This article aims to serve as your comprehensive guide to understanding the nuances of foreign trusts. Whether you’re a trustee, grantor, settlor, or beneficiary, we’re here to unravel the complexities and shed light on potential pitfalls and opportunities within the realm of cross-border trust taxation.

Demystifying ‘US Person’

ClassificationBefore delving into the specifics of foreign trusts, it’s crucial to understand who falls under the umbrella of a ‘US person’ for tax purposes. In this context, a US person includes US citizens, green card holders, or individuals meeting the threshold of days’ presence in the US, thereby establishing US residency.

Decoding Foreign Trusts
The foundational step in this intricate process is discerning whether the entity at hand qualifies as a trust. While this might seem straightforward, exceptions exist. For an entity to be deemed a trust:

• There must be an arrangement, either written or oral.
• The arrangement must be established through a will or an intervivos (lifetime) declaration.
• Trustees must have the entitlement to take title to property, safeguarding it for the beneficiaries.
• Beneficiaries cannot participate in discharging the trustees’ responsibilities.

Having ascertained that an entity is indeed a trust, the subsequent task is determining its ‘foreign’ status. A foreign trust encompasses any trust failing both the ‘Court’ and ‘Control’ tests.

The Court Test
The Court Test hinges on whether a US court can exercise primary supervision over the trust’s administration. This entails exclusive authority to resolve issues pertaining to the trust’s administration, involving the fulfilment of duties dictated by the trust instrument and applicable law.

The Control Test
The Control Test is met if one or more US persons possess the authority to control all ‘substantial decisions’ of the trust. ‘Control’ implies the power to make substantial decisions without being subject to the veto of any other person. ‘Substantial decisions’ are those authorized or required under the trust instrument.

It’s noteworthy that a seemingly domestic trust can be classified as foreign if, for instance, a foreign person holds the power to veto trust decisions. Additionally, if a US trust transforms into a foreign trust due to a trustee ceasing to be a US person, there is typically a 12-month grace period for rectification.

Distinguishing Trust Types
Foreign trusts fall into two primary categories: Foreign Grantor Trusts and Foreign Non-Grantor Trusts.

Foreign Grantor Trust with US Grantor
A trust initiated by a US person typically qualifies as a ‘grantor trust’ if the US grantor retains specific ‘grantor trust powers.’ These might include control over beneficial enjoyment or the authority to distribute income for the grantor or their spouse.

If the grantor has no grantor trust powers but the trust is ‘foreign,’ it automatically attains grantor trust status if income or principal could potentially be distributed to US persons in the future. This rule prevents US persons from utilizing foreign trusts to shield income from US taxation.

Foreign Grantor Trust with Non-US Grantor
When the grantor is a non-US person, grantor trust status is contingent upon circumstances such as revocability or exclusive payments to the grantor or their spouse. The income is deemed to belong to the non-US grantor, subjecting them only to US tax on US source income.
Foreign Non-Grantor Trust (with US or Non-US Grantor)

Taxation of a Foreign Non-Grantor Trust mirrors that of a non-US individual. A Foreign Non-Grantor Trust is not taxed by the US on its foreign-sourced income, but certain US-sourced income may be subject to US withholding tax or income tax.

Navigating Distributions and Tax Implications
Distributions from a Foreign Non-Grantor Trust to US beneficiaries entail a complex set of rules. Tax attaches to any distributable net income (DNI) which is distributed, while undistributed net income (UNI) might trigger a ‘throwback tax.’ The fair rental value of foreign trust property used by a US beneficiary is treated as a distribution as are loans to US beneficiaries that fail to meet certain “qualified loan” requirements.

Ownership of Foreign Corporations and Reporting Requirements
Particular attention is needed when a Foreign Trust has an interest in foreign corporations meeting the criteria of a ‘controlled foreign corporation’ (CFC) or ‘passive foreign investment company’ (PFIC). Stock ownership by a trust in such entities may trigger additional tax and reporting obligations for US owners and US beneficiaries, even without receiving distributions.

Compliance and Reporting Obligations
Apart from the need to file a US tax return, US grantors, beneficiaries, and trustees may be required to file additional information returns. This includes Forms 3520, 3520-A, FBARs, and Form 8938. Appointing a US agent for a foreign trust can be advantageous, preventing unilateral IRS determination of taxable income for US beneficiaries.

Planning Strategies and Mitigation Techniques
Considering the intricate tax consequences for US beneficiaries, several planning techniques can be employed to mitigate adverse outcomes. This includes establishing structures meeting grantor trust criteria, careful distribution planning, and utilizing elections and exemptions.

A Call to Pro-Active Action
Trustees, settlors, and beneficiaries are urged to comprehend and proactively address the implications of a foreign trust having ties to the US. This involves staying informed about residency changes, potential migration of trusts, and adopting strategic planning measures. By navigating the complexities of US tax rules for foreign trusts, stakeholders can optimize outcomes and ensure compliance with evolving regulations while retaining the benefits of planning with trusts. Contact us to discuss trust planning.