules on FDAP income that continue to apply. FFIs that have not registered with the IRS, so-called “non-participating FFIs” may not obtain refunds of overwitheld tax unless required by a treaty or the trust is not the beneficial owner of the income. Where the income is distributed by the FFI to a beneficiary, the beneficiary may be able to apply for the refund. The same holds true with respect to the grantor of a FFI trust. See Treas. Regs. Sections 1.1474-5(a)(1) and 1.1471-1(b)(7) .

Mitigating the Impact of FATCA on Foreign Trusts

There may be methods for a FFI Trust to avoid withholding under FATCA. One method is for the FFI Trust to enter into an agreement with the IRS and become a “participating FFI”. This would require any “affiliate” of the FFI Trust to enter into the agreement as well. See Reg. 1.1471-4 . Ownership is not based on the trustee but on the beneficiaries or grantor of a grantor trust. The “affiliate” test is based on 50% or more of the same owners. A FFI Trust having a grantor who created other foreign trusts may have problems with the affilite requirement. See Treas. Reg. Section 1.1471-5(f)(3) . A Participating FFI must register with the IRS; identify U.S. person beneficiaries and owners, and their interests, to the IRS; adopt verification procedures; complete various other requirements; and file Form 8966 annually.

Another potential way to mitigate FATCA problems for a FFI Trust is where the trust is situated in a Model 1 IGA jurisdiction. An FFI or NFFE situated in a country that entered into a Model 1 IGA with the United States may be exempt from FATCA withholding. For such entities there are no withholding requirements even with respect to payments to nonparticipating FFIs or account holders who have not made disclosures to the IRS. See Model 1 IGA Article 4 paragraphs 1 and 2.

Intergovernmental Model Agreements

There are essentially two types or formats used in the IGA area; Model 1 and Model 2. Under a Model 1 IGA, FFIs are required to report to their home country tax authority which in turn will share such information with the Internal Revenue Service. The benefit under a Model 1 IGA is that the FFI Trust does not provide information directly to the IRS and can avoid the 30% withholding by continually meeting the disclosure requirements. Under a Model 2 IGA, an FFI must still directly report to the IRS unless the IGA provides to the contrary. If an FFI Trust, for example, does not become a “participating FFI” or is otherwise exempt, it will not avoid withholding. See, however, Model 2 IGA Article 3 paragraphs 2 and 5.

Under a Model 1 IGA, a foreign trust, including a foreign trust which is an FFI or NFFE, must identify all controlling persons, including the settlor or grantor, trustees, beneficiaries, protectors, holders or a power of appointment and any other person having control of the trust under the country have jurisdiction over the trust. The applicable revenue agency of such jurisdiction of trust management must report such information to the IRS on behalf of the trust. Where the trust has one or more “controlling” U.S., regardless of ownership or beneficial interests, the ownership test is not applied and all NFFEs and FFIs must report this information. The trust is considered a U.S. account subject to FATCA.

Another situation is a U.S. trust with foreign beneficiaries. Assume, for example that the foreign beneficiaries reside in a Model 1 IGA jurisdiction. In this case the trustee will be required to report all information regarding controlling foreign persons to the IRS which in turn will report it to the country’s revenue agency. With “reciprocal” Model 1 IGAs, U.S. trust companies and banks serving as trustees must obtain detailed lists of all potential beneficiaries, including future, or contingent beneficiaries, as well as minor beneficiaries, to comply with FATCA and the IGAs. It is still uncertain whether individual professional trustees will have the same reporting obligations.

Drafting Foreign and Domestic Trusts In Light of FATCA

There are important issues that must be considered in drafting the terms of a trust that will be subject to the FATCA reporting rules taking into account whether the trust is “foreign” or “domestic”, the important persons involved and their country of residence, the residence of the trust and whether the jurisdiction in issue has an IGA with the United States.

Resolution of these important issues must be done with U.S. tax or estate counsel.