By Gina Gatchell, Director

Introduction

Trusts are a way of life in N.Z. They are quintessentially used for a variety of purposes. Estate planning, asset protection, and wealth management are common examples. Whilst especially so for high-net-worth individuals and their families, trusts have formed part of the N.Z. landscape for decades. Frequently used nowadays when structuring ownership of income-earning assets, the most common example is the ownership of shares in a business – such as and including an incorporated entity.

The origin of N.Z.’s relationship with trusts, which stems from the country’s British heritage, is briefly explained as follows.

During the 20th century, the flexibility of the trust allowed it to continue to respond to changing economic and social conditions and to government policies, particularly taxation policies. The discretionary family trust became more and more popular, sometimes combined with a business trust. As noted, trust structures also began to be used more commercially – by banks, for superannuation schemes, and for investments (such as unit trusts).1

N.Z. trust law, has, in recent years, been through an extensive overhaul. The 1956 Trustees Act was repealed on 30 January 2021, replaced by the 2019 Trust Act which became effective the same day. Consequently, the way that trusts are now administered in N.Z. has changed significantly. Changes were made pursuant to the need for modernization of N.Z.’s trust regime, as identified by a 2013 Law Commission report.

This article explores what it means for U.S. citizens owning a foreign trust, in this case, in N.Z.

The following discussion is centred around Section 679 of the Internal Revenue Code. The reader should be aware that other U.S. tax and reporting obligations exist. Those cover situations under which a U.S. person is the beneficiary, or trustee and not the grantor, of a foreign trust.

Defining a foreign trust for U.S. tax purposes

For U.S. tax and information reporting purposes, a foreign trust is defined as ‘any trust other than a domestic trust’. Two tests, the court test, and the control test must be satisfied as follows.

A domestic trust is any trust if:

1. a court within the U.S. can exercise primary supervision over the administration of the trust, and:
2. one or more U.S. persons have the authority to control all substantial decisions of the trust.

Therefore, if:

1. a foreign trust is one that a court within the U.S. has no power to exercise primary supervision over, and:
2. one or more U.S. persons have the authority to control all substantial decisions of the trust,

then:

the trust will be a foreign trust for U.S. tax purposes.

Thus, unless some aspect of a trust formed in N.Z. is subject to court authority within the U.S., (such as where the foreign trust contains U.S.-situs assets), then the trust will be a foreign trust for U.S. tax purposes. Any U.S. citizen with a relationship with a foreign trust should plan carefully. For U.S. citizens redomiciling in N.Z., there are important tax planning considerations. These should be considered prior to establishing a N.Z. trust.

Defining a ‘grantor’ for U.S. tax purposes

Whilst the term ‘grantor’ is not defined, it is synonymous with the N.Z. term ‘settlor’. Simply put, a grantor, for U.S. tax purposes, is a U.S. person who transfers property to any trust. The term ‘U.S. person’ includes U.S. citizens, Lawful Permanent Residents,3 and individuals who are U.S. tax resident under the Substantial Presence Test.

Following is a discussion around U.S. primary authority aspects of foreign trust ownership. The sources are the Internal Revenue Code (Code) and Treasury Regulations (Regulations). The discussion starts by looking at the key provisions of Section 679 and is followed by a look at some of the Regulations for Section 679.

Section 679 Foreign Trusts having One or More U.S. Beneficiaries

As previously mentioned, the key section in the Code relating to the U.S. tax treatment of foreign trusts is Section 679 Foreign Trusts having One or More U.S. Beneficiaries.

The key requirement for Section 679 to apply is a U.S. beneficiary. Section 679 contains rules around when a foreign trust has a U.S. beneficiary. The intention of this requirement is to tax transactions where a U.S. beneficiary might otherwise be in receipt of income without U.S. tax implications. If there is no U.S. beneficiary, and funds are transferred by a U.S. person to a foreign trust, a U.S. person cannot be the recipient of wealth, because there is no U.S. beneficiary.

Note that any U.S. situs assets held by a foreign trust will likely have U.S. tax implications for non-U.S. beneficiaries. This situation can arise where a foreign trust with no U.S. beneficiaries contains U.S.-situs assets, and a foreign non-grantor trust (where no U.S. persons have transferred assets however the trust contains U.S. situs assets). Both situations fall outside of Section 679 and thus the scope of the following discussion.

Seconding the requirement to have a U.S. beneficiary is that there needs, at some point, to have been a transaction where property has been transferred to a foreign trust. This includes direct, and indirect transfers.

Section 679 contains four elements. These are:

• transfers to foreign trusts,
• trusts acquiring U.S. beneficiaries,
• trusts treated as having a U.S. beneficiary, and:

• a presumption that a foreign trust has a U.S. beneficiary.

Transfers to foreign trusts

The first element treats transferors as the owner of any property transferred to a foreign trust.

A United States person who directly or indirectly transfers property to a foreign trust5 shall be treated as the owner for his taxable year of the portion of such trust attributable to such property if for such year there is a United States beneficiary of any portion of such trust.

This is known as the ‘general rule’.

Two exceptions from the general rule exist.

Exception one excludes transfers by reason of death of the transferor. Exception two excludes transfers at fair market value.

Example 1: Death of transferor. D., a U.S. person, passes away. Upon passing, his assets form part of his estate. This does not constitute a transfer to a foreign trust for U.S. tax purposes.
Example 2: Transfer at fair market value. G., a U.S. person transfers property with a fair market value of US$100 to FT, a foreign trust. FT pays G US$100 cash for the property. The transfer was done at fair market value and the property within the foreign trust is not subject to Section 679 attribution.
Example 3. Transfer not at fair market value. G., a U.S. person transfers property with a fair market value of US $100 to FT, a foreign trust. FT does not pay G any consideration for the property. The transfer is not a transfer at fair market value for U.S. tax purposes. G. is deemed to be the owner of the $100 property for U.S. tax purposes.

U.S. persons treated as owners of property transferred to a foreign trust must follow the provisions of the Code. Effectively, the foreign trust is looked through and the U.S. person, and not the foreign trust, is taxed on income attributable to the respective assets placed in the foreign trust.

5-year look back rule

Non-U.S. persons transferring property to a foreign trust who subsequently become U.S. persons within 5 years of a transfer will be subject to U.S. tax implications. This is due to a 5-year look-back rule.6

The intention of which is to tax all transactions which had been intended to circumvent U.S. tax rules by way of transferring those assets to a trust before the onset of U.S. tax residency. Intention, however, isn’t relevant for the purposes of applying this rule. 

One doesn’t need to read between the lines to comprehend that these are far-reaching provisions.

Example. Non-resident alien becomes resident alien. On January 1, 2002, A, a non-resident alien individual, transfers property to a foreign trust, FT. On January 1, 2006, A becomes a resident of the United States7 and has a residency starting date of January 1, 2006.8 Under paragraph (a) of this section, A is treated as a U.S. transferor and is deemed to transfer the property to FT on January 1, 2006. Under paragraph (b)(2) of this section, the property deemed transferred to FT on January 1, 2006, includes the undistributed net income of the trust, as defined in section 665(a), attributable to the property originally transferred.

Section 679(4)(B) contains step-up in basis provisions for the undistributed net income attributable to the pre-residence period.

Outbound trust migrations

A U.S. person might transfer property to a trust which was not a foreign trust at the time of the transfer. If the trust subsequently becomes a foreign trust whilst the U.S. transferor is alive, property previously transferred is deemed transferred on the date the trust becomes foreign.
Example 3. A, a U.S. person, transfers property worth $100 to a domestic trust, DT, formed in the U.S. on 1 December 2012. DT becomes FT on 31 December 2012. $100 is deemed to be transferred on 31 December 2012.

Trusts acquiring U.S. beneficiaries

A U.S. person might transfer property to a foreign trust which has no U.S. beneficiaries.
In the immediately preceding taxable year, if there was no U.S. beneficiary for that year, the U.S. person is treated as having income equivalent to the undistributed net income at the close of the preceding tax year attributable to the portion of the trust.

Trusts treated as having a U.S. beneficiary

For U.S. tax purposes foreign trusts are treated as having a U.S. beneficiary unless the terms of trust expressly state that ‘no part of the income or corpus of the trust may be paid or accumulated during the taxable year to, or for the benefit of a U.S. person’.

Future benefits, which may be dependent on an event and are therefore contingent are included as being for the benefit of a U.S. person.
Attribution rules exist to capture indirect transfers to other foreign entities including foreign corporations, foreign partnerships, and other foreign trusts.

Example. FT’s trust instrument requires payments to FC, a foreign corporation. FT has no U.S. beneficiaries. FT’s trust instrument also states that no U.S. person can be a beneficiary. of which D, a U.S. person, is the 75% owner. D indirectly benefits from the transfer of property to FC. FT is deemed to have a U.S. beneficiary.
Foreign trusts which upon cessation could benefit a U.S. person will be treated as having a U.S. beneficiary for a taxable year.
A U.S. beneficiary who became a U.S. person more than 5 years after the transfer of any property to a foreign trust will not be treated as a U.S. beneficiary for the above purposes and is disregarded.
This test is done on a transaction basis. That is to say that the test is done for each individual transfer.

Certain Agreements and Understandings Treated as Terms of the trust

A U.S. person, even if not named as a beneficiary of a foreign trust, might receive a benefit from an agreement or understanding whether it is written, oral or otherwise. In this case the agreement or understanding is treated as a term of the trust.

Example: A, a U.S. person, rents accommodation from B, who owns a house which is owned by a foreign trust.
A pays market rent to B.
B needs to pay some personal expenses.
B arranges for the foreign trust to pay cash to A’s visa card in exchange for A using his visa card to pay B’s expenses.
A derives a benefit indirectly from the payment from the foreign trust to his credit card.

Uncompensated Use of trust property

If a U.S. person, whether named as a beneficiary of a foreign trust or not, receives a benefit, or a benefit is accumulated arising out of property owned by a foreign trust that person is deemed to have received a benefit. This might be a payment, directly or indirectly, to the U.S. person, of income or corpus of the trust, or an accumulation of income for the U.S. person.

Example: P, a U.S. citizen, has his credit card paid by G’s foreign trust. P is not named as a beneficiary of G’s foreign trust and has no relationship to G other than being a friend. P is deemed to have received a benefit because the payment has been made from the trust’s corpus or accumulated income.

Presumption that a Foreign Trust has a U.S. beneficiary

It is presumed, by the Treasury Department, that a foreign trust, into which a U.S. person has transferred property, directly or indirectly, has a U.S. beneficiary. That is, unless it can be established otherwise.10

Tying the provisions of Section 679 together

The following example illustrates the interrelationship between the four elements of Section 679.

Grantor, a U.S. person, creates FT, a foreign trust, and transfers property to FT for the benefit of his non-dependent adult children A, B, and C, none of whom is a U.S. person. Grantor does not have the right to uncompensated use of any trust property, and there are no agreements or understandings that would allow a U.S. person to benefit. A, B, and C each have a 1/3 proportionate share in the trust. FT’s trust instrument provides that no part of the income or corpus of the trust may be paid or accumulated during the taxable year to or for the benefit of a U.S. person and if the trust were terminated, no part of the income or corpus could be paid to or for the benefit of a U.S. person. The trust instrument explicitly provides that it cannot be amended to include any other beneficiaries. Grantor has not retained any rights or interests that could benefit herself as the grantor, but she has retained the power, exercisable in her sole discretion, to dispose of trust income or corpus for the benefit of A, B, and/or C, without the distribution being weighed against each beneficiary’s proportionate share. Because no trust property can be distributed or accumulated for the benefit of a U.S. beneficiary, 679 does not apply. However, because Grantor retained the power to control beneficial enjoyment of the trust corpus for the benefit of A, B, and C, in her sole discretion and without limit, Grantor is treated as owner of the trust under IRC § 674.11

Treasury Regulations

Treas. Regs. §1.679-0 through §1.679-7 govern the interpretation of Section 679. The following is a discussion around some of the key provisions in the Regulations.
Treas. Reg. 1.643(d)-1 Definition of “foreign trust created by a United States person’12 refines the definition of a foreign trust for U.S. tax purposes.
Treas. Reg 1.643(d)-1 also contains apportionment rules. These apportionment rules govern how the Code should be interpreted, where both U.S. persons, and non-U.S. persons have transferred property to a foreign trust.

‘Property’ includes money, and any other type of property. Real estate, all types of financial assets including stocks, financial instruments, personal property such as and including motor vehicles and boats are typically transferred into N.Z. discretionary family trusts.

Example. On January 1, 1964, the date of the creation of a foreign trust, a U.S. person transfers to it property having a fair market value of $60,000 and a person other than a U.S. person transfers to it property having a fair market value of $40,000. Immediately after these transfers, the foreign trust created by a U.S. person is 60 percent of the entire foreign trust, determined as follows:
$60,000 (Value of property transferred by U.S. person) / $100,000 (Value of entire property transferred to trust) = 60 percent.

The undistributed net income for the calendar years 1964 and 1965 is $20,000 which increases the value of the entire foreign trust to $120,000 ($100,000 plus $20,000). Accordingly, as of December 31, 1965, the portion of the foreign trust created by the U.S. person is $72,000 (60 percent of $120,000). On January 1, 1966, the U.S. person transfers property having a fair market value of $40,000 increasing the value of the entire foreign trust to $160,000 ($120,000 plus $40,000) and increasing the value of the portion of the foreign trust created by the U.S. person to $112,000 ($72,000 plus $40,000). Immediately, after this transfer, the foreign trust created by the U.S. person is 70 percent of the entire foreign trust, determined as follows:

$112,000 (Value of property transferred by U.S. person) / $160,000 (Value of entire property transferred to the trust) = 70 percent [4].

Interaction with other sections of the Code

Treas.Reg. 1.679(b) highlights that Section 679 has authority over Sections 673 through 678 of the Code which cover other scenarios when a grantor may be treated as the owner of the trust:
Interaction with sections 673 through 678. The rules of this section apply without regard to whether the U.S. transferor retains any power or interest described in sections 673 through 677. If a U.S. transferor would be treated as the owner of a portion of a foreign trust pursuant to the rules of this section and another person would be treated as the owner of the same portion of the trust pursuant to section 678, then the U.S. transferor is treated as the owner and the other person is not treated as the owner [10].

Conclusion and key takeaways

This article has discussed the main provisions of Section 679. U.S. persons should seek advice before transferring property to any type of foreign entity. U.S. persons should be aware that any connection, regardless of intention, can have U.S. tax implications for the person. Professional advice should be sought any time a U.S. person thinks they have received a benefit, or are accumulating, a benefit from a foreign trust.

Disclaimer

The information contained in this article is of a general nature and is not intended to provide investment advice nor does it fully cover all the elements of the U.S. tax treatment of foreign trusts.  No responsibility will be accepted for any reliance on the information in this article. Specific taxation advice should be sought. We provide in-depth expertise and solutions to our clients in this area.  

1 Review of Trust Law in New Zealand, Law Commission, Issues paper, November 2010 N.Z.LC IP19.pdf (lawcom.govt.N.Z.)

2 Code Section 7701(a)(30)(E)

3 Otherwise referred to as ‘Green-card holders’.

4 U.S. Treasury regulations are issued by the Internal Revenue Service. They are the Treasury Department’s official interpretation of the Internal Revenue Code and are tax law.

5 The full text includes “other than a trust described in section 6048(a)(3)(B)(ii))” which refers to includes certain deferred compensation and charitable trusts which are section 402(b), 404(a)(5) or determined to be exempt under Section 501(c)(3).

6 Section 679(a)(4) Special Rules Applicable to Foreign Grantor Who Later Becomes a U.S. person.

7 within the meaning of section 7701(b)(1)(A)

8 within the meaning of section 7701(b)(2)(A)

9 26 CFR § 1.679-5 – Pre-immigration trusts. | CFR | US Law | LII / Legal Information Institute (cornell.edu)

10 Section 679(d) Presumption that foreign trust has United States beneficiary

 

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